China has been steadily accumulating US treasury securities for decades. Additionally, trade data from the US Census Bureau shows that China has been running a big trade surplus with the US since 1985. This means that China sells more goods and services to the US than the US sells to China.
The question is, is China, the world’s largest manufacturing hub and an export-driven economy with a burgeoning population, trying to “buy out’ the US markets through its debt accumulation, or is it a case of forced acceptance? This article discusses the business behind the continuous Chinese buying of US debt.
China is primarily a manufacturing hub and an export-driven economy. Chinese exporters receive US dollars for their goods sold to the US, but they need Renminbi (RMB or Yuan) to pay their workers and store money locally. They sell the dollars they receive through exports to get RMB, which increases the USD supply and raises demand for RMB. China's central bank (People’s Bank of China – PBOC) carried out active interventions to prevent this imbalance between the US dollar and Yuan in local markets. It buys the available excess US dollars from the exporters and gives them the required Yuan. PBOC can print Yuan as needed. Effectively, this intervention by the PBOC creates a scarcity of US dollars which keeps the USD rates higher. China hence accumulates USD as forex reserves.
Why Does China Buy U.S. Treasury Bonds?
If the Pboc Refrained From Intervening
The international trading which involves two currencies has a self-correcting mechanism. Assume Australia is running a current account deficit, i.e. Australia is importing more than it is exporting (scenario 1). The other countries which are sending goods to Australia are getting paid AUD, so there is a huge supply of AUD in the international market, leading the AUD to depreciate in value against other currencies. However, this decline in AUD will make Australian exports cheaper and imports costlier. Gradually, Australia will start exporting more and importing less, due to its lower-valued AUD. This will ultimately reverse the initial scenario (scenario 1 above). This is the self-correcting mechanism that occurs in the international trade and forex markets regularly, with little or no intervention from any authority.
China-US Business: A Different Case
China’s strategy is to maintain export-led growth, which aids it in generating jobs and enables it, through such continued growth, to keep its large population productively engaged. Since this strategy is dependent on exports (mostly to the US), China requires RMB in order to continue to have a lower currency than the USD, and thus offer cheaper prices. If it stops interfering in the previously described manner, the RMB would self-correct and appreciate in value, thus making Chinese exports costlier. It would lead to a major crisis of unemployment due to loss of export business. China wants to keep its goods competitive in the international markets, and that cannot happen if the RMB appreciates. Therefore, it keeps the RMB low compared to the USD using the mechanism that's been described. However, this leads to a huge pileup of USD as forex reserves for China.
Why Other Countries Don't Follow This Strategy
Though other labor-intensive, export-driven countries such as India carry out similar measures, they do so only to a limited extent.
One of the major challenges resulting from the approach that's been outlined is that it leads to high inflation. China has a tight, state-dominated control on its economy and is able to manage inflation through other measures like subsidies and price controls. Other countries don’t have such a high level of control and have to give in to the market pressures of a free or partially-free economy. Additionally, China, being a strong nation, can withstand any political pressure from other importing nations, which is usually not feasible in the case of other countries. For example, Japan had to give in to the US's demands in the 1980s, when it tried to curb JPY rates against the USD.
How China Uses Its USD Reserves
China has approximately 3.13 trillion dollars of US reserves as of February 2018. Like the US, it also exports to other regions like Europe. The Euro forms the second biggest tranche of Chinese forex reserves. China needs to invest such huge stockpiles to earn at least the risk-free rate. With trillions of US dollars, China has found the US treasury securities to offer the safest investment destination for Chinese forex reserves.
Multiple other investment destinations are available. With Euro stockpiles, China can consider investing in European debt. Possibly, even US dollar stockpiles can be invested to obtain comparatively better returns from Euro debt.
However, China acknowledges that stability and safety of investment take priority over everything else. Though the Eurozone has been in existence for around 18 years now, it still remains unstable. It is not even certain whether the Eurozone (and Euro) will continue to exist in the mid-to-long term. An asset swap (US debt to Euro debt) is thus not recommended, especially in cases where the other asset is considered riskier.
Other asset classes like real estate, stocks, and other countries' treasuries are far riskier compared to US debt. Forex reserve money is not spare cash to be gambled away in risky securities for want of higher returns.
Another option for China is to use the dollars elsewhere. For example, the dollars can be used to pay Middle East countries for oil supplies. However, those countries too will need to invest the dollars they receive. Effectively, owing to the acceptance of the dollar as the international trade currency, any dollar supply eventually resides in the forex reserve of a nation, or in the safest investment – US treasury securities.
