FACT OR FICTION: IS CHINA´S HOLDING OF U.S. DEBT A SOURCE OF LEVERAGE? / GEOPOLITICAL FUTURES

Fact or Fiction: Is China’s Holding of US Debt a Source of Leverage?

Beijing faces a number of constraints.

Summary This is the second piece in an occasional series re-examining the economic relationship between the United States and China. Here, we explore Chinese holdings of U.S. debt and explain why these holdings exemplify the Chinese economy’s dependence on the U.S. rather than being a source of leverage. China needs the U.S. market more than the U.S. needs cheap Chinese goods. China is a significant holder of U.S. debt, but it is not the largest holder. China has significantly reduced its holdings of U.S. debt with no perceivable ill effect on the U.S. economy. As long as the U.S. dollar is the reserve currency and U.S. bonds remain attractive investments, China can do relatively little with its U.S. debt to harm the U.S. economy. Introduction Much has been made of the fact that China has been the largest holder of U.S. debt for most of the last eight years. The latest statistics available from the U.S. Department of the Treasury indicate that China held $1.15 trillion in Treasury securities at the end of October 2016, and the total value of official Chinese holdings of U.S. securities as of June 2015 was $1.84 trillion. Chinese holdings of U.S. Treasury securities alone have increased in value by a preternatural 93.6 percent since April 2000.

A screen shows the U.S. national debt as U.S. Federal Reserve Chair Janet Yellen (front L) testifies before the House Financial Services Committee on Capitol Hill in Washington, on Feb. 10, 2016. Yellen warned that the U.S. economy faced risks from tightening domestic financial conditions as well as global economic turmoil. NICHOLAS KAMM/AFP/Getty Images

Many claim that China has a significant financial advantage to wield in its relationship with the U.S., and China has done nothing to dissuade these claims. As recently as 2011, a senior editor at the People’s Daily newspaper said that China should “use its ‘financial weapon’ to teach the United States a lesson” in response to increased U.S. arms sales to Taiwan. There is just one small problem with this recommendation: No such weapon or advantage exists. China’s large holdings of U.S. debt are not a geopolitical lever; rather, they are a symptom of the structural problems that make China vulnerable to the U.S.   China’s Imperative We begin this analysis in the same way that we begin all of our analyses – on the basis of imperatives and constraints. China is an export-driven economy with a very basic, overriding imperative: It must preserve access to the U.S. market for its exports.

 

The U.S. is by far the world’s largest market for Chinese exports. In 2015, the value of U.S. imports of Chinese goods was triple the value of Japan’s imports and six times the value of Germany’s. (These figures do not take into consideration goods that are first exported to Hong Kong and then sent to the U.S.) Furthermore, China has no good alternative to the U.S. market in the event that U.S. imports dramatically decrease. The U.S. economy is the largest in the world, representing 24.4 percent of global GDP per the latest figures available from the World Bank. The world’s only comparable market is the European Union, which comprises 22.1 percent of global GDP, but there are significant obstacles to China increasing its exports there. First, Europe is still reeling from the 2008 financial crisis. Second, the EU is built around another massive exporter – Germany. Third, 15.6 percent of Chinese exports already go to the EU. It is not an exaggeration to say that if China jeopardizes its access to the U.S. market, the domestic economic and social ramifications could challenge the power of the Chinese Communist Party (CCP).

 

Because of its exports to the U.S., China’s trade balance with the U.S. is weighted heavily in China’s favor. In 2015, China had a positive trade balance of over $260 billion with the U.S. alone and an overall positive trade balance of $600 billion. According to the State Administration of Foreign Exchange, China’s current account surplus was $330.6 billion in 2015 and, according to the most recent data, $64.1 billion in the second quarter of 2016. Though China’s foreign exchange reserves have dropped by almost 20 percent since January 2015, according to the People’s Bank of China, the country still has $3.05 trillion in foreign exchange reserves, largely due to years of export-driven surplus. China does not publish the precise make-up of its foreign exchange reserves, but a report by the Congressional Research Service estimates that the dollar composition is around 70 percent of the total.

