DEUTSCHE BANK: The Debt Ceiling Crisis Leaves The Chinese With A Dilemma

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Deutsche Bank, Bloomberg Finance LP

The battle over the debt ceiling in Congress raises a few questions.

For instance: what if the debt ceiling isn't raised in a timely manner, and the U.S. defaults on its debt for political reasons?

Pursuant to that, who should be most concerned in such an event?

Bilal Hafeez, Deutsche Bank's global head of FX strategy, says it's China.

Data from the U.S. Treasury and the Federal Reserve show that China is the third-largest holder of U.S. government debt, with a $1.135 trillion portfolio of Treasury securities. The U.S. Social Security Trust Fund is the largest holder ($2.672 trillion) while the Federal Reserve is the second-largest ($2.077 trillion).

In a note to clients, Hafeez writes:

Looking at the top holders of U.S. Treasuries, recipients of U.S. social security should be most concerned, followed by the Fed and then China. In theory, the first group can pressure congress and end up with other funds to fill the gap left by Treasury losses; meanwhile, the Fed has a money printing press to cover any losses, so that leaves the Chinese with a dilemma. History could be instructive. The Nixon shock of 1971 saw the U.S. break the link between the dollar and gold, which in effect was a U.S. default-in-kind. Up until that point, major currencies were pegged to the dollar. That shock resulted in a wholesale re-organisation of the global financial system towards free-floating currencies, less capital controls and a race by central banks to establish inflation credibility in the absence of a gold anchor.

Rapidly industrialising Japan felt the full effects of this, and moved off the dollar peg. Economically it was only until the late 1980s that the Japanese growth engine fell apart, but the immediate consequence of the Nixon shock was a dramatic rise in USD/JPY volatility as Japan moved to a free-float. Should the Chinese and other countries lose faith in U.S. Treasuries, their response could end up being similar: a move away from a managed peg against the dollar, and towards a free-float. The immediate benefit would be that reserve accumulation and hence U.S. Treasury buying would no longer be needed, but the necessary cost would be much higher FX volatility. Perhaps it's time to read "Lǜ jīdàn hé huǒtuǐ."

"Lǜ  jīdàn  hé huǒtuǐ" translates to "Green Eggs and Ham," the title of a Dr. Suess book read aloud by Republican Senator Ted Cruz in his 16-hours-long filibuster against Obamacare last week.



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