What could the sell-off in US debt from China and other emerging markets be a sign of?

Record sales of US government securities by central banks around the world. China's central bank is selling off its foreign exchange reserves, as are Russia's, Brazil's, and Taiwan's. Although China still holds the largest US government securities holdings at $1.4 trillion, it has reduced them by $200 billion since August. Net sales of US debt by monetary authorities in other countries for the year to July were $123 billion, the biggest drop since records began in 1978.

However, not only does this not particularly bother the $12.9 trillion US government debt market, but its price is also rising, and its yield is falling.

Why?

Because US debt is being bought up vigorously by private and institutional investors such as pension and mutual funds around the world, but especially within the US itself, reaching record domestic purchases of $1.6 trillion this year.

On the surface, it seems that the dumping of US government securities by emerging market central banks is a panic move, aimed at protecting the depreciating local currencies that were bought with the dollars being sold.

And it's probably such a move.

China, for example, made its currency more convertible by loosening its peg to the dollar on August 11. This was perceived as a devaluation and angered the monetary authorities in China, who believe that a cheaper currency means higher exports (despite the failures of Japan, the UK, the US and Zimbabwe in this competition), and hence GDP growth, of which exports are a component in the calculation.

In this context, to protect its currency, China began massive dollar sales.

But other strategies are also visible beneath the surface, as this is a loophole for the yuan to appreciate if such a maneuver becomes a goal of the Chinese authorities...

From where to where?

Until now, the US has been consuming Chinese goods on loan, financed by the revenues of Chinese (emerging market) producers of those same goods. The Chinese central bank, in turn, has been buying dollar assets with newly printed yuan, creating inflation.

The goal: to keep the yuan weak in this way, and the effect — distortion of the country's financial markets, outright overheating of multiple market segments, including the stock market, real estate, banking — shady and commercial, as we clearly see in China today.

Meanwhile:

...so over time, emerging markets increased their exposure to US debt, which was one of the reasons why the yield on US government securities decreased after the crisis.

The other reason was the Fed with its $2.5 trillion purchases of government securities.

Emerging markets were indeed part of the currency war, but that war was waged by the Fed after 2008 (and probably since the Fed's inception)—it's still being played out today through Yellen's refusal to raise interest rates, which would have made the dollar more expensive.

At that time, American politicians were complaining because American companies were finding it harder to export with cheap foreign currencies; never mind that someone was producing real goods and providing them in exchange for the paper and electronic numbers called dollars, making the standard of living of dollar holders significantly higher than it would otherwise be.

Because of the practical currency imperialism of the US dollar, the US could accumulate painless trade deficits, something that everyone else pays for with a weak currency, a decline in imports and standards, and problems refinancing debts.

This process of clearing US debt by emerging market central banks looks like a silent exit from an, to put it mildly, unprofitable deal — the dollar's legacy as the world's reserve currency.

Question: what would you do if you had 4.5 trillion dollar-denominated assets in your reserves, like the People's Bank of China did a year ago (today it's 3.5 trillion) and you wanted to clear them, that is, reduce your exposure without losing?

A) You will announce that you will sell them because with the huge US public debt you have exposure to the nominally most indebted entity in human history, crashing the market?

B) Would you try to quietly get rid of them, even if it meant making the markets think you were helpless, or even happy?

Even if they are theoretically confused, the Chinese monetary authorities are not fools. The yuan's depreciation can be seen simply as an inevitable short-term step and an excuse to clear dollar assets without the US panicking.

Whether it's panic or strategy, dedollarization is already happening.

The BRICS have created an investment bank and a financial assistance fund — not that they will be any different from the IMF and the World Bank, say, but they are enough to show that the dollar will no longer be in such demand — especially if someone manipulates it as they please.

The beginning of the end

Given that the theme of their lives is that if they don't raise their government debt ceiling they will go bankrupt, for Americans to be happy that China is running away from their Treasury bills and they are buying them themselves is absurd; and that's exactly what's happening.

They expected that the sell-offs would increase financing costs, but instead they themselves bought up their government's debt and yields fell.

What is missed is that US inflation was low because someone (emerging market central banks) was buying government debt, thereby competitively devaluing their currency, so that cheaper Chinese goods kept US standards high.

This dynamic is changing, which means higher prices in the United States, a poorer and more indebted American population, and financial intermediaries overseas full of the debt securities of a record government in debt.

In a word — a broken pension system and a confused investment environment.

There's no point in fooling ourselves: the US can pay off its $18 trillion debt with hyperinflation alone, it would never go bankrupt. The debt ceiling there will always be raised.

Purchased by institutional investors within the country, this debt is much easier (now) politically to devalue, becoming in practice “domestic”.

Whether purposefully or spontaneously, de-dollarization is a fact, just as it is a fact that it is increasingly difficult for anyone to produce and offer real goods against the electronic money and the Fed's paper money, allowing the so-called mufti-style "painless trade deficits" that the US has been complaining about for so long.

The inflation premium or the beginning of the end

With higher imported goods, a possible weakening of the dollar, colossal fiscal problems, and the Fed's active monetary policy, we shouldn't be surprised if at some point consumer price inflation starts to show. Something that the Fed is supposedly aiming for.

If others devalue it so the US can import cheaply, the dollar will also weaken relatively.

And if the inflation premium jumps, with these levels of corporate and public debt overseas, things will get scary, because the interest rate for businesses will also go up, regardless of the interest rate policy of the central authorities.

This will be the sign for the $2.5 trillion that commercial banks currently hold as excess reserves on interest-bearing deposits at the Fed to flood into the financial system, leading to inevitable even higher inflation and higher interest rates.

And high interest rates and difficult financing are the poison of debt-addicted economies. In the case of the US, this will affect everyone.

The article was published on the blog medium.com.

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