Pentagon: China’s U.S. debt holdings aren’t security threat

China’s holdings of more than $1 trillion in U.S. debt and the prospect that it might “suddenly and significantly” withdraw funds don’t pose a national security threat, according to a first-ever Pentagon assessment.

“China has few attractive options for investing the bulk of its large foreign exchange holdings out of U.S. Treasury securities,” given their extent, according to the report dated July 20 and obtained by Bloomberg News.

China is the second-largest holder of U.S. government debt after the Federal Reserve. Acting at the direction of Congress, the Defense Department studied the rationale behind the investments and whether “the aggressive option of a large sell-off” would give China leverage in a political or military crisis. China’s debt holdings have been cited as a sign of U.S. vulnerability by Republicans in this year’s election campaign.

“Does the America we want borrow a trillion dollars from China? No,” Mitt Romney said Aug. 30 in accepting the presidential nomination at the Republican convention in Tampa, Fla.

China’s holdings of U.S. government securities were $1.164 trillion as of June, according to Treasury Department data released Aug. 15. China has increased its holdings this year, as the American economy stalled and Europe’s sovereign-debt crisis deepened.

‘FINANCIAL WEAPON’
Chinese commentators have occasionally suggested using the debt holdings to pressure the U.S. on its pro-Taiwan policies. A senior People’s Daily editor wrote in an August 2011 editorial that “now is the time for China to use its ‘financial weapon’ to teach the U.S. a lesson if it moves forward” with additional arms sales to the island democracy, according to the Pentagon report.

“Attempting to use U.S. Treasury securities as a coercive tool would have limited effect and likely would do more harm to China than to the United States,” according to the report, which was sent to congressional committees by Defense Secretary Leon Panetta. “As the threat is not credible and the effect would be limited even if carried out, it does not offer China deterrence options” in a diplomatic, economic or military situation, the Pentagon found.

The Pentagon’s conclusions were backed by analysts such as David Ader, head of U.S. government bond strategy at CRT Capital Group LLC in Stamford, Conn.

The Chinese “are very astute money managers and they would recognize that the damage of doing that would have negative consequences for them and for global trade, which is already in a difficult place,” Ader said in an interview.

While the total size of the U.S. debt “and trend of the debt is a national security risk,” China’s holdings “are a side issue,” Derek Scissors, a China analyst for the Heritage Foundation in Washington, said in an e-mail.

CHINESE ‘SELF-INTEREST’
Still, “if deterrence breaks down and a conflict starts, China is going to attack the U.S. bond market and accept the ensuing financial losses,” he said.

The Pentagon consulted with the Treasury and State departments and the Director of National Intelligence in compiling the report, said Pentagon spokeswoman Major Catherine Wilkinson.

“Chinese officials often act as if they are doing the U.S. a big favor by buying U.S. debt, and sometimes officials suggest that this policy could be easily changed to punish the United States,” Wayne Morrison, an Asia trade specialist with the nonpartisan Congressional Research Service.

“In fact, the Chinese are acting out of their own self-interest,” Morrison said in an e-mail. “They have to buy U.S. dollar assets as long as they are intervening in currency markets to hold down the value of the RMB against the dollar,” he said, referring to China’s currency, the renminbi.

China decreased its Treasury holdings last year with little apparent impact in the market, Treasury data show. The world’s most populous country reduced its position in Treasuries in the first yearly decline since Bloomberg began tracking the data in 2001.

The holdings declined 0.7%, or by $8.2 billion, to $1.15 trillion last year. The decline was much steeper in the second half of the year when China’s stake plunged 12%, or by $163 billion, from an all-time high of $1.31 trillion in July 2011, the data show.

During that period, 10-year Treasuries rallied as the U.S. credit rating was reduced by Standard & Poor’s to AA+ from AAA and the European sovereign debt crisis worsened, pushing the yield to 1.88% from 2.8%.

Foreign investors held 50.3% of the $10.52 trillion in outstanding Treasuries as of June, government data show. That’s down from April 2008, when they reached 55.7% of the $4.64 trillion in U.S. marketable debt.

BI-PARTISAN CONCERNS
Both Democrats and Republicans have raised concerns in the past about the risks of China and other countries holding a large proportion of U.S. Treasury debt.
U.S. Sen. Richard Shelby, R-Ala., said in a February 2006 interview that China at some point may be able to influence U.S. economic policy because of its holdings. “What if they dumped their bonds all at once?” he said.

When Democratic Senator Hillary Clinton of New York, who is now Secretary of State, was running for president in 2007, she wrote Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke to say the amount of U.S. debt held by investors abroad meant “we can too easily be held hostage to the economic decisions being made in Beijing, Shanghai and Tokyo.”

A sudden and large reduction of China’s holdings “could cause short-term” secondary market disruptions and interest-rate increases for Treasury debt issues, according to the Pentagon report.

COSTS TO CHINA
It also “would impose significant costs on China,” as the supply of U.S. Treasuries increased and the value of China’s holdings fell sharply, the Pentagon found.

Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York, one of 21 primary dealers that trade directly with the Fed, said other buyers would step in if China eliminated or reduced its U.S. holdings.

“In an environment like today, if Treasuries were to sell off 50 basis points in the 10-year sector, you’d see a lot of demand from domestic and non-traditional foreign investors, including other central banks, which would step in to purchase at lower prices and somewhat higher yields,” Jersey said. A basis point is 0.01 percentage point.

The Pentagon said in its report that the Fed also is “fully capable of purchasing U.S. Treasuries dumped” by China and “reducing the economic impact.”

A Chinese move to “suddenly and significantly” reduce its Treasury holdings “would fundamentally change the international finance and business community’s perception of China as a reliable and respected economic and financial partner,” the Pentagon said.