China’s Dollar Holdings Are Sinking Like A Stone. The Question Is, Why?

China has the world’s largest holdings of reserve assets, about $3 trillion. Included in that reserve position is what was the world’s largest portfolio of U.S. Treasury securities (outside of the Federal Reserve balance sheet and U.S. government retirement and benefit funds), of about $1 trillion.

However, as recently as 2014, that U.S. Treasury note position was $1.4 trillion. As reported in this article, the exact Chinese position in U.S. Treasuries today is $980.8 billion. This is the first time since 2010 that Chinese holdings of Treasuries have fallen below $1 trillion.

In fact, China is no longer the world’s largest holder of Treasuries. That honor now belongs to Japan, which has $1.2 trillion of Treasuries. Why the decline of over $400 billion in China since 2014? Why the decline of almost $100 billion in the past year?

The popular explanation is that China is dumping U.S. Treasuries in order to reduce its dependence on the U.S. dollar and U.S. Treasury debt in particular. This explanation has some plausibility based on the fact that the U.S. has frozen the Treasury assets of the Central Bank of Russia in retaliation for its invasion of Ukraine.

All Treasury securities are issued in digital form, and that digital ledger and the dollar payments system are controlled by the U.S. Treasury and the Federal Reserve. It’s entirely possible that China has watched what happened to Russia and decided to make itself less vulnerable by reducing its Treasury position.

If that’s your goal, it’s not even necessary to dump Treasuries on the market. You can just wait patiently until your holdings mature and the Treasury will send you the money. A two-year note you purchased two years ago will mature now, and you’ll just get the proceeds with no further action.

As long as you don’t rollover the proceeds into new Treasuries, then your position goes down. Of course, your cash position in U.S. dollars goes up, but that’s a separate problem. You can choose to invest that cash in German or Japanese bonds or any other asset class you like.

But, there’s another explanation for the portfolio shrinkage that is far more troubling. China is in financial distress and actually needs the cash to prop up its banking system and to support its currency.

China may be in the early stages of a liquidity crisis. The reduction of its Treasury securities position, far from being a sign of an aspiring hegemon walking away from dollars, may actually be a sign of acute weakness with China desperately trying to come up with dollars any way they can.

My estimate is that the decline in China’s Treasury portfolio is an indication of financial distress rather than financial autonomy. We’ll soon find out.

We can be sure that what happens in China won’t stay in China. If there’s a dollar shortage in China, there is likely a dollar shortage in the entire world. That could presage a global liquidity crisis. China may turn out to be a very large canary in a coal mine.

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