China does not want US debt default

The big political drama in Washington over the next few months will be the fight over the federal debt ceiling. The worst-case scenario is that Congress refuses to raise the ceiling and the US Treasury defaults on its debt. Since US Treasury debt fuels the entire global financial system, the result could be a massive global economic crisis. If that happened, how well would the world’s second largest economy, China, survive the crash? And would a US default give China an opening to create a new global financial system less dependent on the dollar?

The good news is that a US default is unlikely. Most likely, Congress will reach a deal whereby the debt ceiling is raised now in exchange for promises of federal spending cuts later. That’s what the Tea Party Congress did in 2011 and the outcome that Senate Minority Leader Mitch McConnell predicted.

If negotiations fail, the Biden administration still has many options to prevent a default, ranging from accounting tricks to deciding to ignore the debt ceiling altogether, on the grounds that it violates the US Constitution’s requirement of timely repay all federal debts.

The big political drama in Washington over the next few months will be the fight over the federal debt ceiling. The worst-case scenario is that Congress refuses to raise the ceiling and the US Treasury defaults on its debt. Since US Treasury debt fuels the entire global financial system, the result could be a massive global economic crisis. If that happened, how well would the world’s second largest economy, China, survive the crash? And would a US default give China an opening to create a new global financial system less dependent on the dollar?

The good news is that a US default is unlikely. Most likely, Congress will reach a deal whereby the debt ceiling is raised now in exchange for promises of federal spending cuts later. That’s what the Tea Party Congress did in 2011 and the outcome that Senate Minority Leader Mitch McConnell predicted.

This article was originally published in ChinaFile.

This article was originally published in ChinaFile.

If negotiations fail, the Biden administration still has many options to prevent a default, ranging from accounting tricks to deciding to ignore the debt ceiling altogether, on the grounds that it violates the US Constitution’s requirement of timely repay all federal debts.

But strange things sometimes happen in Washington. If the United States defaulted, what would be the extent of the damage? No one is certain; the global economy is simply too complex. A real possibility is a global financial crisis and an economic depression even worse than that of 2008-09. Indeed, the huge market for US Treasuries supports the global financial system in two ways. Much of the world’s credit is priced, directly or indirectly, based on US Treasury bond interest rates. And many loans, both in the United States and around the world, rely on US Treasury bonds as collateral.

In the event of a default, interest rates on US Treasuries would skyrocket (because investors would demand a higher rate in exchange for the risk of not being repaid), and the Treasuries might no longer be usable. as collateral (because their underlying value would not be clear). The entire global financial system could simply freeze. Moreover, one of the main tools used to contain the 2008-09 crisis, the massive creation of money by the Federal Reserve to finance purchases of US Treasuries, may not work if the Treasury market ceases. to work.

As in 2008-09, a global economic collapse would hurt China greatly. It would fare slightly better than most other countries because it operates a closed financial system that relies primarily on domestic savings and is protected from the vagaries of global financial instability by capital controls. But the impact of a US debt default would still be devastating. In 2008-2009, the loss of trade finance and the collapse of global demand caused Chinese exports to fall by almost 20% and more than 20 million workers lost their jobs.

Fifteen years ago, the Chinese government could respond by launching a massive debt-financed economic stimulus program because the country’s debt level, at 140% of GDP, was relatively low and it still had needs. important in terms of infrastructure and housing. Today, the room for maneuver is much narrower: debt has soared to almost 300% of GDP, and infrastructure and housing are seriously overbuilt.

Although serious, the economic consequences for China of a US default would likely not threaten the power of the Chinese Communist Party. Whatever pain the Chinese people have been forced to endure can rightly be blamed on outside forces. And in a pinch, the government could still support a minimum level of growth by increasing its indebtedness, since it would be borrowing from its own future, and not from foreign creditors.

This brings us to the second question. If the United States defaults, could China create a substitute system built around the renminbi? The short answer is no.

The US Treasuries market is huge and deeply intertwined with the rest of the world. (That’s why a default would be so bad.) There are $23.9 trillion in Treasuries outstanding; foreigners hold $7.5 trillion, or 31%, of that pile. Last year, daily trade averaged $600 billion. In practice, this means that it is easy for large corporations and governments to hold treasury bills of any amount, trade large volumes quickly, and easily obtain or assign as much collateral as they need it to borrow.

China’s government bond market is nowhere near large enough, liquid enough, or integrated enough with the rest of the world to substitute for US Treasuries. According to my colleagues’ calculations, the total value of Chinese government bonds at issuance of $3.3 trillion is less than half the value of US Treasuries held by foreigners. Foreign holdings of Chinese government bonds are only $340 billion, or one-twentieth of the country’s Treasury holdings. The daily turnover of the Chinese government bond market is $30 billion, about 5% of the Treasury market average.

After the crisis of 2008-09, because it decided that it was too dependent on the global dollar-based financial system, China tried to internationalize the renminbi. His efforts bore little fruit. The renminbi accounts for just 2.8% of the world’s central bank official reserves (compared to 60% for the US dollar and 20% for the euro), a figure that has not changed much in recent years. Similarly, it represents only 2.4% of global foreign currency exchange.

China has failed to internationalize the renminbi for the same reason it is relatively insulated from global financial shocks: capital controls. Bringing money in and out of China still requires permission from Beijing. From the Chinese government’s point of view, this is a good thing. When economic conditions deteriorate in China, it is difficult for Chinese citizens to withdraw their money and park it overseas. And by limiting the amount of money foreigners can bring into China and controlling the conditions under which they can withdraw it, Beijing is reducing the risk of a global financial panic leading to a damaging outflow of foreign capital. As a result, Beijing doesn’t have to work so hard to maintain domestic financial stability.

The problem is that if you want to create a substitute for the US Treasuries market and the world’s central currency, the US dollar, you have to accept these risks. International investors need to be confident that they can invest as much money as they want in your bonds, that the value of those holdings will remain relatively stable, and that they can cash out whenever they want without penalty.

At present, foreign investors generally do not believe that the Chinese government bond market can offer any of these things. They are perfectly happy to invest small amounts in Chinese bonds to diversify their portfolios or to take advantage of short-term increases in the value of the renminbi. But more than one central banker has told my research team that they are reluctant to invest much of their reserves in Chinese bonds because they fear the funds will not be available when they really need them. that is, in an emergency. This sentiment is even more strongly shared by private financial institutions who trade much more frequently and want a secure source of collateral to support day-to-day transactions.

In short, the reason the US Treasuries market is such an indispensable part of the global financial system is that the US is willing to take financial risks that no other country, even as big as China, is. dares and has proven over many decades that it can safely manage these risks. Unfortunately, there may be no alternative. So if reckless policies in Washington force the market to freeze, the world will suffer immense economic and financial damage. Like everyone else, China will be an unlucky bystander, forced to wait until the United States can settle its internal differences and resume its stewardship of the global financial system.

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