Many worry that China’s ownership of American debt affords the Chinese economic leverage over the United States. This apprehension, however, stems from a misunderstanding of sovereign debt and of how states derive power from their economic relations. The purchasing of sovereign debt by foreign countries is a normal transaction that helps maintain openness in the global economy. Consequently, China’s stake in America’s debt has more of a binding than dividing effect on bilateral relations between the two countries.
Even if China wished to “call in” its loans, the use of credit as a coercive measure is complicated and often heavily constrained. A creditor can only dictate terms for the debtor country if that debtor has no other options. In the case of the United States, American debt is a widely-held and extremely desirable asset in the global economy. Whatever debt China does sell is simply purchased by other countries. For instance, in August 2015 China reduced its holdings of U.S. Treasuries by approximately $180 billion. Despite the scale, this selloff did not significantly affect the U.S. economy, thereby limiting the impact that such an action may have on U.S. decision-making.
Holders of U.S. Debt
Furthermore, China needs to maintain significant reserves of U.S. debt to manage the exchange rate of the renminbi. Were China to suddenly unload its reserve holdings, its currency’s exchange rate would rise, making Chinese exports more expensive in foreign markets. As such, China’s holdings of American debt do not provide China with undue economic influence over the United States.
Why do countries accumulate foreign exchange reserves?
Any country that trades openly with other countries is likely to buy foreign sovereign debt. In terms of economic policy, a country can have any two but not three of the following: a fixed exchange rate, an independent monetary policy, and free capital flows. Foreign sovereign debt provide countries with a means to pursue their economic objectives.
The first two functions are monetary policy choices performed by a country’s central bank. First, sovereign debt frequently comprises part of other countries’ foreign exchange reserves. Second, central banks buy sovereign debt as part of monetary policy to maintain the exchange rate or forestall economic instability. Third, as a low-risk store of value, sovereign debt is attractive to central banks and other financial actors alike. Each of these functions will be discussed briefly.
Any country open to international trade or investment requires a certain amount of foreign currency on hand to pay for foreign goods or investments abroad. As a result, many countries keep foreign currency in reserve to pay for these expenses, which cushion the economy from sudden changes in international investment. Domestic economic policies often require central banks to maintain a reserve adequacy ratio of foreign exchange and other reserves for short-term external debt, and to ensure a country’s ability to service its external short-term debt in a crisis. The International Monetary Fund publishes guidelines to assist governments in calculating appropriate levels of foreign exchange reserves given their economic conditions.
A fixed or pegged exchange rate is a monetary policy decision. This decision attempts to minimize the price instability that accompanies volatile capital flows. Such conditions are especially apparent in emerging markets: Argentinian import price increases of up to 30 percent in 2013 led opposition leaders to describe wages as “water running through your fingers.” Since price volatility is economically and politically destabilizing, policymakers manage exchange rates to mitigate change. Internationally, few countries’ exchange rates are completely “floating,” or determined by currency markets. To manage domestic currency rates, a country might choose to purchase foreign assets and store them for the future, when the currency might depreciate too quickly.
A low-risk store of value
As sovereign debt is government-backed, private and public financial institutions view it as a low-risk asset with a high chance of repayment. Some government bonds are seen as riskier than others. A country’s external debt may be viewed as unsustainable relative to its GDP or its reserves, or a country could otherwise default on its debt. Generally, however, sovereign debt is more likely to return value and therefore is safer relative to other forms of investment, even if earned interest is not high.
Why does China buy U.S. debt?
China buys U.S. debt for the same reasons other countries buy U.S. debt, with two caveats. The crippling 1997 Asian Financial Crisis prompted Asian economies, including China, to build up foreign exchange reserves as a safety net. More specifically, China holds large exchange reserves, which were built up over time due in part to persistent surpluses in the current account, to inhibit cash inflows from trade and investment from destabilizing the domestic economy.
China’s large U.S. Treasury holdings say as much about U.S. power in the global economy as any particularity of the Chinese economy. Broadly speaking, U.S. debt is an in-demand asset. It is safe and convenient. As the world’s reserve currency, the U.S. dollar is extensively used in international transactions. Trade goods are priced in dollars and due to its high demand, the dollar can easily be cashed in. Furthermore, the U.S. government has never defaulted on its debt.
A Conversation with Scott Miller
0:12 - Can China use its creditor position as an instrument of power or leverage against the U.S?
2:09 - Why do countries buy each other’s debt?
3:40 - If China sells its U.S. Treasury Bonds, what would happen? How would the economies of both countries be affected?
5:43 - Would countries still eagerly buy US Treasury Bonds if the US dollar was no longer the world economy’s reserve currency?
