The sum and substance of holding US Treasuries

This article appeared originally in Gulf News: link to original article

Why do countries invest in US Treasuries? What makes them an attractive investment? What are the pros and cons for countries holding treasuries?
Do countries with currencies pegged to the US dollar benefit the most from holding Treasuries? What happens when the Fed hikes the interest rate?
When return on investments is calculated, a main component in the return-risk calculation is the one labelled “risk-free”, i.e., the return on US Treasuries. And so to answer the first and second questions, holding US Treasuries (US debt) means a constant flow of return in US dollars.
Take the 2008 financial crisis for instance. According to the Treasury, US debt surged significantly where “debt held by the public” — Treasuries held by all investors except the federal government — increased from below $5 trillion (Dh18.36 trillion) before the crisis to more than $10 trillion post-crisis. What happened? Countries bought Treasuries that the US needed to issue to fund bailing out its economy.
In answering the third and forth questions, a quick look at the top 10 holders of US Treasuries shows that being pegged to the dollar is not associated with a country’s holdings of US debt. To illustrate, Hong Kong is the only country among the top 10 with its dollar pegged to the US dollar.
When the top 20 countries are considered, Saudi Arabia is another that has its riyal pegged to the US dollar. For a few countries, holding US debt ensures that they have a reliable inflow of US dollars to pay back their own debt that is issued in US dollars — as in Japan’s case.
For others, re-investing US dollars into the US economy by buying Treasuries reduces pressures to expand money supply in their own economies. It also ensures an upward pressure on the US dollar versus their own currencies — as in China’s case.
Another explanation is for countries that rely heavily on imports, exports, and re-exports, highlighting and inflating their need for US dollars to manage all trade transactions — examples being Singapore’s case and also of Hong Kong.
To sum up, listed explanations and other ones could be grouped into one major benefit for countries — having a constant inflow of US dollars. On the other hand, the main benefit for the US is allowing it a free hand to bail out its economy when needed, and to fund the gap between US generated revenues and their domestic or other expenditures.
What about the cons? For the US, it’s the expansion of US debt, which is not an issue as long as countries and other investors in its Treasuries maintain the same trust level in the US role as guarantor of the world’s economy. Put differently, as long as no one comes knocking the Fed’s door to cash their investments.
In Kennedy’s own words; “if everyone wants gold, we’re all going to be ruined because there is not enough gold to go around.”
So what if everyone came wanting US dollars?
And that’s the con of holding US Treasuries for all major investors in US debt — but only if trust is lost. Now, what happens when the Fed hikes rates? Countries are encouraged to purchase additional Treasuries, as part of a general direction to increase investments in the US.
This is especially crucial for countries with currencies pegged to the US dollar, where increasing their inflows of US dollars would balance the peg costs. And for a Fed wanting to shrink its massive assets holdings, this is timely and is a win-win situation.
The end result would be having more US debt held by foreign investors, with shifts in debt ownership from domestic to foreign. The last question that I want to leave you with: how long can a country maintain its currency’s peg to the US dollar with a depreciating currency, shrinking revenues of US dollars, Fed rate hike, surging import prices, and $124 billion of banks’ foreign liabilities?