With the political clash over the U.S. debt ceiling in full swing this week, I’ve been inundated with people asking variants of the same question: with the U.S. in (temporary) danger of defaulting, will China, which holds at least $1.2 trillion worth of U.S. Treasuries, finally get fed up and dump its share of the U.S. national debt? It certainly sounded that way, with the official People’s Daily condemning Congress’ handling of the debt crisis as “irresponsible” and “immoral,” while Chinese diplomats urgently pressed their American counterparts for reassurance.
In fact, as I pointed out in a National Public Radio (NPR) interview on Thursday, China may well be unhappy with the situation, but unless it dramatically changes its approach to its own economy, it’s pretty much “along for the ride.” You can listen to that report, and read the text, by clicking here.
China’s growth model for the past 30 years relies, in large part, on running a trade surplus (selling more than it buys from abroad) in order to maximise capital accumulation and therefore investment at home. At the same it, it encourages inflows of foreign investment into China in order to speed up that process even further, while restricting Chinese money from flowing abroad, in all but a few controlled circumstances. The result is that foreign currency flows into China and piles up, with no outlet to flow back out again. Normally, all those excess dollars that were piling up in China would fall in value relative to the RMB, until the imbalances corrected themselves. However, in order to keep those imbalances in place, the Chinese government intervenes to buy up all those excess dollars (and euros, and yen) itself, to keep its currency from appreciating, and accumulates them as official reserves. It has to invest those reserves somewhere until it decides to use them to buy U.S. goods or make more direct investments with them abroad.
Since the U.S. is China’s largest customer, and since many smaller customers also settle their international trade in U.S. dollars, roughly 70% of China’s $3 trillion reserves are in dollars. In theory, it could sell some of those dollars for other currencies or for commodities, like gold or oil, but in practice, given the huge sums they are already holding, its hard for China to sell off even some of its dollars without undermining the value of what it has left. Even if it could do that, there just aren’t any markets that are as large or liquid as the market for U.S. Treasuries, to accommodate the amounts of money we’re talking about. The fact is, as long as China wants to sell goods for dollars, and decides to accumulate those dollars as reserves rather than spending them on imports or investments, it has little choice not only to hold the Treasuries it already owns, but keep buying more and more.
Outside of central bank circles, this is poorly understood, even within China. Occasionally, we’ll hear about a Chinese general threatening to use China’s holdings of U.S. debt as a weapon. China is the creditor, the U.S. is the debtor, and if the U.S. doesn’t behave, China may very well decide to foreclose. People who talk this way — either from fear, or from arrogance — simply do not know what they are talking about. Unless it dramatically changes its whole approach to its own economy, China is simply in no position to sell its Treasuries, or refuse to buy new ones.
In fact, it’s the U.S. which has been encouraging China to move in precisely that direction: rebalancing its economy in order to run lower surpluses and accumulate fewer reserves — or even reverse the flow by becoming a net importer and net exporter of capital. China has been reluctant to do this because of the short-term pain it would inflict on existing export industries — but in the long-run, it would be to China’s advantage, by giving Chinese consumers greater buying power and a better standard of living. It would benefit the U.S. too, by directing the dollars that China has earned, and would continue to earn, towards buying American goods and investing in American industries, rather than shoring up American deficits. So the day that China actually is in a position to buy fewer U.S. Treasuries will actually be a good day, not just for China, but for Americans as well.
Until then, China and the U.S. are locked in a dysfunctional co-dependence. The U.S. consumes too much and save too little, so it needs to borrow from China. China saves too much and consumes too little, so it has to lend to Americans to let them to keep buying what China produces. Whether this is a good investment or not is — unfortunately — not the issue. So while they may fret and fume, don’t expect China to dump the U.S. debt, unless it finds a way to dump its own reliance on lopsided trade and investment first.