China’s official FX reserves hit a stunning USD 3.2 tr in July. In order to prevent too rapid a nominal appreciation against the USD, the People’s Bank of China (PBoC) is forced to recycle a large share of the balance-of-payments surplus into dollar-denominated assets. Official FX reserves are typically invested in liquid, high-grade debt instruments. About half of China’s FX reserves are invested in US treasuries and agencies, making the Chinese government the single largest creditor of the US government.
Beijing will have no choice but to pile into US government debt for the foreseeable future. If the Chinese current account surplus gradually moves back to 7.5% of GDP by 2015, as the IMF – assuming an unchanged real effective exchange rate – projects, and assuming China will be running a capital account surplus of 2% of GDP a year (below its historical average!), it could see its FX holdings increase by USD 3.5 tr by 2015. Even under much less aggressive assumptions, FX reserves are bound to increase by a massive USD 2.0-2.7 tr over the next five years. Assuming China keeps the share of dollar-denominated assets constant (at an estimated 2/3), continues to invest the bulk of its dollar-denominated holdings in US treasuries and reduces its exposure to agencies, holdings of US treasuries could rise from currently USD 1.2 tr to nearly 4 tr under the admittedly aggressive IMF baseline scenario.
If, on the other hand, the Chinese authorities, who project a current account surplus of 4% of GDP, are correct, China will accumulate only USD 2.25 tr in additional FX reserves by 2015 (assuming a relatively small capital account surplus of 1.5% of GDP). This would nonetheless sufficient to push total Chinese holdings of US government debt to nearly USD 3 tr. If only 1/2 of the cumulative increase in FX reserves were invested in US government debt, Chinese holdings would turn out lower, but would still exceed USD 2.5 tr by 2015. In short, even under such a “best-best-case” scenario, Beijing’s exposure to Washington and Washington’s reliance on Chinese financing will continue to grow tangibly.
Assuming furthermore (as per Congressional Budget Office) that US treasuries (held by the public) climb to USD 12.6 tr (or 70% of US GDP) by 2015, China could end up holding close to 1/3 of the total – or 2 ½ times today’s share – under the IMF baseline scenario. Or to put it differently, Beijing would hold 37% of Chinese GDP worth of US treasuries (up from 20% of GDP today), while Washington would owe 20% of US GDP worth of treasuries to the Chinese government (up from 7.5% of GDP today). Under the other scenarios, these ratios would be somewhat lower, but not dramatically so.
A number of caveats are in order. First, the current account projections might be way off the mark. The IMF estimates appear to be at the high end. China’s real effective exchange rate will almost certainly appreciate. And if it does not, would the deficit countries be prepared to absorb the rising trade surpluses such a projection implies? That said, it is difficult to see why the surplus should fall much below 3-4% of GDP, short of Beijing allowing the RMB to rise very significantly in nominal terms. And this looks similarly unlikely.
Second, China might ease restrictions on private-sector capital outflows (while maintaining controls on inflows). This might help lower the cumulative balance-of-payments surplus, FX reserve accumulation and thus the pace of treasury accumulation. While the Chinese authorities profess a desire to move towards greater capital account openness, this will invariably be a very gradual process and will not be anywhere near completion by 2015. Besides, the capital account would have to shift into deficit to make a tangible dent in the overall balance-of-payments surplus. This does not look like a very probable scenario at the moment. Even if FDI outflows, which face the least restrictions, rise to USD 100 bn a year, this would be insufficient to push the capital account into deficit, given continued strong FDI and “other” capital inflows. Moreover, a sharp rise in outward FDI might trigger rising political resistance among recipient countries. It already has. (No wonder that Beijing put a bilateral investment treaty near the top of its agenda during last May’s SED.)
Third, China might decide to accumulate dollar-denominated assets other than US government debt and/or divest a share of its existing holdings of US government debt. The China Investment Corporation (CIC) is reportedly to receive another USD 200 bn, in addition to its initial USD 110 bn allotment, of PBoC foreign reserves. However, the new allocation would amount to less than 6% of official reserve holdings. Moreover, the traumatic 2008 experience when the CIC’s equity investments lost significant value will ensure that any larger shift out of US treasuries into higher-risk assets will be a very gradual process. The speed of diversification will inevitably lag the increase in FX reserves over the next few years. Even a deteriorating US fiscal outlook would not do much to change this given that virtually all other USD assets would presumably be similarly negatively affected by rising US sovereign risk. Purchasing non-treasury USD assets would not allow China to diversify the risk associated with its USD assets. If it did shift out of treasuries, Beijing might end up fuelling the very crisis it seeks to avoid. Chinese holdings of US treasuries are bound to grow further.
In short, even determined efforts by the Chinese authorities will be insufficient to prevent a further, significant accumulation of US treasuries. It will not be possible to shift additional reserve holdings into higher-risk instruments sufficiently quickly to avoid a further accumulation of US treasuries. Only the US treasury market offers sufficient depth to absorb Chinese USD investments. Long story short: Beijing will continue to accumulate claims on the US government, while Washington will see its liabilities vis-a-vis China continue to rise. The financial stakes in Sino-US relations will be rising inexorably for the foreseeable future – relentlessly raising the bilateral economic and political stakes.