China's Stake in the U.S. Debt Crisis
China is one of the primary holders of U.S. dollar–denominated debt. As President Obama and the leaders in the U.S. Congress debate solutions to the debt ceiling crisis, Chinese leaders are watching closely.
Q1: What are the implications for China?
A1: In short, China has significant national economic interests in the stability of the U.S. dollar and in the United States’ meeting its payment obligations. China holds roughly US$1.1 trillion worth in U.S. treasuries, more than a third of its overall foreign exchange holdings. China carefully manages its currency, the renminbi (RMB), to closely track the value of the U.S. dollar. Any major disruption in the stability of the dollar will therefore have powerful implications for the stability of the RMB and has potential complications for China’s own economic health.
China has been under significant pressure from the international community, led by the United States and the Europeans, to allow the RMB to appreciate from what is widely perceived to be an artificially low value, and since being unpegged from the dollar in June 2010, it has appreciated slightly, between 5.5 to 6.0 percent in one years’ time. Within China though, the RMB’s value is widely perceived to be a key factor in managing competitiveness of an export sector that is a strong source of new GDP growth and employment, the sine qua non of domestic political stability in the view of most Chinese leaders. As China heads toward a year of political transition in 2012, any external source of instability will be examined through a prism of domestic political stability. A crisis in the value of the dollar that could spur inflation or a disruption in China’s export machine will therefore be viewed with alarm.
The market turmoil that would result from the United States not raising the debt ceiling or approving a national budget by August 2 would (1) directly impact U.S. consumer confidence and spending ability, thus reducing demand for Chinese exports; and (2) force tough inflationary decisions in Beijing about maintaining a link between the RMB and a plummeting dollar; and (3) increase the risk to Beijing of maintaining its pole position as a global purchaser of international debt instruments. This is a perfect storm of sorts for China. First, and despite Chinese long-term planning to move toward an economic model of domestic consumption, exports to the United States are still a significant driver of economic growth in China. Second, China is already facing inflation as a result of maintaining existing alignment with the dollar, and further weakness would exacerbate this phenomenon to a politically dangerous state. And finally, even if the two parties in the U.S. Congress and President Obama reach a compromise on the debt ceiling prior to August 2, the credit rating of U.S. debt could be downgraded to the point that new debt issuances come with an increasingly unacceptable risk.
Q2: What is at stake for China?
A2: There are three levels of consideration for the Chinese observing the prospect of U.S. default. First, the highly publicized and contentious nature of this debate is an additional nail in the coffin of the Chinese perception of the United States as a stabilizing force and responsible actor in global economic affairs. Chinese perceptions of U.S.-style democracy have suffered as a result of the chaotic to-and-fro between the legislative and executive branches on the debt ceiling issue, but this negative perception has a consequence for the openness of China’s economic, trade, and financial future as well. U.S. advocacy on trade and economic issues just lost a little bit more credibility by virtue of the last few weeks, and those Chinese supporting U.S. “liberal” attitudes on trade and investment just became further isolated. America’s detractors have more evidence for their case that the Washington Consensus is dead and the United States is in decline.
Second, and as suggested above, the value of the RMB and that of the U.S. dollar are inextricably linked in China’s political consciousness to the competitiveness (and thus stability) of its export sector. Given that many export businesses are based in wealthier communities in coastal China, the fears of job losses among a more privileged and politically volatile group of Chinese society is real, making increased political tension more likely.
Finally, Chinese financial and economic leaders have taken a very cautious road in internationalizing the RMB. However if there is a perception that the dollar is in question and there are no other clear alternatives for holding securities, then the time frame for speeding up the internationalization of the RMB may be accelerated, albeit no less arduous a task. Ultimately, the downward pressure on the value of Chinese assets may not result in a drastic Chinese sell-off of U.S.-denominated debt, but to the extent there is a discussion within Zhongnanhai and among China’s financial analysts, it certainly stimulates the debate about the need for alternatives.
Q3: What is the impact on the United States of China’s concerns?
A3: While China holds 17 percent of U.S. foreign-held treasury securities, a sizable percentage, China does not hold a strategic hammerlock on the United States’ international financial position. China is unlikely to preemptively abandon the dollar because of its own fears of resulting international chaos. However, China’s certain goal to reduce its dependence on U.S. dollar–denominated debt is becoming more urgent. The status of the dollar as the sole reserve currency may take a major hit as a result of the failure to increase the debt ceiling on an orderly basis.
Charles W. Freeman III holds the Freeman Chair in China Studies at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Jeffrey D. Bean is a research assistant with the CSIS Freeman Chair in China Studies.
Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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