These large sums of money appear impressive, but they present a serious challenge to China’s growth model. The value of the yuan would increase if the hundreds of billions of dollars earned from exports entered the Chinese economy, making Chinese exports less competitive. This puts China in a catch-22. On the one hand, China wants to keep the value of its currency low enough on the dollar that its exports remain competitive on the global market. On the other hand, China cannot afford for the yuan to depreciate much because dropping values encourage capital flight, a problem that has become increasingly acute in recent years. Thus, China uses its massive pile of dollars to buy yuan and ensure that the yuan-dollar exchange rate remains in the Goldilocks zone – not too high, not too low. Although China is often accused of manipulating its currency to keep the yuan low to boost Chinese exports, its reserves have nosedived during the past year because of severe downward pressure on the yuan. As a result, China has spent hundreds of billions of dollars propping up the yuan. Still, the funds spent on boosting the yuan do not account for the vast majority of the dollars that China earns in its trade surplus. China must do something with these dollars, and one of the most attractive options is to invest in U.S. debt. Here again, the U.S. plays a dominant and unavoidable role in the global economy. The latest available International Monetary Fund statistics indicate that the combined value of U.S. private and public debt securities was $36.7 trillion in 2013, or in relative terms, 41 percent of the world’s total debt securities. Debt securities from EU states (28 percent of the world’s total) provide the only other market of sufficient scale to handle the large sums of money China must invest. But our readers know that European banks are currently on shaky ground; therefore, EU debt securities are a much riskier investment than U.S. debt securities. The U.K. and Japan may provide investment options, but in terms of scale, are probably not big enough to handle the sums China seeks to invest. Besides, these nations have serious economic and political issues of their own. In other words, China invests in U.S. debt because it does not have much of a choice.

 

The US Imperative The U.S. needs two things from its economic relationship with China: cheap imports and money. Of all U.S. imports, 21.8 percent came from China 2015, a number that has steadily increased over the past 15 years. China cannot afford to see its exports curtailed, nor can the struggling American middle class afford to see an increase in the price of imports from China. The first piece in this series examined the trading relationship between the U.S. and China. We determined that there are very few (if any) strategically important Chinese commodities or products that the U.S. could not either import from elsewhere or produce domestically. However, shifting factory production to other countries or to the U.S. would cost U.S. companies considerable money. Those costs would be intensely felt by the average American, considering the sheer breadth and extent to which China currently supplies the U.S. with goods. The pain China would feel upon losing access to the U.S. market and the pain the U.S. would feel upon losing access to cheap Chinese imports, however, are not equivalent. The Chinese economy and the legitimacy of the CPC itself is built on exports, and losing access to the U.S. market could tear apart China’s social and political fabric. While U.S. consumers would suffer, and a breakdown in economic ties between China and the U.S. could result in a severe U.S. recession, the U.S. government and American political institutions would not be threatened. In other words, China needs exports to the U.S. more than the U.S. needs Chinese imports. In addition to cheap imports, the U.S. also gets money from its relationship with China. As of Dec. 23, the U.S.’ total outstanding public debt was $19.89 trillion, according to the U.S. Department of the Treasury. That amounts to a 208 percent increase in U.S. public debt since March 2003, and while U.S. government spending in the wake of the 2008 financial crisis has been a big driver in that increase, it should be noted that U.S. national debt was already on the rise prior to the recession. Furthermore, the amount of U.S. national debt held by foreign countries increased from $1.28 trillion in 2003 to $6.15 trillion in the third quarter of 2016, which, in percentage terms, is a whopping increase of almost 383 percent. In return for buying Chinese exports, the U.S. has enjoyed relatively cheap imports and has been able to spend significantly beyond its means. Some of this spending has been funded by Chinese investment in U.S. debt; put another way, China has lent the U.S. substantial amounts of money. There are, however, two significant reasons these facts do not give China leverage over the U.S. despite the obvious utility of its relationship with the U.S.: China’s relative share in the U.S. debt and the U.S. dollar’s position as the global reserve currency.

