Holding upwards of $1.1 trillion in U.S. debt, it is no secret that China is America’s leading foreign creditor. It came as no surprise, then, that while traveling through Asia last week U.S. Secretary of State Hillary Clinton gave strong assurances to Beijing that policymakers in Washington would soon reach an agreement raising the country’s debt ceiling. Yet, as each day passes without resolution, the unthinkable possibility that the world’s largest economy might actually default on its debt obligations seems increasingly conceivable.
What exactly would a U.S. default mean for Sino-American relations? Perhaps surprisingly, the reputational consequences would likely overshadow the economic effects of such an event.
The notion that China will stop buying U.S. treasury bonds or perhaps commence a massive sell-off of T-bills it already holds as a way to defend itself from financial losses or punish the U.S. for reckless behavior is unfounded. China has little choice but to continue buying U.S. debt in the near-term, even if the U.S. suspends interest payments to Beijing for a period of time. Here’s why.
First, U.S. treasuries are still the most viable investment vehicle for China and its massive foreign exchange reserves. While shrinking of late, China’s trade surplus with the U.S. is still significant—nearly $50 billion in the last quarter alone. The U.S. debt market is nearly singular in its ability to absorb such huge quantities of dollars. One reason China buys T-bills is because the market is both deep and liquid, allowing parties to get prices, buy, and sell quickly. So long as China wants to maintain its export-led growth model, it will need to find places to invest its reserves and U.S. Treasuries will remain the first option, post-default or not.
Second, China wants to maintain a stable yuan-dollar exchange rate. The People’s Bank of China buys up all the dollars that enter the economy and uses them to buy Treasuries which props up the value of the dollar vis-à-vis the yuan. This has enabled China to preserve its export competitiveness longer than it otherwise would have.
Third, Beijing is too smart to employ the “nuclear” option of selling off a large portion of its U.S. debt since this move would debase the value of its remaining dollar denominated investments.
In other words, a U.S. default isn’t likely to have a lasting impact on Sino-American financial relations as things should return to the status quo rather quickly once the U.S. cleans up its fiscal mess. Nonetheless, China is keenly aware of its exposure to U.S. government debt and has been slowly apportioning a smaller percentage of its reserves toward buying T-bills of late. But, this is not a direct response to the debt ceiling debate. Rather, this is part of Beijing’s long-term plan that involves a stronger, internationalized yuan and a more consumption-based economy. An American default would simply further validate this strategy.
On the other hand, while the financial relationship of the two powers should continue unchanged, a U.S. default would generate serious reputational consequences for both countries. And, in this case, China would emerge the clear winner.
For more than 60 years, the U.S. has been the world’s unchallenged leader on global economic issues. This status has made it easier for the U.S. to get other countries to want the kinds of economic policies favored by the U.S., what Joseph Nye dubbed “soft power”. Indeed, it has attempted to use this against China by insinuating that its policy of keeping the yuan undervalued is not fitting of a leading global economy.
However, American moral authority on economic issues is eroding due to recent events viewed around the world as either reckless or self-serving.
An American default would represent the third major strike against America’s reputation as a responsible and stabilizing force in the global economy.
The first strike came in 2008 when the subprime bubble popped and plunged the world into recession. Since then, a seemingly endless stream of reports and documentaries on the American financial system has transformed its image from being the envy of the world into the poster child for capitalism gone wrong.
The second strike came in the fall of 2010 when the Federal Reserve went ahead with a controversial second round of quantitative easing, now ubiquitously (perhaps infamously) known as “QE2”. The Fed’s bond buying program launched just a month after Brazil’s Finance Minister, Guido Mantega, said the world was “in the midst of an international currency war.” While the Fed said QE2 was designed to stimulate the domestic economy by keeping interest rates low, many outsiders viewed it as a return to “beggar-thy-neighbor” policies; a veiled attempt to depress the dollar’s value and make U.S. goods more competitive in foreign markets.
A default on its debt obligations would mark the third strike against America’s once favorable international economic reputation. That the “debt crisis” is self-inflicted only serves to harden the blow. The fact of the matter is, if the U.S. defaults, it won’t be because markets wouldn’t lend—it’s because politics wouldn’t allow the country to borrow. In the world’s eyes, this looks negligent at best, foolhardy at worst.
Meanwhile, China’s reputation as a responsible global economic leader has improved since the global crisis. Though it did face increased criticism from some corners when it reinstated its de facto yuan-dollar peg, China justified this by arguing that in uncertain times, its role was to maintain a stable currency in a very unstable global economy. It has since allowed the yuan to appreciate against the dollar, albeit at a very slow pace.
Beijing also implemented a $586 billion stimulus plan in 2008 that was praised by the International Monetary Fund (IMF) as not only good for China, but a boon for an ailing global economy. Lastly, China is poised to become the third most powerful voice within the IMF when the latest quota review is completed. In short, its leadership credentials are rising even as America’s are coming under greater scrutiny.
Thus, while the financial consequences of a U.S. default for Sino-American relations would be fleeting, the reputational consequences could be enduring. American default will further erode any moral authority the U.S. has vis-à-vis China on economic issues such as the yuan-dollar exchange rate. In the long-run, China might actually emerge the biggest “winner” if the U.S. defaults, gaining insulation from American criticism and perhaps assuming the mantra of the world’s most responsible economic power.
Daniel McDowell is a Bankard Fund for Political Economy Fellow at the University of Virginia and has written for Foreign Policy magazine, Washington Times, and is a regular contributor to World Politics Review.