China’s $2 Trillion Hole
The US debt negotiation ceilings are going to the wire. China, the biggest holder of Treasury debt, is watching on helplessly as it gets taken to the financial cleaners.
The political drama in Washington over raising the United States’ federal debt ceiling has grabbed the world’s attention. While the main protagonists in the play are the Republicans and Democrats, one spectator anxiously awaiting the outcome of the bitter partisan struggle is undoubtedly China, the largest single holder of US Treasury debt (roughly $1.1 trillion). In a nightmarish scenario of an American debt default, the prices of the Treasury bonds China has accumulated are bound to decline significantly.
Even if the US government decides to pay the interest on outstanding bonds before honouring its other obligations, the financial markets will likely demand higher interest rates (especially if the US credit rating is downgraded), thus causing the prices of US bonds to fall. Because about 60 percent of China’s $3.2 trillion in foreign exchange reserves consists of dollar-denominated assets (in addition to $1.1 trillion Treasury bonds, China has bought hundreds of billions of dollars in mortgage-backed securities), the paper losses from the price declines of dollar-denominated bonds, and the depreciation of the dollar itself, will likely be in at least the tens of billions of dollars.
To Beijing’s credit, the Chinese government has kept relative silence so far. Except for vague calls for the United States to protect its investors, no Chinese officials have said anything that could be construed as a threat of dumping US Treasury debt if Congress fails to raise the debt ceiling. To be sure, China has maintained an ultra-low profile out of self-interest. It will only hurt itself more if it raises alarm about a possible US default and spooks the financial markets.
China’s $2 trillion dilemma is well-known. One obvious question to ask here is whether Chinese leaders know the phenomenal risks of holding trillions of dollars in US debt, given the low interest rate and the depreciating value of the dollar. Should Beijing have diversified its forex investments? Why not invest in assets not denominated in the US dollar?
The answer is, sadly, China has tried practically every trick known to get into non-dollar assets. It has set up a $300 billion sovereign wealth fund to invest excess foreign reserves in foreign companies. It has encouraged state-owned companies to acquire assets abroad, such as natural resources and firms. It has launched an experimental scheme to settle foreign trade in the renminbi, instead of the dollar. It has dabbled in purchasing distressed European sovereign debt. The list goes on.
Unfortunately, these efforts to diversify forex holdings have yielded disappointing results. Chinese attempts to acquire natural resources have met with strong resistance in most parts of the world (except in Africa). China’s sovereign wealth fund’s investments overseas haven’t been successful either, mostly due to political opposition. Chinese state-owned firms seem to have done better. But the tens of billions of dollars they have spent on projects may not generate economic benefits. Expanding the use of the renminbi to settle trade reduces currency risks, but does little to restrain the growth of China’s dollar holdings – in the two years since China began this experiment, Chinese forex holdings grew more than 50 percent.
So for the moment, China finds itself in a $2 trillion hole it has dug for itself over the last decade. It watches the political paralysis in Washington and the resulting economic uncertainty in complete helplessness. Contrary to the fears harboured by many Americans that China would use its mammoth Treasury holdings as a financial weapon of mass destruction against the United States, China is being taken to the equivalent of the financial cleaners in the unfolding US debt ceiling drama.
It’s tempting to accuse the Americans, the Republicans in particular, of behaving recklessly. But for Beijing, the more meaningful thing to do is to figure out how to get out of its $2 trillion hole. Allowing a more rapid pace of revaluation of the renminbi is clearly one. But there’s another – possibly better – alternative. Why not give each Chinese citizen $1,000 in US Treasury bonds and let them decide what to do? Call it a special social harmony dividend. This could transfer the financial risks from the Chinese state to the Chinese people, while boosting the wealth and consumption of the average Chinese – in other words, killing two birds with one stone.
The political drama in Washington over raising the United States’ federal debt ceiling has grabbed the world’s attention. While the main protagonists in the play are the Republicans and Democrats, one spectator anxiously awaiting the outcome of the bitter partisan struggle is undoubtedly China, the largest single holder of US Treasury debt (roughly $1.1 trillion). In a nightmarish scenario of an American debt default, the prices of the Treasury bonds China has accumulated are bound to decline significantly.
Even if the US government decides to pay the interest on outstanding bonds before honouring its other obligations, the financial markets will likely demand higher interest rates (especially if the US credit rating is downgraded), thus causing the prices of US bonds to fall. Because about 60 percent of China’s $3.2 trillion in foreign exchange reserves consists of dollar-denominated assets (in addition to $1.1 trillion Treasury bonds, China has bought hundreds of billions of dollars in mortgage-backed securities), the paper losses from the price declines of dollar-denominated bonds, and the depreciation of the dollar itself, will likely be in at least the tens of billions of dollars.
To Beijing’s credit, the Chinese government has kept relative silence so far. Except for vague calls for the United States to protect its investors, no Chinese officials have said anything that could be construed as a threat of dumping US Treasury debt if Congress fails to raise the debt ceiling. To be sure, China has maintained an ultra-low profile out of self-interest. It will only hurt itself more if it raises alarm about a possible US default and spooks the financial markets.
China’s $2 trillion dilemma is well-known. One obvious question to ask here is whether Chinese leaders know the phenomenal risks of holding trillions of dollars in US debt, given the low interest rate and the depreciating value of the dollar. Should Beijing have diversified its forex investments? Why not invest in assets not denominated in the US dollar?
The answer is, sadly, China has tried practically every trick known to get into non-dollar assets. It has set up a $300 billion sovereign wealth fund to invest excess foreign reserves in foreign companies. It has encouraged state-owned companies to acquire assets abroad, such as natural resources and firms. It has launched an experimental scheme to settle foreign trade in the renminbi, instead of the dollar. It has dabbled in purchasing distressed European sovereign debt. The list goes on.
Unfortunately, these efforts to diversify forex holdings have yielded disappointing results. Chinese attempts to acquire natural resources have met with strong resistance in most parts of the world (except in Africa). China’s sovereign wealth fund’s investments overseas haven’t been successful either, mostly due to political opposition. Chinese state-owned firms seem to have done better. But the tens of billions of dollars they have spent on projects may not generate economic benefits. Expanding the use of the renminbi to settle trade reduces currency risks, but does little to restrain the growth of China’s dollar holdings – in the two years since China began this experiment, Chinese forex holdings grew more than 50 percent.
So for the moment, China finds itself in a $2 trillion hole it has dug for itself over the last decade. It watches the political paralysis in Washington and the resulting economic uncertainty in complete helplessness. Contrary to the fears harboured by many Americans that China would use its mammoth Treasury holdings as a financial weapon of mass destruction against the United States, China is being taken to the equivalent of the financial cleaners in the unfolding US debt ceiling drama.
It’s tempting to accuse the Americans, the Republicans in particular, of behaving recklessly. But for Beijing, the more meaningful thing to do is to figure out how to get out of its $2 trillion hole. Allowing a more rapid pace of revaluation of the renminbi is clearly one. But there’s another – possibly better – alternative. Why not give each Chinese citizen $1,000 in US Treasury bonds and let them decide what to do? Call it a special social harmony dividend. This could transfer the financial risks from the Chinese state to the Chinese people, while boosting the wealth and consumption of the average Chinese – in other words, killing two birds with one stone.
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