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What China's Actions Mean for the Dollar and Your Portfolio

The United States and China have been locked in a dysfunctional relationship for far too long. We here in the states have been consuming Chinese imports at an ever-rising rate. And China has helped fuel our addiction by keeping its goods very cheap. It's managed this by pouring much of its export profits into U.S. Treasury bills and bonds, keeping its currency , the yuan, artificially low.

Now, the two countries are locked in an uncomfortable scrum. China is legitimately concerned that the United States will be unable to pay back the hundreds of billions of dollars it owes. And the United States desperately wants the yuan to strengthen. There's a straightforward solution, and policy makers in both countries would like to see it happen: A rising middle class. In China, that boosts domestic consumption. And that would help to reverse persistent large trade deficits. It's starting to happen, but perhaps not fast enough to avert a crisis.

The Worst Case Scenario

In a doomsday scenario, China starts to panic about potential U.S. government bond defaults and decides to sell a large amount out of its U.S. bond portfolio. That would cause a quick run on the dollar, and lead to an alarming spike in interest rates. As we're running large budget deficits right now and will need to keep issuing hundreds of billions of dollars worth of bonds, our debt service costs would skyrocket. That's why it's imperative that the United States balances its budget before any China problems spiral out of control.

Of course, China has ample reason not to panic. After all, the United States represents its largest export market, and a weakened American economy would stumble as a trade partner. Any major shift in bond ownership that weakens the U.S. dollar would reduce the value of China's foreign bond portfolio by a commensurate amount.

The Middle Path

Rather than make an abrupt shift in its bond portfolio, China can gradually reduce its exposure to the United States. And it's doing just that. China trimmed its exposure to U.S. bonds by $33 billion to $867 billion in April, according to data released last week. This is not the start of a fast drawdown of U.S. bond holdings, as China will proceed slowly. But it's a sure sign that the United States shouldn't count on China to help support its addiction to debt.

In an ideal world, Chinese domestic consumption would start to rise, and China's trade balance would swing from surplus to deficit , which would have myriad benefits for both sides. For the United States it would mean higher exports. And increased foreign earnings would to help mitigate any potential inflationary fall in the dollar. For China, rising domestic consumption would help create jobs at a time when export-oriented factories are starting to see a slowdown.

Yet as noted earlier, that is likely to happen far too slowly to be of real help. That's why U.S. policy makers are practically begging China to let its currency rise. China has reasons to move very slowly on the currency front. For starters, it would see a drop in the value of its foreign bond holdings. More important, its exports would become less competitive compared with other exporters such as Vietnam, Malaysia and the Philippines. Policy planners dread any potential civil unrest that would come from a swelling tide of laid-off factory workers. Trouble is, an artificially weak yuan is unsustainable, and the longer China drags its feet, the higher the risks of a global economic crisis.

How This Plays Out

Despite all of the potential pitfalls, investors need not panic. The United States has been running large trade deficits for a very long time, and fears of its deleterious effects have been evoked ever since. Yet remarkably, the dollar remains strong, thanks to the very long and successful track record of the U.S. economy, and the perceived "safe haven" that the dollar offers.

But investors might need to brace for a long period of subpar U.S. economic growth, unless its exports can rise sharply. Just a few years ago, investors were cheering the fact that the dollar was moving into a long-term weakening phase, which would ultimately enable the country to export its way out of its problems. Trouble is, the global crisis of 2008 and 2009 turned the euro into the lagging currency. President Obama has expressed hopes for an export boom. But with a strong dollar, a weak euro and an even weaker yuan, it's not clear how that can happen.

So what can we expect during the next few years? Well, economics is known as the "Dismal Science" for a reason, and many forecasts miss the mark. But economists generally agree that China will only slowly reduce its exposure to U.S. bonds. Which means that the United States hopes that other buyers will emerge for its new debt. (Budget deficits are expected to remain high for at least the next three to five years). More than likely, Uncle Sam will have to pay higher and higher interest rates to attract buyers for its bonds. And higher interest rates can stifle economic activity.

To be sure, the economy can handle interest rates that are higher than current levels. For example, inter-bank lending rates (set by the Federal Reserve) might move up to 3% rather than the current near-zero levels. That might actually be a positive for the stock market, as it would reduce fears of an inflationary bubble, which would justify higher price-to-earnings ratios as risk is reduced. Yet as we recall from the 1970s, if interest rates must rise closer to 7% or 8%, then it's, "Katy, bar the door." Stocks went nowhere in the 1970s as most investors were content to simply clip high-yielding bond coupons.

-- David Sterman

David Sterman has worked as an investment analyst for nearly two decades. He started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and has made numerous media appearances over the years, primarily on CNBC and Bloomberg TV. David has a master's degree in management from Georgia Tech. Read More...

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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