Sensing Vulnerability

The Chinese military made headlines recently by calling on China to dump U.S. bonds in retaliation for a $6.4 billion U.S.-Taiwan arms deal.

“Our retaliation should not be restricted to merely military matters, and we should adopt a strategic package of counter-punches covering politics, military affairs, diplomacy and economics to treat both the symptoms and root cause of this disease,” said Luo Yuan, a researcher at the Academy of Military Sciences.

I’m not sure which disease Mr. Luo had in mind, but there is no question that the U.S. economy is recovering only slowly, and remains vulnerable to relapse. An asset sale by China could cripple our halting recovery by driving up U.S. interest rates. Some observers have downplayed the report, noting that China’s military is not involved in economic policy making. The U.S. State Department has retorted that such a move would undermine China’s nearly $800 billion investment in U.S. Treasuries.

But shortly after the PLA’s bellicose outburst, a Communist Party directive leaked to the Asia Times revealed that Beijing has ordered its asset managers to sell risky dollar assets, such as asset-backed securities and corporates, while maintaining dollar investments only in U.S. guaranteed securities such as Treasuries. The leaked directive made no reference to Taiwan or military policy, but the timing is certainly suspicious.

As to doubts China would make a move that would hurt its own portfolio, some analysts believe the policy may be a financially ingenious play just before the Fed is set to end its quantitative easing policy: The ensuing widening risk spreads may trigger a flight to safety that would boost the dollar. But a stronger dollar will slow U.S. export growth, hurting jobs and manufacturing, and higher interest rates will bring the U.S., California and other failed states to their knees.