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Analysis: China's yuan move ups ante on U.S. bond market risks

NEW YORK (Reuters) - China’s move to give the yuan more flexibility reignited worries that the biggest foreign holder of U.S. debt may need to buy fewer Treasuries as it lets its currency rise.

The currency shift revived a bond market debate about the U.S. reliance on foreign investors to finance its swelling budget deficits and keep Treasury yields low.

Near term, there may be little change in the U.S. government’s borrowing costs, which remain cheap -- thanks to muted inflation and persistently strong foreign demand for dollar-denominated assets.

But by 2015, should the ratio of debt to gross domestic product go on rising, the government’s debt burden could become unwieldy. At that stage, any lack of foreign enthusiasm for Treasuries could cause yields to spike higher, some analysts worry.

According to a Treasury Department report to Congress made earlier this month, the U.S. debt will top $13.6 trillion this year and climb to an estimated $19.6 trillion -- or 102 percent of gross domestic product by 2015.

“Once you get out to 2015, I am interested in what is the refunding problem and whether the buyers are the ones we have at the present time,” said Leonard Santow, managing director of economic and financial consulting firm Griggs & Santow in New York.

CHINA, JAPAN AND PRIVATE BUYERS

Much of the net buying of Treasuries over the past year has been from private investors, increasingly seeking safety in the dollar-denominated Treasury market in preference to the euro zone, which is struggling with a sovereign debt crisis, Santow said.

“The big buyers in the last year or two have been the private foreign investors. A lot of these probably are there because they feel it is safe to be in the dollar and in Treasury securities,” Santow said.

China, which holds $900 billion of Treasuries and Japan, with $796 billion, are the two biggest foreign holders of Treasuries via their central banks’ purchases, which have been modest over the past year, he said.

Should private investors’ flight to safety into Treasuries ease, that would likely put upward pressure on bond yields, Santow said.

Foreign investors own nearly $4 trillion, or half of the $8 trillion in U.S. Treasuries outstanding. Foreign central banks own about $2.7 trillion, and private foreign investors have been steadily buying more and hold about $1.2 trillion, Santow said.

SOME NAIL-BITING SCENARIOS

If bond investors sensed that the U.S. interest payments on its debt were becoming increasingly burdensome, they would likely demand higher yields, a situation that would make the government’s task even trickier.

According to the Bank for International Settlements, net global government debt issuance was near $2.7 trillion dollars in 2008, accelerating to more than $4 trillion in 2009.

As a result, “what has to happen is additional inflationary pressures and a turnaround in terms of interest rates,” said Herbert Kaufman, a professor of finance at the W.P. Carey School of Business at Arizona State University.

Over several years, in the United States, inflation pressures could rebound to between 5 percent and 7 percent a year from about 2 percent now. Kaufman said that could roughly double longer-term U.S. Treasury bond yields to between 6 percent and 10 percent, which would ramp up the costs of government borrowing substantially.

The benchmark 10-year U.S. Treasury note is currently yielding about 3.14 percent.

Even in a scenario of muted inflation, the U.S. government’s interest costs on its debt, currently running at about $200 billion a year, could run to between $400 billion and $500 billion a year within five years, Santow estimated. Those costs would likely eat up much of the tax revenues gained from the economy continuing to grow.

A less viable situation would occur if the U.S. economy grew less than about 3 percent a year, curbing tax revenue, Santow warned.

Reporting by John Parry; Editing by Jan Paschal.

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