6 Moves to Check Mate: China's Economic Lever of Mass Destruction

The following is inspired by the rumoured defection of China’s central bank governor, Zhou Xiaochuan, over $430 billion in losses on a short US Treasury position. According to undisclosed sources, the governor was facing ‘punishment’ for the losses and fled the country. The rumor was false.

True or not, as I watched the blogosphere hurl conspiracy theories across the wires at Internet speed, I came up with my own grand/crackpot theory. My theory is so bizarre and so maniacal that it is easily dismissed – but this is precisely why it could work.

Caveat: the following may appear to be the ravings of a lunatic. This article is far-fetched, conceptual and not grounded with empirical data. It is not meant to be a comprehensive thesis. Please simply consider the following a source for discussion.

If China truly wants global economic and military dominance, it clearly must find a way to push the United States aside. One way is to grow in earnest – and it has since it entered the World Trade Organization several years ago. Good ol’ fashioned elbow grease might land China in first economic spot sometime in the next 10-30 years, depending on who you believe. [Others say it will never happen.]

What if China wants to speed up the process? This is when the maniacal plot thickens.

As most of us know, due to large trade surpluses China is a big creditor to the United States. China lends us the money to pay for some of our schools, roads and military. The US Treasury needs to keep borrowing and spending money to keep the economy afloat. In fact, the CBO recently stated that 4.5% of the Q2 GDP figure was due to government stimulus. It is clear that government spending is critical to maintaining some semblance of a functioning US economy.

China is not our only creditor, but with over $844 billion in US Treasury securities they are a big one (about 21% of all USTs held by foreigners). Some suggest China’s actual holdings may be even higher, due to secret purchases made via non-Chinese intermediaries.

What nobody really knows is if China is hedging its US Treasury position (or even creating a net short position, as the Zhou rumor implied). Also, nobody really knows if China is accumulating gold bullion. Although China has recently talked down the price of gold, it is likely the country has purchased bullion on the open market and is hoarding domestic production.

This portfolio posturing is the scene setup for China’s shortcut plan to become the dominant economy and military on the planet.

Given the above, here’s how this crackpot scheme would unfold:

1. China gradually increases its net short position in US Treasuries by discretely selling its holdings of US Treasuries (or letting Treasuries mature), buying puts, selling calls, and selling forwards. It does so at a pace that isn’t noticeable and doesn’t significantly impact prices.
2. Once China’s net short position is desirably large, it begins openly selling US treasuries en masse, triggering a market panic.
3. US Treasury prices and the US dollar plummet as investors rush for the exits. New funding for US spending immediately dries up.
4. The US Treasury is forced to choose between catastrophic spending cuts and outright debt monetization – both alternatives would cripple the US economy, leading to a hyperinflationary depression.
5. US imports from China stop, however profits from the short position and gold position are used to offset export losses and build domestic Chinese consumption.
6. China becomes the dominant economy while the US collapses under the weight of its own debt.

 This is a simplistic scenario. The scenario could cripple the US to China’s advantage, or it could be mutually-destructive. Perhaps the strategy is only used once the scales are clearly in China’s favour.

Also, a reasonable regime would likely avoid destroying a large trading partner, but this article is not about reason. It is about lunacy and the economic leverage that China possesses.

Even if this scenario were to unfold, in reality it could play out with numerous twists and turns, but my job today is to simply lay down the theory’s groundwork. This is a strategy article and a conversation-starter.

Some areas for further exploration:

A) Could the US retaliate with a military strike?

B) What if the contract counterparties collapse along-side the US?

C) What happens after the sell-off stabilizes? (Think Weimar Republic and the rise of the Nazi Party.)

Now please discuss amongst yourselves…