As US government financing challenges grow, watch for coercive US attempts to transfer the costs and risks to foreign investors, says David Skilling

This post highlights a few selected arguments from my latest client note on capital wars. My central conclusion is that capital wars are more likely, and nearer-term, than widely expected. The note was discussed in a Financial Times column last week:

The rapidly worsening US fiscal outlook – total federal debt has just passed $40 trillion – makes unorthodox macro policy increasingly likely. Measures to induce or require the Fed or private sector financial institutions to buy US Treasuries (fiscal dominance/financial repression) are moving closer to the mainstream of the US policy debate as government borrowing requirements and debt servicing costs continue to rise. The US 10-year yield breaking above 5% this week to almost 20-year highs further highlights these pressures.

The US government financing requirement is growing substantially as foreign demand for Treasuries continues to weaken. Foreign holdings of Treasuries now represent ~30% of marketable Treasuries, down materially from ~50% in 2015. This reduction has been driven by a weakening share of foreign official holdings, such as by central banks, for both economic as well as geopolitical reasons.

This softer foreign demand for US Treasuries is placing upward pressure on US yields. Fiscal dominance and domestic financial repression are plausible US responses to these financing challenges. But these policy measures come with domestic economic, financial, and political costs.

There is likely to be a strong US preference for imposing financing costs on foreign investors. A core organising belief of the Trump Administration is that the US has been systematically ‘ripped off’ across multiple domains. Its response has been to reset the terms of US global engagement: tariffs, military burden sharing, conditional technology access, and more.

This logic is likely to extend to measures to coerce foreign capital to finance US government borrowing, an international form of financial repression. There are already early signs. The US has required investment commitments as part of tariff negotiations with countries such as Japan and South Korea.

As US financing pressures grow, expect coercive measures to direct foreign capital into US Treasuries. Purchases of long-term US Treasuries could be explicitly linked to US security guarantees, access to advanced US technology, US swap lines, and market access.

Essentially every area in which the US has leverage can be exploited to allocate more of the costs and risks of financing the US government to foreign investors. Indeed, from Athens and Napoleonic France to the British Empire, history shows examples of fiscally constrained great powers using instruments of power – military, technology, finance – to extract resources from smaller powers.

These measures will create significant economic and geopolitical tension. Many current account surplus countries in Europe, East Asia, and the Gulf want to retain more capital to deploy domestically, supporting economic growth and financing strategic priorities: military spending, industrial and innovation policy, and so on. Capital wars are the consequence, as growing US demand for foreign capital intersects with a constrained supply of capital to the US and elsewhere.

There is much uncertainty as to how this will play out, and the extent to which the US can monetise its geopolitical, technological, and financial advantages to coerce foreign capital inflows.

But irrespective of the precise trajectory, implementing an extractive financing model would represent a rupture in the international financial system. Capital flows will become an increasingly important vector of global economic and geopolitical tension. Changing patterns of global capital flows will have first-order implications for US and global rates, exchange rates, as well as the geographic pattern of economic activity.

Capital wars are more likely and nearer-term than the consensus expectation. These capital wars are also likely to be much more consequential than the recent trade wars. Firms and investors should position for disruptively changing patterns of capital flows, both coerced and voluntary, as the global system shifts from the market state towards state capitalism.

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*David Skilling ((@dskilling) is director at economic advisory firm Landfall Strategy Group. The original is here. You can subscribe to receive David Skilling’s notes by email here.