Republicans in the U.S. Congress reached an 11th hour compromise with President Obama about the fiscal year 2011 budget, narrowly avoiding the machinery of government being shut down. However it was more a temporary settlement than a practical solution. According to the Congressional Budget Office’s (CBO) estimate, the new budget bill facilitated by the Republicans would actually cut federal spending by less than 1% of the targeted US$38 billion.
But the real key issue about U.S. debt is its medium- to long-term prospects. Currently the U.S. annual fiscal deficit and total national debt as shares of GDP are roughly 10% and 100% respectively, far exceeding the recognized 3% and 60% safety standards. Rather than improve, the situation could considerably worsen after the US economy recovers as healthcare costs are set to rise significantly as the Baby Boomers start to retire and American tax rates are kept low. Never short of reform initiatives, President Obama proposes to reduce the deficit by US$4 trillion over the next 10 years. According to the CBO, the U.S. deficit as a share of GDP could drop to an average 3.1% from 2014 to 2021 if tax and spending policies unfold as specified. However, this is problematic due to the U.S.’s wrangling partisan politics. Republicans insist on cutting spending while Democrats favor raising taxes. Little can be achieved if the two parties do not constructively adjust their behavior.
Another structural risk is that the U.S. is increasingly relying on external sources to finance its debt. Currently almost half of the U.S. national debt held by the public outside the U.S. government, i.e., two-thirds of the total US$14.3 trillion, is financed by foreigners. However, it is not certain whether the world is willing or capable to continue financing the U.S. Latest U.S. Treasury data shows nearly half of the total foreign holdings have been purchased by its two largest creditors, China and Japan. Unfortunately, it cannot be taken for granted that these two giant surplus countries will continue to be stable sources of U.S. debt financing.
Japan’s capability to support its ally is obviously weakening. A debt-to-GDP ratio of more than 200%, the highest in the world, has already left little space for Japan’s macroeconomic policy. However, the violent earthquake and tsunami and the nuclear power plant damage add insult to injury. Speculation loomed large that Japan might have to dump US Treasury securities for reconstruction. The Japanese government quickly intervened, coordinately with the G-7 and calming the market. Japan prefers not to retreat from American bonds so as to prevent yen appreciation harming its exports. However, accumulating further debt could be more and more difficult. Japan’s current account surplus is expected to shrink due to the effects of the disaster on its advanced car and electronics industries. In the long run, while analysts cite the limited economic loss of the 1995 Osaka-Kobe Earthquake as a precedent and hold optimistic views about the impact of this disaster, the heavily-indebted situation nowadays does make a big difference for the recovery. With the world’s “oldest” population, Japan is also seeing its high savings rate rapidly declining, which would make debt sustainability more problematic. Even though Japan will keep holding its present levels of U.S. debt, any future purchases will be very difficult.
China as the No. 1 shareholder currently owns 26% of US Treasury securities. Its interest and willingness to hold US debt is also declining. China’s mandatory foreign exchange settlement policy since 1994, and the resulting huge accumulation of foreign reserves, is a sort of self-help measure to cushion its economy against external financial turbulence. Unexpectedly, the reserve rose dramatically and exceeded US$3 trillion by the end of March 2011. Investing the bulk of the reserve in U.S. Treasury securities used to be considered a safe choice. This, however, turned out to be a misperception and miscalculation after the US-originated 2008 financial crisis. It is true that currently China is actually trapped in dollar credit without an immediate exit. Nevertheless, this lesson will definitely drive China to diversify its reserves and seek de-dollarization in the long run. China expedited the process of establishing the Shanghai international financial center and pushing internationalization of the RMB. Since July 2009, the number of pilot enterprises settling exports in RMB has increased from 365 to over 67,000. Actual foreign transactions in RMB reached ￥360.3 billion in the first quarter of 2011, 70% of the total amount of last year. Central bank officials indicate recent reforms will be accelerated to facilitate FDI in RMB and the foreign purchase of Chinese debt in RMB by both governments and private companies.
The highest incentive for China to adjust its monetary policy to curb inflation and transform the economy is coming from within the country. The result will raise the cost of US borrowing. In order to support official foreign reserves, Chinese currency issuance has been growing faster than its GDP for a long period. By the end of 2010, the quantity of China’s money and quasi-money (M2) was ￥72.6 trillion (US$11 trillion), 531% more than 10 years ago, while its GDP for the same period was only ￥39.8 trillion (US$6 trillion), a gain of 322% in a decade. Inflation pressure has increased. The stimulus package of ￥4 trillion at the end of 2008 and the rising costs of commodities imports finally pushed inflation to break out late last year. The Consumer Price Index (CPI) and the Producer Price Index (PPI) rose 5.0% and 7.1% respectively in the first quarter of 2011 and are expected to continue rising. A series of measures have been adopted to tighten money supply which will have a spillover effect on the world financial market. China has many more reasons than any time in the past to see less trade surplus and RMB appreciation. All these mean the U.S. will see its cost of borrowing overseas rising sharply.
Sovereign debts are the last resort of the global financial super-cycle while the U.S. national debt is undoubtedly the “last of the last”. Not only China is concerned about US debt; so is the whole world. The Russian economist Mikhail Delyagin proposes a debtless world as the final solution to the recurrent financial crises. Certainly human society is too sophisticated to afford such a dramatic “retroversion”. However, it is time for the U.S. to really take its debt issue seriously. As a New York Times writer said three years ago, America still enjoys the privilege of being “too big to fail”, but its cost is rising. If the U.S. government is not committed enough to push reform, we should hope the world will help. Otherwise, the world will suffer, and the U.S. as well.
Ye Yu is a research fellow in Center for World Economic Studies, SIIS