As it stands, the US government holds roughly 40 per cent of its debt through the Federal Reserve and government agencies like the Social Security Trust Fund, while American and foreign investors hold 30 per cent each. Emerging economies – many of which use large trade surpluses to drive GDP growth and supplement their foreign-exchange reserves with the resulting capital inflows – are leading buyers of US debt.
Over the last decade, these countries’ foreign-exchange reserves have swelled from $750bn to $6.3trn – more than 50 per cent of the global total – providing a major source of financing that has effectively suppressed long-term US borrowing costs. With yields on US ten-year bonds falling by 45 per cent annually, on average, from 2000 to 2012, the US was able to finance its debt on exceptionally favorable terms.
But the ongoing depreciation of the US dollar – which has fallen by almost half since the Bretton Woods system collapsed in 1971 – together with the rising volume of US government debt, undermines the purchasing power of investors in US government securities. This diminishes the value of these countries’ foreign-exchange reserves, endangers their fiscal and exchange-rate policies, and undermines their financial security.
Nowhere is this more problematic than in China, which, despite the recent sell-off, remains by far America’s largest foreign creditor, accounting for more than 22 per cent of America’s foreign-held debt. Chinese demand for Treasuries has enabled the US to increase its government debt almost threefold over the last decade, from roughly $6 trn to $16.7 trn. This, in turn, has fuelled a roughly 28 per cent annual expansion in China’s foreign-exchange reserves.
China’s purchases of American debt effectively transferred the official reserves gained via China’s trade surplus back to the US market. In early 2000, China held only $71.4bn of US debt and accounted for 8 per cent of total foreign investment in the US. By the end of 2012, this figure had reached $1.2trn, accounting for 22 per cent of inward foreign investment.
But China’s reserves have long suffered as a result, yielding only 2 per cent on US ten-year bonds, when they should be yielding 3-5 per cent. Meanwhile, outward foreign direct investment yields 20 per cent annually, on average. So, whereas China’s $3trn in foreign-exchange reserves will yield only about $100bn annually, its $1.53trn in foreign direct investment could bring in annual returns totalling around $300bn.
Despite such low returns, China has continued to invest its reserves in the US, largely owing to the inability of its own under-developed financial market to generate a sufficient supply of safe assets. In the first four months of this year, China added $44.3bn of US Treasury securities to its reserves, meaning that such debt now accounts for 38 per cent of China’s total foreign-exchange reserves. But the growing risk associated with US Treasury bonds should prompt China to reduce its holdings of US debt.
Zhang Monan is a fellow of the China Information Center, a fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform.
The rest of this piece can be read on economia.