Arthur R. Kroeber
The big political drama in Washington in the next few months will be the fight over the federal debt ceiling. The worst-case scenario is that Congress refuses to raise the ceiling and the U.S. Treasury defaults on its debt. Since U.S. treasury debt powers the entire world financial system, the result could be a massive global economic crisis. If that happens, how well would the world’s second-biggest economy, China, survive the crash? And would a U.S. default give China an opening to create a new global financial system less dependent on the dollar?
The good news is a U.S. default is improbable. Most likely, Congress will reach a deal under which the debt ceiling is raised now in exchange for promises of federal spending cuts later. This is what the “Tea Party” Congress did in 2011, and the outcome that Senate Minority Leader Mitch McConnell has forecast.
If negotiations fail, the Biden Administration still has plenty of options to prevent a default, ranging from accounting tricks to a decision to ignore the debt ceiling altogether, on the ground that it violates the Constitution’s requirement for timely repayment of all federal debts.
But strange things sometimes happen in Washington. If the U.S. did default, how bad would the damage be? No one knows for sure; the world economy is just too complex. One real possibility is a global financial crisis and economic depression worse even than the one in 2008-2009. This is because the huge U.S. Treasury market underpins the global financial system, in two ways. Much credit around the world is priced, directly or indirectly, in relation to the interest rates on U.S. treasuries. And many loans both in the U.S. and in the rest of the world depend on U.S. treasuries as collateral.
In a default, interest rates on U.S. treasuries would skyrocket (because investors would demand a higher rate in exchange for taking the risk that they might not be paid back), and treasuries might no longer be usable as collateral (because their underlying value would not be clear). The entire world financial system could simply freeze. Moreover, one of the main tools used to contain the 2008-2009 crisis—massive money creation by the Federal Reserve, to fund purchases of U.S. treasuries—might not work, if the treasury market stopped functioning.
As in 2008-2009, a global economic meltdown would hurt China a lot. It would fare slightly better than most other countries because it runs a closed-off financial system that relies mainly on domestic savings, and is protected from the ups and downs of global financial instability by capital controls. But the impact of a U.S. debt default would still be devastating. In 2008-2009, the loss of trade finance and collapse in global demand sent China’s exports plummeting by nearly 20 percent, and upwards of 20 million workers lost their jobs.
Fifteen years ago, China’s government could respond by unleashing a massive debt-financed economic stimulus program, because the country’s debt level, at 140 percent of GDP, was relatively low and it still had significant needs for infrastructure and housing. Today, the space for maneuver is far narrower: debt has soared to nearly 300 percent of GDP, and both infrastructure and housing are seriously overbuilt.
Though severe, the economic consequences to China of a U.S. default would probably not be regime-threatening. Whatever pain the Chinese people were forced to suffer could rightly be blamed on outside forces. And in a pinch the government could still support a minimum level of growth by adding to its debt pile, since it would be borrowing from its own future, not from foreign creditors.
This leads us to the second question. If the U.S. defaults, could China create a substitute system, built around the renminbi? The short answer is no.
The U.S. treasury market is huge, and deeply intertwined with the rest of the world. (That’s why a default would be so bad.) There are $23.9 trillion in treasury bonds outstanding; foreigners hold $7.5 trillion, or 31 percent, of that pile; daily trading last year averaged $600 billion. In practice, this means it is easy for large companies and governments to hold treasuries in any amount, trade large volumes quickly, and easily obtain or dispose of as much collateral as they need for borrowing.
China’s government bond market is nowhere near big enough, liquid enough, or integrated enough with the rest of the world to substitute for U.S. treasuries. According to calculations by my colleagues, the total value of Chinese government bonds (CGBs) on issue—$3.3 trillion—is less than half the value of U.S. treasuries held by foreigners. The foreign holdings of CGBs are a mere $340 billion, one-twentieth of the country’s treasury holdings. The daily turnover of China’s government bond market is $30 billion, about 5 percent of the treasury market average.
After the 2008-2009 crisis, because it decided it was too dependent on the dollar-driven global financial system, China tried hard to internationalize the renminbi. Its efforts have borne little fruit. The renminbi accounts for just 2.8 percent of global official central bank reserves (compared to 60 percent for the U.S. dollar and 20 percent for the euro), a figure that has not changed much in the past several years. Similarly, it makes up just 2.4 percent of global trading in foreign exchange.
China has failed to internationalize the renminbi for the same reason it is relatively insulated from global financial shocks: capital controls. Bringing money in and out of China still requires permission from Beijing. From the Chinese government’s point of view, this is good. When economic conditions worsen in China, it is hard for Chinese citizens to take their money out and park it abroad. And by limiting the amount of money foreigners can bring in to China, and controlling the conditions under which they can take it out, Beijing reduces the risk that a global financial panic leads to a damaging outflow of foreign investor capital. As a result, Beijing does not have to work so hard to maintain domestic financial stability.
The problem is that if you want to create a substitute for the U.S. treasury market—and for the world’s linchpin currency, the dollar—you have to accept those risks. International investors need to feel confident that they can put as much money as they want into your bonds, that the value of those holdings will stay relatively stable, and that they can cash out whenever they want with no penalty.
At present, foreign investors generally do not believe that China’s government bond market can deliver any of those things. They are perfectly happy to put small amounts into Chinese bonds to diversify their portfolios or to take advantage of short-term rises in the value of the renminbi. But more than one central banker has told my research team that they are reluctant to put much of their reserves into Chinese bonds because they worry the funds would not be available when they really needed them—i.e. in an emergency. That sentiment is even more strongly held by private financial institutions that trade far more frequently and want a source of safe collateral to back daily transactions.
In short, the reason the U.S. treasury market is such an indispensable part of the global financial system is that the United States is willing to take on financial risks that no other country—even one as big as China—dares to, and has proved over many decades that it can manage those risks safely. There is, perhaps unfortunately, no alternative. So if reckless politicking in Washington forces the market to freeze up, the world will suffer immense economic and financial damage. Like everyone else, China will be an unlucky bystander, forced to wait until the U.S. can sort out its internal disputes and resume its stewardship of the global financial system.
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