 

Dispelling Myths The biggest myth surrounding the issue of China as a holder of U.S. debt securities is the outsized role China is perceived as playing. As noted above, U.S. government debt currently totals $19.89 trillion. This is a somewhat misleading figure, however. Intragovernmental holdings make up $5.47 trillion of that figure, which means that almost 30 percent of the debt is money that the U.S. government owes to itself. Of the remaining $14.41 trillion, $6.15 trillion is held by foreign sources and the rest is held by various U.S. pension funds, insurance companies and other investors. Of the amount held by foreign sources, only $1.84 trillion is held by China, 61 percent of which is held in U.S. Treasury securities. (The rest is in equities and corporate or U.S. agency securities, as shown below.)

There are two key things to note here. First, China holds about 12.8 percent of total outstanding U.S. government debt. Second, Japan, rather than China, is the largest foreign holder of U.S. government debt. Although China was the largest holder of U.S. Treasury securities from September 2008 through October 2016, Japan had previously been the dominant holder – a distinction it held as far back as 2000.

 

 

Even assuming that China uses various proxies, like Belgium, to buy or sell U.S. securities, China’s holdings of U.S. debt as a percentage of the whole are much smaller than they are made out to be. This, however, is not the most important point. Although China’s share of U.S. debt holdings could increase, this would not necessarily mean that China’s leverage over the U.S. would proportionately increase. Consider the fact that in the last 12 months for which data is available (October 2015 – October 2016), China has reduced its holdings of U.S. Treasury securities by 11.1 percent and it did not result in a serious economic catastrophe for the U.S. In fact, this reduction has had almost no impact on the market for U.S. treasuries. China has sold roughly $140 billion worth of U.S. securities during this period, but the yield on the 10-year bond has increased by only 40 basis points – four-tenths of one percent. This is the worst that has happened as a result of China’s reduced holdings. Those who claim that the U.S. is constricted by China’s debt chokehold often stoke fears of a scenario in which China dumps all of its U.S. debt holdings at once. The example above, however, is an indicator of an important fact: U.S. debt is held by many countries around the world, and it is still considered to be one of the safest, most reliable assets money can buy in the global market. Therefore, buyers will be interested when China sells a large sum of U.S. Treasury securities. All of this stems from several simple facts: The U.S. dollar is the global reserve currency, the U.S. is by far the most dominant economy in the world today, and the U.S. has never defaulted on any of its debts. As long as that remains the case – and we have no reason to believe that it will change for decades to come – China’s ability to leverage its position as a technical creditor of the U.S. will be limited at best. Furthermore, even if it could, China would not want to use its position as a creditor to harm the U.S. If China announced tomorrow that it is selling all $1.15 trillion worth of its U.S. Treasury securities, for instance, the potential negative consequences would hurt China far more than they would harm the U.S. The U.S. might see a temporary decrease in the value of the dollar, but there would also be an increase in the value of the yuan, making China’s exports less competitive in the American consumer market. As discussed above, this would violate China’s fundamental economic imperative. In addition, the value of the securities themselves would begin to decrease as soon as the market caught wind of China looking to sell its U.S. Treasury securities, and China would lose value on the debt it sought to sell. Moreover, China would see a negative impact on any other assets it holds in dollars. There would also be the small problem of where China would move its newly acquired cash in such a scenario – both the euro and the yen present economic and political challenges that aren’t associated with the dollar.   Conclusion As a percent of total U.S. debt, China’s holdings are relatively small. If China uses its holdings of U.S. debt as a “financial weapon,” it would deliver damaging wounds to the Chinese economy while having a relatively minor short-term impact on the value of the dollar. This makes it highly unlikely that China would take such an action. China has already begun to whittle down some of its holdings of U.S. securities (in favor of U.S. equities and real estate), but this has had little substantive impact on the U.S. economy. China’s holding of a significant absolute sum of U.S. debt is a symptom of China’s dependence on an export-driven economic model as well as its dependence on the U.S. consumer market, but it is not a lever that China can use against the U.S. to gain the upper hand.