One more reason for China to continuously buy US treasury securities is the gigantic size of the US trade deficit with China. The monthly deficit is around $25-35 billion, and with that large amount of money involved, treasuries are probably the best available option for China. Buying US treasuries enhances China's money supply and creditworthiness. Selling or swapping such treasuries would reverse these advantages.
Impact of China Buying US Debt
US debt offers the safest heaven for Chinese forex reserves, which effectively means that China offers loans to the US so that the US can keep buying the goods China produces.
Hence, as long as China continues to have an export-driven economy with a huge trade surplus with the US, it will keep piling up US dollars and US debt. Chinese loans to the US, through the purchase of US debt, enable the US to buy Chinese products. It’s a win-win situation for both nations, with both benefiting mutually. China gets a huge market for its products, and the US benefits from the economical prices of Chinese goods. Beyond their well-known political rivalry, both nations (willingly or unwillingly) are locked in a state of inter-dependency from which both benefit, and which is likely to continue.
Effectively, China is buying the present day “reserve currency”. Until the 19th century, gold was the global standard for reserves. It was replaced by the British pound sterling. Today it is the US treasury securities which are considered virtually the safest.
Apart from the long history of the use of gold by multiple nations, history also provides instances where many countries had huge reserves of pounds sterling (GBP) in the post-World-War-II era. These countries did not intend to spend their GBP reserves or to invest in the UK but were retaining the pounds sterling purely as safe reserves. When those reserves were sold off, however, the UK faced a currency crisis. Its economy deteriorated due to the excess supply of its currency, leading to high-interest rates. Will the same happen to the US if China decides to offload its US debt holdings?
Well, it's worth noting that the prevailing economic system after the WW-II era required the UK to maintain a fixed exchange rate. Due to those restraints and the absence of a flexible exchange rate system, the selling off of the GBP reserves by other countries caused severe economic consequences for the UK. Since the US dollar has a variable exchange rate, however, any sale by any nation holding huge US debt or dollar reserves will trigger the adjustment of trade balance at the international level. The offloaded US reserves by China will either end up with another nation or will return back to the US.
The repercussions for China of such an offloading would be worse. An excess supply of US dollars would lead to a decline in USD rates, making RMB valuations higher. It would increase the cost of Chinese products, making them lose their competitive price advantage. China won’t be willing to do that, as it makes no economic sense.
If China (or any other nation having a trade surplus with the US) stops buying US treasuries or even starts dumping its US forex reserves, its trade surplus would become a trade deficit – something which no export-oriented economy would want, as they would be worse off as a result.
The ongoing worries about China's increased holding of US treasuries or the fear of Beijing dumping them are uncalled for. Even if such a thing were to happen, the dollars and debt securities would not vanish. They would reach other vaults.
Risk Perspective From the Us
Although this ongoing activity could lead to the US becoming a net debtor to China, the situation for the US may not be that bad. Considering the consequences that China would suffer from selling off its US reserves, China (or any other nation) will likely refrain from such actions. Even if China were to proceed with the selling of these reserves, the US, being a free economy, can print any amount of dollars as needed. It can also take other measures like Quantitative Easing (QE). Although printing dollars would reduce the value of its currency, thereby increasing inflation, it would actually work in favor of US debt. Real repayment value will fall proportionately to the inflation – something good for the debtor (US), but bad for the creditor (China).
The US budget deficit continues to shrink and is expected to be a very small percentage of GDP in the long run. This indicates a healthy state for the US economy, with domestic savings easily covering small deficits. Presently, the risk of the US defaulting on its debt practically remains nil (at least for now and the next few years). Effectively, the US may not need China to continuously purchase its debt; rather China needs the US more, to ensure its continued economic prosperity.
Risk Perspective From China
China, on the other hand, needs to be concerned about loaning money to a nation who also has the limitless authority to print it in any amount. High inflation in the US would have adverse effects for China, as the real repayment value to China would be reduced in the case of high inflation in the US. Willingly or unwillingly, China will have to continue to purchase US debt to ensure price competitiveness for its exports at the international level.
The Bottom Line
Geopolitical realities and economic dependencies often lead to interesting situations in the global arena. China's continuous purchase of US debt is one such interesting scenario. It continues to raise concerns about the US becoming a net debtor nation, susceptible to the demands of a creditor nation. The reality, however, is not as bleak as it may seem, for this type of economic arrangement is actually a win-win for both nations.