The Debt Ceiling and China

Debt ceiling breach or no, China relies on its $1.3 trillion in US debt to keep its currency stable. Photo by China Photos/Getty Images.

Will debt ceiling drama make China dump our debt? Does it matter? Should investors be freaked over the possibility?

No, no and no. Headlines might hype the issue, but investors have plenty of reasons to breathe easy.

Don’t be fooled by the strongly worded editorial in China’s state-run paper, which “expressed concern over developments in Washington which could affect [China’s and Japan’s] several-trillion-dollar investments in US Treasury bonds.” It doesn’t imply China will shed its $1.3 trillion in US Treasurys if Congress doesn’t raise the debt limit before the October 17-ish deadline. Rather, the opposite: China won’t—nay, can’t—dump Treasurys en masse, so it’s forced to beg and plead for US politicians to “stop rocking the boat.”

Consider why China has this whopping investment in the first place. It isn’t because China’s government wants to “own” us or influence US policy. It’s because China’s yuan is pegged to the dollar. If you peg your currency to a certain asset, you have to own a lot of it—otherwise no one will have faith in its backing. If you want to weaken your currency, you buy more of the asset backing it. And if you want to strengthen your currency, you do the reverse—hence why many European and Asian nations depleted their foreign currency reserves during the 1992 ERM crisis and 1998’s Asian Contagion. In order to keep their pegged currencies from tanking, they had to (and then they dumped the pegs, but that’s a topic for another day).

China has no interest in strengthening the yuan a ton. Policymakers have allowed it to appreciate a bit over time, but they’re heavily incentivized to keep it low—China’s many exporters rely on the artificially cheap yuan to keep their goods competitive worldwide. If China got antsy and dumped all its Treasurys in one go, the yuan would skyrocket. For any nation, the economic fallout would be vast. But for China in particular, it could very well be economic and political suicide! It would bring deflation at home and make exports too pricey to buy. China’s economy could very well implode, causing its 1.1 billion people to revolt, and the Communist Party would find it a tad difficult to maintain its iron grip. That’s the last thing Beijing wants. Chinese leaders want political stability, so they need a stable yuan. Hence, they need dollars. Many, many dollars.

That doesn’t change with the publication of another state-run editorial calling for “a new international reserve currency that is to be created to replace the dominant US dollar, so that the international community could permanently stay away from the spillover of the intensifying domestic political turmoil in the United States.” One, it’s an argument for a long-term shift, not an instant flip. Two, China doesn’t have to peg the yuan to the dollar—no international authority forces them to do this. China chooses to—a logical choice when you remember the US happens to have the deepest, most liquid and safest capital markets on the planet. Even if China slowly switched to a trade-weighted currency basket, the dollar would still play a vital role. To exclude it would be asinine—why would backing currency with euros, yen or sterling be any better? Political risk will always be a factor when you peg your currency to another—but it isn’t the only one.

Even if they were to do something dumb (always a possibility where Communists are concerned) and hold a US Treasury fire sale, it wouldn’t be catastrophic for the US. China owns about 7.9% of outstanding Treasurys—they may be our largest foreign creditor, but they’re far from the majority owner. Those owning the bulk of our government’s net debt—investors, pension funds, countries we traditionally view as liking us—seem more than happy to have it. Heck, after S&P downgraded the US in 2011—theoretically making Treasurys less attractive, assuming you think ratings agencies have merit—all these folks have bought more!

With or without China, demand for US Treasurys is sky-high. Banks don’t have to take a balance sheet hit to own it. Moody’s and Fitch confirmed this doesn’t change if we breech the debt ceiling—even the backward-looking raters know we don’t default. The risk of owning Treasurys doesn’t increase if we have to prioritize payments. The full faith and credit of the United States government still matters. So if China sold, others would buy! Yes, if China sold massive amounts at once, yields would probably rise some—the sheer scale of the supply increase would push prices down. But it wouldn’t last long. The rest of the world would see a tasty discount on one of their favorite investments, and they’d likely snap up more on the cheap—and with competition to buy so fierce, they’d eventually have to bid prices back up where they were pre-fire sale. Short term, the hit might look big! But in the mid to longer term prices would even out, with minimal (if any) lasting impact on Treasury markets.

And from a government interest cost perspective, take note that this is all in the secondary market. The government’s interest costs are fixed at issuance in the primary (auction) market. While secondary market rates influence new issuance, remember: The average maturity of US debt is over five years (and getting longer). A short-term blip won’t impact debt costs much.

The China issue is one of many ghost stories surrounding the debt ceiling. Ghost stories don’t hold sway over markets in the long run. In the short term, as they circulate, the fear they bring can shake sentiment, bringing heightened market volatility. But over time, markets weigh fundamentals. And as investors realize their fears were false and slowly become more optimistic, they allow themselves to see strong fundamental reality, and they bid stocks higher. So let others freak out over China’s fear-mongering! Look past the noise and politicking and get ready for more bull market ahead.