The Purpose of China's U.S. Treasury Bond Purchases
China's significant investment in U.S. Treasury bonds aims to maintain competitive export pricing. With a focus on export-driven economic growth for job creation, China actively manages the value of its currency, the renminbi (RMB), to stay competitive against the U.S. dollar. The U.S. owes a substantial portion of its debt to China through U.S. Treasuries, mainly due to their recognized safety and stability. While concerns exist about China divesting U.S. debt, potentially hindering economic growth, substantial sell-offs pose risks for China, too, reducing the likelihood of such actions occurring.
China, known primarily for its manufacturing prowess and export-oriented economy, has consistently maintained a substantial trade surplus with the United States since 1985. This signifies that China's exports to the U.S. consistently surpass its imports from the U.S.
Chinese exporters, in the process of selling their goods to the U.S., receive payments in U.S. dollars (USD). However, they require Chinese currency, the renminbi (RMB or yuan), to remunerate their workforce and conduct local financial transactions. Consequently, they exchange the USD earned from exports for RMB, a practice that augments the supply of USD while concurrently bolstering the demand for RMB.
China's central bank, the People's Bank of China (PBOC), proactively intervenes to rectify the U.S. dollar and yuan imbalance within local markets. The PBOC achieves this by purchasing surplus U.S. dollars from exporters and providing them with the necessary yuan. Notably, the PBOC possesses the capacity to print yuan as required, effectively generating a scarcity of U.S. dollars through this intervention. This artificial scarcity serves to maintain higher USD exchange rates, facilitating China's accumulation of USD as foreign exchange reserves.
Automatic Adjustment of Currency Flows
In international trade involving two currencies, a natural self-correcting process occurs. Let's consider a scenario where Australia experiences a current account deficit, indicating that it imports more than it exports (scenario 1). As a result, countries exporting goods to Australia receive Australian dollars (AUD), leading to a surplus of AUD in the global market and causing the AUD's value to depreciate relative to other currencies.
The depreciation of the AUD, however, makes Australian exports more competitively priced and imports more expensive. Over time, Australia began to export more and import less, driven by its devalued currency. This gradually reverses the initial scenario (scenario 1). This self-correcting mechanism is a common occurrence in international trade and forex markets, typically requiring minimal or no external intervention.
The Importance of a Depreciated Renminbi in China's Economic Strategy
China's primary strategy revolves around sustaining export-driven growth, a vital factor in job creation, and ensuring the continued productivity of its vast population. This approach hinges on maintaining a lower-valued currency, the RMB, relative to the USD, allowing China to offer competitively priced goods in international markets.
Discontinuing the People's Bank of China's intervention, as previously outlined, would naturally lead to RMB appreciation. This, in turn, would elevate the cost of Chinese exports and potentially trigger a severe unemployment crisis due to reduced export demand. China's goal is to preserve the competitiveness of its products in global markets, which necessitates preventing RMB appreciation. To achieve this, China employs the described currency management mechanism, albeit accumulating a substantial reserve of USD in the process.
The Role of the People's Bank of China (PBOC) in Managing Chinese Inflation
While countries like India, which share characteristics of labor-intensive, export-oriented economies, do employ some similar measures, they do so to a lesser degree. A significant consequence of the strategy outlined is the potential for elevated inflation. China, with its stringent, government-dominated economic control, possesses the capability to address inflation through alternative methods, including subsidies and price regulations. In contrast, other nations lack a comparable degree of control and must contend with market forces in free or partially free economies.
China's Utilization of USD Reserves
At the close of 2021, China's central bank held approximately $3.3 trillion in total foreign exchange reserves. Similar to the United States, China engages in exports to various regions, including Europe. The euro constitutes a substantial portion of Chinese forex reserves, diversifying investment options.
While China could consider investing its substantial U.S. dollar reserves in European debt for potentially better returns, its utmost concern remains the safety and stability of investments. The Eurozone, despite its two-decade existence, still grapples with stability issues, making asset swaps, such as shifting from U.S. debt to Euro debt, an imprudent choice.
Compared to alternative asset classes like real estate, stocks, or other countries' treasuries, U.S. debt remains the safer choice for forex reserves. These reserves aren't discretionary funds to be risked in pursuit of higher returns.
An alternative for China lies in utilizing its dollar holdings for payment in transactions such as oil purchases from Middle Eastern countries. However, these recipient nations, too, ultimately seek secure investments, often culminating in the safety of U.S. Treasury securities due to the widespread acceptance of the dollar as a global trade currency.
The Consequences of China's Acquisition of U.S. Debt
Chinese forex reserves find their safest refuge in U.S. debt, effectively implying that China extends loans to the U.S., facilitating the purchase of Chinese goods by the U.S. This symbiotic relationship thrives as long as China maintains an export-focused economy, yielding substantial trade surpluses with the U.S. The acquisition of U.S. debt by China serves as a conduit for Chinese loans to the U.S., enabling the latter to access Chinese products. This arrangement is mutually advantageous, granting China access to a vast market for its goods while affording the U.S. the economic benefits of competitively priced Chinese imports. Despite their well-documented geopolitical tensions, both nations find themselves deeply interdependent, yielding benefits that are likely to persist in the future.
The U.S. Dollar's Role as a Global Reserve Currency
In the past, gold served as the global standard for reserves until the 19th century when it was replaced by the British pound sterling. Nowadays, U.S. Treasuries are regarded as the safest option. History reveals that several nations amassed significant GBP reserves after World War II, not for spending or investing in the UK, but purely as a safe reserve.
