Could China use its U.S. debt holdings to squeeze us on foreign policy?

ajtr

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Debt’s life, debt’s what all the people say: Big squeeze coming from China?

Could China use its U.S. debt holdings to squeeze us on foreign policy?

That's unlikely, at least in the short term, according to most of the witnesses who testified before the U.S.-China Economic and Security Review Commission last week. Beijing's role as our banker does give it significant influence in Washington. But what's often lost is the fact that China relies just as much on the U.S. as a destination for its investments. To avoid a jarring shift in this so-called balance of financial terror, Washington should do two things. First, to remain a credible borrower, we need to tackle the deficit. Second, we should lead a multilateral effort to confront China on its trade practices and currency valuation, a cause many countries worldwide can get behind. It also would reduce the chances of Beijing converting its economic influence into outsized foreign policy power.

Currently, the New York Fed puts China's holdings of U.S. Treasury Securities at $755 billion, making it our second largest foreign investor, just behind Japan. But the real figure could be closer to $1 trillion when you add in Hong Kong's $153 billion and possible offshore investments through third parties. As for foreign currency reserves, Beijing holds around $2.4 trillion, according to the People's Bank of China.

Fears that China might dump much of that debt -- and trigger an international sell-off -- are unfounded. For one, Beijing would suffer considerable losses on its U.S. holdings (although Cornell Professor and Brookings Senior Fellow Eswar Prasad argued, Beijing would lose less than most analysts believe). More fundamental, though, is another issue: If not here, where? There is simply no other market deep enough to absorb all of the capital China has invested. As Dr. Derek Scissors of the Heritage Foundation put it, China has two options for its money: "buy U.S. bonds or build a really big mattress." And since China's foreign currency investments are what allow it to keep the renminbi pegged artificially low against the dollar, the mattress idea won't get much bounce.

On the flip side, we do rely heavily on Chinese investment to finance everything from stimulus spending to the wars in Iraq and Afghanistan. If Beijing were to try to use its creditor status to pressure Washington, we could push back with trade sanctions and potentially find other lenders. Neither is an attractive prospect, however, as China would no doubt match our sanctions with those of its own, and our growing deficit could make the search for alternative sources of financing difficult. For the short term, at least, it seems we're coming to state of mutually assured economic destruction; both countries need each other and neither is likely to risk any serious damage to the relationship.

As a result, the U.S. has more leverage than you might think, both in economic and foreign policy. Tufts' Fletcher School Professor and FP blogger extraordinaire Dazzlin' Daniel Drezner criticized the supplicant attitude the Obama Administration adopted early on towards China when Secretaries Clinton and Geithner both seemed to plead for continued lending. He sees our more recent decisions like the sale of arms to Taiwan as a needed adjustment of this misguided course. Right now, he argues, China's economic clout has given it more autonomy and a greater ability to resist U.S. pressure. But Beijing remains unable to force Washington's hand on various economic and foreign policy decisions.

China's influence is much stronger in many of the developing countries where it's heavily invested. These nations depend on Beijing for significant financial and technical assistance and don't offer enough in return to balance their relationships. China is cultivating various suppliers of raw materials from the developing world, ensuring individual countries are easily replaceable should they refuse to kowtow to Beijing. As a result, Chinese economic investment will likely translate into political returns from such countries -- an outcome that could pose serious challenges to U.S. foreign policy goals, especially in the longer term.

Indeed, the greatest threat China poses to the U.S. is over the long term. If another reserve currency were to emerge that could absorb Chinese investment, the U.S. would no longer be China's only option. Beijing has recently shown interest in either internationalizing the renminbi or in using IMF-issued Special Drawing Rights, although a Chinese economist reportedly dismissed the latter as "the Esperanto of international reserve currencies." But such alternatives might look more attractive if the U.S. is unable to get its economic house in order and tackle the skyrocketing deficit. Granted, China, too, has domestic concerns. Prasad explained that much of the bluster we see from China is in response to instability within the country where nationalism is seen as a safe channel for political expression. If nationalism grows too strong or loses its effectiveness as a safety valve, all bets are off.

To try to rein in China's economic and foreign policy reach, most of the witnesses suggested the U.S. take advantage of the fact that we're not the only country frustrated with Beijing's trade and currency policies. ASEAN countries, the EU, and various developing nations are all suffering from Chinese economic controls, and working with these partners to pressure China on trade and its exchange rate would be a useful step. India, in particular, as a powerful country not closely bound to China, might prove a key ally. Nearly all of the panelists advocated using the G20 as a mechanism to address these concerns multilaterally. But the general feeling was that Washington is just going to have to get used to the fact that, after twenty years alone on the world stage, the U.S. is no longer pulling all the strings.

