Last week, the United States once again walked up to the precipice of a debt default, and once again the world wonders why any country, much less the world’s largest economy, would endanger its financial reputation and thus its ability to borrow.
Though a potential global financial crisis was averted at the last minute, one notable development has been a string of warnings by Chinese officials. Prime Minister Li Keqiang told Secretary of State John Kerry that he was “highly concerned” about a possible default. Yi Gang, deputy governor of China’s central bank, warned that America “should have the wisdom to solve this problem as soon as possible.” An opinion essay in Xinhua, the state-run media agency, called “ for the befuddled world to start considering building a de-Americanized world.”
These statements, unusually blunt coming from the Chinese, show that repeated, avoidable crises threaten the privileged position of the U.S. as issuer of the world’s main reserve currency and (until now) risk-free debt.
It is unlikely that China would provoke a sudden, international financial calamity — for instance, by unloading U.S. Treasury securities and other government debt. Nonetheless, the process of repeated crises and temporary reprieves will only solidify the Chinese government’s determination to diversify its holdings away from dollar-denominated assets. Moreover, these crises provide ammunition to advocates within the Chinese government for expanding the role of the renminbi in international markets. Both of these trends will erode the ability of the United States to issue debt at super-low interest rates, and accelerate the ascent of China’s currency.
Foreign entities — governments, companies and individuals — hold nearly half of the publicly held debt owed by the United States. Of China’s $3.6 trillion in foreign exchange reserves, about 60 percent is estimated to be held in U.S. government securities.
As foreign exchange reserves have soared over the last decade, Chinese monetary authorities have attempted to diversify away from dollar-denominated assets, with limited success. The motivation for diversification is understandable: Since July 2005, the Chinese currency has been appreciating against the U.S. dollar, so that in terms of local purchasing power, dollar-denominated holdings have been losing value.
In addition, the fiscal battles in Washington have made the Chinese authorities more anxious. The overarching problem is that over the longer term, U.S. government finances are not sustainable, in the absence of enhanced tax revenues and restrained spending.
However, Chinese policy makers have fairly limited room for maneuver. First, they are locked into a development model that relies heavily on exports as a source of growth. It’s well recognized that adjustment to a new, more domestically oriented growth model is required. But that process will take a long time, and progress thus far has been halting. Hence, it’s likely that China will continue to accumulate large foreign exchange reserves.
Second, most of the earnings received by Chinese exporters are in dollars, so that currency is what the People’s Bank of China accumulates. In principle, the dollars could be exchanged for other convertible currencies, like the euro or the Swiss franc. But any move to sell dollars in large-enough amounts to make a dent in dollar-denominated holdings would likely drive down the value of the dollar in such a way as to diminish the value of the securities held by the central bank.
Third, even if the Chinese could diversify their holdings away from dollars without realizing capital losses, the question would be — as always — what is the alternative? Government bonds issued by Germany, Switzerland and Britain are safe, but there just aren’t sufficiently large amounts of those securities available for purchase.
China can move away from the dollar in other ways — namely by way of its sovereign wealth fund, the China Investment Corporation (with over $500 billion under management). But again, the question is what can be purchased, and how much. Political resistance to Chinese acquisition of foreign-owned companies, particularly when issues of national security are at stake, have highlighted the dilemma.
Does that mean we Americans can rest easy? The answer is no.
To begin with, the fact that fiscal policy is partly in the hands of individuals who don’t believe that debt default is a serious issue understandably makes foreign investors uneasy. Within China, advocates of economic reform have a big argument for accelerating the policy shift that de-emphasizes exports and promotes domestic private consumption to shrink China’s trade surplus.
Moreover, China has been encouraging the invoicing of trade in renminbi, with some success (albeit starting from very low levels). In addition, China is loosening restrictions on renminbi-related financial transactions, with an eye to increasing the Chinese currency’s role in international finance. Eventually, this will mean a reduced demand for the dollar.
Over the longer term, both of these outcomes might be positive from China’s — and the world’s — perspective. However, if timed poorly, they would mean that demand for U.S. Treasury securities would decline at exactly the moment when interest rates on U.S. government debts rose. The resulting strain on government finances is not not be an outcome that patriotic Americans of any stripe should welcome.
Menzie D. Chinn, a professor of public affairs and economics at the University of Wisconsin, Madison, is the author, with Jeffry A. Frieden, of “Lost Decades: The Making of America’s Debt Crisis and the Long Recovery.”
© 2013 The International New York Times