As the COVID-19 pandemic continues to ravage the global economy, many observers are becoming concerned with the rise in U.S. government debt. The unprecedented fiscal measures undertaken to prevent a “Greater Depression” has heightened this anxiety, as Washington approved more than two trillion dollars in loans to businesses, direct payments to citizens, and other forms of financial assistance.
It is China, not the United States, who is foremost interested in keeping U.S. debt; by weaponizing its Treasury bonds, Beijing will lose more than gain.
On top of all that, amid the recent Sino-American tensions, there have been rumors that Beijing will weaponize its U.S. debt portfolio and slash its U.S. debt holdings—worth more than one trillion dollars. As South China Morning Post reports, “China may move to reduce its vast holdings of US Treasury securities in the coming months in response to a resurgence in trade tensions and a war of words between the world’s two largest economies over the origins and handling of the coronavirus outbreak.”
Such fear is misguided, however. It stems from a flawed understanding of the notion of “sovereign debt” and the realities of the modern global economic environment. China’s holdings of the U.S. debt do not provide it with overarching economic influence over the United States; they are merely how Beijing runs a trade surplus with America (to ensure the value of China’s exports exceeds the cost of its imports). China’s debt holdings do not provide any political leverage to China, nor does their sell-off present a threat to the American economy.
It is China, not the United States, who is foremost interested in keeping U.S. debt; by weaponizing its Treasury bonds, Beijing will lose more than it gains.
CONVENTIONAL WISDOM vs. THE REALITY OF THE TRADE DEFICIT
The conventional wisdom concerning the purchases of U.S. government bonds by China is the following: America has a vast current account deficit; they import much more than they export. The rise in the current account deficit is proportionate to the increase in U.S. debt; the trade gap, by definition, must be filled by borrowing to offset the imbalance or the consumption of goods and services will have to drop.
“The culprit is a large saving deficit; the country has been living beyond its means for decades and drawing freely on surplus savings from abroad to fund the greatest consumption binge in history.”
Because the value of American imports exceeds exports, Washington needs to finance this difference by borrowing from other countries—countries such as China and Japan—to finance what’s known as its “consumption binge” (inordinate levels of consumption, financed by debt). “The culprit is a large saving deficit; the country has been living beyond its means for decades and drawing freely on surplus savings from abroad to fund the greatest consumption binge in history,” writes Yale’s Stephen Roach.
Since so much of the American way of life relies on its consumption habits, it follows that conventional wisdom assumes that the U.S. needs China (and Japan, and other countries with large trade surpluses substantial enough to buy American debt). This way of thinking, nevertheless, is flawed.
However paradoxical it may seem, a rise in trade deficit does not result in the rise in debt. Instead, it is the rise in the foreign holdings (or American financial assets owned by foreigners) of U.S. debt that results in the trade gap.
Even if we assume that China purchases U.S. debt to subsidize America’s “consumption binge,” then a potential sell-off of U.S. Securities will inflict considerable damage on China and backfire. Remember, much of China’s economy still depends on exports, and it has a large trade surplus with the U.S. (it exports more than it imports). If Americans are no longer able to “finance” their consumption, the demand for Chinese goods and services will drop in the U.S., as will China’s economic well-being.
If China were to sell off U.S. Securities, Chinese exporters will face falling profits and be forced to layoff thousands of workers, sending their economy further into a tailspin. As an old saying puts it, “if you owe $100 to a bank, that’s your problem; but if you owe a bank $100 million, then this is the bank’s headache.”
So why does China purchase U.S. debt when it puts them in a precarious position?
THE REAL REASON WHY CHINA BUYS U.S. DEBT
We should not confuse the chain of causation: it is not the trade deficit that forces the U.S. to borrow from abroad. It is the rise in foreign holdings of U.S debt that increases the trade gap. That, in turn, reflects on the dollar’s status as the global currency: many countries purchase dollar-denominated assets simply because they need dollars to trade with other countries.
“The biggest effect of a broad scale dump of US Treasuries by China would be that China would actually export fewer goods to the United States.”
China, Japan, and many other countries have export-dependent economies. They, therefore, make maneuvers on the global financial markets that allow them to run trade surpluses. In particular, their central banks purchase U.S. dollar-denominated financial assets—government bonds.
Put differently, in today’s globalized economy, the United States runs a trade deficit because of foreign money flows that push up the value of the dollar. Meanwhile, countries that appreciate (or increase) the value of the dollar by buying dollar-denominated financial assets, such as China and Japan, run the obverse of trade deficits—trade surpluses. (Estimates on the dollar’s over appreciation range from six to twenty-seven percent).
Increased demand for dollars pushes up its price, making it overvalued with respect to other currencies. An overvalued dollar, in turn, harms U.S. exporters. With each rise in the value of the U.S. dollar against foreign currencies, American companies will obtain fewer dollars for the same amount of foreign currency they receive when selling their products abroad.
Conversely, the dollar’s appreciation cheapens the imports, thereby leading to an overreliance on imported goods as opposed to domestically manufactured ones. The U.S. saw the devastating consequences of this when their import-dependent economy could not pivot quickly enough to meet the demands for medical manufacturing brought on by COVID-19.
