Did China just drop the nuclear bomb on the US dollar?

Last week, an over-the-top sensational report with an arresting headline set off incessant chatter on the Internet. The report, headlined ‘ China Has Divested 97 Percent of Its Holdings in U.S. Treasury Bills ’, seemed to confirm long-held fears that China would “dump” the US dollar, with catastrophic consequences for the world’s leading reserve currency.

Citing the latest US Treasury report, the report, on CNSNews.com, claimed that China had sold off an astonishing 97% of short-term US government securities - from $210 billion in May 2009 to just over $5.6 billion in March 2011.

To some, that seemed to be validation of the fear that China, among the world’s top buyers of US sovereign debt, had “ dropped the nuclear bomb ” on the US dollar.

The notion that China is the US’ “banker” - because it buys so much of US sovereign debt - and can therefore do incalculable harm to the US dollar and the economy is widely held. A WikiLeaks cable from March 2009 reveals that no less than Hillary Clinton, in a conversation with Australian Prime Minister Kevin Rudd, wondered aloud about the difficulty of dealing “toughly with your banker”.

The Chinese side has always been happy to feed that false impression, since in their estimation it enhances the political and strategic leverage that China has over the US.

Last year, for instance, Chinese military leaders sounded a shrill warning that if the US persisted in arms sales to Taiwan, over which China claims territorial sovereignty, China would resort to “economic sanctions”, including by dumping US government bonds.

One general, Luo Yuan, a researcher at the Academy of Military Sciences, said: “We should go in for a strategic mix of retaliation across politics, military matters, diplomacy and economics… For example, we could sanction them using economic means, such as by dumping some US government bonds.”

In that context, the latest CNSNews.com report that China had dumped 97% of short-term Treasury bills represented, for some, the sum of all fears for the fate of the US dollar.

But, as Tyler Durden (at the Zerohedge.com blog) points out (in this clinical shredding of the CNSNews.com report ), it represents an incorrect understanding of the facts of the case, and a misrepresentation of China’s true appetite for long-term US Treasuries.

As Michael Pettis, professor at Peking University’s Guanghua School of Management, told me in an interview in 2009 , China’s threats to dump the US dollar “look like an atomic bomb, but there’s nothing in it.”

Pettis noted:

I keep hearing about this nuclear threat, but I’m not sure how they can actually do it.

If China caused a huge collapse in the value of the dollar, and a huge increase in the value of the euro, Americans would probably sell off European assets and use the proceeds to buy American assets indirectly from Chinese, who would be exchanging very cheap American assets for very expensive European assets, thus representing a massive transfer of wealth from China, which would be holding all these depreciating assets, to the US.

These ideas of “nuclear options” are the sort of things that politicians and ordinary people get very nervous about. But I cannot figure out how you go about doing this in a way that benefits China and disrupts the US. It’s one of the things that keeps us awake at night unnecessarily.

China’s problem is that is caught in a ‘dollar trap’: it cannot diversify its nearly $3 trillion in foreign exchange holdings because no market is deep enough.

As the Economist noted in April ,

Even if China bought all of the outstanding sovereign debt of Spain, Ireland Portugal and Greece, it would have almost half of its reserves left over. (of course, it would have helped solve the euro area’s debt crisis - but that do-goodism comes at a price.)

Alternatively, the report noted, China could snap up Apple, Microsoft, IBM and Google together for less than $ 1 trillion (at then prevailing valuations). Even buying the 50 most valuable sports franchises would use up only 2% of China’s reserves.

Likewise, buying all of Manhattan and all of Washington, DC, would only cost it $500 billion. Heck, even buying the entire assets of the US Department of Defence would cost it only $1.9 trillion.

“These frivolous calculations,” Economist noted, “illustrate the vast scale of China’s reserves but also the great difficulty it faces in diversifying them. Any purchase big enough to warrant China’s attention will also move the market against it . China can buy almost anything for a price-but almost nothing for today’s price.”

In other words, as China’s central bank governor Zhou Xiaochuan, noted last month, China is suffering from too much money . China’s $3 trillion in foreign reserve holdings is feeding inflation and becoming difficult to manage monetary policy.

In the end, for all the heat it generates, the tug-of-war between the US and China is just the back-and-forth between two “frenemies” who are joined at the hip .

I could explain that idea using arcane macroeconomic mumbo-jumbo - or alternatively point you to this animated rap video featuring Barack Obama and Hu Jintao. Enjoy…