One of the big worries Americans have about China’s rising economic power concerns its immense holdings of U.S. government debt. The fear is that Chinese actions regarding these holdings could end up destabilizing the U.S. economy, or that they could be used as a political tool to influence American policy. If China, let’s say, got angry at Washington over its support for Taiwan or the Dalai Lama, Beijing could retaliate by dumping U.S. Treasury bills. Or perhaps China would sell Treasuries as part of a no-confidence vote on the future of the U.S. economy. By selling American debt, China would weaken the value of the dollar, damage investor sentiment towards the U.S. economy and make it harder for Washington to finance its giant budget deficits.
Very scary stuff indeed. But how realistic is such a scenario? Will China ever really dump U.S. debt? That’s the ultimate question. It’s especially relevant to ask right now since Chinese purchases of U.S. government debt have been tapering off. In December, China was actually a net seller of U.S. Treasuries, reducing its holdings by $34 billion to a total of $755 billion. That decline dropped China to second place on the list of the largest foreign owners of U.S. sovereign debt. (Japan reclaimed the No.1 spot.)
What does that sell-off mean? No one really knows. The problem with analyzing Chinese attitudes towards its dollar holdings is that the necessary data isn’t available. The government doesn’t break down the country’s reserves by type of currency. That leaves us guessing about what Beijing might be up to. China could simply be making a financially sound decision to shift out of low-yielding U.S. Treasuries into some other dollar-denominated investments with a better return. If that’s the case, the impact on the U.S dollar would be nil. Or China could be diversifying into other currencies, perhaps in a very minor way. Jing Ulrich, chairman of China equities & commodities at JPMorgan in Hong Kong, speculated in a recent report that:
China could be more actively diversifying its currency reserves away from U.S. Treasuries, and we expect the country might be marginally shifting some exposure to other currencies.
The conventional wisdom is that China would never just dump U.S. Treasury bills since it would end up boomeranging right back on Beijing. By selling off U.S. debt, China would depress the value of its own national wealth and undermine its most important trading partner. But Eswar Prasad, a very smart economist at Cornell University and a senior fellow at the Brookings Institution, submitted some very interesting testimony to the U.S.-China Economic and Security Review Commission on Feb. 25 regarding the implications of China’s U.S. debt holdings. You can read his entire statement here, but here are a few crucial takeaways. Prasad believes a Chinese threat to dump Treasuries carries some weight, since the costs of doing so aren’t as large as many analysts believe. Here’s what he says:
Many analysts argue that any threat by China to shift a large portion of its reserves out of U.S. government paper is just bluster as such a move would impose huge costs on China itself. But these costs tend to get overstated in popular discussions of the matter…Any Chinese threat to move aggressively out of Treasuries is a reasonably credible threat as the short-term costs to the Chinese of such an action are not likely to be large.
Prasad also addresses the key question: How important is China to U.S. deficit financing anyway? China’s share of total outstanding U.S. government debt (held by the public) is now at 10%, he notes. Even if you estimate, as some analysts do, that China’s holdings might be higher than the reported U.S. data suggests, Prasad says China has “a significant but not overwhelming share.”
Still, that doesn’t mean China’s decisions regarding its U.S. debt purchases wouldn’t have a meaningful impact. Prasad says:
But can China make a big difference to U.S. interest rates given that its share of the financing of the U.S. budget deficit has fallen over time? The answer lies not in the absolute amounts of financing that China brings to the table, but in how its actions could serve as a trigger around which nervous market sentiments could coalesce. Given that there are no clear prospects of reining in exploding deficits and debt in the U.S., especially if one factors in rising health care and entitlement costs, changes in availability of deficit financing at the margin can have potentially large consequences.
But Prasad also adds a word of caution, noting that there are real financial constraints on China that limit its flexibility on U.S. debt purchases:
The reality is that, so long as China continues to accumulate reserves at a pace of around $400 billion a year, there are few relatively safe investments other than U.S. government bond markets that are deep and liquid enough to absorb a significant portion of such massive inflows.
My own view is that China would lose more than it would gain by any dramatic shift out of U.S. Treasuries. At least at this moment. But as China continues to strive for ways to diversify its currency reserves and investment holdings, combined with its (slow-moving) efforts to internationalize its own currency (the yuan), the risk that would come with a decision to dump Treasuries looks likely to decrease over time.