Who will buy all those treasurys?

(breakingviews.com) -- Chinese doubts about the value of U.S. Treasury bonds highlight a crucial question: Who will buy the estimated $2.7-4.2 trillion of debt expected to be issued over the next two years?

With annual foreign purchases accounting for less than a tenth of the low end of that range, and domestic investors unable to bridge the gap, the Chinese are right to worry.

Yu Yongding, former adviser to the People's Bank of China, recently demanded guarantees for the value of China's $682 billion of Treasury securities. Then Luo Ping, director of the China Banking Regulatory Commission, said that China had misgivings about the U.S. economy, but despite this it would continue to buy Treasuries.

The two statements appear designed to raise the issue non-confrontationally before new chief U.S. diplomat Hillary Clinton's visit to Beijing on February 20.

China worries about the dollar's value against other currencies, particularly the yuan. With U.S. interest rates so low, the dollar's value may slide. However, President Barack Obama has repeatedly said he wants a strong dollar, and indeed its trade-weighted value rose 13.9% between April and December 2008.

The other area of concern for China is the value of its Treasuries. Given the U.S. borrowing requirement and its lax monetary policy, T-bond yields could well rise sharply, causing a corresponding price decline.

If China's holdings match Treasuries' average 48-month duration, then a 5% rise in yields, from 1.72% on the 5-year note to 6.72%, would lose China 17.5% of its holdings' value, or $119 billion.

Foreign buyers have absorbed a little over $200 billion of Treasurys annually, a useful contribution to financing the $459 billion 2008 deficit, but only a modest help towards the $1.35 trillion minimum average deficit forecast for 2009 and 2010.

Unless that changes substantially, there will be $1 trillion annually to be raised by the Treasury from domestic sources, more than double the previous record from domestic and foreign sources together, plus whatever is needed to bail out the banks.

Even if the U.S. savings rate were to rise from zero to its long-term average of 8% of disposable personal income, that would create only an additional $830 billion of savings - not enough to fund the domestic share of the deficit. Interest rates would probably have to rise substantially to pull in more foreign investors.

Yu is right to worry.