Should China Reduce American National Debt?

The debate over whether China should hold the largest chunk of America’s national debt has many arguments. According to data published by the American Ministry of Finance on April 15, 2009, China’s share of America’s national debt rose by $23.7 billion in March 2009 to total $767.9 billion in April. This increase has continued since September 2008 and puts China firmly in the first position among countries that hold America’s national debt. Given the impact of the sustained financial crisis, weakening U.S. dollar, and with the current system that makes the RMB exchange rate continue to change under constant attack, China’s action of increasing its holding of America’s debt once again gives rise to controversy. Considering the extent of the global financial crisis and Warren Buffett’s advice, steering clear of America’s national debt is an obvious choice. This, therefore, calls into question whether China should adjust its investment strategy to reduce its holding of America’s debt.

Why Does China Want to Hold America’s National Debt?

In answering this question, we must take note of the fact that China currently holds a large portion of the foreign currency reserves. The amount stood over $1.97 trillion in March 2009. The U.S. trade surplus is a major source of these reserves and one of the driving forces behind China’s economic development. Historically, Japan and South Korea owe their national development to the crucial initiative of seizing the American market. China must similarly balance its economic development with reliance on the American market. This means that China’s large foreign exchange reserves are inevitable in the long-term. Economists have long understood that it is very difficult to achieve sustainable diversification of foreign exchange earnings, while also maintaining effective management of huge foreign reserves.

Actually, the management of commercial bank assets is the same as the management of reserve assets. It is based on what is referred to as the “Three Characteristics ” of mobility, security and profitability. Based on this principle, foreign reserves can be divided into three levels as follows.

(1) First-Level Reserve Assets: High mobility, low returns. Include demand deposits, short-term national debt, etc.

(2) Second-Level Reserve Assets: Balance between liquidity and profitability. Include intermediate-term national treasury bonds and bank checks, money orders, etc.

(3) Third-Level Reserve Assets: Meeting security needs, primarily medium and long-term investments, with a view to profitability and adding value. Include long-term treasury bills, class A shares, etc.

Theoretically, all of the above support China’s decision to hold U.S. National Debt in the form of bonds.

Why would American national debt become China’s primary choice of foreign reserve investments? The answer lies primarily in the fact that the U.S. is the world’s largest economic system, has the most developed capital market, and the U.S. is one of the world’s largest issuers of government debt. The risk associated with American national debt is low while liquidity is strong. The economy of the U.S dollar is still stronger than the economies of the euro and (Japanese) yen. Given this background, purchasing U.S. national debt is reasonable.

In my opinion, the Chinese government invests in American national debt for yet another important reason. This reason, I believe, is not based on the investment interest rate, but the hope of stabilizing the exchange rate between the Chinese currency and the U.S. dollar in order to protect Chinese exports. Purchasing large amounts of U.S. debt annually may prevent the RMB rate from rising, but the fact remains that repeated RMB revaluation does not favor Chinese exports. For security reasons, investment opportunities for China’s foreign exchange reserves are few. While private sector-led foreign investment initiatives are still in the experimental stages, some countries have a sentimental resistance to inward investment by sovereign wealth funds . Finally, the difficult and slow increase of investment in foreign enterprises, means that investing in America’s national debt has become the obvious choice.

The Risk and Reward of Purchasing America’s National Debt

The U.S national debt return is low while its mobility is high. If the debt is maintained as a first-level reserve, this ratio is suitable. As a result, a possible reduction of holdings this debt is a non-issue. The major problem is that since China holds a very large amount of U.S. debt under the condition of low returns, we must take a look at the risk factor.

In buying U.S. debt, China faces approximately three kinds of risk –reimbursement, inflation and depreciation of the U.S. dollar against the RMB. Regarding the risk of reimbursement, one may think that the probability of this occurring is negligible. [The argument is that] as a debt payment tool, the U.S. dollar issues rights in the Federal Reserve when the proportion of the national debt required to repay the principal and interest on the fiscal revenue exceeds the level anticipated by the government. When perhaps the national debt as a proportion of household deposits exceeds a threshold for micro-economic wealth accumulation, the method of last resort for payment is the release of U.S. dollars. In such situations, there is no reason to think that the Federal Reserve will decline to issue bank notes for repayments.

Regarding the risk of inflation of the U.S. dollar, the American Ministry of Finance has issued a bond that adjusts the return ratio according to the inflation index. This type of bond can effectively remove the risk of inflation. China may choose to purchase this kind of bond. At the same time, China may also negotiate with the U.S. to control the risk of inflation more tightly. In other words, “the risk of inflation is reduced.”

The main risk lies in the depreciation of the U.S. dollar. In order for the U.S. to surmount the financial crisis, it has to adopt a weak dollar policy. In March 2009, the U.S. injected $120 million into the economy. This action, at least in the short term, makes it impossible for the U.S. dollar to become stronger. Regarding this risk, Harvard University Professor Benjamin Friedman remarked in March at the China Development Forum 2009 that it would be impossible to force the U.S. government into helping to maintain a low RMB. In fact, from 2008 to the present, the U.S. dollar has depreciated against the RMB and economists predict that in the near future, the dollar will continue to depreciate against the RMB. If China does not reduce the $767.9 billion in American debt, the depreciation of the dollar will certainly cause its value to shrink, meaning that China will pay for the U.S. financial crisis.

Should China Reduce its Holding of U.S. National Debt?

The answer to the question is obvious; China should gradually reduce its holding of American national debt, but not yet. Actually, as early as 2006, Cheng Siwei believed that China could appropriately relax the range of fluctuation of the RMB to prevent the growth of foreign exchange from outpacing growth, and gradually reduce the amount of American national debt held. Why can’t China reduce American debt at the moment? For the following three reasons:

(1) China is the largest holder of American national debt. If China did sell U.S. national debt, who would purchase it? China’s approach in dealing with the U.S. national debt affects other countries’ decisions about the issue; the significance of underselling could be enormous. If China announced their decision to reduce or sell U.S. debt, other holders would possibly emulate China through selling the debt that these countries hold, while prospective buyers may stop purchase. The countries that hold a small amount of debt could sell their debt quickly, but China may find it very difficult to find a buyer. Such underselling would definitely cause American national debt to depreciate substantially. China’s U.S. dollar holdings would depreciate and its foreign exchange reserves would sharply decrease. Therefore, the loss outweighs the gain.

(2) If the amount of U.S. dollar bonds in holding is reduced, this will cause the bond price to drop and the interest rate to rise, with an attendant rise in capital cost. This will delay U.S. economic recovery and prolong the American economic crisis; U.S. dollar depreciation will reduce demand for foreign manufactured goods—an outcome that would not favor China. This would negatively affect the restoration of the growth of China’s exports and do more harm than good to the prospects for China’s emerging from recession.

(3) Massively reducing the American national debt will hurt the international reserve position of the U.S. dollar. This is America’s core advantage. This will encourage U.S. retaliation and economic sanctions that can only result in a double loss. Not only will this harm Sino-U.S. relations, but also it will hurt China’s own interests. Therefore, to maintain global economic stability, China must continue to hold American national debt. When may we reduce it? I believe that we should at least wait until the American economic resurgence. At the same time, we should consider this issue carefully and fundamentally change the basis of our development. China’s domestic demand does not depend on attracting many U.S. dollars and will not cause many investment problems. China must relax exchange rate controls, encourage domestic enterprise to ‘go out’ and invest overseas, and speed up the internationalization and advancement of the RMB. If this had been done, it would certainly have been unnecessary for China to purchase American national debt on such a massive scale.