US Image in China Already Tarnished by Debt Fight

In the eyes of China, the biggest foreign holder of US Treasuries, the damage to America's reputation as steward of the world’s safest asset may already be done—even if a last-minute agreement to raise the debt ceiling is hatched.

The partisan infighting alone that’s brought the decision to the brink of a default may accelerate China’s diversification away from U.S. assets, investors said.

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“They think this is totally crazy and like a bunch of kids in a schoolyard,” said David Riedel of Riedel Research, referring to a conversation he had with a high-ranking government official with the city of Beijing. “They can’t believe we would jeopardize how much value U.S. assets have in terms of safety and security over political bickering.”

Riedel, who makes frequent trips to Asia and whose firm focuses on emerging markets, said these thoughts echo similar comments from executives at Chinese companies as well.

“They’re calling me to ask what’s going on,” he said.

China is the largest holder of Treasury securities, according to data from the United States Treasury. However, the country has made hints that it will slowly diversify away from U.S. assets. In October of last year, the country owned $1.18 trillion.

“The high-stakes political posturing is a shock to these countries,” said Jina Ventures’ Ron Shah, who said he’s heard the same thing from contacts in India and the United Arab Emirates. “The point for them is not about whether or not a deal will be reached. The chance that the U.S. will leave this issue lingering is creating material damage to the safety of the U.S. dollar and Treasuries amongst the emerging powers in Asia.”

As Senator Harry Reid on Monday said talks with the GOP were actually going “backward” the two-year Treasury fell, sending its yield to the highest in three weeks. The 10-year yield climbed above 3 percent. Meanwhile, the dollar plunged and gold surged to a new record.

“The damage is done,” said Brian Kelly, head of Brian Kelly Capital and a ‘Fast Money’ trader. “Look at Aussie and Kiwi dollar today, that is where the buyers are.”

Kelly points out that U.S. credit-default spreads are wider than those for other triple-A countries like Finland. This could mean that the market is assuming, at the very least, that the U.S. loses its triple-A credit rating from this showdown.

“The ‘AAA’ mystique has been broken as a result of the political bickering,” said Sean Egan of Egan-Jones Ratings. “However, the main event is redirecting our spending to a more sustainable level and reducing our debt to GDP to a more manageable ratio over the next three to seven years.”

After this political display, it remains to be seen whether China is willing to be that patient, investors said.

To be sure, many traders say that China can’t sell too much of its Treasuries position because it has nowhere else to go. Gold, Euro, Japanese bonds and other options don’t have the liquidity of Treasury markets and are still riskier than dollar assets, they said.

“The Chinese are in the same position as an equity investor who is a 10 percent holder in a company and the CEO is feuding with the Board,” said Nicholas Colas of ConvergEx Group. “The stock is getting hit, but there’s no way to cut down your position. At the end of the day you have no one to blame but yourself, because better due diligence would have meant you looked elsewhere to make an investment.”

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