Chinese policymakers’ recent statements on the need for an alternative to the US dollar as a reserve currency have given rise to frenzied speculation that the country might at some stage “drop the bomb” —- that is, sell its massive holdings of US Treasuries.

But David Roche, president of independent research consultancy Independent Strategy, reckons the monetary “nuclear option” might instead be exercised by Japan, where public debt runs at 170% of GDP and a new, “clueless, populist, big-spend” government recently took office.

“We’ve all been looking at China and worrying about its intentions for the dollar,” says Roche. “But perhaps we’ve been looking the wrong way down the railway track. Perhaps the train will come the other way —- from Japan —- and knock us down.”

There are two reasons that restrain China’s hand in this matter, reasons Roche. “China owns more than $3 trillion of dollar-denominated assets, much of it in the US. The Chinese central bank alone owns $2 trillion.”

In other words, China’s stock of US Treasury holdings is so high that “any diversification away from the dollar that it wishes to do must be slow and subtle” as otherwise, China will end up hurting its own investments. “If they get out of the dollar in a way that depresses the dollar’s value by, say, 10%, it translates into a 3% GDP loss in China.”

Additionally, it might be tempting for policymakers in China to postpone their ‘dollar trap’ problem and revive manufacturing jobs by returning to the old pattern of exporting goods to the US and recycling the dollar earnings into US Treasuries.

But the risk, notes Roche, is in becoming “overfocussed” on China. “The wild card may be Japan, but nobody recognises it.” The newly elected government of Yukio Hatoyama is “populist, not reformist, and is committed to big spending.” The government has to deal with “totally impossible fiscal arithmetic,” with public debt at 170% of GDP, and “they don’t appear to have a clue about what they are doing. What if they decide to sell their massive holdings of US Treasuries just to fund their own budget deficits?”

In any case, says Roche, Japan cannot be a marginal buyer of US Treasuries because its “external balance situation is horrendous.” But they do own “one helluva lot” of Treasuries, and for a government that is so committed to spending, the temptation might run high, says Roche.

Although the US current account deficit fell in recent months as a consequence of a slowdown in US consumer spending and a short-term increase in US savings rates, US reliance on the funding and goodwill of foreign governments increased, Roche notes.

“Foreign private inflows into the US are falling; foreign private sector investors are funding less and less of the US external financing requirement, and the flow from foreign governments and central banks is increasing.” This renders the US vulnerable, says Roche. 

In his reckoning, reigniting the credit bubble, as the US administration is doing, will accelerate the inevitable ‘dollar crisis’. “If the consumer has learnt nothing —- which is likely —- and banks offer him money, he will trot off to the market and buy stuff, as the cash-for-clunkers programme proved. You’ll get a bubble economy, savings rates will come down drastically, and US external financing requirement will rise.”

If at that point, China or Japan refuse to pitch in, “the dollar will go down very sharply, and US interest rates at the long end will shoot up, you’ll get a vertical yield curve and the bubble will burst.”

How long will that take? “One to two years —- certainly not a decade,” says Roche.