What If China Stops Buying U.S. Government Debt

 (Image credit: Getty Images via @daylife)

GORDON CHANG

Just about everyone worries that Beijing, perturbed by the ongoing squabble in Washington, will sour on Treasuries.  This concern is embedded in the provocative title of Eamonn Fingleton’s recent Forbes posting: “If Republicans Want to Shut Down Washington, They’ll Have to Ask China’s Permission First.”

The Republicans in fact did not seek Beijing’s approval, and neither did Democrats.  Are both sides making a mistake by not taking into account China’s “feelings,” as the Communist Party demands everyone do?    

It’s clear Chinese officials are watching closely.  “The United States, the world’s sole superpower, has engaged in irresponsible spending for years,” observed Xinhua News Agency in an editorial on Wednesday.  “With no political unity to redress its policy mistake, a dysfunctional Washington is now overspending the confidence in its leadership.”

The official organ’s warning, entitled “On Guard Against Spillover of Irresponsible U.S. Politics,” hints that Beijing leaders are thinking of further diversifying their portfolios away from dollar-denominated debt.  If the Chinese don’t continue buying Treasury securities, the Federal government will have to find others to take up the slack.  Many, including the respected Congressional Research Service, argue that Treasury may then have to pay substantially more for borrowed funds and higher interests rates could result in lower long-term growth.

China is by far the largest foreign holder of U.S. Treasury securities.  At the end of July, the last month for which official statistics are available, it had stockpiled $1.2773 trillion in Treasuries.  The country is way in front of second-place Japan, whose portfolio was $141.9 billion smaller.  If you add in the Treasuries of autonomous Hong Kong, the hoard of the People’s Republic increases by $120.0 billion. 

The direction is unmistakable.  China, excluding Hong Kong, ended last century in December 2000 with just $60.3 billion in Treasury securities.

So, yes, it does look like Obama, Boehner, Pelosi, and Reid should have been on the line to Beijing before beginning their most recent spat.  Yet historical data reveal a surprising trend.  In July 2011, China set a record with its $1.3149 trillion of Treasuries.   Then, over the course of the last two years, Beijing offloaded $37.6 billion of these instruments. 

In short, the Chinese have not in fact been funding the Federal deficit since the middle of 2011.  And during that period, the Federal government was able to continue operating, global markets did not panic, and rates on Treasuries declined.  Significantly, China decreased its holdings at a time when the U.S. Treasury increased its borrowing from abroad, by $1.749 trillion in 2011 and by $821 billion last year. 

All this is not to say the U.S. should run budget deficits—it definitely should not—but it does tell us that we do not need the Chinese to do so. 

Of course, Washington’s statistics cannot capture China’s purchases of Treasuries through nominees.  From time to time, there is unusual activity in foreign debt markets, notably London, indicating the Chinese are trying to hide purchases and sales.  There is, however, nothing to suggest that, over time, their transactions behind the screen do not track the ones out in the open.

In any event, Beijing’s surreptitious transactions are not large enough to substantially disrupt or influence global markets.  Even if all of China’s purchases of Treasuries over the last two years had been through nominees, it does not mean we relied on the Chinese.  After all, the combined value of U.S. private and public debt securities dwarfs Beijing’s holdings.  In 2011, the last year for which U.S. Treasury data is available, U.S. debt securities amounted to a staggering $33.7 trillion, 34.2% of the world’s total.  In comparison, China’s foreign exchange reserves, which are thought to be mostly in Treasuries, totaled only $3.50 trillion at the end of this June.

And now we know what happens if China stops buying Treasuries.  Nothing will happen.  It has, in fact, already stopped adding to its stockpile.

But what happens if the Chinese really get mean?  Every so often, Beijing’s civilian officials—and sometimes generals and admirals—publicly talk about dumping Treasuries to hurt the United States.  These words, unlikely to be off-the-range comments in the Communist Party’s tightly run system, are meant to intimidate Washington at particularly sensitive times.  China, however, has never implemented the “nuclear option,” the phrase heard in Beijing circles as early as August 2007. 

Why hasn’t China “nuked” us?  If Beijing sold Treasury securities in massive quantities, it would cause a panic, but the world’s deep markets would quickly adjust.  The Chinese, we should remember, would get back dollars.  Because they are doing this to undermine America, they would have to either buy hard assets or convert the proceeds into other currencies.  As a practical matter, China’s deficit-plagued central government needs the income so most of the funds would go into interest-bearing instruments denominated in euros, pounds, francs, and yen.  

The euro, pound, franc, and yen would obviously soar in value, so Brussels, London, Bern, and Tokyo would have to go out into the markets to rebalance their currencies.  The only practical way to rebalance would be to buy .  .  .  dollars. 

So why don’t the Chinese go nuclear?  They know that in a short period calm would return to the markets, America’s debt would end up held by its friends, and they would be stuck with a wide variety of assets their managers had shunned in the first place. 

 Follow me on Twitter @GordonGChang