Is it a risk for America that China holds over $1 trillion in U.S. debt?
by China Power/ CSIS
Many worry that China’s ownership of American debt affords the Chinese economic leverage over the United States. This apprehension, however, stems from a misunderstanding of sovereign debt and of how states derive power from their economic relations. The purchasing of sovereign debt by foreign countries is a normal transaction that helps maintain openness in the global economy. As of December 2016, Japan holds more U.S. debt than any other foreign entity, including China. Consequently, China’s stake in America’s debt has more of a binding than dividing effect on bilateral relations between the two countries.
Even if China wished to “call in” its loans, the use of credit as a coercive measure is complicated and often heavily constrained. A creditor can only dictate terms for the debtor country if that debtor has no other options. In the case of the United States, American debt is a widely held and an extremely desirable asset in the global economy. Whatever debt China does sell is simply purchased by other countries. For instance, in August 2015 China reduced its holdings of U.S. Treasuries by approximately $180 billion. Despite the scale, this selloff did not significantly affect the U.S. economy, thereby limiting the impact that such an action may have on U.S. decision making.
Furthermore, China needs to maintain significant reserves of U.S. debt to manage the exchange rate of the renminbi. Were China to suddenly unload its reserve holdings, its currency’s exchange rate would rise, making Chinese exports more expensive in foreign markets. As such, China’s holdings of American debt do not provide China with undue economic influence over the United States. This page examines the role U.S. debt plays in the global economy by exploring the reasons countries buy sovereign debt; explaining in more detail why China buys U.S. sovereign debt; and discussing which financial actors hold the most U.S. sovereign debt.
Why do countries accumulate foreign exchange reserves?
Any country that trades openly with other countries is likely to buy foreign sovereign debt. In terms of economic policy, a country can have any two but not three of the following: a fixed exchange rate, an independent monetary policy, and free capital flows. Foreign sovereign debt provide countries with a means to pursue their economic objectives.
The first two functions are monetary policy choices performed by a country’s central bank. First, sovereign debt frequently comprises part of other countries’ foreign exchange reserves. Second, central banks buy sovereign debt as part of monetary policy to maintain the exchange rate or forestall economic instability. Third, as a low-risk store of value, sovereign debt is attractive to central banks and other financial actors alike. Each of these functions will be discussed briefly.
- FOREIGN RESERVES
Any country open to international trade or investment requires a certain amount of foreign currency on hand to pay for foreign goods or investments abroad. As a result, many countries keep foreign currency in reserve to pay for these expenses, which cushion the economy from sudden changes in international investment. Domestic economic policies often require central banks to maintain a reserve adequacy ratio of foreign exchange and other reserves for short-term external debt, and to ensure a country’s ability to service its external short-term debt in a crisis. The International Monetary Fund publishes guidelines to assist governments in calculating appropriate levels of foreign exchange reserves given their economic conditions.
- EXCHANGE RATE
A fixed or pegged exchange rate is a monetary policy decision. This decision attempts to minimize the price instability that accompanies volatile capital flows. Such conditions are especially apparent in emerging markets: Argentinian import price increases of up to 30 percent in 2013 led opposition leaders to describe wages as “water running through your fingers.” Since price volatility is economically and politically destabilizing, policymakers manage exchange rates to mitigate change. Internationally, few countries’ exchange rates are completely “floating,” or determined by currency markets. To manage domestic currency rates, a country might choose to purchase foreign assets and store them for the future, when the currency might depreciate too quickly.
- A LOW-RISK STORE OF VALUE
As sovereign debt is government-backed, private and public financial institutions view it as a low-risk asset with a high chance of repayment. Some government bonds are seen as riskier than others. A country’s external debt may be viewed as unsustainable relative to its GDP or its reserves, or a country could otherwise default on its debt. Generally, however, sovereign debt is more likely to return value and therefore is safer relative to other forms of investment, even if earned interest is not high.
Why does China buy U.S. debt?
China buys U.S. debt for the same reasons other countries buy U.S. debt, with two caveats. The crippling 1997 Asian Financial Crisis prompted Asian economies, including China, to build up foreign exchange reserves as a safety net. More specifically, China holds large exchange reserves, which were built up over time due in part to persistent surpluses in the current account, to inhibit cash inflows from trade and investment from destabilizing the domestic economy.
China’s large U.S. Treasury holdings say as much about U.S. power in the global economy as any particularity of the Chinese economy. Broadly speaking, U.S. debt is an in-demand asset. It is safe and convenient. As the world’s reserve currency, the U.S. dollar is extensively used in international transactions. Trade goods are priced in dollars and due to its high demand, the dollar can easily be cashed in. Furthermore, the U.S. government has never defaulted on its debt. Read more…