The increase in imports, and the fall in exports, enhance America’s trade deficit, allowing China, Japan, and other countries to run trade surpluses. China purchases U.S. government bonds not out of a feeling of altruism for Americans, but because of pure self-interest: it needs markets for its goods and services. If it stops purchasing Treasury securities, the dollar’s price will fall relative to the yuan, dramatically reducing China’s trade surplus with the U.S.
Moreover, given that the U.S. dollar is a global currency and is extensively used in international transactions. China needs dollars to be able to trade with other nations, which it obtains by buying up the U.S. Treasury securities.
The purchases of sovereign U.S debt is an instrument of China’s economic policy that is foremost aimed at benefiting China. Therefore, in the unlikely event that Beijing unloads its holdings of U.S. debt, China will be the first to lose; China’s trade surplus with the U.S. will shrink or even disappear. As economist Scott Miller puts it, “The biggest effect of a broad scale dump of US Treasuries by China would be that China would actually export fewer goods to the United States.”
U.S. DEBT AS A SAFE HAVEN
China’s holdings of U.S. debt ($1.1 trillion) represent just a little over 4% of the total U.S. debt, which is far less than Japan ($1.27 trillion), the Social Security Trust Fund ($2.89 trillion), and the U.S. Federal Reserve ($8 trillion). Selling these holdings will not have a dramatic impact on the liquid and deep market of U.S. government bonds.
In the era defined by globalized, increasingly interdependent economies, if one of the big players like the U.S. falls, everyone else will too.
Furthermore, America’s financial markets are the most liquid, open, transparent, and well-governed in the world. International investors trust U.S. institutions, and America has the world’s largest economy. As a result, there is always ample demand for U.S. financial assets, including U.S. Treasuries, because of the U.S. dollar’s “safe haven” status.
There is, therefore, always ample demand for the U.S. Treasuries, especially with the global economic outlook worsening from the coronavirus pandemic. Even if China sells off U.S. debt, there will always be somebody—from America’s allies, private companies and financial institutions to the Federal Reserve, the lender of the last resort—willing to or interested in purchasing them. The health of the global economy hinges on the state of the U.S. economy.
For example, as a result of rising tensions between the U.S. and China over Beijing’s consolidation of power in Hong Kong, we saw a rise in the value of the dollar. As CNBC reports, “The dollar edged higher on Wednesday as worries about the U.S. response to China’s proposed security law for Hong Kong supported safe-haven demand for the greenback.” Investors were worried about the economic impact of a worsening U.S.-China relationship, so they began purchasing safe dollar-denominated assets.
In the era defined by globalized, increasingly interdependent economies, if one of the big players like the U.S. falls, everyone else will too. As Michael Hirson, the former chief representative for the U.S. Treasury Department in China, put it, “China dumping Treasuries could panic global markets without hurting the US,” but it would “hurt China’s reputation as a source of stability and responsibility.”
THE FEAR IS MUCH WORSE THAN THE RISK
One could argue that a potential Chinese sell-off would trigger a rise in interest rates, making it harder for the U.S government, businesses and consumers to borrow, exacerbating the difficulties wrought by the COVID-19 pandemic. This is because there is an inverse relationship between interest rates (or yields) and the price of a financial asset: the higher the demand for an asset, the higher the price, so the issuer of the debt (the U.S. government) can offer lower interest rates to purchasers. Conversely, if there is less demand, interest rates will presumably rise.
“U.S. ultimately holds the high cards [in case of the Chinese sell off]: the Fed is the one actor in the world that can buy more than China can ever sell.”
However, history shows there is no reason to worry about sudden spikes in interest rates were Beijing to unload its holdings of U.S. Treasuries. For example, between mid-2014 and late 2016, China sold approximately $600 billion worth of U.S. government bonds, but interest rates on U.S. debt not only did not rise—they fell. During the 2011 U.S. debt-ceiling crisis, when S&P downgraded America’s sovereign credit rating amid Congress’s inability to raise the debt ceiling, “markets promptly gobbled up more Treasuries than ever; the yield on the ten-year bond soon fell by more than a percentage point,” The Economist notes.
Yields on U.S. Treasuries are ultimately determined by global economic dynamics rather than the actions of the country which holds a little over 4% of the total U.S. debt. In fact, as paradoxical it may seem, a massive sell-off by China means yields on Treasury securities will most likely not rise, but lower (or the rise will be trivial); investors around the world would fly to safe assets as the economic situation worsens. “U.S. ultimately holds the high cards [in case of the Chinese sell off]: the Fed is the one actor in the world that can buy more than China can ever sell,” writes Brad Setser of the Council on Foriegn Relations.
There is no reason for Washington to worry about these rumors that China could cut its holdings of the U.S. Treasuries. These threats are meant to instill fear, but in reality, they are groundless. Beijing knows full well that doing so would be a self-defeating tactic. If China decreases its holdings of U.S. Treasuries, it may, in fact, help the American economy, while inflicting considerable damage on China.
It’s not only that these fears are misguided. If the general sentiment driven by fear of the Chinese retaliation prevails in Washington, then the U.S. will become constrained in its policy towards China—lest Beijing exercises the dreaded “nuclear option” and collapses the U.S. economy.
Fear of China unloading U.S. debt—unjustified, unreasonable, and groundless fear—is much more dangerous than the move itself.