A cursory scan of the last three months of financial media might give one the impression that China is preparing to cut its ties to U.S. Treasuries and the dollar. Between the renminbi’s recent devaluation – driven by net capital outflows, not intervention – and reported declines in Chinese purchases of U.S. Treasuries late last year, it is hardly surprising to hear voice given to fears that China could “dump the dollar.” Analysts worry that China is beginning a process of unwinding its $1.3 trillion holdings of U.S. Treasuries to further its aims of internationalizing the RMB and limiting its financial interdependence with the U.S. If true, this process would increase borrowing rates for the U.S. government, disrupt the global financial system by undermining faith in Treasuries and the dollar, and perhaps even lead to rising tensions between the U.S. and China by eliminating an important source of mutual interest.
Fortunately, this account of the data and recent trends is a rather dubious one. Even if taken at face value, China’s reported reduction in Treasury holdings of $26 billion in 2014 is far from unprecedented. The People’s Bank of China did the same in 2011 when capital inflows took a dip, cutting into the foreign exchange reserves available for investment in Treasury securities. China’s recent capital outflows may have had the same effect, with speculators trading yuan for dollars rather than the other way around. These outflows have been driven by external concerns over China’s slowing economy and growing domestic debt, not a concerted strategy from Beijing.
There is also reason to doubt the veracity of the data itself. Through the end of last year, the financial press reported net Chinese purchases of Treasury debt in the realm of $150 billion, a figure that seems irreconcilable with the reported drop in Chinese holdings. Many have speculated that the difference is a result of Chinese purchases through intermediaries like Belgium’s Euroclear. This past summer, Belgium’s Treasury holdings unexpectedly doubled to the tune of between $150 and $200 billion, commensurate with China’s reported net purchases.
China’s reasons for routing new purchases through intermediaries are now clear. With capital outflows and economic weakness forcing down the renminbi’s value, public net Treasury purchases at scale would have generated additional unwanted downward pressure. These purchases were driven not by pro-export intervention but by a more fundamental need: to put Chinese surpluses in the only market large and liquid enough to support them. Only the market for U.S. Treasuries has the size and depth to safely hold an annual inflow of nearly $100 billion. Far from unwinding, the truth of Chinese Treasury purchases is that they are hardly Beijing’s choice at all.
For China to truly begin cutting its holdings, at least two of three conditions must be met: China would have to rebalance its economy from exports and investment to domestic consumption, the renminbi would have to be internationalized, and China would have to find a new safe and stable market in which to park its excess liquidity.
The first two conditions would solve China’s perpetual problem, namely that incoming export revenues are denominated in dollars. China’s efforts to rebalance output away from exports and toward domestic consumption would mean that the PBOC would no longer end up with mostly dollars that can only be put into dollar-denominated assets. Unfortunately, the domestic rebalancing program has thus far been unsuccessful and shows no signs of changing course. The most recent figures show Chinese household consumption at 35 percent of GDP, half of the equivalent figure for the U.S. and almost unchanged since 2008. The fundamental problem is that a highly unequal distribution of income puts most money into the hands of a small, wealthy elite or the government itself, not the poor households most likely to spend it. Until this rebalancing happens or Beijing is willing to tolerate substantially lower growth, the country will continue to rely on exports and the dollar receipts that come with them.
The internationalization of the renminbi, which at scale would enable China to be paid in its own currency for its exports, is an even more far-fetched ambition. True, the renminbi’s share of world payments has increased sevenfold since 2012…from a quarter of a percent to 1.8 percent today, according to data from SWIFT. The global payments system remains a two-player game between the dollar at 45 percent of payments and the euro at 30 percent. The renminbi’s task has become even harder over the past two years as the dollar has regained substantial share due to the Eurozone’s renewed troubles with Greece. The dollar retains several special advantages over other currencies, most notably its role as the preferred currency for oil and other commodities trading, making competition with it far more difficult than with any other currency.
The RMB also remains hamstrung by capital controls, unlikely to be fully lifted until 2020 at the earliest, and with financial markets too small and opaque to satisfy the world’s demands of an international reserve currency. China’s domestic debt market stands at just $3.8 trillion, a ninth of the size of America’s, and exposes holders of RMB assets to the risks of a market still riddled with corruption. Few would be willing to stake the future of their liquid assets on such a market when the dollar stands as a ready alternative. Without either of these conditions met, China will continue to receive mostly dollar receipts that can only be spent on dollar assets like Treasuries.
The final, and non-negotiable, condition of a Chinese shift away from Treasuries is the existence of an alternative market in which to park its liquidity (denominated in RMB if they meet one of the above conditions). These very large balances need to be put somewhere, ideally somewhere with negligible risk of default and a rate of return above zero. At present, no such market exists beyond U.S. Treasuries. Moreover, without a clear alternative in place, a move by China to dump its Treasuries would risk starting a fire sale in which the value of its own portfolio would burn.
This obstacle is not one that China can overcome alone. The size and liquidity of the market for Treasuries reflects an international consensus that it is the safest and most reliable in the world. For evidence, look no further than the 24 percent yearly average increase in foreign Treasury holdings during the first three years of the financial crisis, compared to 13 percent during the seven years before. China alone accumulated $670 billion in Treasury debt during that period, half of its current holdings and a reminder that when push comes to shove, not even China can resist fleeing back to the safety of the dollar.
None of this is changing anytime soon. Amid slowing growth, China’s trade balance reached a record high in February and will eventually return to padding its foreign exchange reserves once capital outflows subside. The only real change on the horizon is the chance that the Chinese miracle could be past its heyday. Even if true, however, 6 to 7 percent growth is more than enough to entice foreign capital back into Chinese markets once market jitters over its domestic debt subside. And if it isn’t, the last thing Beijing will do is put the economy of its best trading partner at risk by dumping the dollar. So fear not – as long as the U.S. keeps spending, China will keep buying.
Joshua P. Zoffer has worked as a geopolitical and macroeconomic consultant focusing on currency related issues. His work has previously been published in The National Interest and International Affairs Forum.