Over the past several blog posts, I’ve focused almost exclusively on the sovereign debt crisis in Europe, and for good reason.  The next jolt to the world economy will likely come from Europe.  How well or should I say how poorly the European Union handles Greece defaulting on its bond obligations will determine the severity of the impact on the world economy.  There are lots of interesting articles on the sovereign debt crisis in Europe that I could write about.  But I’m going to let that situation percolate awhile and instead focus on an obscure article I read recently in the British newspaper, The Telegraph. 

In this article by Ambrose Evans-Pritchard, the head of China’s central bank stated that Beijing plans to reduce its portfolio of US bonds as soon as it is safely possible.  At the World Economic Form, Li Daokui, stated that China will in the future be investing more in physical assets.  “We would like to buy stakes in Boeing, Intel, and Apple… Once the US Treasury market stabilizes we can liquidate more of our holdings of Treasuries,” he said. 

It is estimated that China owns $2.2 trillion of US debt, and is second only to The Federal Reserve in the amount of US debt owned.  While China accumulated US bonds over the last three decades, The Fed accumulated its bonds in the last couple of years as a result of the Quantitative Easing program, which ended in June of this year. 

China is clearly worried that about the US debt issue, which now exceeds $14 trillion.  Mr. Li described the debt deals this summer on Capitol Hill as “just trying to buy time,” saying it will not be enough to stop the growing debt crisis that is mounting.

It’s always interesting to see how the rest of the world looks at us in the United States.  So hearing the comments of a Chinese official in a British newspaper about how the U.S. is handling it’s debt crisis is like being the proverbial fly on the wall listening into a conversation about your class behavior between your grade school teacher and your mom.  It’s interesting to hear what they’re thinking but at the same time you know there’s going to be consequences.      

So why is this proposed change in China policy important to those of us in the commercial real estate industry in the Pacific Northwest?  Why should we care whether the Chinese are buying more of our debt or conversely liquidating their holdings of US bonds?  BECAUSE U.S. TREASURY RATES ARE DETERMINED BY SUPPLY AND DEMAND!!! 

We now know that both The Federal Reserve and China are planning to stop buying our debt.  So what happens when the top two buyers of our debt are no longer buying?  To make matters worse China intends to liquidate some or all of their holdings of US debt which will only add to the supply of bonds available on the market to be purchased.  Is it conceivable that the rest of the world can purchase their normal market share of US debt plus China’s and The Fed’s too?  I don’t think so.  Logic tells me it’s not possible but smarter people than me who are in the know may disagree. 

Assuming I’m correct, then the rest of the world cannot buy the volume of debt we are currently hemorraghing.  What then?  That means over time treasury yields (interest rates) will have to increase in order to entice enough buyers to buy our debt.  If treasury rates go up, then interest rates of all kinds will follow, including interest rates on commercial real estate.  One offsetting factor are the spreads over treasury rates that lending institutions are charging these days are close to an all time high.  If lenders wanted to absorb some of the rise in treasury rates they could do so by lowering the spreads they are charging.  That is a possibility.  Another possibility is that Congress and the president could pass meaningul legislation to reduce our budget deficits.  I’ll let you determine the chances of that happening…

Source: China to ‘liquidate’ US Treasuries, not dollars; The Telegraph Blogs, by Ambrose Evans-Pritchard, September 15, 2011.