February 25, 2009 | Commentary on Foreign Aid and Development, China, Taiwan

Will China Keep Buying Our Debt?

The China ATM has dispensed over a trillion dollars to the United States in this decade. But now Beijing faces serious troubles at home. How long will it be willing to keep shipping hundreds of billions of dollars a year to an increasingly suspect customer?

First, the background. The US trade deficit consistently runs hundreds of billions a year - peaking most recently at nearly $700 billion in 2006. And, while trade deficits are neither inherently good nor bad, they must be financed.

Foreign citizens are normally quite willing to finance our trade deficit. They see America as a good place to buy equity shares and build manufacturing facilities. Or (as in these troubled times) they see US Treasury bonds as relatively safe places to store savings.

Foreign governments, central banks and such also buy T-bonds as a good place to store cash. In recent years, the share of foreign-government purchases of US Treasuries has soared. China is an especially important financier of US trade deficits, having amassed and invested over $1.5 trillion in reserves since 2000.

Why has Beijing gorged so heavily on US government debt? No one knows (except its communist leadership), but theories abound.

China (like Japan and Germany) has designed its economy to be an export platform, selling largely to the heretofore insatiable US consumer. Running big trade surpluses necessitates accumulating reserves of like amount, and those reserves have to be invested somewhere. We buy their stuff, and they buy our bonds, and neither can seem to stop.

Some suspect the Chinese are building financial leverage - that is, building a "club" to coerce the US government to yield to their demands on other fronts, lest they dump their dollar reserves on the world market and tank the US dollar and possibly economy.

But there's a big hole in this idea. Remember the old joke: When you owe the bank $1 million, the bank tells you what to do - but when you owe the bank a $100 million, you can tell the bank what to do.

In other words, China can't dump its reserves without taking huge losses - and tanking its own export-driven economy.

The Chinese have accumulated reserves as they prevent their currency, the renminbi, from appreciating. They sell their currency and buy dollars in world markets to offset market pressures that would otherwise force the renminbi up and the dollar down.

But why are the Chinese manipulating the value of their currency? It may be, as Treasury Secretary Timothy Geithner briefly suggested, to protect their competitiveness in global markets, or they might be trying to protect their domestic financial system.

Whatever China's reasons for its past policies, it's now, like everybody else, in economic trouble. (Memo to President Hu Jintao: An export platform is especially vulnerable to a world-trade collapse.)

The Beijing central planners face a real conundrum. To sustain their economy and avoid a political upheaval, they need to keep on exporting more than they import. With exports plunging, this means they must clamp down on imports. It also means acquiring more international reserves (and buying US Treasury bonds).

But they may also need to use their existing reserves to prop up their own economy and possibly to recapitalize their banks much as we are doing. Yet doing so would mean selling US Treasuries and triggering the soaring renminbi and declining exports they tried to avoid in the first place..

And as they consider their options, party leaders watch us closely. They see a US government borrowing trillions a year in a forlorn attempt to spend its way out of the unfolding recession.

They know that US government borrowing will drive up US interest rates, relieving some of the upward pressure on the renminbi. But those higher interest rates also mean a longer recession, a weaker recovery and fewer imports from China. And all this government borrowing is threatening the US credit rating.

The Chinese must soon wonder if the United States is such a safe place to invest after all. Add in the fact that it's faced its own troubles at home, and Beijing may lose its appetite for US Treasuries. What happens then?

If China simply starts buying more of other countries' debt, and less of ours, it will put a little upward pressure on US interest rates. But if it stops buying Treasuries, then the dollar would slide and US interest rates would jump.

And if Beijing stopped buying any foreign debt, its exports would plunge further and unemployment would skyrocket. Economic and political implosion of China itself would be near-certain.

Bottom line: This is an inherently unstable situation, fraught with peril for both countries. We'd all be best off if Beijing were to gradually reduce its purchases of US securities - producing an orderly rebalancing of global trade and capital flows as China became less export-dependent and the US less dependent on China's ATM (and exchange rates trended toward market-based levels).

This is how countries fix economic problems before they create a global meltdown.

J.D. Foster, is Norman B. Ture Senior Fellow in the Economics of Fiscal Policy for the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

J.D. Foster, Ph.D. Norman B. Ture Senior Fellow in the Economics of Fiscal Policy
Thomas A. Roe Institute for Economic Policy Studies

First appeared in the New York Post