China’s large (and growing) holdings of U.S. government debt have been a point of discussion for a number of years now. But they’ve really come to the forefront as the U.S. faces the (unlikely) prospect of a sovereign debt default.
However the U.S. resolves the debt ceiling issue, the fact is that China owns a lot of U.S. government debt. Here, we explain why that is – and what it means (for both the U.S. and for China).Chinese ownership of U.S. government debt: the facts
- China is the largest single foreign holder of US government debt; in May 2011 it held almost 26 percent of all foreign-held Treasury securities. See this graph Major Foreign Holders of U.S. Treasury Securities, June 2010-May 2011.
- China’s holdings of US government debt have been increasing – from about 6 percent of all foreign-held Treasurys in 2000 to about 26 percent today. See this graph Major Foreign Holders of U.S. Treasury Securities, 2000-2010.
- After five months of reducing its holdings of US Treasury securities, in April 2011 China increased its holdings. China bought more Treasurys in May, too, bringing its total holdings of US government debt close to $1.16 trillion. See this graph China's Holdings of U.S. Treasury Securities, June 2010-May 2011.
- China is voicing concern about the prospects of a U.S. government debt default. “We hope that the U.S. government adopts responsible policies and measures to guarantee the interests of investors,” said Hong Lei, a Chinese foreign ministry spokesman, at a news conference. Li Daokui, an adviser to the Chinese central bank, urged US politicians to assure China that its massive investments in Treasuries are safe, Reuters reported. And the State Administration of Foreign Exchange, which manages China’s currency reserves, posted on its website “We hope the US government will earnestly adopt responsible policies to strengthen international market confidence, and to respect and protect the interests of investors.”
There are a few factors behind China’s huge holdings of US government debt. The first and most significant is China’s intervention in the currency markets to keep the value of the yuan artificially low. Rather than allowing the relative value of the yuan to change based on market conditions – to float freely – China has in essence pegged the value of the yuan to the value of the U.S. dollar. That peg keeps the value of the yuan below what it would be if the yuan were freely traded (economists argue about how much the yuan is undervalued, though most estimates range from 15 to 40 percent).
So how does China do that – how does China keep its currency undervalued relative to the U.S. dollar? It uses yuan to buy U.S. dollars, putting more yuan into the market to keep its price fixed (and relatively low). But then China ends up with substantial holdings of U.S. dollars.nswer Part B: The US-China trade imbalance leads to huge dollar reserves
The second reason China owns so much U.S. government debt is that U.S. consumers buy so much from China (much more than China buys from the U.S.). If the trade balance between China and the U.S. were actually balanced – meaning China imported about as much from the U.S. as it exported to the U.S. – then the dollars China received from Americans buying their goods (exports) would be sent back to the U.S. to purchase American goods (imports). And vice versa.
But because China sells so much more (exports) to the U.S. than it buys (imports), it ends up with a big surplus of dollars. As Colin Barr writes in Fortune, “There is no great reason to expect funds to stop flooding into the United States as long as others continue to base their economies on selling stuff to us.”Answer Part C: Hot money flows into China leads to huge dollar reserves
A third reason that China owns so many dollar-denominated assets is because of speculative “hot money” flows into China. Though China tries hard to limit speculative investments in its currency, there has still been so-called “hot money” flows into China. Hot money refers to capital inflows from overseas investors who anticipate that the yuan will appreciate in the near future.
As FutureofUSChinaTrade.com expert commentator Geng Xiao explained, “The huge asset bubble in China is generated by the expectation that the renminbi (NYSEARCA:RMB) is going to appreciate. So a lot of people are investing in RMB assets and selling the U.S. dollar assets to the central bank – Chinese and foreigners are doing it. So you see a huge foreign exchange reserve bubble in China. The central bank of China is taking a lot of dollars.”
In fact, analysts suggest that even as China continues to allow the yuan to slowly appreciate, it might do so “in an unpredictable way in an effort to limit RMB speculation and inflows of ‘hot money,’ which could destabilize China’s economy.”Answer Part D: FDI in China leads to huge dollar reserves
Finally, China owns a lot of dollar-denominated securities because of foreign direct investment in China. U.S. companies investing in China (whether through a joint venture or other partnership with a Chinese firm, by building a facility, or by buying a Chinese firm or other assets) use U.S. dollars to make their investments – putting more American cash into China’s coffers. As Ronald McKinnon and Gunther Schnabl write, China’s “ongoing current account surplus coupled with huge net inflows of FDI have a double-barreled impact on increasing China’s dollar liquidity.”