Incidentally, a couple of times during the hearing, Commissioner Larry Woertzel citied this Defense News article as evidence that the recently released QDR intentionally softened its tone on China for fear of angering our banker in Beijing. I don't see much support for that in the article itself, but I'd be interested to hear if anyone else has insights into that question.
 
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could USA refuse to honor the debt and make Chinese holdings worthless ??as there is no market for them currently, what can China do to make USA payup??(not much) Since US govt is the only buyer left for this worthless junk they will decide where,when and how much and what price they will give for it; so USA still has the upperhand.
 
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Koji

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That would have the same effect. The US would lose their financial credibility instantly and their economy will tank anyways. Japan, Taiwan, and SK also hold a huge portion of American debt.
 
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USA current financial situation has already lost alot of credibility any reduction in USA's credit rating and things like this may become possible,in history debt based economies and trade always lead to defaults.
 

no smoking

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USA current financial situation has already lost alot of credibility any reduction in USA's credit rating and things like this may become possible,in history debt based economies and trade always lead to defaults.
Suffering the financial lost is a problem of your ability. Denial of your debt is a problem of your personality. If US gov dishonor its debt, the whole world will question its credibility. Meanwhile the credibility of US dollar will be impacted as well since you can just issue a new version of dollar to replace it. So, the possible scenario would be: every individual, banker, business man and gov would sent their US dollar deposit back to US asking for some commodities: oil, machine, etc. Meanwhile all US importer will be forced to pay their purchase with foreign currency. This means that US has to take back more than 30 trillions US in a short period. Do you think US can live with that?

By the way, india is not that important.
 
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Very simply put how does a nation not honoring it's debt obligations of trillions of dollars harm the nation? (it dosen't it benefits the nation)
 

no smoking

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Ok simply put: 1. you will never expect to borrow money from foreigners any more. Even if you are lucky enough to find a banker, the interest will be rocket high since your creditability is negative.
2. since you credibility is negative, another kind of bond you issued--your currency will be worthless, from then on you have to pay every importation deal with gold, foreign currency or even commodity.
3. Since your currency become worthless, all the money your gov or domestic banks lend to other countries or foreign companies can be paid back immediately, they may clean their millions dollars debt with several erupe dollar.
4. Since your currency value is going down so quickly that your exportation will die in weeks unless you would accept your own worthless currency from your foreign customers.
 
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No smoking many of these things have already have happened the government is taking over many banking and financial institutions, the risk to the currency is short term which would be absorbed and recovered, as social cost escalate health care,medicare,medicaid etc when the boomers retire the revenue from their incomes will also be gone and an added expense will increase, with no new industries booming the picture looks grim for this decade, in all this ,does any debt holding nation seriously think they will be paid for their debt, currently interest rates are .01% and US treasury yield is almost zero. US is now looking at military solutions for their problems so I see very few nations making anything on their US debt holdings for a long time and even fewer recovering their IOU's from USA.
 
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Armand2REP

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Of course they can't. They sell their USD FOREX they not only devalue their own holdings by dragging the dollar down, they also increase inflation by not having as much FOREX to back the RMB. They would have to free-float the fiat currency and destroy their export model. China won't be ready to break from the USD until consumer spending reaches the 60% mark.
 

ajtr

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Is it time to ding Beijing?

There is a growing drumbeat to do something about China's undervalued currency. In November, Paul Krugman urged the Obama Administration to take the situation seriously. As the financial crisis abates, he wrote, trade imbalances would blossom again.

So picture this: month after month of headlines juxtaposing soaring U.S. trade deficits and Chinese trade surpluses with the suffering of unemployed American workers. If I were the Chinese government, I'd be really worried about that prospect.

In the Financial Times in December, a retired University of Chicago economics professor called for a 10 percent tariff on all U.S. imports from China. Last week, a group of 15 Republican and Democratic senators demanded the Commerce Department to treat China's currency policy as a subsidy. In just over a month, the Treasury will need to state yet again whether it considers China a currency manipulator.

So what is to be done? There is a very strong case that China's currency is undervalued. The most telling indicator is that China's foreign exchange reserves have hit $2.4 trillion and are growing at a rate of roughly $400 billion per year. There is also a strong, but more subtle, argument that it would be in China's own interest to revalue its currency. But the Chinese leadership has frozen the RMB against the dollar since the middle of 2008.

