U.S. Treasury Holders Grin and Bear It

JULY 26, 2011   THE WALL STREET JOURNAL

By TOM ORLIK

The U.S. government is flirting with default on the world's most important risk-free financial instrument: Uncle Sam has issued or guarantees 55% of all triple-A-rated bonds, according to Nomura. But despite dire warnings by some policy makers during another weekend of stumbling debt-ceiling negotiations, most markets continue to snore at the threat. Why?

First, most investors still don't believe even a fractured U.S. Congress would be stupid enough to force a default. Several days remain to secure a deal, and there will be wiggle room to prioritize payments and avoid a default for a short while after that. Perhaps as importantly, most of the biggest holders of Treasurys have little choice but to wait out any uncertainty. And that isn't just U.S. banks that are pushed toward owning them by capital rules and the Federal Reserve, which owns $1.63 trillion of Treasurys after its latest quantitative-easing program.

Take China. It held at least $1.159 trillion of U.S. Treasurys at the end of May, about 26% of the total held by foreigners, and would be the biggest loser in a default. Beijing's hackles are raised. The Chinese government has repeatedly expressed its displeasure to the U.S., and Secretary of State Hillary Clinton's trip to Shenzhen is under a cloud. There are also signs that China is starting to find new places to invest. Analysis by Standard Chartered Bank suggests that in the first four months of the year, China sharply reduced the share of new reserves allocated to Treasurys.

But, like other big holders of U.S. debt, it has no incentive to do anything that would damage the value of its investment. And it has few other options on where to park the bulk of its cash. The key lies in the mainland's continued reliance on an export-driven growth model, supported by an undervalued yuan. China's trade surplus is shrinking, yet it was still $46 billion in the last quarter. And in order to keep the yuan stable against the dollar, China's central bank still has to buy up every cent that enters the country.

Once it has those surplus dollars, the options for investing them anywhere other than U.S. Treasurys are limited. A debt deal in Europe is good news on that front, but the sovereign-debt market remains fragmented, meaning there is no comparably liquid, high-quality euro bond available. The market in Japanese government debt is huge, but a move by China into yen in 2010 sparked an irritated response from a Tokyo ever concerned about the value of the currency.

A statement from China's reserve managers last week pointed out that markets for oil and gold were too small and volatile to house reserves.

With the main U.S. creditors in no hurry to exit, the yield on Treasurys remains low, with the benchmark 10-year note at 2.97%. Arguably, what U.S. leaders need is a market response to force them into action, just as a market slump made them rethink their decision to vote down the Troubled Asset Relief Plan during the financial crisis.

But big holders of U.S. debt have little incentive to sell and risk destabilizing the market. And Beijing, in particular, remains hamstrung by its reliance on the U.S. consumer to help drive its export industries—and Washington's debt pile to provide a home for its burgeoning reserves.

Write to Tom Orlik at Thomas.orlik@wsj.com