China does not see any choice but to keep buying US government debt, Luo Ping, a director-general at the China Banking Regulatory Commission (CBRC), told a New York risk-managers conference on Thursday.
"Except for US Treasuries, what can you hold? Gold? You don’t hold Japanese government bonds or UK. bonds. US. Treasuries are the safe-haven. For everyone, including China, it is the only option,” The Financial Times quoted Luo as saying. Even if the US dollar depreciates because of Washington’s financial bailouts, he added, China does not have any other options.
Luo is acknowledging something of an open secret. Despite occasional hints (or threats) that China might attempt to bankrupt the United States by suddenly selling all of the US debt it holds, that really is not an option. It would destroy China economically in the process, unless there were some alternative place for Beijing to invest. But for a number of reasons, there is none.
Over the past two decades, the United States and China have developed a special relationship based on the safety of US debt. In essence, the United States provides China access to the wealthiest consumer market in the world, which in turn soaks up China’s massive output of consumer goods. This not only provides income for Chinese exporters, but also helps ensure social stability in China by maintaining employment – which is Beijing’s primary economic policy goal. China in turn invests its large trade surpluses, earned in U.S. dollars, into U.S. Treasury debt (e.g. 30-year bonds or 10-year notes). This allows China to store its earnings in one of the largest and most liquid financial markets in the world, without needing to convert between currencies. Meanwhile, the recycling of surpluses into Treasury instruments helps bankroll continued US spending. It is vendor financing on a global scale.
This relationship has fuelled unprecedented booms in both US consumer spending and Chinese industrialization. Even in the midst of recession, China continues to sock away savings – but now, because of the financial crisis, many wonder whether US Treasury debt is the best vehicle for storing those funds.
Simply put, it costs a lot to buttress a collapsing financial market. As the cost of US financial bailout efforts piles up, Washington’s balance sheet is deteriorating. Since the credit crisis began in the fourth quarter of 2007, bailouts have put US government commitments at nearly $US9 trillion. To be sure, this is more akin to a line of credit than a tally of actual spending – though the actual federal outlays to date, around $US3 trillion, represent roughly 20 per cent of US gross domestic product (GDP) – but the stakes are high and investors are nervous.
China is the largest holder of US government debt, so it is no wonder that Yu Yongding, the head of China’s World Economics and Politics Institute and a former advisor to the central bank, said on Wednesday that because of its "reckless policies” the United States should "make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way.” His remarks were meant to impress upon Washington that, as the primary financier of US debt, China holds significant power in the relationship.
In general, as a country’s balance sheet comes under increasing strain, investors tend to sell that country’s assets and move their funds to a country with more attractive fundamentals (such as a trade or budget surplus). But the conventional wisdom that US debt is becoming a questionable asset and is about to be dumped by investors has not proven true. Instead, money from all over the world has been flooding into American markets, sending the dollar to its highest levels – and bond yields to their lowest – in years.
US Treasuries remain the primary vehicle for investing surpluses – and in particular Chinese surpluses. The reasons are many. For one, most other countries do not have debt markets large enough to support the level of investment China needs to make. The US debt market is larger than the three next-largest markets combined. Indeed, only Japan has a larger debt market than the United States – but because Japan’s debt represents some 170 per cent of its GDP, it has a credit rating no better than that of the better-run states in Sub-Saharan Africa. The US Treasury debt market, while large, represents only about half of the US GDP – a much more manageable fraction.
Of the top 10 largest debt markets, the four that are in the eurozone – Germany, France, Italy and Spain – potentially provide viable alternatives for China. However, these also pose problems. Much like Middle Eastern oil states, China not only receives most of its income in dollars, but also effectively pegs its own currency on the dollar. This means that for the Chinese, savings and investments held in dollar-denominated assets are relatively safe, stable and accessible. From Beijing’s perspective, it does not make much sense to convert surplus dollars into euros, only to become more exposed to the risk of currency fluctuations. (And even that assumes that one trusts, for example, Italian financial governance.)
If Beijing does not view euro-based debt as a viable alternative to the United States because of currency stability, it has even less confidence in remaining four of the top ten debt markets, which are denominated in even less stable currencies. The markets for the Brazilian real, the South Korean won, and even the Canadian dollar and British pound are simply too small, fractured and volatile to provide the level of safety of the US dollar. And in any case, all of these markets are much too small to absorb Chinese trade surpluses month after month. Only the regular issuance of multi-billion-dollar debt tranches by the United States, fuelled by US budget and trade deficits, can suffice.
If government paper cannot fill its needs, China could turn to commodities – if anything, perhaps gold could provide a viable store of value without subjecting China to the fiscal swashbuckling of a foreign government. But even here, the size of the gold market could not support China’s investment needs. Even if China were somehow able to absorb the total annual output of the world’s gold mines – roughly 80 million troy ounces – doing so would both collapse global debt markets and send gold prices to stratospheric heights. (Not exactly a welcome scenario for a country utterly dependent upon international trade.) And for all that, China could sock away the same amount of value after only about three months of trading with the United States.
Ultimately, steering funds clear of American debt markets is not desirable – or even possible – for the Chinese. Luo, the CBRC director-general (who is known for his colloquial style), put Beijing’s viewpoint about as plainly as it can be put in his speech in New York.
"We hate you guys, but there is nothing much we can do.”