China fears U.S. debt default as much as anyone (2024)

President Joe Biden put foreign policy on the back burner on Sunday when he returned to the United States to resume crunch talks with Republican leaders to avert what would be an unprecedented debt default.

Departing the G7 summit in Japan, the Democrat accused the GOP of adopting "extreme positions" to oppose a higher borrowing limit that would fund his administration's legislative agenda. House Speaker Kevin McCarthy and other senior Republicans have called for government spending cuts in order to reduce the national deficit.

Treasury Secretary Janet Yellen, in another letter to McCarthy this week, said it was "highly likely" the United States would default on its debt—estimated at $31.46 trillion—as early as June 1, "if Congress has not acted to raise or suspend the debt limit" by early next month.

A financial crisis triggered by a partisan impasse over the debt ceiling would have disastrous consequences for the U.S. economy, analysts say, as well as for the markets of allies and adversaries including China. In the long run, it would erode global confidence in a country that has built a decades-long reputation for paying its bills on time.

"Our ability to counter China requires us to show up. It requires us to show up in embassies and it requires us to show up on the ground with money," Commerce Secretary Gina Raimondo told the Senate Appropriations Committee last week.

A short default lasting no more than a week could still result in a 0.7 percentage point decline in the U.S.'s gross domestic product and the loss of 1.5 million jobs, credit ratings agency Moody's said in a report earlier this month.

If it lasts for weeks or months, the "blow to the economy would be cataclysmic," according to its economists, who predicted a 4.6 percent drop in GDP between the second half of this year into 2024 and the loss of 7.8 million jobs.

Otherwise, risk-free Treasury securities—IOUs sold to investors at varying rates and terms, underwritten by trust in the U.S. government's ability to honor them—could, for the first time, face downgrades across financial systems.

Emily Jin, a research assistant at the Center for a New American Security, told Newsweek: "The U.S. debt ceiling—and how close the U.S. is to breaching it—is a metric for U.S. immediate-term economic stability."

"Defaulting on the debt would have immediate negative consequences for the U.S. economy. However, continuously raising the debt ceiling without implementing sustainable economic growth measures poses long-term risks to the U.S. economy," she said.

China's Stake

The ripples wouldn't end there. Foreign governments and private investors hold $7.57 trillion of the national debt, according to the government's latest data for March. The figure represents 31 percent of the $24.3 trillion U.S. Treasury market, the U.S. government's primary source of financing.

China's stake has declined over time to $869.3 billion, or 11 percent of foreign-owned debt. Japan tops the foreign holders' list at $1.08 trillion, or 14 percent, and the United Kingdom is third at $714 billion, or 9 percent.

The marketplace for Treasury securities anchors the global financial system. A default in which the U.S. is unable to settle one or more outstanding debt payments would raise investment risk that triggers interest rate hikes and weakens the U.S. dollar, the world's dominant currency.

The extent of disruptions to markets at home and abroad is difficult to predict, but researchers believe a recession is likely, including for China, despite its relatively insulated financial system.

If the financial crisis of 2007-08 is any indication, the Chinese economy could suffer from a collapse in global demand for its manufacturing sector, which is still in the middle of a post-pandemic resurgence. A worst-case scenario puts tens of millions of jobs at risk.

"A U.S. default will be a huge negative shock to both the U.S. and global economy. The negative impact on China likely takes place via two related but distinct channels: the financial market and trade," said Guonan Ma, a senior fellow at the Asia Society Policy Institute.

"Increased financial turmoil dampens investor confidence generally, Chinese investors included. Given that China is the second-largest foreign holder of U.S. Treasuries, Beijing will feel very uncomfortable to add to its holdings in light of reduced risk-adjusted returns, on top of the rising geopolitics," Ma told Newsweek.

"A default will likely plunge the U.S. and global financial markets into chaos, as U.S. Treasuries are the bedrock of these markets and the broader financial system. This would pump up uncertainties and dampen business and consumer sentiments, which in turn would hurt two-way trade orders," he said.

De-dollarization

A U.S. default may seem improbable, but Washington's brinkmanship could undermine the dollar's standing as the reserve currency of choice. China watchers in particular expect recent events to reinforce Beijing's desire to break its dependence on the dollar.

To be sure, China's leaders appeared to reach this conclusion 15 years ago, in part as a matter of ideological principle, after the last financial shock wave. However, efforts to popularize the Chinese yuan, although notable, have been slow going.

