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China’s U.S. Debt Portfolio Will Not Be Weaponized for the Trade War

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The U.S.-China trade war has reignited debate over the question
of whether Chinese ownership of U.S. government debt is an asset
that Beijing will weaponize. In other words, is the possibility
that the Chinese could sell off large swaths of their $1.1 trillion
holdings of U.S. treasury securities, causing bond prices to fall
and interest rates to rise, something that should concern U.S.
policymakers? Although profligate spending and an accumulating
national debt may well be the toxins that eventually destroy the
U.S. economy, the fact that the Chinese own some of that debt
neither gives Beijing leverage over U.S. policy nor does it present
a threat to the U.S. economy.

The fact that the Chinese
own U.S. government debt neither gives Beijing leverage over U.S.
policy nor does it present a threat to the U.S. economy.

For starters, consider why the Chinese buy U.S. debt in the
first place. For two decades, the Chinese have been purchasing U.S.
treasuries not as a favor to the citizens of the United States, but
because it has been in China’s interest to do so. Nobody in
Washington forces or begs the Chinese to buy U.S. debt. All by
themselves, the Chinese (like investors at home and across the
globe) see the value proposition. It just so happens that U.S.
government-issued debt securities are considered the least risky
investments in the world. Investors know their assets are safe,
accessible, and guaranteed to be repaid virtually on demand.

That’s not to say Americans haven’t benefited handsomely from
China’s investment decisions. The inflow of Chinese (and other
foreign) capital to U.S. debt and equity markets has helped keep
interest rates well below historical averages, effectively serving
to subsidize U.S. consumption, which, in turn, has kept Chinese
factories—as well as factory workers, software engineers,
designers, accountants, and sales representative in other countries
(including the United States)—humming along for decades.

Another reason for China’s appetite for U.S. treasuries is that
purchasing dollar-denominated assets helps prop up the value of the
dollar, which is an outcome that has been favorable to Beijing from
an exporting perspective because U.S. demand for Chinese goods
tends to rise with the value of the dollar. Meanwhile, over the
years, a strong or strengthening dollar has helped preserve the
value of China’s existing portfolio of U.S. debt and other
dollar-denominated assets.

In summary, U.S. treasuries are attractive investments to the
Chinese because of their limited risk, relative liquidity, impact
on U.S. interest rates (i.e. demand for Chinese goods), and impact
on the value of the dollar (i.e., demand for Chinese goods; value
of Chinese-owned U.S. asset portfolios).

Second, even if China did want to sell treasuries (for reasons
belligerent or benign), the impact wouldn’t be profound unless
massive amounts of selling were undertaken abruptly. But that
approach almost certainly would hurt China more than the United
States. China’s debt portfolio, which is valued currently at just
over $1.1 trillion, would fetch far less as the fire sale caused
bond prices to drop—a 5 percent price decline, for example,
could amount roughly to a $50 billion loss for Chinese investors.
Meanwhile, the resulting higher interest rates would be
short-lived, as demand for U.S. debt from other investors would
pick up the slack.

Consider Figure 1 (nearby), which depicts total U.S. debt, total
foreign-held U.S. debt, and Chinese-held U.S. debt. Total U.S. debt
in 2018 was about $21.5 trillion. Foreigners held $6.3 trillion
(30%), of which Chinese investors held $1.1 trillion (5%). Chinese
investors are the largest foreign holders of U.S. debt, but the
value of those holdings accounts for just 17% of all foreign-held
U.S. debt and only 5% of total U.S. debt, which indicates that U.S.
debt is a popular investment choice. In other words, if China were
to sell its treasuries, it is very likely that there would be
sufficient demand in other countries and in the United States to
keep interest rates from rising significantly. And if interest
rates remained steady because non-Chinese demand for U.S. debt
picked up the slack, then China’s selling will have had no
“strategic” impact.

So, it seems that China could create, at most, a short-term
problem for the United States by dumping its treasuries, but only
if Beijing is willing to absorb a big loss. That seems
unlikely.

Now, factor in the phenomenon known as “flight to
safety” or “flight to quality” and the notion that China can
use its debt holdings to exert any influence over U.S. policy
becomes untenable. As my colleague Logan Kolas wrote recently:

Demand for U.S. debt tends to rise in the midst of global
crises. U.S. treasuries are considered the safest assets in the
world, so investors often turn to them during times of financial
strain. Increased tensions caused by escalating tariffs and trade
wars induce policy uncertainty and perverse economic decisions.

Paradoxically, even if the crisis is precipitated by the U.S.
government’s firing of the first shot and its escalation of
the trade war, the ensuing global uncertainty encourages foreign
investors to lend more money to the offending government because it
is trustworthy.

Figure 2 (nearby) plots a Policy Uncertainty Index alongside the
value of foreign-held U.S. debt. It suggests a positive correlation
between the two and supports the conclusion that any precipitous,
unexpected, or unconventional policy measures undertaken by
governments that can shake markets, including measures intended to
drive up U.S. interest rates, will increase demand for U.S. debt,
which will keep those rates low.

Beijing understands this and will not weaponize its U.S. debt
portfolio.



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