China’s increasing economic size makes it an increasingly important international actor. Over the past decade, China emerged, next to Germany and Japan, as a major net capital exporter. Large current account surpluses have translated into a major improvement of China s international financial position. In USD terms, China is today the world’s second-largest creditor. Net foreign claims today amount to USD 1.7 tr (or 20% of GDP) compared to USD 3.4 tr (or 60% of GDP) in Japan. By contrast, the US, the world’s largest creditor in the immediate aftermath of WWII, is today the world’s largest net debtor with net foreign liabilities amounting to USD 3.9 tr (or 25 % of GDP).
Financial power has many dimensions and can be exercised in a variety of way. A country can extend aid and offer investment. It can offer preferential access to its markets (Hirschman 1945/ 1980). It can be a source of foreign direct investment and technology transfers. China’s growing international financial resources, rising outward investment and its prominent position as an importer and exporter have materially increased its influence (and interests) over the past few decades. A large net foreign creditor position can help limit financial vulnerabilities. In extreme scenarios such a war, countries and countries can draw down their foreign assets in order to finance vital imports, as Britain did during the early days of WWII, provided these assets do not get frozen. Ay, there’s the rub.
China’s increasing financial prowess, and especially its very significant creditor position vis-à-vis the US, provides it with little bilateral influence. As a consequence of China’s mercantilist policies, reflected in a controlled, competitive exchange rate and large external trade surpluses, China has accumulated large net foreign assets. Importantly, foreign claims are largely held by the Chinese public sector forced to absorb large balance-of-payments surpluses in order to prevent exchange rate appreciation in the context of controls on private-sector capital outflows. A significant share of these surpluses has been recycled, as central bank foreign assets typically are, into liquid, high-grade, but low-yielding US and European government debt. China s outsized international creditor position is a by-product of its policy of export-oriented industrialisation rather than an objective as such. In fact, China’s large claims on the US government has made if, if anything, more vulnerable in the past few years. Naturally, financial integration does always create financial sensitivities, but being a captive investor raises financial and economic risks in a way that an equally large, but more diversified asset portfolio would not create.
Being a large international creditor provides China with greater policy flexibility (in normal times) as well as with the capacity to lend to other countries in convertible currency. This is especially the case with regards to smaller countries or countries in financial dire straits. In relation to the US, however, China’s creditor position yields little influence. It may have made Washington more reluctant to pursue economically confrontational policies towards Beijing, but it does not provide Beijing with a lever of direct influence vis-a-vis Washington, mainly because of the US’s reserve-currency country status and China’s dependence on the US as an export market. China remains too dependent on the US in terms of trade and the US is not sufficiently dependent on China financially as to be open to Chinese financial pressure. The flipside from Beijing s point of view is that the Chinese economy does not only depend on the US export market, but that financially it is heavily exposed to the US government.
Two thirds of China’s foreign assets are reserve assets, largely held in the form of liquid, high-grade sovereign debt, mostly in US treasuries and agencies. According to the US Treasury, China holds an estimated USD 1,100 bn worth of US treasury securities – and another USD 450 bn worth of agency debt. This likely underestimates the actual size of Chinese holdings, but it shows how exposed China is to the US. Nonetheless, it affords China little influence. The threat to stop buying or even selling US treasuries would be neither credible and even if it were made, let alone realised would cause greater damage to China than for the US.
First, economically and financially, China would shoot itself in the proverbial foot if it were to sell large amounts of US treasuries. The value of its holdings would decline and higher US interest rates would weigh on the US growth outlook, hurting Chinese exports. Furthermore, China would have to find other dollar assets to invest in, unless it is willing to accept RMB appreciation – and too rapid a RMB appreciation is hardly in China’s interest in terms of exports and dollar-denominated US debt holdings. If it does re-invest in dollar-denominated assets, this would presumably help ease financing conditions in other parts of the US economy, potentially offsetting the negative effect of higher rates in the treasury market. But these assets would be less liquid and carry higher credit risk. A Chinese threat to divest US debt may therefore not be considered very credible by Washington. From a financial perspective, the diversification benefits are doubtful, while credit risk would increase from China’s perspective.
Secondly, even if Beijing were to sell large holdings of US debt, it is unclear how sizeable an impact this would have on US yields. In the very short run, it might disrupt financial markets, but the medium-term impact would likely be manageable, as other foreign (official) buyers would step in, albeit at higher interest rates (e.g. Japan, Gulf countries). In the current environment, the situation might act in order to prevent excess market volatility. Last but not least, any politically motivated fire sale of US debt would trigger a very severe political backlash – and not just from the US. A fire sale (as opposed to a gradual unwinding of holdings) would also undermine China’s standing as a reliable financial investor and economic partner in the eyes of many other countries.
Financially, economically and politically, Beijing would pay a high price for pushing up US borrowing costs and, in all likelihood, a much higher price than Washington would end up paying. First, the US has access to a more diversified investor base (with parts of which it maintains close political relations) than Beijing has markets to invest in – at least as long as Beijing seeks to maintain a stable USD-RMB exchange rate. Second, in the short run, the US market is also substantially more important to China in terms of both exports and imports than vice versa – and the Chinese export sector is relatively more employment intensive! Last but not least, Beijing’s concern about maintaining near-double-digit growth rates would diminish the credibility of any action that risks triggering an outright economic conflict with the US, or a severe US economic slowdown on the back of financial instability.
An unwillingness to let the RMB appreciate, potentially significantly, and a reluctance to incur large financial losses on its foreign asset holdings (in that order) presently limits Chinese flexibility as regards the holdings and purchases of treasuries. China, after all, benefits greatly from its access to the US market. It affords China to pursue an export-led growth strategy, underpinned by sizeable domestic and foreign investment in the tradable sector and supported by an undervalued exchange. It also provides China with access to advanced technology supporting productivity growth. Appreciating its exchange rate would make exports less competitive. All other things being equal, it might reduce economic growth at the margin due to a less favourable contribution from net exports and, possibly, lower investment in the tradable sector. However, it would also shift resources away from the tradable sector and might lead to increasing investment there. The net effect of RMB appreciation on employment would not necessarily be negative, for the non-tradable service sector tends to be more employment-intensive than the relatively more capital-intensive, export-oriented manufacturing sector. The relative strength of the growth and employment effects naturally depend on the magnitude and speed of the appreciation.
In short, China’s holdings of US debt do not lend themselves as a coercive instrument. They may act as a sort of limited deterrent. Naturally, rising cross-border asset holdings and trade have increased interdependence, raising the costs of economic conflict for both sides – but the potential costs of a conflict due to China’s trade dependence are substantially higher for Beijing than for Washington. The Sino-US economic-financial relationship is therefore best described as one of ―asymmetric interdependence‖ (or asymmetric vulnerability), skewed in Washington’s favour for now.
