China, U.S. in debt dance, for better or worse

However grim Washington’s debt and deficit negotiations may seem to Americans, the impasse is nearly as disturbing for China.

As the United States’ biggest foreign creditor — holding an estimated $1.5 trillion in U.S. government debt — China has been a vocal critic of what it considers Washington’s politicized profligacy.

“We hope that the U.S. government adopts responsible policies and measures to guarantee the interests of investors,” Hong Lei, a foreign-ministry spokesman, said at a news conference late last week.

China might prefer to respond by starting to dump some of its U.S. debt. But in this financial version of the Cold War, analysts say, both sides fear mutually assured destruction. China increased its holdings in May for the second straight month, after five months of declines.

Growth in the U.S. economy began to slow this year, making stocks look less attractive. The debt of other countries is either too risky or there isn’t enough of it. European governments are mired in a debt crisis far scarier than the kerfuffle in Washington over the borrowing limit.

“The best thing we have going for us right now is that Europe is such a mess,” said Jay Bryson, global economist at Wells Fargo Securities.

Financially strong countries such as Germany, Switzerland and Australia don’t issue enough debt to satisfy countries like Japan, China, and the U.K., which need to park hundreds of billions of dollars in cash reserves in assets they can sell when needed.

The U.S. government issues bonds to pay for things it can’t afford with tax revenue.

There is a congressional limit to the overall amount it can borrow. The government reached that $14.3 trillion limit on May 16. Since then, the Treasury has relied on accounting maneuvers and higher-than-expected tax receipts to avoid running out of cash. But the Treasury Department says it will have exhausted those maneuvers by Aug. 2.

One reason the United States would want to avoid defaulting on its debt is that such a move could alienate China, which is a steady purchaser of Treasurys. China, meanwhile, already has too much invested in U.S. debt to do much more but continue to buy, hold and grumble.

It is the ultimate “too big to fail” global relationship, said Andy Rothman, an analyst in Shanghai for the investment bank CLSA.

If China even hinted that it might try to sell part of its U.S. debt, “other countries might sell their dollar assets,” Rothman said, noting that this would drive down the value of China’s holdings. “It would be financial suicide for China.”

China got into this situation, experts say, by indulging its own economic interests. To bolster what has become the world’s largest export economy, China has focused on policies that reward domestic savings and hold down the value of its currency.

The result: huge trade and current-account surpluses. China has accumulated more than $3 trillion in foreign currency reserves, far more than any other nation.

Most of those reserves are held in dollars, and recycled back to the United States through investments in Treasury bonds and other dollar-denominated securities — even stocks. And while some of China’s foreign-exchange reserves are plowed into European and Japanese debt, those bond markets are not big or liquid enough to absorb the bulk of China’s ever-larger foreign holdings.

China has tried to diversify its foreign-exchange portfolio by creating a sovereign wealth fund that can invest some of the reserves overseas. The government has also encouraged Chinese companies to expand overseas and to acquire mines and natural resources to fuel China’s hungry economy. But because China has too much foreign money for any other outlet to absorb, most of its fast-growing reserves continue to be destined for the U.S. bond market.

“China has no choice but to keep buying,” said Zhang Ming, an expert at the Chinese Academy of Social Sciences, a Beijing research group. “After all, U.S. Treasury bonds are still the largest and most liquid investment product in the world.”

All of which has helped enable America’s own fiscally dubious habits.

The United States’ huge deficits — not only in government spending, but in trade and savings as well — have weakened its economy and strangled consumption. Many economists say that would poison the long-term prospects for the dollar, if it were not still the world’s reserve currency and most reliable safe haven.

How might the Beijing-Washington debt standoff be resolved? Mainly, the Americans hope China will ramp up its domestic consumption and perhaps make even more direct investments in the United States. The Chinese, meantime, hope the United States will deal with its huge debt problems and maintain the value of the dollar — and with it the value of China’s dollar-based holdings.

For all the stresses in both directions, the fiscal Cold War means “China is increasingly integrated with the future of the U.S.,” said Rothman, the Shanghai analyst. “But that could be a good thing, for both sides.”

The New York Times

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