 Global Economy > World Debt Threat
For good reasons,
China finances US deficit
By Jin Chen
Reporting from Davos
By selling its treasury bills, the United States is financing its ever ballooning budget deficit, which is projected officially to be $521 billion in 2004. Who are the buyers? One of the large purchasers is the Chinese central bank, or the People’s Bank of China (PBOC). Official Chinese foreign-exchange reserves have tripled since 1999, to $450 billion in 2003, most of which are in dollar-denominated US Treasury securities.
Why would anyone buy or sit on US Treasury bills in large quantity, which have been depreciating significantly in value against the euro and yen and which yield unusually low interest? This was one of the key questions posed to the Chinese participants at the World Economic Forum in Davos, Switzerland, in January. Those present were concerned.
If the Chinese central bank sells in large quantity dollar-denominated securities, one of the immediate consequences will be further plunging of the dollar after its more than 20-percent fall last year against the euro. The degree of this plunge could be moderated by the Federal Reserve by increasing the Federal Funds Rate, but increasing the US interest rate will bring another unpleasant result: choking the US fragile economic recovery, which has already been characterized as a so-called jobless recovery.
It turns out, however, that China is helping to finance the US budget deficit for its own reasons. First, one of the important lessons the Chinese took away from the Asian financial crisis of 1997 and 1998, as well as other emerging-market crises, is that emerging markets need substantial foreign-exchange reserves simply as a cushion for the proverbial rainy day. This is both because of the unpredictability of international financial markets and because of many internal problems of the Chinese financial system, such as large nonperforming loans.
Second, like Japan, China’s current exchange-rate policy is geared toward promoting exports, which are one of the key engines for China’s economic growth. The growth of China’s trade over the past five years, from 1998 to 2003, almost tripled while growth in world trade remained essentially flat. Exports of foreign affiliates as a share of China’s total exports grew steadily since the mid 1990s from approximately 40 to 55 percent in 2003. That is, foreign affiliates contributed more than half of the growth of China’s exports. Purchasing dollar-denominated securities is a by-product of China’s exchange-rate policies.
Third, China could choose to shift a substantial amount of its foreign-exchange reserves from the dollar to the euro-denominated securities. But the problem in this scenario is that the European financial markets are not nearly as efficient as those of the United States; while improving, they still have many institutional barriers to trading in large values.
Only gradually will China shift the composition of its foreign-exchange reserves from dollar-dominated to a more balanced mixture of key currencies. This largely has to do with a change in China’s foreign-exchange rate policy from pegging the RMB to the dollar to pegging the RMB to a basket of key currencies. When will this happen? The Chinese are proud that their gradualist reform approach has proved, so far, to be wiser than the “shock therapy” that many of the Eastern European countries experienced. Under the official guideline that “stability overrides everything else,” only when Chinese officials feel fairly certain with small experimental steps that this change of policy will not disturb financial stability will they dare to make the move publicly.
Jin Chen is a former editor-in-chief of Harvard China Review based in Cambridge, Massachusetts.
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