Treasury holdings as a political weapon?

Imagine the following scene in the not too distant future:

The US Navy confronts the PLAN (People’s Liberation Army Navy) in the South China Sea. Someone miscalculates and shooting starts and the situation escalates wildly. Eventually, there are three American carrier task forces, accompanied by submarines, along with the fleets of Asian allies like the Philippines, Japan, Australia and so on, in the area.

Just as PLAN forces are outnumbered and the Chinese tactical situation look hopeless, the PBoC picks up the phone to New York, “I have $1 trillion in Treasury assets to sell – now.” The theory is, some Americans may be patriotic willing to die for their country, but how many would be willing to lose their homes for their country? How about losing their jobs for their country?

Is this the plot for a twisted Tom Clancy novel? Bearish Apocalyptic fantasy? How plausible is this scenario?

The rehearsal

We may be seeing a rehearsal of that hypothetical Chinese threat, but from a country that has far more cordial relationship with the United States. Recently, Saudi foreign minister Adel al-Jubeir delivered a warning that the Kingdom of Saudi Arabia (KSA) may be forced to sell as much as $750 billion in Treasury holdings if Congress passes the Justice Against Sponsors of Terrorism Act, which would open KSA to lawsuits stemming from 9/11 (via the NY Times):

Saudi Arabia has told the Obama administration and members of Congress that it will sell off hundreds of billions of dollars’ worth of American assets held by the kingdom if Congress passes a bill that would allow the Saudi government to be held responsible in American courts for any role in the Sept. 11, 2001, attacks.

The Obama administration has lobbied Congress to block the bill’s passage, according to administration officials and congressional aides from both parties, and the Saudi threats have been the subject of intense discussions in recent weeks between lawmakers and officials from the State Department and the Pentagon. The officials have warned senators of diplomatic and economic fallout from the legislation.

Most analysts and observers have pooh-poohed the threat. Marc Chandler asked a few good questions about the logistical problems of a $750b selloff in Treasury securities:

Where would such a large sum of money be invested? Not only is nearly every other bond market too small, but those large enough to absorb significant flows, like Germany bunds or Japanese government bonds offer negative yields. If a large holder of US Treasuries were to dump them quickly, the demand shock would likely cause a spike, which in effect undermines the valuation of the remainder of the portfolio.

He offered one alternative of moving the funds into the offshore USD market. Though it does achieve the technical objective of a sale of Treasury securities, it does not really achieve the political objective:

There is something else Saudi Arabia could do. It could take a page from the playbook of the former Soviet Union.

When it saw how the US treated its special ally Great Britain in the Suez Crisis, the Soviet Union was wary of the US using its financial power for political ends; it feared that its assets in the US could be frozen. The Soviet Union took the dollars it had in the US and deposited them with a UK merchant bank. That merchant bank was able to lend out those dollars without the interest rate cap that prevailed in the US at the time. This is to say that the offshore dollar market was launched not by good capitalists and the internationalization of savings, but the Communists seeking to move out of reach of US officials.

Saudi Arabia could do the same thing. It could takes its US Treasury holdings and bring them to a foreign custodian, who is not subject to US laws. This may be more difficult to do with some of the other assets it may own in the United States. Overall this course would prove to be less disruptive for it than selling Treasuries.

An act of desperation

Here is a different perspective. Rather than focus on the technical and logistical issues of a sale, Andy Critchlow viewed the threat in political terms instead:

Saudi Arabia rarely jokes about money. So investors can’t easily dismiss a threat that the kingdom will dump its American assets if the U.S. Congress passes a bill allowing victims of the Sept. 11, 2001 attacks to sue it for damages. Though a fire-sale would be devastating, it suggests the alternative – an Iran-style freezing of assets – would be an even worse outcome.

Critchlow believes that KSA is getting backed into a corner and desperately needs the money:

SAMA, which also acts as a form of sovereign wealth fund, has sold assets to offset a steep decline in oil revenue over the past year. The size of its reserves has fallen by 17 percent to $593 billion in the year to February, according to its last financial report. At this rate, Riyadh could burn through most of SAMA’s booty by 2020 unless crude rebounds. Without access to those funds, the Saudi royal family would struggle to keep the peace at home.

That is why Al-Jubeir’s threat is not to be taken lightly. Sure, jettisoning assets on this scale in a hurry is incredibly risky. The Saudi riyal is tied to the dollar, and a rapid exit would test the central bank’s ability to maintain the currency peg. A hurried sale could also freak out global financial markets, too, which might further squeeze demand for oil.

That Riyadh is willing to ponder such a messy outcome suggests just how existentially it needs money to keep its hold on power. That’s perhaps the scariest message from the whole kerfuffle.

Indeed, KSA is engaged in a last-ditch surprising effort at reform in order to right its economic ship in light of reports that the social contract in the Gulf States is starting to fray. We have seen several stories and profiles of Prince Mohammed bin Salman, the chief architect of the “Vision2030” plan for the Kingdom. Bloomberg called their profile The $2 Trillion Project to Get Saudi Arabia’s Economy Off Oil. The Telegraph characterized the plan as a Thatcherite revolution in the desert.

Rather than focusing on how real the $750b Treasury selloff threat is, analysts should see these threats as signs that someone is being backed into a corner. Imagine being trapped in a room where there is a tense standoff and someone pulls out the pin out of a grenade, “If you come any closer, I drop this thing and we will all blow up together.”

That’s the sort of situation where no one wins, whether the other party is China or Saudi Arabia.