By Shawn Tully
March 22, 2018

Donald Trump is on the warpath against China over trade: On Thursday afternoon, he announced plans to impose a range of tariffs against hundreds of lines of Chinese-made goods. But it’s crucial to recognize where those dollars that China gains from selling us their goods are going.

The surplus flows right back into U.S. Treasuries, to fund our gigantic and ballooning federal deficits, in addition to providing tons of growth capital to stateside industries—all at bargain rates. Hence, the U.S. is extraordinarily dependent on cheap loans from China. And our reckless fiscal path, made far more treacherous by the recent tax cuts and spending hikes, is greatly worsening that dependence.

Message to Trump: While you’re battling with China, think hard about what happens if the Chinese start snubbing U.S. debt.

Read Fortune‘s recent feature, “How Debt Could Blow Up the Trump Economy.”

To see why that’s such a threat, it’s important to understand how the U.S. has been able to keep growing at a moderate but steady pace despite an explosion in deficits and debt. In most periods, the U.S. Treasury’s brobdingnagian borrowing would have pushed interest rates skywards as the federal government competed for the limited pool of domestic savings with capital-hungry businesses. But rates have remained extremely low because the U.S. has been able to tap a record pool of foreign savings, from nations lured by the matchless safety of U.S. government bonds and the excellent returns on our private sector equity and debt alike.

And our paramount foreign creditor, and leading enabler of our rampant borrowing, has been our biggest trading partner: China. Today, the Chinese own around $1.2 trillion in Treasuries; if they were to lose their appetite for our bonds, the economic repercussions could be catastrophic.

An outcome the U.S. can’t afford

China is already on the road to purchasing less of our newly issued debt, whatever happens on the trade front. Although its annual trade surplus with the U.S. has stabilized at around $350 billion, it’s well below its peak of a few years ago. And China’s waning power as an exporter, primarily due to the stronger yuan, has substantially lowered its holdings of foreign reserves. So just when the U.S. deficit is set to jump from $667 billion in 2017 to close to $1 trillion in this fiscal year, and an estimated $2.4 trillion by 2027 if current spending and tax policies continue, China will be meeting a lot less of our fast-growing need for funding. Put simply, the supply of Treasuries will explode, and foreign demand will likely prove more reserved than in the past, thanks in large part to shrinking purchases from China.

That scenario already threatens to cause precisely what the U.S. can’t afford: a spike in interest rates. Of course, yields are bound to rise somewhat because of the Federal Reserve’s pledge of serial short-term rate increases and a newly resurgent economy. But the Congressional Budget Office is forecasting that the 10-year Treasury yield will reach only 3.7% by the end of 2027, up from around 2.8% today. Even if yields stabilize in that range, interest on the debt would reach almost $1.1 trillion by 2028, according to a forecast from the Committee for a Responsible Federal Budget. (That’s the equivalent of two-thirds of projected spending for Social Security a decade hence.)

Given the weight of those carrying charges, any significant rise in “real,” or inflation-adjusted yields would prove disastrous. (What matter is real not nominal rates, since the Treasury would recoup moderate increases in inflation via higher tax collections on higher incomes.) A real-rate surge would increase borrowing costs for Uncle Sam and for businesses, and make it ever more expensive for the federal government to meet its obligations on everything from military spending to retirement benefits.

It’s conceivable that Trump’s feud with China will trigger the most extreme form of retaliation: A sudden pullback on purchases of U.S. debt. Today, the Chinese own around $1.2 trillion in Treasuries, 20% of the $6 trillion in federal debt held by foreign sovereign investors; the Japanese hold another $1.1 trillion. If the Chinese decline to roll their money into new Treasuries as the old ones mature, the worldwide market for U.S. sovereign debt would shrink, causing a sudden rise in real rates.

A heavy weight to carry

Imagine that by 2028, yields on the ten-year rise not to 3.7%, but an extra point, to 4.8%. By Fortune’s estimates, total federal debt would jump from a projected $33 trillion to $36 trillion, and annual interest expense would soar from $1.1 trillion to $1.5 trillion. That’s equal to 75% of projected spending on our biggest entitlement, Medicare. And that rising obligation would crowd out even further the government’s ability to invest in other spending that would bolster the economy.

Granted, that’s not the most likely outcome. “It’s more likely that China would respond to tariffs by devaluing the yuan, or by making it much more difficult for U.S. companies to do business in China,” says Mark Zandi, chief economist at Moody’s Analytics. The reason is that a sharp increase in rates would tank the value of the U.S. bonds in China’s giant portfolio of foreign reserves. On the plus side for China, it would also counteract pressure on the dollar from China’s trading the maturing Treasuries for local currency, but even a somewhat stronger dollar wouldn’t compensate for the drastic drop in the price of China’s holdings of fixed-income securities.

China’s motive for ditching U.S. debt doesn’t have to be anger or retaliation. Its leaders could reckon that protectionism will hobble U.S. growth; if that were to happen, fears that America can’t handle its debt and deficits might prompt investors worldwide to demand higher rates for the extra risk of holding Treasuries. Then, the Chinese and other overseas lenders would rush for the exits before a looming spike in yields pummels prices of U.S. bonds.

Still, it’s possible that the bad blood over trade could escalate. It’s a case where one nation—China—gets hit hard, and the other nation, the U.S., gets crushed. China can afford a fight where it retaliates against our tariffs by shunning our debt. But its opponent already totters, weakened by an addiction to debt. Trump should tread carefully before risking a fight that America can’t afford.

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