China, Debt and Currencies- huh?

We received an interesting question via email. I will paraphrase:

1) Is it true that China owns a significant portion of America's debt, and if so what are the implications of this? Is having China as one of our primary backers a necessarily bad thing, or are bonds bonds, regardless of the holder?

2) Is it true that China's currency is artificially tied to the value of the dollar, and should they choose to remove this pin from the cork board, it could drastically devalue the dollar even more than it already has?

Let's start with the first compound question. Yes, China owns a significant portion of America's debt. But we should first define "America's debt" to be sure we are talking about the same thing. There is U.S. Government debt or "Treasury bonds" which are obligations of the U.S. Federal Government backed by taxes and "U.S. Agency debt" which is the debt of Federal Agencies like the Federal Home Loan Bank (FHLB), Ginne Mae and Federal Housing Administration (FHA) debt. These are also considered direct government obligations. There is private debt of U.S. entities like corporations and mortgage securities. Until a few months ago, Fannie and Freddie debt was technically private debt. Now the distinction is not so clear, but Fannie & Freddie debt is backed by private loans which are guaranteed by the government. I make this distinction because people tend to say things like "foreigners own X% of our government/country/debt/homes/money" which are all too nebulous to be useful.

So, how much do foreigners own? According to table 2 on page 10 of this joint report from the Fed and Treasury, foreigners own $3.3 Trillion of our $9.6 Trillion direct government debt- about 34%. Interestingly, Japan is the biggest holder of Treasuries at $553B compared to China's $467B, but if you include Agency debt, China holds $843B and Japan $782B (the Middle East oil-exporters are a distant third at $109B, followed by Luxembourg at $84B and the UK at $71B).

Here is where it becomes difficult to answer the question. Most of that debt is held by the foreign central banks in the form of reserves. Whoa! Hold on. What? China has an artificial peg which keeps its currency at a relatively fixed ratio to the U.S. dollar at roughly 7:1. (It's called a 'peg', not a 'pin' by the way). The Chinese central bank intervenes in the currency markets to buy or sell dollars when the exchange rate starts to stray. For example, say China has one factory and the U.S. just one buyer. The U.s. buyer buys one widget from China. The Chinese factory wants Yuan, not dollars, so it goes to the currency market to 'buy' Yuan with dollars. This 'buying' of Yuan should raise the price per dollar. Instead of 7Y/$1, the seller may give you only 6Y for the same $1. For reasons we'll explore in a minute, the Bank of China steps in and sells some Yuan for dollars at a lower price, driving the exchange rate back to 7Y/$1.

Ok. So how does the BoC do this? Since they are the central bank, they essentially print Yuan and sell it for dollars. As they do this over and over en masse, the BoC accumulates dollars and keeps the currency from rising. They then take that pile of dollars and buy U.S. debt to earn a return on the dollars. Why do they do this? China keeps the peg in place because an artificially weak currency keeps their exports cheap and attractive to foreigners. Why buy U.S. debt when the returns are a paltry 3% or so? Holding massive U.S. dollar reserves as a developing country is a defense against a collapse of their own currency. They want the Yuan weak, but not silly weak. If there were a flight out of Yuan, they can use the reserves to keep the currency stable. The second reason is that the U.S. needs to borrow so we can keep buying Chinese stuff. This is the same reason the auto makers, Sears and Best Buy have financing arms- so you can finance the purchased product. Another reason is that commodities, an essential import to manufacturing, are priced in dollars.

As the U.S. imports too much stuff from the rest of the world with dollars, foreigners sell the dollars in exchange for their own currency. This causes the dollar to fall, which should make foreign goods more expensive. More expensive imports encourages less consumption, more domestic production and helps eventually stabilize the currency. This is the concept behind free-floating currencies- supply and demand (for goods and currencies) will help activity adjust to 'natural' levels appropriately.

China has been under a lot of pressure to allow the Yuan to appreciate because of the massive trade deficit. By keeping the rate fixed at an artificially low level, the Chinese are able to sell stuff at artificially low prices, sucking economic activity and profit from the U.S. They have been slowly allowing the Yuan to appreciate, but not significantly (6.83 recently, down from 7.8 a few years ago). The Euro has been forced to bear the brunt of the dollar weakness, hurting European exports to the U.S.

Question 2, can China remove the peg and drastically devalue the dollar? They could, but the consequences would not be as severe for the U.S. as you might first think. First, Chinese exports would plummet, hurting the Chinese economy dramatically. Second, the U.S. would see import prices rise, but our Chinese imports are relatively small in importantance to our standard of consumption compared to Chinese dependence on exports. Said another way, we can afford to not buy 8 bazillion plastic pens for $10 at Walmart while China can't afford to not sell them. There is little reason to think China will suddenly abandon the peg which will cause the dollar to plummet bringing economic disaster to the U.S. It is more likely that the peg is dropped at a time when China can't sustain it because of its own economic troubles. Most likely is that the peg is dropped at a time when both currencies appear to be nearly balanced.

Back to question 1, is having China as one of our primary backers a necessarily bad thing, or are bonds bonds, regardless of the holder? You have identified the key here: bond holders are bond holders. I suppose it could be a 'bad' thing if China suddenly changed policy causing some temporary economic dislocation or if they tried to destabilize the economy as intentional economic warfare, but beyond that there isn't much  an economic bomb to be afraid of. Imagine for a moment, China becomes outwardly hostile and aggressive (ala Germany in the '30s). We could simply decide to default on all paper held by China. Owning another country's sovereign debt does not bestow any rights on the holder- China does not own our property outright, they own our IOUs. Are we beholden to the Chinese because we need money? Having them willingly buy our debt at low interest rates is advantageous for sure, but remember that China holds just 9% of our debt and it took a decade to accumulate that much. If they chose not to buy another bond, the impact would not be disaster, just higher interest rates. And those higher rates might have discouraged the housing bubble in the first place. Perhaps we should blame China for the spending binge that got us into trouble then?

Currencies are not an intuitive subject. It is hard to grasp and harder to see the consequences in such an interconnected system. I just scratched the surface here and no doubt there are lots of "but what about..."  Ask questions and we'll see if we can wade through them.