For these four reasons, China ends up with huge holdings of U.S. dollars. In fact, China’s total currency reserves rose to almost $3.2 trillion in April, up 5 percent from March, according to China’s National Bureau of Statistics. About two-thirds of those currency reserves (“the world’s largest by a wide margin,” according to the Financial Times) are estimated to be in dollar-denominated assets. (China won’t reveal the composition of its foreign reserve holdings.)
What to do with those dollars? China could simply sit on its dollar holdings, but like any smart investor, they would prefer to earn a return. So China uses its U.S. dollar holdings to buy dollar-denominated debt and other investments, including U.S. Treasury securities (which are still considered the safest, most liquid investments in the world).
“As [China] generates dollars, they ultimately have to invest them in something,” Larry Dyer, a U.S. interest rate strategist with HSBC Holdings Plc in New York, told Bloomberg. “The size of the Treasury market makes it one of the few things that can absorb their flows without having a significant price reaction.”
Of course, China also buys securities denominated in other currencies (including the euro and the Japanese yen), in part because foreign exchange holdings facilitate trade and reduce speculation against the yuan. China has also created a sovereign wealth fund to invest some of its foreign reserves. And they have encouraged Chinese companies – flush with U.S. dollars from American purchases of China’s exports – to spend money overseas, to invest directly in other countries (including the U.S.) and to acquire natural resources around the world.
But still, there is no other market big enough or liquid enough to replace the U.S. bond market as the principal end-spot for China’s huge foreign money holdings. “China has no choice but to keep buying,” Zhang Ming, an expert at the Chinese Academy of Social Sciences told the New York Times. “After all, U.S. Treasury bonds are still the largest and most liquid investment product in the world.”
In a statement posted to its website, China’s State Administration of Foreign Exchange “reiterated a long-standing pledge to diversify China’s foreign exchange reserves, but also repeated comments made last year about the difficulty of investing in precious metals and industrial commodities. Using official reserves to acquire such assets would only push up their price, and so hurt the Chinese individuals and companies that are already buying large amounts of gold, oil and other commodities,” reported the Financial Times.
As Eswar S. Prasad, a Cornell economics professor and former head of the China division at the International Monetary Fund, told the New York Times, “There’s really nothing different China can do. Even if they felt the United States was going off a cliff, there’s no other place for them to put their money.”Question #2: What are the implications – for the U.S. economy and the Chinese economy – of China’s huge U.S. Treasurys holdings? Answer Part A: A possible (if highly unlikely) US debt default makes China really, really nervous
The idea of a default on U.S. Treasury securities makes everyone really nervous (as it well should). Christine Lagarde, the new head of the International Monetary Fund (NYSE:IMF) called the consequences of a U.S. default “real nasty.” She said that a default would cause interest rate hikes and stock market falls across the world. “Not just for the United States, but for the entire global economy, because the U.S. is such a big player and matters so much for other countries.”
In all likelihood, the White House and Congress will come to some agreement to raise the debt ceiling before August 2. As PBS reports, “Susan Irving, who does budget analysis for the General Accounting Office, points out that in the past, the debt limit has always been raised in the nick of time, as during the last such crisis in 1995-96.”
If Congress doesn’t raise the debt ceiling, the U.S. Treasury Department will not be able to meet all of its daily payment obligations (revenues cover about 50 cents of every dollar the Treasury spends). However unlikely it might be that the Treasury would have to choose who to stop paying, it’s worth considering.
Most analysts believe that even if Congress fails to raise the debt ceiling, the U.S. Treasury Department would ensure that holders of Treasury securities are paid first (along with Medicare, Medicaid and Social Security; unemployment insurance; and defense contractors). According to analysis by the Bipartisan Policy Center, the Treasury might instead stop paying active-duty soldiers, federal workers, veterans, and taxpayers due refunds (though Ben Bernanke, chairman of the Federal Reserve, rejected the notion that the Treasury would prioritize who to pay and not pay).
But as unlikely it is that the Congress will not raise the debt ceiling; as unlikely it is that even if the debt ceiling weren’t raised the Treasury would default on Treasury securities, what if the U.S. were to default on its debt? The prospect of a sovereign debt default isn’t zero, and that makes China understandably nervous, for a number of reasons:
- If the Treasury stops paying bondholders, China could see significant capital losses (it owns nearly $1.16 trillion in U.S. Treasury securities).
- A US government debt default could send the value of the dollar plummeting. That would even further reduce the balance sheet value of China’s dollar-denominated assets.
- A default that sent US financial markets into turmoil again and raised borrowing costs for US consumers could significantly decrease American purchases of Chinese consumer goods.