Amid biting sanctions by the West last year, Russia ditched dollar transactions for more yuan settlements in its resources trade with China. In December, Chinese leader Xi Jinping said his country would soon use the yuan for oil and gas purchases from the Middle East.

In March, a Brazilian bank became the first in Latin America to sign up for the yuan-dominated CIPS cross-border payment system—launched by China's central bank in 2015 to rival SWIFT and CHIPS—in a sign of the BRICS bloc's desire to find alternatives to Western financial institutions.

China is today the largest trading partner of roughly two-thirds of all countries, but the dollar remains by far the most widely held reserve currency and the go-to currency for financial transactions, according to the International Monetary Fund.

IMF statistics from the fourth quarter of 2022 showed the dollar accounted for 58.36 percent of global central bank reserves, compared to 20.47 percent for the euro and just 2.69 percent for the yuan.

Beijing's tight capital controls may shield the Chinese financial system from the worst financial fallout, but the same risk-averse monetary policy also prevents China and the yuan from emerging as part of an alternative to the U.S. Treasury market.

"In the long term, China may aim to trim its exposure to U.S. Treasuries and indeed dollar assets generally. The challenge for China is that in the short term, there are no viable alternatives qualified to fully replace U.S. Treasuries as a safe and liquid reserve asset," said Ma.

"Therefore, we are seeing tension between U.S. Treasuries as a safe reserve asset and their increased riskiness of default due to domestic politics of debt limit and geopolitics," he said.

For the time being, said Jin, it remains in China's national interest "to protect the value of its significant holdings in U.S. assets, as they make up a substantial portion of China's foreign exchange reserves."

China's holdings of U.S. long-term securities—including Treasury bills, agency bonds, corporate and other bonds, and corporate entity stocks—total $1.42 trillion, according to Jin's analysis of recent Treasury Department data.

"Despite any Chinese statements and pundits suggesting otherwise, China is likely interested in the stability of the U.S. dollar, as it has a vested interest in the value of its U.S. dollar-denominated assets. China is long the U.S. dollar," she said.

Down to the Wire

The Biden administration's choices in recent days suggest the debt ceiling negotiations are a domestic priority with far-reaching implications that outweigh any other foreign policy issue on the president's agenda—and it cut short Biden's trip to the Asia-Pacific to prove that point.

Major stakeholders around the world, including China, may consider the move prudent, but it won't stop China availing itself of the opportunity to score political points while putting itself forward as a benign or even more reliable partner.

Avril Haines, director of national intelligence, told the Senate Armed Services Committee in early May that China and Russia likely conduct "information operations" to portray the U.S. as "not capable of functioning as a democracy, and the governance issues associated with it."

A May 22 editorial by China's official news agency Xinhua declared the U.S. "a great threat to global financial stability."

"Behind the recent U.S. debt crunch, banking crisis and inflation challenge are its deficit financial policies, aggressive adjustment of monetary policies and extreme political polarization, which have been channeling its own risks to the rest of the world," it said, echoing remarks last week by a Chinese Foreign Ministry spokesperson.

The Global Times, a state-owned tabloid published by the Communist Party's flagship newspaper, said on Sunday that global investors were "diversifying their foreign exchange asset allocation, including by increasing yuan holdings and de-dollarization."

A Reuters analysis in March of China's central bank data said dollar deposits at Chinese commercial banks increased this year on account of a weaker yuan, rising U.S. interest rates and Western talk of "de-risking" investment from China.

The appropriations stalemate has been months in the making, since it became clear America would have a divided government.

Biden and McCarthy continued debt ceiling talks this week but failed to reach an agreement with just 10 days to go before Yellen's "hard deadline." But both sides suggested a deal was likely.

"We reiterated once again that default is off the table and the only way to move forward is in good faith toward a bipartisan agreement," Biden said in a White House statement on Monday.

"I believe we can still get there. I believe we can get it done," McCarthy told reporters after the hourlong meeting, which was followed by negotiations by their respective teams.

Arthur Kroeber, managing director of economic research firm GaveKal Dragonomics, foresaw the deadlock in January and said China would have little choice but to wait it out.

He wrote in ChinaFile, the Asia Society's online magazine, at the time: "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."

Update 24/05/23, 5:00 a.m. ET: This article was updated with comments from Emily Jin of the Center for a New American Security.

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