Source: The Wall Street Journal

The China Capital SurgeOf the many nightmares that keep investors awake, fear that China's central bank will start to sell its piles of U.S. Treasuries is the most unlikely. Not only would that action cause far more damage to China, the real risk to investors is precisely the opposite problem—that more, not less cash will flood into America.

The People's Bank of China cannot simply sell Treasury bonds, pocket the cash and go home. If it wants to reduce its holdings, it must swap them for something else. There are broadly four options.

First, Beijing could sell U.S. Treasury bonds and buy other dollar-denominated assets. This would have little net impact on the U.S. market, except perhaps to cause a slight increase in Treasury yields and an equivalent, and welcome, contraction in U.S. risk premia. Those who sold assets to China's central bank receive money that becomes part of the larger pool that funds U.S. Treasury obligations.

Second, the People's Bank could sell U.S. Treasury bonds and buy assets denominated in euros or yen. Any major exchange would immediately cause the dollar to drop sharply, giving the U.S. economy an export-related boost as European or Japanese exports collapse and imports surge. But both countries would almost certainly retaliate strongly against Chinese trade. Recent reports that China has sharply increased its purchase of yen are already causing worry in Japan.

Third, China could sell its U.S. Treasury bonds and use the dollars to buy hard commodities. This simply reassigns the problem of recycling China's trade surplus to commodity exporters, with almost the same net results.

Finally China could sell U.S. Treasury bonds for cash and purchase assets in China. This option would be most damaging for China. The People's Bank currently sells huge amounts of yuan to Chinese exporters to suppress the value of its currency versus the dollar. Switching strategies and buying yuan would cause that exchange rate to soar, wiping out China's export industry and causing unemployment to surge.

Any sharp reduction in China's Treasury bond holdings is thus likely either to be irrelevant to the U.S. or to cause far more damage to China than to the U.S. If anything, China is likely to buy more dollar-denominated assets. And there are other global trends that will reinforce this buying spree.

The world's major capital-exporting countries are desperate to maintain or even increase their capital exports, which are simply the flip side of trade surpluses. China, for example, is unwilling to allow the yuan to rise against the dollar because it wants to protect and even increase its trade surplus. In Japan, any trade-surplus contraction will lead almost directly to reduced production and higher unemployment. So Japan, too, is eager to maintain capital exports. The same goes for Germany.

On the flip side, the world's capital importers face a dire situation. The second-largest importers of capital, behind the U.S., until now have been the highly-indebted trade-deficit countries of Europe. The Greek crisis caused a sharp drop in private capital inflows, as investors worried about insolvency. Only official lending has prevented defaults. These countries are unlikely soon to see a resurgence of net capital inflows. The world's second-largest net capital importer, in other words, is about to stop importing capital.

This leaves the U.S., which has the largest trade deficit in the world and is also the world's largest net importer of capital. As capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if capital surges into the U.S.

The U.S., in other words, is not likely to face the "nuclear option" of a Chinese disruption of the U.S. Treasury bond market. It is far more likely to be swamped by a tsunami of foreign capital. This tsunami will bring with it a corresponding surge in the U.S. trade deficit and, with it, a rise in U.S. unemployment.

Therein lies the problem: A reduction in net foreign capital inflows means a welcome decline in the U.S. trade deficit, but the U.S. is likely to see just the opposite, as foreign capital pushes into U.S. markets and the U.S. trade deficit surges. The problem isn't too little capital inflow. On the contrary, the U.S. faces too much.