Still, the prospect that the U.S. would actual default on its Treasury securities is very unlikely. “The market is assigning a near-zero probability of an actual default happening,” Thomas Simons, a money market economist at Jefferies & Co. told the Washington Post. “Until the there is a significant event that makes Treasurys much more dangerous, foreign governments are going to continue to invest in the U.S.”
Simons is referring to the fact that China – and other holders of U.S. Treasurys – increased their holdings in May, even after it was clear that the U.S. Congress would soon need to raise the debt ceiling, or else. That’s in part because there’s not really anywhere else for these investors to put their money, but it’s also because faith still remains strong that the U.S. government will honor its bond obligations.Answer Part B: A possible (if highly unlikely) sudden sell-off of Treasurys makes the U.S. really, really nervous
So China doesn’t really have a better option for investment of its U.S. dollar holdings than Treasury securities. And, it’s hard to imagine a scenario within which suddenly selling off its Treasury holdings in large quantities would be in China’s economic interest. There are a number of reasons why:
- A sudden, large sell-off of China’s dollar-denominated holdings could diminish the value of those securities in international markets (flooding the market with sudden supply often leads to sharp reductions in value). That means large losses on the sale – China likely would not be able to sell those securities for their book value. And, it would decrease the value of China’s remaining dollar-denominated holdings. (Same result if China’s fire sale led to a devaluation of the dollar, which it probably would.)
- If China’s sudden sell-off slowed economic growth and/or raised interest rates in the U.S. (which it probably would), that would mean less U.S. demand for imported Chinese goods. Plus, the U.S. funds its trade deficit with borrowed money – if investors like China didn’t buy U.S. debt, then the U.S wouldn’t be able to buy more goods than they sell. Because China’s economy is heavily dependent on exports to the U.S., a reduction in U.S. demand could lead to a significant slowdown in China’s economic growth (which presents all sorts of problems, including social stability concerns, for China’s leaders).
To paraphrase Keynes, if you owe your banker $1,000 you’re at his mercy. If you owe him a million, he’s at yours. In other words, the U.S. and China are in this together. China owns so much U.S. government debt that it really doesn’t have many alternatives to complaining about America’s fiscal mismanagement. Quoted in the New York Times, Andy Rothman, an analyst in Shanghai for the investment bank CLSA, said “It is the ultimate ‘too big to fail’ global relationship.”
It’s Keynes’ banker analogy. If China tried to dump its holdings of dollar-denominated assets, that would “lead to financial losses for the Chinese government, and any shocks to the U.S. economy caused by this action could ultimately hurt China’s economy as well" (see here). (It’s probably less about being a “responsible investor” than it is about looking after their own self interest.)
But still, what if China launched a sudden sell off? How would that affect the U.S.? According to a Congressional Research Service report from earlier this year, “In the unlikely worst case scenario, if China stopped buying Treasury securities at a time when the U.S. budget deficit is unusually high, it could destabilize financial markets by throwing into doubt the U.S. government’s ability to sustain its current fiscal policy.”
In addition, a sudden sell-off by China could dampen U.S. economic growth (at a time when growth is anemic at best). “Especially if such a move sparked a sharp depreciation of the dollar in international markets and induced other foreign investors to sell off their U.S. holdings as well. In order to keep or attract that investment back, U.S. interest rates would rise, which would dampen U.S. economic growth, all else equal" (see here).
And, according to a Congressional Research Service report, “The initial effect [of a sudden sell-off of Treasurys by China] could be a sudden and large depreciation in the value of the dollar, as the supply of dollars on the foreign exchange market increased, and a sudden and large increase in U.S. interest rates, as an important funding source for investment and the budget deficit was withdrawn from the financial markets.”
Indeed, China’s continued purchased of Treasury securities has a number of positive implications for the U.S. economy (at least in the short term):
- Capital investment increases because the greater demand for U.S. assets puts downward pressure on U.S. interest rates, and firms are now willing to make investments that were previously unprofitable.
- Interest-sensitive household spending, on goods such as consumer durables and housing, is also higher than it would be if capital from China did not flow into the United States.
- China’s purchases of Treasurys fund U.S. budget deficits (see here).
So “while the Obama Administration has pushed China to appreciate its currency, it has also encouraged it to continue to purchase U.S. securities. Some analysts contend that, although an appreciation of China’s currency could help boost U.S. exports to China, it could also lessen China’s need to buy U.S. Treasury securities, which could push up U.S. interest rates" (see here).Ultimately, as long as everything proceeds business as usual, China’s huge Treasury holdings simply uphold the status quo
The status quo is a relatively undervalued yuan, which keeps China’s exports artificially cheap (and its imports artificially expensive), and China’s export-led growth engine in overdrive. The status quo is a U.S. that is addicted to spending more than it earns (and financing the balance). And a sizable US-China trade deficit.