However, when these GBP reserves were eventually sold, it led to a currency crisis in the UK, causing economic deterioration and soaring interest rates. The question arises: could the U.S. face a similar scenario if China decides to divest its U.S. debt holdings?
It's essential to consider that the post-WWII economic system required the UK to maintain a fixed exchange rate, which, coupled with the absence of a flexible exchange rate system, resulted in severe economic repercussions when other nations sold off their GBP reserves.
In contrast, the U.S. dollar operates with a variable exchange rate, meaning that any substantial sale of U.S. debt or dollar reserves by any nation will prompt international trade balance adjustments. China's potential offloading of U.S. reserves could either find its way to another nation or return to the United States.
The consequences of such divestment for China would be dire, resulting in an oversupply of U.S. dollars, causing a drop in USD rates and increasing RMB valuations. This, in turn, would elevate the cost of Chinese goods, eroding their competitive pricing advantage. Such a move by China would seem economically irrational. If any nation with a trade surplus against the U.S., like China, were to cease purchasing U.S. Treasuries or begin offloading U.S. forex reserves, it would transform their trade surplus into a deficit, a scenario no export-oriented economy desires, as it would leave them worse off.
The persistent concerns surrounding China's growing holdings of U.S. Treasuries or the prospect of Beijing selling them off are unwarranted. Even in such a scenario, the U.S. dollars and debt securities would not vanish; they would simply find their way into other repositories.
Assessing the Risk Perspective of U.S. Debt Owed to China
Despite China's increasing creditor status towards the U.S., the situation may not be dire for the U.S. As China would suffer significant consequences from selling its U.S. reserves, they and other nations will likely avoid such actions. Even in the event of China selling these reserves, the U.S., with its free-market economy, possesses the flexibility to print additional dollars as required. Measures like quantitative easing (QE) can also be employed. While printing dollars may devalue the currency and elevate inflation, it would ultimately benefit U.S. debt by decreasing the real repayment value, which is advantageous for the debtor (U.S.) but detrimental to the creditor (China).
Despite the rising U.S. budget deficit, the likelihood of the U.S. defaulting on its debt remains minimal, unless a deliberate political decision is made to do so. In essence, it may not be the U.S. reliant on China's continuous debt purchases, but rather China depending more on the U.S. to sustain its ongoing economic prosperity.
Analyzing the Risk Outlook of China's Holdings of U.S. Debt
Conversely, China finds itself faced with a significant concern when it comes to providing loans to a nation that wields unlimited authority to generate currency at will. The specter of high inflation looming over the United States is a source of unease for China, as it could result in the diminishment of the actual value of repayments to China in the event of such inflationary pressures.
Whether by voluntary choice or compelled by circumstances, China appears destined to remain an active purchaser of U.S. debt instruments. This ongoing commitment is driven by the imperative to uphold and sustain its competitive pricing advantage in the intricate and highly competitive landscape of international trade and exports.
China's Evolving Approach to U.S. Treasury Holdings: Analyzing the Impact
China's ownership of U.S. Treasuries experienced a peak period from 2012 to 2013, reaching a value exceeding $1.3 trillion. Subsequently, there has been a gradual size reduction. In mid-2022, the holdings dipped below the $1 trillion mark for the first time since 2010, standing at approximately $971 billion as of Q3 2022.
Contrary to popular belief, China is not the largest foreign holder of U.S. debt; Japan holds this distinction, with holdings amounting to approximately $1.1 trillion as of Q3 2022, as per data from the U.S. Department of the Treasury. China's decision to invest in U.S. Treasuries is underpinned by several sound reasons. Firstly, U.S. Treasuries are renowned as one of the world's safest assets, providing a secure and stable investment. Secondly, the U.S. dollar maintains its status as the world's primary reserve currency in international trade, enabling the Chinese central bank to effectively manage dollar-denominated assets. Given China's currency peg to the dollar, such assets play a crucial role in maintaining the peg.
However, the key driver behind China's U.S. Treasuries accumulation is its trade imbalance with the United States. China consistently exports more to the U.S. than it imports, resulting in an excess of U.S. dollars. Nevertheless, Chinese companies and their workforce require payments in the local currency, the yuan (or renminbi). Consequently, the Chinese banking system must exchange dollars with the central bank, which then seeks strategic allocation. These dollars are subsequently invested in U.S. Treasuries, providing a reliable return.
The Scenario of China suddenly divesting all its U.S. Treasuries is unlikely, given the economic hardship and the challenge of handling surplus dollars that would entail. Such a move would have an immediate impact on interest rates for Treasuries, as a large-scale sell-off would artificially depress their prices in the bond market, leading to increased yields. Without intervention from the Federal Reserve, it is estimated that this event could raise long-term Treasury yields by 30 to 60 basis points.
The intricate dynamics between China and the United States in the realm of debt financing and economic interdependence underscore the complexities of global economic relationships. China's role as a creditor to the U.S. raises concerns due to the latter's ability to print unlimited currency, potentially leading to inflationary pressures that could affect China's real repayment value. Nevertheless, the compelling need to ensure price competitiveness for its global exports forces China to continue its acquisition of U.S. debt. This nuanced relationship underscores the profound interconnectedness of the two economic giants and highlights the importance of maintaining a delicate balance in the global financial landscape. As the world watches, the choices and decisions made by both nations will undoubtedly have far-reaching implications for the future of the global economy.