China is America’s single largest foreign creditor, holding about 8 per cent of the stock of US Treasuries. Most Chinese netizens and opinion makers are not knowledgeable about the country’s budget dispute. But almost all Chinese people understand that the US government has been playing the world economic game to its advantage.
The US issues, at rates of almost zero, Treasuries that are bought by investors all over the world. So long as the federal government increases the debt stock at a pace slower than the US gross domestic product growth rate (usually 2-4 per cent a year) minus the real interest rate (zero, or even negative in recent years), it can roll over the debt almost for ever, never worrying about paying it back.
What is intriguing to most Chinese analysts is that Congress and the White House do not seem to understand the game’s benefits. The evidence is the US budgetary mess. Bitter fights over government budgets are commonplace among politicians all over the world. This is a good thing. But a technical default of some of the existing Treasury bonds would be the beginning of the end for the wonderful game the US federal government has been playing.
What is equally difficult to understand, from the perspective of many academic economists, is the Chinese government’s attitude and behaviour regarding the American debt issue. For many years, economists in China have argued that the government should diversify away from Treasuries, anticipating the US government’s continued high large primary budget deficit and political disputes.
But Beijing has actually increased its exposure. Many argue that this is because of a lack of alternative ways to manage China’s large foreign currency reserves. This is an incorrect supposition.
One alternative – although it might not be easy – is to sell half of its Treasuries (about $1.2tn) and to allocate the funds among three categories of financial asset.
First it could buy up to 5 per cent of the shares of all multinationals that have been operating in the Chinese market and are listed on global stock exchanges. Buying shares in these companies is like investing in China itself.
Second, it should increase the holdings of all non-US sovereign bonds rated higher than double A plus, such as German or Australian government bonds. This can help hedge against the risk of a dollar depreciation against other currencies.
Third, it could buy up to 5 per cent of the shares of public utility companies in mature market economies. Such an approach would greatly reduce Beijing’s dependence on Treasuries.
The only explanation for the Chinese government’s interest in Treasuries is its relationship with the US. China’s holding represents both a “hostage” scenario and a bonding instrument for the two largest economies in the world. Each year in May, a Chinese vice-premier and the US secretary of state engage in a Strategic and Economic Dialogue. The Chinese holding of the US Treasuries reminds the American delegates to tone down their attacks on issues such as alleged currency manipulation or subsidies to state-owned enterprises.
It is indeed a delicate political economy equilibrium – and would quickly collapse if the US political situation created a realistic threat of default. Even if the US is able to avoid the catastrophe of a default, the potential for a repeat of the uncertainty means there are no guarantees the Chinese government can resist domestic pressure, not least from economists, calling for diversification away from investments in Treasuries. Netizens are also stepping up the pressure on China’s decision makers to stop lending to the US federal government.
Beijing may have to yield to domestic pressure and pursue its economic interest by following the practice of Japan, which claims to enjoy the best alliance in Asia with the US but has started unloading its Treasuries. We do not know how long long-term political logic can prevail over the economic rationale.
The writer is a professor of economics at Tsinghua University