Cleary, a sudden and massive sell-off of U.S. Treasury securities by China is not in either country’s economic interest. But what if China were to slowly reduce its holdings of U.S. debt? If that reduction was the result of China allowing the yuan to appreciate and transitioning to a consumption-based economy, then that would be good for the U.S. (and for China).
Although a falling dollar may harm China’s short-term growth via reduced Chinese exports (and export sector-related employment), it would also improve China’s terms of trade with the United States, raising China’s overall consumption since it could now spend less to acquire the same amount of American goods (which would also create jobs in other sectors of the economy because of increased consumer purchasing power).
For the U.S., according to experts at the Congressional Research Service, “economic theory suggests that a slow decline in the trade deficit and dollar would not be troublesome for the overall economy. In fact, a slow decline could even have an expansionary effect on the economy, if the decrease in the trade deficit had a more stimulative effect on aggregate demand in the short run than the decrease in investment and other interest sensitive spending resulting from higher interest rates.”So what’s the take-home message?
- China has massive U.S. dollar reserves (“the world’s largest by a wide margin”). That’s because of its exchange rate policy; its huge trade surplus with the U.S.; some hot money flows into China; and foreign direct investment in China.
- China invests much of its dollar reserves in U.S. Treasury securities (and other dollar-denominated assets). Indeed, China is the largest single foreign holder of US government debt; in May 2011 it held almost 26 percent of all foreign-held Treasury securities.
- A possible (if highly unlikely) US debt default makes China really, really nervous because it could cause China significant capital losses; it could cause a dollar depreciation (which reduces the value of China’s dollar-denominated assets, and leads to relative appreciation of the yuan); and it could lead to a reduction in American demand for Chinese imports.
- A possible (if highly unlikely) sudden sell-off of Treasurys makes the U.S. really, really nervous because it could destabilize global financial markets (again); it could raise U.S. borrowing costs; and it could dampen already anemic U.S. economic growth.
- It’s hard to imagine a scenario within which suddenly selling off its Treasury holdings in large quantities would be in China’s economic interest. That’s because a sudden, large sell-off of China’s dollar-denominated holdings could diminish the value of those securities in international markets; and if China’s sudden sell-off slowed economic growth and/or raised interest rates in the U.S. (which it probably would), that would mean less U.S. demand for imported Chinese goods.
- To paraphrase Keynes, if you owe your banker $1,000 you’re at his mercy. If you owe him a million, he’s at yours. In other words, the U.S. and China are in this together.
- A slow reduction in China’s dollar-denominated holdings, especially if it were the result of allowing the yuan to float freely, would yield positive gains over the long term for both the U.S. and Chinese economies.
Over the long term, business as usual is not sustainable – China must consume more and the U.S. must save more. From the Congressional Research Service report:
“The United States continues to press China to make its currency policy more flexible so that the yuan will appreciate more significantly against the dollar and to adopt policies that promote domestic consumption as a major source of China’s economic growth (as opposed to export and fixed investment-led growth that has resulted from China’s currency policy). This is viewed as a major step towards reducing global trade imbalances, including the large U.S.-China trade imbalance.
“However, in order for that to occur, the United States must also boost its level of savings. If China consumed more and saved less, it would have less capital to invest overseas, including in the United States. Thus, if the United States did not reduce its dependence on foreign savings for its investment needs, and China reduced its U.S. investments, the United States would need to obtain investment from other countries, and the overall U.S. current account balance could likely remain relatively unchanged.”
Done right – slowly, over time – that rebalancing will be good for China and good for the U.S.
What do you think about the implications of China's massive US government debt holdings? Do you think that's sustainable over the long run? Share your thoughts below.
 The official name of China’s currency is the renminbi (RMB), which is denominated in yuan units. Both RMB and yuan are used interchangeably to describe China’s currency.
 Between July 2005 and July 2008 China allowed the yuan to appreciate, about 21% total against the dollar. Beginning in June 2010 China once again allowed appreciation, a total of about 3% through December 2010.
 Global Insight predicts that China’s foreign exchange reserves will increase to $3.47 trillion by the year 2015 – an increase of $619 billion over 2010 levels. See http://www.fas.org/sgp/crs/row/RS21625.pdf
 See the April 25, 2011 letter written by Matthew E. Zames, a managing director at JPMorgan Chase and the chairman of the Treasury Borrowing Advisory Committee, to Treasury Secretary Timothy Geithner.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.