Who Owns U.S. Debt? (Source: CSIS China Power)
You've probably already read or heard that China "owns" the United States by holding a considerable amount of its government debt. With just under 1 trillion in U.S. dollar-denominated Treasuries, it is true that China holds one of the largest international claims on U.S. debt. To be precise, it is the second largest creditor, just behind Japan. But there is a major difference: the state of diplomatic relations between Uncle Sam and Xi Jinping.
Beyond an economic weapon, the large holding of US debt also allows the yuan to be kept artificially low, thus favoring Chinese exports by making them comparatively cheaper than US exports.
What are foreign exchange reserves?
Foreign exchange reserves are a central bank's reserves of foreign currency. Foreign exchange reserves are generally held in the form of foreign government treasury bills and bonds, which allow these reserves to earn interest and therefore a certain return while remaining extremely liquid. One notable exception is that gold reserves are included in the composition of foreign exchange reserves. Strictly speaking, gold is a reserve of value. Thus, the European Central Bank - ECB - holds in its vaults a mountain of dollars, yen and renminbi, special drawing rights (a tool created by the IMF based on a basket of currencies) and gold.
To build up these foreign exchange reserves, a central bank has two possibilities:
- The first method is purely arbitrary and simply consists of buying foreign currencies against its reference currency. The goal is to build up reserves in foreign currencies or in gold - since gold is mainly denominated in USD. For the more curious, it is possible to monitor the gold stocks of the different central banks, or for ECB assets.
- The second method is more passive, as it is related to the role of the central bank as the exchange agent of last resort. Let's take an example. When a company exports goods or services, say LVMH, it receives payments in foreign currency. The French group sells a significant portion of its goods to China and the United States. As a result of these international sales, LVMH receives payments in euros but also in U.S. dollars and renminbi (or yuan, or CNY). Once the payments are collected, LVMH will probably choose to keep a small portion of these foreign currencies to cover its own operations and investments abroad, but will probably convert the bulk of its foreign currency revenues into euros. This is the currency in which the group pays its taxes and its employees, dividends, debts, interest and some suppliers. To do this, LVMH will turn to its banks, which will act as intermediaries between their central bank and LVMH in currency exchange operations.
But what are foreign exchange reserves actually used for?
Foreign exchange reserves play several roles in the global economy and are linked directly or indirectly to exchange rates and inflation. Foreign exchange reserves also have a strategic dimension by ensuring solvency and liquidity while also playing a potential cushion role in case of crisis. In short, the applications are numerous. Let's go into a little more detail.
Foreign exchange reserves can be used to :
- To control - at least partially - the value of the national currency. In the case of an exporting country like China, there is a logical interest in keeping a weaker currency than that of its export markets. This makes exports cheaper for the client country, thus making exported goods and services more competitive than domestic goods and services in the importing country. To ensure this, China will buy large amounts of this foreign currency as it did between 2000 and 2010 with the dollar, to keep the renminbi relatively low. This is simply a supply and demand mechanism. This mechanism is also the reason why Japanese stocks rise when the yen falls: the Japanese economy is largely outward looking, and a competitive currency is supposed to help it. Well, it does go down to some extent: the beneficial effects start to fade when the yen weakens too quickly, as it is currently doing. But that's another story.
- To control - at least indirectly - inflation. As we have just seen, by playing with its foreign exchange reserves, a country can manipulate its exchange rate. It is therefore possible for a country to create artificial inflation by depreciating its currency, making exports more competitive but also making imports more expensive. But the mechanism for controlling the value of the national currency can also work in the opposite direction. For example, the Japanese central bank may undertake to sell large quantities of US dollars for yen in order to boost the value of its currency (increased demand = higher prices). A central bank like the BoJ is therefore always playing a delicate balancing act: it must keep the value of its currency "low" in order to favor exports without making it too low, in which case excessive inflation on imports - on which Japanese domestic demand is highly dependent - would strongly punish Japanese economic agents.
