The role of China in the U.S. debt crisis.

AuthorDorn, James A.
PositionReport

In 2001, the U.S. gross public debt was about $6 trillion; a decade later it was $14 trillion; by the end of 2012 it exceeded $16 trillion. A large part of that increase was absorbed by foreign holders, especially central banks in China mad Japan. with the U.S. government gross debt ratio now in excess of 100 percent of GDP, not including the trillions of dollars of unfunded liabilities in Social Security and Medicare, it is time to stop blaming China for the U.S. debt crisis.

China is the largest foreign holder of Treasury debt, with a portfolio estimated at $1.2 trillion or 8.4 percent of the U.S. gross public debt of $14.3 trillion at year-end 2011 (Table 1). Total foreign ownership accounts for $4.5 trillion, while the bulk of the debt is held by U.S. government trust funds, the central bank, and domestic investors. The Social Security Trust Fund and the Federal Reserve now hold nearly $6 trillion of U.S. public debt. Of course, no matter who holds the public debt, U.S. taxpayers eventually have to fund it.

The cause of the U.S. debt crisis is overspending and an explosion in entitlements, especially Medicare and Medicaid. The stimulus programs in response to the 2008-09 financial crisis have also contributed to U.S. public debt. The Federal Reserve has vastly expanded its balance sheet and in fiscal year 2011 was the largest buyer of new U.S. Treasury debt, acquiring 77 percent (Gramm and Taylor 2012).

China has also acquired a large share of new Treasury debt issues but recognizes that its policy of undervaluing its exchange rate to maintain export-led growth, and building up a massive stock of foreign exchange reserves now totaling $3.4 trillion, is not sustainable. It does not make sense for a capital-poor country like China to be a net exporter of capital. While one cannot blame China for the U.S. debt crisis, which is due to profligate government spending, one can point to an unintended consequence of China's policy of financial repression--expanding the size and scope of the U.S. government.

The following sections examine financial repression in China and its impact on the U.S. debt crisis, the rebalancing that needs to occur in China to advance the role of the market and limit the power of government, the problems with China's attempt to build a "harmonious society," and the reforms that need to occur in China and the United States to achieve lasting peace and prosperity.

Financial Repression in China

Capital markets in China are tightly controlled. Benchmark interest rates for deposits and loans are set by the government to ensure that state-owned banks have a profitable spread between low deposit rates and higher loan rates. Typically, real rates on deposits have been negative. Capital controls limit investment alternatives, and the pervasiveness of the state has prevented privatization and real capital markets from emerging. The result is a highly inefficient financial sector with investment funds directed by state-owned banks primarily to state-owned enterprises. The lack of capital freedom means the range of investment choices open to individuals is narrowly limited, thus reducing their opportunities for wealth creation. (1)

Without private competitive capital markets, China suffers from the politicization of investment decisions and thus extensive rent-seeking and corruption. Steps are being taken to liberalize interest rates, relax capital controls, and increase transparency, but political factors still dominate in a one-party system without a just role of law.

The difficulty is that China wants to protect its dynamic export sector by undervaluing the exchange rate, but in doing so the People's Bank of China (the central bank) must buy dollars at the pegged rate with newly created renminbi (the "people's currency"), which could lead to inflation unless offset or "sterilized." Yet, if the PBOC increases the interest rate to tighten monetary policy, that maneuver attracts more capital inflows. To combat inflationary pressures, therefore, the government relies on administrative controls (credit quotas) and reserve requirements, in addition to sales of central bank bills.

Relaxing interest rates and capital controls, and letting the market determine the exchange rate, would allow China to rid itself of financial repression. The government would not have to hold excessive amounts of dollar assets, mostly in the form of U.S. Treasuries and agency debt. Domestic consumption as a share of GDP would increase as the real exchange rate appreciated and as the real return on deposits increased. (2)

For years various members of Congress, including both Democrats like Senator Charles E. Schumer of New York and Republicans like Senator Lindsey Graham of South Carolina, have attacked China for its undervalued exchange rate and tried to use the threat of protectionism to push China to allow faster appreciation of the renminbi (also known as the yuan) against the dollar. What they fail to realize is that if China had a truly market-determined exchange rate, it could go down as well as tip. Moreover, a free-market rate would mean the end of interventions by the PBOC and a sharp decline in the demand for U.S. debt. Interest rates on Treasuries and agency debt would increase, and Congress would have to get its fiscal house in order. It is doubtful those who blame China for U.S. ills would favor that outcome.

China is unlikely to quickly rid itself of dollar assets, but it could begin shifting out of U.S. public debt--especially if Beijing expects higher U.S. inflation. The Strategic and Economic Dialogue is a forum designed to smooth U.S.-China relations and avoid the dead end of protectionism. Both the United States and China can gain from further trade liberalization and from more open capital markets (Dorn 2008).

The liberalization process would take time, and its speed...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT