Debt’s life, debt’s what all the people say: Big squeeze coming from China?

Lizzie Threlkeld’s idea of a good time is attending a meeting of the U.S.-China Economic and Security Review Commission. Here is her thoughtful report:

By Elizabeth Threlkeld
Best Defense deputy chief East Asian finance bureau

Could China use its U.S. debt holdings to squeeze us on foreign policy?

That’s unlikely, at least in the short term, according to most of the witnesses who testified before the U.S.-China Economic and Security Review Commission last week. Beijing’s role as our banker does give it significant influence in Washington. But what’s often lost is the fact that China relies just as much on the U.S. as a destination for its investments. To avoid a jarring shift in this so-called balance of financial terror, Washington should do two things. First, to remain a credible borrower, we need to tackle the deficit. Second, we should lead a multilateral effort to confront China on its trade practices and currency valuation, a cause many countries worldwide can get behind. It also would reduce the chances of Beijing converting its economic influence into outsized foreign policy power. 

Currently, the New York Fed puts China’s holdings of U.S. Treasury Securities at $755 billion, making it our second largest foreign investor, just behind Japan. But the real figure could be closer to $1 trillion when you add in Hong Kong’s $153 billion and possible offshore investments through third parties. As for foreign currency reserves, Beijing holds around $2.4 trillion, according to the People’s Bank of China.

Fears that China might dump much of that debt — and trigger an international sell-off — are unfounded. For one, Beijing would suffer considerable losses on its U.S. holdings (although Cornell Professor and Brookings Senior Fellow Eswar Prasad argued, Beijing would lose less than most analysts believe). More fundamental, though, is another issue: If not here, where? There is simply no other market deep enough to absorb all of the capital China has invested. As Dr. Derek Scissors of the Heritage Foundation put it, China has two options for its money: "buy U.S. bonds or build a really big mattress." And since China’s foreign currency investments are what allow it to keep the renminbi pegged artificially low against the dollar, the mattress idea won’t get much bounce.

On the flip side, we do rely heavily on Chinese investment to finance everything from stimulus spending to the wars in Iraq and Afghanistan. If Beijing were to try to use its creditor status to pressure Washington, we could push back with trade sanctions and potentially find other lenders. Neither is an attractive prospect, however, as China would no doubt match our sanctions with those of its own, and our growing deficit could make the search for alternative sources of financing difficult. For the short term, at least, it seems we’re coming to state of mutually assured economic destruction; both countries need each other and neither is likely to risk any serious damage to the relationship.

As a result, the U.S. has more leverage than you might think, both in economic and foreign policy. Tufts’ Fletcher School Professor and FP blogger extraordinaire Dazzlin’ Daniel Drezner criticized the supplicant attitude the Obama Administration adopted early on towards China when Secretaries Clinton and Geithner both seemed to plead for continued lending. He sees our more recent decisions like the sale of arms to Taiwan as a needed adjustment of this misguided course. Right now, he argues, China’s economic clout has given it more autonomy and a greater ability to resist U.S. pressure. But Beijing remains unable to force Washington’s hand on various economic and foreign policy decisions.

China’s influence is much stronger in many of the developing countries where it’s heavily invested. These nations depend on Beijing for significant financial and technical assistance and don’t offer enough in return to balance their relationships. China is cultivating various suppliers of raw materials from the developing world, ensuring individual countries are easily replaceable should they refuse to kowtow to Beijing. As a result, Chinese economic investment will likely translate into political returns from such countries — an outcome that could pose serious challenges to U.S. foreign policy goals, especially in the longer term.

Indeed, the greatest threat China poses to the U.S. is over the long term. If another reserve currency were to emerge that could absorb Chinese investment, the U.S. would no longer be China’s only option. Beijing has recently shown interest in either internationalizing the renminbi or in using IMF-issued Special Drawing Rights, although a Chinese economist reportedly dismissed the latter as "the Esperanto of international reserve currencies." But such alternatives might look more attractive if the U.S. is unable to get its economic house in order and tackle the skyrocketing deficit. Granted, China, too, has domestic concerns. Prasad explained that much of the bluster we see from China is in response to instability within the country where nationalism is seen as a safe channel for political expression. If nationalism grows too strong or loses its effectiveness as a safety valve, all bets are off.

To try to rein in China’s economic and foreign policy reach, most of the witnesses suggested the U.S. take advantage of the fact that we’re not the only country frustrated with Beijing’s trade and currency policies. ASEAN countries, the EU, and various developing nations are all suffering from Chinese economic controls, and working with these partners to pressure China on trade and its exchange rate would be a useful step. India, in particular, as a powerful country not closely bound to China, might prove a key ally. Nearly all of the panelists advocated using the G20 as a mechanism to address these concerns multilaterally. But the general feeling was that Washington is just going to have to get used to the fact that, after twenty years alone on the world stage, the U.S. is no longer pulling all the strings.

Incidentally, a couple of times during the hearing, Commissioner Larry Woertzel citied this Defense News article as evidence that the recently released QDR intentionally softened its tone on China for fear of angering our banker in Beijing. I don’t see much support for that in the article itself, but I’d be interested to hear if anyone else has insights into that question.