- To ensure good liquidity to the country's economic agents in particular to protect strategic imports. For example, the Bank-Al Maghrib (Moroccan Central Bank) announced at the end of August 2020 that it held $36.23 billion in foreign exchange reserves at the end of 2020, or nearly 7 months of imports of goods and services. Holding large foreign exchange reserves allows a country to maintain sufficient liquidity for certain key imports such as foodstuffs or hydrocarbons essential to the population. As these are traded on world markets mainly in US dollars, the country's economic agents must always keep USD on hand. In case of economic stress, the central bank must be able to assist them, otherwise the country may find itself unable to import these essential resources!
- To act as a shock absorber to absorb severe unforeseen economic shocks, be it major recessions, wars or earthquakes. These types of events dry up exports and therefore foreign exchange inflows, which can jeopardize imports of strategic resources if a liquidity crisis occurs. Foreign depositors also tend to flee countries subject to these events and will withdraw their capital to safer countries. This is the phenomenon of risk aversion or "flight to safety". For example, after Fukushima, depositors withdrew their dollars from Japan at an alarming rate. To reassure the markets, international investors and industrial partners, it is therefore essential that a sovereign authority has a reserve capable of absorbing these shocks. To meet financial obligations and ensure solvency. Many developing countries - for example Uganda or Vietnam - have currencies that historically do not really invite the confidence of foreign investors - because their states print money at will, depreciating it in the process. When these states borrow on international markets, they must therefore do so in US dollars or euros in order to satisfy their creditors. It is therefore essential that their central banks keep stocks of US dollars or euros to ensure that their obligations are settled at all times. A very high U.S. dollar, as is currently the case, will therefore make the value of a bond's flows - repayment of principal but also interest - much higher in local currency. This increases the burden of debt: this is the current problem of emerging countries, which are seeing the cost of their debt rise. Conversely, Japan and China, which as we have seen are major holders of US debt, benefit from greater flows once converted into reference currencies. In the same spirit, large foreign exchange reserves can also support a country's economic development by serving as collateral for borrowing USD to finance large infrastructure programs. Indeed, US dollars will necessarily be needed because the international contractors who come to build roads, dams or bridges will not want to be paid in local currency.
- Finally, foreign exchange reserves are also used as a hedge to diversify a central bank's assets and ensure a better return on its assets. Since a central bank is still a bank, it has a vested interest in ensuring that its assets - in this case, its liquidity - yield the best risk-adjusted return. Central banks with large amounts of US dollars will therefore probably be happy with their allocation policy in the current context - US dollars being better paid than euros or renminbi.
The case of China
To return to the US debt held by China, this reserve was mainly built up thanks to the large Chinese trade surpluses. Thus, the Chinese central bank - BPC - has received large quantities of US dollars via the transactions of Chinese companies under its governance. The Chinese Central Bank has accumulated large foreign exchange reserves which it has used to purchase US dollar-denominated assets, mainly Treasury bills - i.e. US debt. These assets are very liquid and are included in the foreign exchange reserves. But what would happen if China sold all the US debt it holds?
First of all, the amount of US debt held by China is certainly impressive in absolute terms, but it is still acceptable when compared to the entire US debt. Still, if China were to start dumping US debt very aggressively, this could, in the worst case, lead to a liquidation on the market. A sudden sell-off could also lead to a sharp increase in the value of U.S. debt, which could have a negative impact on U.S. economic growth. Such a sell-off could also cause the U.S. dollar to fall against the yuan, making Chinese exports more expensive. And a weaker dollar would result in China earning less money on its bond sales. To take it a step further, a sell-off would also cause the market value of US debt to fall, resulting in significant financial losses for China and making US debt cheaper for the US to buy back - especially using its yuan-denominated foreign exchange reserves. The relationship is much more complex, but this gives you a glimpse of the range of possibilities. Still, it is important to understand that a liquidation of the US debt would most likely be as bad for China as for the US.
For all these reasons, the management of foreign exchange reserves is a genuine instrument of sovereignty, but also a very subtle balancing act, the many economic and political issues and repercussions of which are, for us mere commentators, totally unknown.