Despite U.S. debt’s attractive qualities, continued U.S. debt financing has concerned economists, who worry that a sudden stop in capital flows to the United States could spark a domestic crisis.1 Thus, U.S. reliance on debt financing would present challenges—not if demand from China were halted, but if demand from all financial actors suddenly halted.2
From a regional perspective, Asian countries hold an unusually large amount of U.S. debt in response to the 1997 Asian Financial Crisis. During the Asian Financial Crisis, Indonesia, Korea, Malaysia, the Philippines, and Thailand saw incoming investments crash to an estimated -$12.1 billion from $93 billion, or 11 percent of their combined pre-crisis GDP.3 In response, China, Japan, Korea, and Southeast Asian nations maintain large precautionary rainy-day funds of foreign exchange reserves, which—for safety and convenience—include U.S. debt. These policies were vindicated post-2008, when Asian economies boasted a relatively speedy recovery.
From a national perspective, China buys U.S. debt due to its complex financial system. The central bank must purchase U.S. Treasuries and other foreign assets to keep cash inflows from causing inflation. In the case of China, this phenomenon is unusual. A country like China, which saves more than it invests domestically, is typically an international lender.4
To avoid inflation, the Chinese central bank removes this incoming foreign currency by purchasing foreign assets—including U.S. Treasury bonds—in a process called “sterilization.” This system has the disadvantage of generating unnecessarily low returns on investment: by relying on FDI, Chinese firms borrow from abroad at high interest rates, while China continues to lend to foreign entities at low interest rates.5 This system also compels China to purchase foreign assets, including safe, convenient U.S. debt.
Who owns the most U.S. debt?
Around 70 percent of U.S. debt is held by domestic financial actors and institutions in the United States. U.S. Treasuries represent a convenient, liquid, low-risk store of value. These qualities make it attractive to diverse financial actors, from central banks looking to hold money in reserve to private investors seeking a low-risk asset in a portfolio.
Of all U.S. domestic public actors, intragovernmental holdings, including Social Security, hold over a third of U.S. Treasury securities. The secretary of the treasury is legally required to invest Social Security tax revenues in U.S.-issued or guaranteed securities, stored in trust funds managed by the Treasury Department.
The Federal Reserve holds the second-largest share of U.S. Treasuries, about 13 percent of total U.S. Treasury bills. Why would a country buy its own debt? As the U.S. central bank, the Federal Reserve must adjust the amount of money in circulation to suit the economic environment. The central bank performs this function via open market operations—buying and selling financial assets, like Treasury bills, to add or remove money from the economy. By buying assets from banks, the Federal Reserve places new money in circulation in order to allow banks to lend more, spur business, and help economic recovery.
Excluding the Federal Reserve and Social Security, a number of other U.S. financial actors hold U.S. Treasury securities. These financial actors include state and local governments, mutual funds, insurance companies, public and private pensions, and U.S. banks. Generally speaking, they will hold U.S. Treasury securities as a low-risk asset.
The biggest effect of a broad scale dump of US Treasuries by China would be that China would actually export fewer goods to the United States.
– Scott Miller
Overall, foreign countries each make up a relatively small proportion of U.S. debt-holders. Although China’s holdings have represented just under 20 percent of foreign-owned U.S. debt in the past several years, this percentage only comprises between 5 and 7 percent of total U.S. debt. China’s holdings fell to $1.05 trillion in November 2018, marking the lowest level in a year in a half. Moreover, Japan has at times over the past several years overtaken China as the largest foreign holder of U.S. debt.
Internationally, this situation is common: most sovereign debt is held domestically. European financial institutions hold the majority of European sovereign bonds. Similarly, Japanese domestic financial actors hold approximately 90 percent of Japanese net sovereign debt. Thus despite international demand for U.S. sovereign debt, the United States is no exception to the global trend: U.S. domestic actors hold the majority of U.S. sovereign bonds.
- Ashvin Ahuja et al., “An End to China’s Imbalances?,” in China’s Economy in Transition: From External to Internal Rebalancing, ed. Anoop Singh, Malhar Nabar, and Papa N’Diaye (Washington, DC: International Monetary Fund, 2013), 11.
- For those interested in the 2008 crisis and the relationship among U.S. debt, international capital flows, and global trade, see Reserve Bank of India Governor Raghuram Rajan’s highly insightful and accessible analysis, Fault Lines: How Hidden Fractures Still Threaten the World Economy (New Jersey: Princeton University Press, 2010).
- Steven Radelet and Jeffrey Sachs, “The Onset of the East Asian Financial Crisis,” in Currency Crises, ed. Paul Krugman (Chicago: University of Chicago Press, 2000), 111.
- Yu Yongding, “Rebalancing the Chinese Economy,” Oxford Review of Economic Policy, Vol. 28, No. 3, 2012, 560.
- Yu Yongding, “Rebalancing the Chinese Economy,” Oxford Review of Economic Policy, Vol. 28, No. 3, 2012, 560.