It is almost close to being general knowledge that China has been a holder of US debt, specifically US Treasury Securities. The common speculation is that China is able to proactively effect the US economy by using these debt bonds. Let’s see what are the possible ways that this can play out.
China holds USD$1.08 trillion in US debt bonds, as currently as May 2020. China has been accumulating these bonds from as early as 2002, where it held USD$85 billion worth of US Treasury bonds. This works out to a 1000% increase in the amount of bonds held.
Is China really holding the most US debt bonds?
In a short answer, no. Japan holds the most of US debt bonds, totaling USD$1.3 trillion as of May 2020. China comes a close 2nd. In a far 3rd place is the United Kingdom with USD$424 billion. The next 7 places are Ireland, Hong Kong, Brazil, Luxembourg, Switzerland, Cayman Islands, Belgium & Taiwan. They hold approximately USD$200 billion each. These 7 countries hold as much bonds as Japan.
How did China end up with so much US debt?
Almost everything a person uses in a developed country today, is made in China. Naturally, China has a trade surplus with most countries and that includes the US. China has been accumulating a trade surplus with the USA since the 1990s.
China also holds the world’s largest foreign-exchange reserve amounting to USD$3 trillion. Much of it is in US dollars, so it makes good sense to park these dollars in the US Treasury market, which is one of the largest and most liquid pool of safe assets in the world.
What are China’s options?
China as a holder of bonds, is expecting the bonds to be good and of value. It may seem to be possible that China can use these US debt bonds as a tool in negotiation or a means of economic attack. There have been many articles which are of the opinion that China can sell off these bonds someday and crash the US economy. It does sound logical, but is it really true?
China can DUMP US debt bonds
China’s most straightforward strategy is to sell off the US debt bonds. These will definitely affect the US market in Treasury prices and drive up the yields. This will cause an increase in borrowing costs.
Interest rates from corporate bonds to home mortgage interests are based on the Treasury yields. This will almost definitely slow down the economy, or is it?
Who will it hurt, China or USA?
In the event where China chooses to dump the US debt bonds, one thing is for sure – China will be swimming in a huge mountain of US dollars. That doesn’t necessarily benefits China. Money that is not working for you, is dead money. If China wants to sell the bonds, there must be another place to park these money at.
For the US, there are just more bonds available in the market. US Treasury bonds are one of the safest assets in the world. There are a whole list of countries who will look to buy up the bonds when the prices decrease due to increases supply in the market.
Clearly, China will be the one who will be hurt by this move.
What can USA do if China sells?
The US administration’s highest priority will be to stabilize the prices and yields as these inadvertently affect interest rates through the line to the consumer, leading to huge effects across the economy. One thing is for sure, the economy will slowdown and that is not good for any country.
USA has the option to immediately buy up China’s holdings of the debt bonds. This is the easiest way to handle the issue. USA has also been printing greenbacks. As the issuer of the bonds, USA can easily use Quantitative Easing to absorb the bonds.
USA can CANCEL the bonds
Somehow, by some stroke of luck, the way that countries deal over a few hundred years can means surprising results. USA actually has the ability to make these bonds disappear and maintain the market.
USA holds USD$1.6 trillion in Chinese bonds. These bonds go back to as early as 1912 and are gold-backed. The problem is that these bonds were issued by the Qing Dynasty administration, way before the current Chinese Communist Party have been in power.
There is a legal debate on whether the CCP is liable for the debt. The bonds are regarded as sovereign debt. Taiwan was once dragged into the picture as the Republic of China which has at a point in time maintained that they are the true government of the entire China back in the 1970s.
China has been on the narrative that Taiwan is irrefutably the territory of China. This narrative automatically comes with the liability of the Qing Dynasty bonds. The Qing Dynasty bonds have been defaulted in 1938, just before Mao Zedong established the People’s Republic of China in 1949. China has not paid a single penny on these bonds and the USA has continually been demanding China to make good on them. The only way out for both countries is to execute a “debt swap”.
Will the debt swap REALLY happen?
In a modern day scenario, this may be up for speculation and if it really happens, China will be the one seeing USD$1.08 trillion go up in smoke. The likely scenario that will play out will be one where China sells the bonds to other countries, avoiding negotiations with the USA about the issue. This will greatly reduce the leverage that China thinks it has by holding the bonds.
USA would have avoided a serious impact on its economy, which has been quite battered by COVID-19.
In any case, whichever country that buys up the bonds from China are going to get a good discount. USA will see a trillion worth of debt disappear from the negotiation table while still pursuing another trillion from Qing Dynasty bonds.
The only winners are probably all other countries except China and the USA. Do you agree?