The Debt Ceiling: What China Is Doing

Derek Scissors / July 25, 2011

The debt standoff in D.C. is first and foremost about irresponsible government—not just right now but for a decade by both parties, both houses of Congress, and two Presidents. There are also a number of secondary issues, including the impact on America’s biggest foreign creditor: China.

Hang on—this is going to get a bit complicated.

First, there’s the idea that China can just stop buying foreign currency assets. False. The PRC’s own balance of payments rules mean they have to keep buying, and they know they have to.

The situation with Treasury bonds in particular can be confusing, as monthly reporting by the Department of the Treasury is not useful concerning China. For June 2010, for example, it was “discovered” that $268 billion in supposedly British bond purchases were actually Chinese. Something similar will happen when Treasury next revises its monthly figures.

But there is some evidence that China has stopped buying so much in the way of U.S. Treasury bonds. This makes perfect sense: Bonds aren’t a good buy when the seller might tell you tha tpayments are suspended.

So what’s the PRC doing with all the foreign money it continues to rake in ($350 billion more in the first half of the year alone)? That’s far more than China can spend outside the U.S., because China can’t just buy non-dollar assets.

Take oil. China paid only $135 billion for the record amount of oil it needed for all of 2010. Yen or Japanese government bonds—Tokyo would scream at the top of its lungs about even $50 billion in purchases. For one thing, they would push the value of the yen way up.

In general, the PRC can’t make hundreds of billions of dollars in purchases over a six-month period without getting noticed. China takes in such huge amounts of dollars that, if it switched out, there would be a very long paper trail.

This sounds like a mystery, but it’s actually not much of one. The PRC has two basic choices to hold dollars beside U.S. Treasuries: foreign banks and foreign currency accounts at its own banks. And there has been an increase in forex held by Chinese banks.

For the moment, this can only go so far—China is battling a bout of inflation, and a rush of liquidity to domestic banks is not welcome at present. That leaves foreign banks receiving a large sum of Chinese-owned dollars either now or soon.

As it happens, there is evidence of foreign money coming into U.S.-based banks starting earlier this year. It’s not clear that it’s Chinese money but, with the PRC, it’s never entirely clear. What’s attractive about U.S.-based banks? The same thing that’s attractive about American bonds: The market is so big that China can engage in major transactions without any disturbance.

To sum: Beijing is probably not buying Treasuries as intensely as it did last year. Until the U.S. budget situation is resolved, it is most likely just storing money in simple bank deposits both at home and overseas. Boring, but entirely sensible.