ANALYSIS | Why China and Japan Pray the US Doesn’t Default on Debt

() — As the clock ticks down towards an unprecedented US debt default, the world’s second and third largest economies are watching in fear.

China and Japan are the largest foreign investors in US government debt. Together they own $2 trillion, more than a quarter, of the $7.6 trillion in US Treasury securities held by foreign countries.

Beijing began buying US Treasury bonds in 2000, when the United States approved China’s entry into the World Trade Organization, triggering an export boom. This generated huge amounts of dollars for China, which needed a safe place to keep them.

US Treasuries are considered one of the safest investments on the planet, and China’s holdings of US government debt rose from $101 billion to a peak of $1.3 trillion in 2013.

China was the United States’ largest foreign creditor for more than a decade. But an escalation of tensions with the Trump administration in 2019 caused Beijing to reduce its holdings, and Japan overtook China as the top creditor that year.

Tokyo now owns $1.1 trillion, compared to China’s $870 billion, and that heavy exposure means both countries are vulnerable to a possible collapse in the value of US Treasuries if a catastrophic scenario were to unfold for Washington. .

“Large holdings of the Japanese and Chinese Treasuries could hurt them if bond values ​​plummet,” said Josh Lipsky and Phillip Meng, analysts at the Atlantic Council’s Center for Geoeconomics.

The fall in the value of Treasury bonds would cause a decline in the foreign reserves of Japan and China. That means they would have less money to pay for essential imports, service their own foreign debts, or prop up their national currencies.

However, the “real risk” comes from the downturn in the global economy and the likely US recession that could follow a default, they said.

“This is a serious concern for all countries, but poses a particular risk to China’s fragile economic recovery,” Lipsky and Meng noted.

After an initial burst of activity following the abrupt lifting of pandemic restrictions late last year, China’s economy is now faltering as consumption, investment and industrial production show signs of slowing. Deflationary pressure has worsened, as consumer prices have hardly budged in recent months. Another major concern is the rising youth unemployment rate, which reached a record level of 20.4% in April.

The Japanese economy, for its part, is just showing signs of emerging from stagnation and deflation, which have plagued the country for decades.

devastating impact

Even if the US government runs out of money and extraordinary measures to pay all its bills, a scenario that Treasury Secretary Janet Yellen has said could occur as soon as June 1, the probability of a default of the US may still be low.

Some US lawmakers have proposed giving priority to bond interest payments to the largest holders.

This would be done at the expense of other obligations, such as the payment of pensions and salaries of public employees, but it would prevent major debt defaults on countries like Japan and China, according to Alex Capri, a professor at the NUS Business School.

And without a clear alternative, in response to increasing market volatility, investors could swap short-dated bonds for long-dated debt. According to the Atlantic Council’s Lipsky and Meng, this could benefit China and Japan, as their holdings are concentrated in long-term US Treasury bonds.

However, financial contagion and economic downturn are a much bigger threat.

“A US debt default would mean falling Treasury prices, rising interest rates, falling value of the dollar and increasing volatility,” said Marcus Noland, executive vice president and director of studies from the Peterson Institute for International Economics.

“It would also likely be accompanied by a fall in the US stock market, increased stress in the US banking sector and increased stress in the real estate sector.”

This could also shake the interconnected world economy and financial markets.

China and Japan depend on the world’s largest economy to sustain businesses and jobs at home. The export sector is especially crucial for China, as other pillars of the economy, such as real estate, have faltered. Exports generate a fifth of China’s GDP and employ some 180 million people.

Despite rising geopolitical tension, the United States remains China’s top trading partner. It is also the second for Japan. In 2022, US-China trade reached a record $691 billion. The exports from Japan to the United States increased by 10% in 2022.

“As the US economy slows, the impact would be transmitted through trade, depressing Chinese exports to the US, for example, and contributing to a global slowdown,” Noland said.

deep concern

Bank of Japan Governor Kazuo Ueda expressed concern on Friday, warning that a US debt default would cause turmoil in various markets and have dire consequences for the global economy.

“The Bank of Japan will strive to maintain market stability based on its commitment to respond flexibly taking into account economic, price and financial developments,” he told Parliament, according to Reuters.

Beijing, so far, has remained relatively quiet on the matter. The Foreign Ministry said Tuesday that it expects the United States to “adopt responsible fiscal and monetary policies” and “refrain from transmitting risks” to the world.

Chinese state news agency Xinhua public earlier this month a column highlighting the “symbiotic relationship” countries have in the US bond market.

“If the United States defaults on its debt, it will not only bring discredit to the United States, but also bring real financial losses to China,” it said.

There isn’t much Tokyo or Beijing can do other than hope for the best.

Rashly dumping US debt would be “counterproductive,” Capri said, as it would drive up the value of the Japanese yen or Chinese yuan significantly against the dollar, causing the cost of their exports “to skyrocket.”

Long-term benefits?

In the long term, some analysts say a possible US default could prompt China to accelerate its efforts to create a global financial system less dependent on the dollar.

The Chinese government has already finalized a series of agreements with Russia, Saudi Arabia, Brazil and France to increase the use of the yuan in international trade and investment. A Russian legislator declared last year that the BRICS countries, that is, China, Russia, India, Brazil and South Africa, are studying the creation of a common currency for cross-border trade.

“This will undoubtedly serve as a catalyst for China to further push the internationalization of the yuan, and for Beijing to redouble its efforts to bring its trading partners into the recently announced ‘BRICS currency’ initiative,” Capri said.

However, China faces serious obstacles, such as the controls it applies to the amount of money that can enter and leave its economy. Analysts say Beijing has shown little willingness to fully integrate into global financial markets.

“A serious push for de-dollarization would lead to much more volatile yuan trade,” says Derek Scissors, a fellow at the American Enterprise Institute.

Recent data from the international payment system SWIFT shows that the yuan’s share in global trade financing was 4.5% in March, while the dollar accounted for 83.7%.

“There is still a long way to go before a credible alternative to the US dollar emerges,” Lipsky and Meng say.