China has steadily accumulated U.S. Treasury securities over the last few decades. As of December 2019, the Asian nation owns $1.07 trillion, or about 5%, of the $23 trillion U.S. national debt, which is more than any other foreign country. As the trade war between the two economies escalates, leaders on both sides seek additional financial arsenal.
Some analysts and investors fear China could dump these Treasurys in retaliation and that this weaponization of its holdings would send interest rates higher, potentially hurting economic growth.
China is primarily a manufacturing hub and an export-driven economy. Trade data from the U.S. Census Bureau shows that China has been running a big trade surplus with the U.S. since 1985. This means that China sells more goods and services to the U.S. than the U.S. sells to China.
Chinese exporters receive U.S. dollars (USD) for their goods sold to the U.S., 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 the demand for RMB.
China's central bank, People’s Bank of China (PBOC), carried out active interventions to prevent this imbalance between the U.S. dollar and yuan in local markets. It buys the available excess U.S. 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 U.S. dollars, which keeps the USD rates higher. China hence accumulates USD as forex reserves.
China’s strategy is to maintain export-led growth, which aids 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 U.S.), China requires RMB in order to continue to have a lower currency than the USD, and thus offer cheaper prices.
If the PBOC 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 the loss of export business.
China wants to keep its goods competitive in the international markets, and that cannot happen if the RMB appreciates. It thus 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.
One of main reason for China to continuously buy U.S. Treasurys is the gigantic size of the U.S. trade deficit with China. The monthly deficit is around $25 billion to $35 billion, and with that large amount of money involved, Treasuries are probably the best available option for China. Buying U.S. Treasurys enhances China's money supply and creditworthiness. Selling or swapping such Treasurys would reverse these advantages.
Impact of China Buying U.S. Debt
U.S. debt offers the safest heaven for Chinese forex reserves, which effectively means that China offers loans to the U.S. so that the U.S. 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 U.S., it will keep piling up U.S. dollars and U.S. debt. Chinese loans to the U.S., through the purchase of U.S. debt, enable the U.S. 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 U.S. 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.
USD as a Reserve Currency
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 U.S. Treasurys that 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 U.K. but were retaining the pounds sterling purely as safe reserves.
When those reserves were sold off, however, the U.K. 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 U.S. if China decides to offload its U.S. debt holdings?
It's worth noting that the prevailing economic system after the WW-II era required the U.K. 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 U.K.
Since the U.S. dollar has a variable exchange rate, however, any sale by any nation holding huge U.S. debt or dollar reserves will trigger the adjustment of trade balance at the international level. The offloaded U.S. reserves by China will either end up with another nation or will return back to the U.S.
Repercussions
The repercussions for China of such an offloading would be worse. An excess supply of U.S. 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 may not be willing to do that, as it makes little economic sense.
If China (or any other nation having a trade surplus with the U.S.) stops buying U.S. Treasurys or even starts dumping its U.S. 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 U.S. Treasurys 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 for U.S.
Although this ongoing activity has led to China becoming a creditor to the U.S., the situation for the U.S. may not be that bad. Considering the consequences that China would suffer from selling off its U.S. 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 U.S., 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 U.S. debt. Real repayment value will fall proportionately to the inflation—something good for the debtor (U.S.), but bad for the creditor (China).
Although the U.S. budget deficit has been rising, the risk of the U.S. defaulting on its debt practically remains nil (unless a political decision to do so is made). Effectively, the U.S. may not need China to continuously purchase its debt; rather China needs the U.S. more, to ensure its continued economic prosperity.
Risk Perspective for China
China, on the other hand, needs to be concerned about loaning money to a nation that also has the limitless authority to print it in any amount. High inflation in the U.S. would have adverse effects for China, as the real repayment value to China would be reduced in the case of high inflation in the U.S.
Willingly or unwillingly, China will have to continue to purchase U.S. debt to ensure price competitiveness for its exports at the international level.