The question, then, is what policy options are on the table. A menu:

1. Quiet, patient diplomacy. This is the default and is easily the least satisfying to members of Congress. In this approach, the administration works with like-minded countries around the world to apply behind-the-scenes pressure on the Chinese to revalue.

This characterized much of the Bush administration currency diplomacy, which resulted in a substantial appreciation of the RMB from 2005 to 2008. The approach wasn't domestically popular at the time and is likely to encounter new hurdles now (the Chinese are distinctly less interested in receiving financial advice in the wake of the crisis).

2. Naming China a currency manipulator. There is an appeal to this. First, it's honest. By any conventional definition of the word 'manipulate', that's what China is doing. Second, it is a way of venting frustration. The question is whether it will make the Chinese act more quickly. I suspect the opposite; this will slow the Chinese down. There is already speculation that the Chinese will resume appreciating their currency later this year, as concerns about an export downturn give way to concerns about inflation. However, the Chinese do not want to be seen as succumbing to U.S. ultimata. This is a policy that would make us feel better, but likely be counterproductive.

3. Sticks and stones. If name-calling doesn't move the Chinese, what about threats of tariff retaliation? When analysts oppose naming China as a manipulator, it is often because they think this sort of action will follow. This would make it even less likely the Chinese would move, since they could not just let a suitable period of time pass to save face. It would also saddle Americans with the costs of protection and seriously exacerbate existing tensions in Sino-U.S. relations.

4. A WTO challenge. Using the World Trade Organization as the fulcrum to lever Chinese action is more likely to break the WTO than it is to move the Chinese. One might argue that Chinese exchange rate policy contravenes the spirit of WTO rules, but that has not been the traditional interpretation. Even if the WTO adopts an expansive interpretation - a practice the United States has condemned in the past - it is unlikely this would prompt the Chinese to budge.

5. A multilateral framework. What if the major nations of the world got together to condemn China's approach to exchange rates? There are a few problems with this. First, the Obama Administration has worked hard to ensure that China has a seat as one of the major nations. In consensus diplomacy, that gives them veto power. Beyond that, it's hard to give teeth to something like this. The IMF has been authorized to name and shame on imbalances for years and has already criticized China's currency policy. The Chinese are about as troubled as the United States is when the IMF calls U.S. budget deficits unsustainable. The problem is exacerbated in the case of China because they're the lender; the IMF has leverage when countries come with hat in hand, not when they come with bulging wallets.

The fundamental problem is that the Chinese are more scared of the potential pain of currency appreciation than they are of anything the West might realistically throw at them. China recently conducted a "stress test" to look at the possible effects of a currency appreciation. Reuters reports:

According to the initial results of the tests, which focussed on textile, garment, shoe and toy exporters, every percentage point of yuan appreciation would erode one percentage point of their profit margin. This would be a serious blow to profitability since their net profit margin is often only 3 to 5 percent, the newspaper said.

China is afraid of an army of unemployed workers marching around Guangdong sending each other text messages about how unhappy they are. This looks like an existential threat.

In any case, it is a threat China will be compelled to address sooner rather than later. If for no other reason, the Chinese are piling up IOUs from borrowers whose credit looks increasingly shaky and they are making their domestic adjustment problem steadily worse.

From a U.S. perspective, as unappealing as the patient diplomacy option may be, it may be preferable to all the others. The advantage of letting the Chinese solve their own problem is that it frees U.S. diplomats to ask other things of them. These other things, like cutting directed credit to favored industries, or an understanding on subsidies or government procurement, would help American firms and might actually be achievable.
 

amoy

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USA current financial situation has already lost alot of credibility any reduction in USA's credit rating and things like this may become possible,in history debt based economies and trade always lead to defaults.
Agree with u and in fact China is busy hunting for precurement of foreign resources/mines globally with the huge FOREX and is making a headway in regionalizing RMB (firstly within Aisa)

Above all truthfully China must boost its domestic consumption. Most workers are living on wages <2000RMB/month (6.82/$1) on which the pyramid can't stand long.

Meantime don't forget Japan, Taiwan and UK ... are also in the ranks of top US trash bonds holders
 
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China needs to diversify their US debt holding with the least collateral damage US bonds are yielding less than 2% and US treasury notes are yielding less than 1% if the Chinese had it in cash and invested it back into their own economy which has been growing at a double digit rate the return on that investment would be many fold than what they are getting from the worthless bonds and it would help the own Chinese domestic economy.
 

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