Wednesday, April 2, 2014

What if Russia Dumped U.S. Debt?

How Putin Plans to Break America

[jerukbali] Last week, I wrote about the possibility of Putin and Russian officials seeking revenge on the U.S. In particular, I mentioned that Putin could step up to a microphone and announce that the Russian government would be selling off all U.S. Treasuries that it currently owns.
Since that time, the people of Crimea have voted to secede from Ukraine and join Russia. It looks as though the U.S. government will respond, at least at first, with minor sanctions targeted at certain Russian officials. At this time, we can’t say whether this action will be enough to trigger an all-out economic war.
Regardless of your thoughts on sanctions, this is something that must be closely followed by investors, or really for anyone. While I am against sanctions, it doesn’t matter whether or not you are morally opposed to them and whether or not you think sanctions work. Regardless of your opinion, there could be real economic consequences here and it won’t just be for the Russians.
While I previously stated that Putin could announce to the world that Russia will be selling off its U.S. Treasuries that it holds as reserves, perhaps a more likely scenario is that Putin will say nothing at all. In fact, if there's going to be any kind of rush out of U.S. debt by foreign governments or anyone else, then the wise thing to do is to quietly reduce your holdings.
The only reason Putin would publicly make such a bold announcement would be to stick his thumb in the eyes of the U.S. politicians. But if he did that, it is possible it could just escalate things that much more. And making such a statement would mean that the Russian government would not be able to sell its U.S. debt at as high of a price, particularly if any other foreign governments joined in the selling.
Russian Holdings are Small, But…
It was recently reported that there was a reduction in holdings of U.S. Treasuries by foreign central banks. It is not yet clear where this reduction is coming from. Could it already be Russia is quietly backing away from the dollar?
As of the end of 2013, Russia held approximately $138 billion in U.S. Treasuries. This is a fair amount of money, but it's quite small in comparison to China and Japan.
China and Japan each have reserves of U.S. Treasuries in excess of $1 trillion. At the end of 2013, China held approximately $1.268 trillion in U.S. debt, which is almost 10 times the amount of Russia. Japan held about $1.182 trillion. There is no other foreign government/central bank that holds anywhere close to the amounts of China and Japan. The next closest have under $300 billion in reserves.
But while Russia’s holdings are small in comparison to China and Japan, we still have to consider the ramifications of Russia selling all of its U.S. debt, if it were to take this drastic step.
I see a few things that could persuade other foreigners to follow suit and sell U.S. debt.
First, while Russia has “only” $138 billion, or possibly less now, changes are made on the margin. We can understand this as investors.
You don’t need millions of people to start buying a stock to make its price go up a lot. You just need more buyers fewer sellers at the margin, and this can oftentimes be enough to drive the price up significantly.
While Russia by itself cannot collapse the U.S. bond market, it could have a significant impact by deciding to sell.
Second, if Russia starts reducing its holdings and other countries take notice, this could make other holders nervous. This is particularly so if Russia sells fast and reduces its holdings significantly.
Japanese officials and Chinese officials may start looking at each other to see who blinks first. You don’t want to start running for the exits when there is already a mad rush to get out. If there is widespread selling and interest rates jump quickly, then this can lead to big losses.
It hasn’t happened yet and it may not happen for many years to come. But if Putin decides to play ball, then you don’t know if this may be a trigger event. It really can be like dominoes falling.
A third thing to consider in all of this is that Chinese officials may wake up and finally start to reduce its holdings of U.S. debt just because it sees the way the U.S. government is imposing sanctions on Russia. Chinese officials may start to feel more vulnerable themselves and decide that they should not be so dependent on the dollar.
It's also important to note here that holders of U.S. debt don’t even have to sell to reduce their holdings. They just simply have to stop buying. As debt matures, they are paid back the principal, unless they decide to roll it over into more U.S. Treasuries.
The Chinese and Japanese governments have continued to foolishly subsidize the U.S. government by enabling bigger deficits. They are also subsidizing the American people through cheaper consumer goods. Maybe they will wake up if Russia starts something.
Ironically, I think the American people will be better off in the long run if and when foreign countries do dump their U.S. debt and turn away from the dollar. It will be painful in the short term, but it will eventually put more limits on the U.S. government’s ability to spend.
In many ways, Americans have become dependent on foreign countries buying U.S. debt the same way that someone becomes dependent on welfare. It is better in the long run not to have this dependency.
It's highly beneficial for Americans to trade with the Chinese and everyone else, but it doesn’t mean that the Chinese have to help the U.S. government run massive deficits.
The Benefits for Gold
While we can’t be certain that Putin will dump the dollar, what if he does? What will be the ramifications for the economy and our investments?
First, it will likely be bad for the dollar. If it's just Russia cashing in its U.S. debt, then it may only be slightly bad for the dollar. If other countries follow, then it could be really bad for the U.S. dollar.
While I don’t think there are any other currencies that will replace the dollar as the world’s reserve currency, I do think other countries can use fewer dollars. It will start with the Russian officials who now have sanctions against them. They will not do any business in dollars.
If the dollar goes down and you live in the U.S., then you will certainly want to invest in hard assets that will benefit from a declining dollar.
Second, if Russia (and other countries) sells off some of its reserves, then it will likely want to have a replacement. There is the euro or the yen, but these are currencies that have their own set of problems. I think it is likely that foreign central banks will start increasing their goldholdings.
In other words, if you are an American, there are two good reasons to own gold, particularly if Russia starts reducing its holdings of U.S. debt.
So while I'm not predicting a massive dumping of U.S. Treasuries any time soon, I am pointing out the possibilities of it. We don’t want to be surprised.
As I said, Putin may not walk up to a microphone and announce his plans. He may execute his plans quietly, whether it's for revenge or just wise policy. We will monitor the foreign holdings of U.S. debt to see if there are any major changes in the near future.
Source: Geoffrey Pike for Wealth Daily