China’s $2 Trillion Hole
Image Credit: Flickr / SqueakyMarmot

China’s $2 Trillion Hole

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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.  The official press, including tabloids known for nationalist rhetoric (such as the Global Times), has been restrained in its coverage on the issue. 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.  Since 1994, China has kept its currency, the renminbi, effectively pegged to the dollar.  While initially this policy worked well in stimulating Chinese exports and stabilizing domestic prices, Beijing allowed the peg to continue for too long, mainly to maintain an undervalued currency in gaining a competitive advantage in foreign trade.  By the middle of the last decade, the undervaluation of the renminbi became a hot bilateral issue between the United States and China as America’s bilateral trade deficits with China soared. 

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Under pressure from Washington, Beijing reluctantly began to raise the value of its currency in mid-2006 (when its total foreign exchange reserves totalled just under $1 trillion). China’s revaluation process was disrupted by the global economic crisis in 2008.  Fearful that its growth could falter if revaluation made Chinese exports less competitive, the Chinese government suspended raising the value of the renminbi in late 2008.  As a result, Chinese current account surpluses continued to balloon. The numbers are astounding.  In July 2009, China reported $2.2 trillion in forex reserves, more than double the amount in 2006. Today, two years later, China’s forex reserves have reached $3.2 trillion.

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