Why the US and China are getting upset over debt: Maley

As US President Barack Obama gets ready to meet the Dalai Lama later today, news comes that China has been vigorously selling US government debt.

China dumped $US34.2 billion of Treasuries last December, its fastest rate of selling in a decade.

At the end of 2009, China’s holdings of US government debt stood at $US755.4 billion. This represents a drop of 6% from the peak of $US801.5 billion last May.

This is a big shift for China, which has been the biggest lender to the US government since September 2008.

The big question is, how worried should the US be?

There’s almost certainly a political element in China’s selling.

Hostility between Washington and Beijing escalated after the US government approved a $6.4 billion arms deal to Taiwan.

And China strenuously opposed Obama’s meeting with the Tibetan spiritual leader, threatening to “take corresponding action to make relevant countries see their mistakes.”

More worrying, however, is that the selling also reflects fundamental Chinese worries about US government finances.

For more than a year, Chinese officials have been expressing concerns over the burgeoning US budget deficit, which is expected to hit $1.6 trillion, or 10.6% of GDP.

Earlier this month, Chinese publication The People’s Daily ran a story quoting Chinese economists who warned the US government would have to print more money to finance its large deficit, which would push the US dollar down and erode the value of China’s dollar-denominated assets.

The story quoted Cao Honghui, from the Chinese Academy of Social Sciences (which is a government think-tank), warning that the US should not transfer the problems of its enormous debt to creditor countries such as China.

The report also noted that China’s State Administration of Foreign Exchange had issued a statement in December saying China would diversify its foreign currency holdings – both currencies and securities – to reduce risk.

Signs of increasing Chinese impatience with the US budget deficits come as US Federal Reserve board members have issued public warnings about the need for Washington to rein in its spiralling deficit.

Thomas Hoenig warned earlier this week that if a government turned to its central bank to print money to help it bridge its budget shortfalls, the result would be overly rapid money creation that would eventually lead to high inflation.

Some days earlier, fellow board member, Richard Fisher, said that the US “cannot count forever on the largesse or the misfortune of others to mask our own imbalances here at home.”

But while China is certainly showing impatience at extending largesse to the US government, there are limits on China’s ability to express its frustration by dumping US government debt.

China has foreign exchange reserves of $2.4 trillion dollars, and it is estimated that more than 60 per cent of its reserves are invested in US dollar denominated assets.

If China starts aggressively selling off US government debts, it risks slashing the value of its existing US investments.

What’s more, US government debt is looking more attractive after ructions over Greece’s ballooning deficits curbed investors’ appetite for investing sovereign debt of weaker members of the European Union.

Meanwhile, there are signs that Washington is responding to this growing pressure to curb its deficit. President Obama is expected to sign an executive order to set up a bipartisan commission to look at spending cuts and tax initiatives to curb the country’s debt.

This article first appeared on Business Spectator.