Can China make the dollar crash?

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With more than USD 27,000 billion in government debt, the US government is the world's largest debtor. Like other countries, the US finances its debts by selling paper, such as government bonds. Those who buy these government bonds are lending money to the United States. The US has to repay the money after an agreed period. In addition, the lender is paid interest on the amount they lend.

Around 7,000 billion dollars in US debt is held by foreign governments. Japan (USD 1,251 billion) and China (USD 1,072 billion) were the largest foreign lenders at the end of 2020. The Belgian state has US debt tucked under the mattress, too (we even make the top 10!).

Exports and oil

The reason why China has wound up with so much US government bonds over the past two decades is quite simple: the US has run a trade deficit for decades. This means the country spends more on imported goods and services than it generates from its own exports. That is very true of the trade balance with China, the world's largest exporter. The Chinese state receives dollars from Chinese companies that they have received in payment for their exports. Among other things, these dollars are used by the Chinese government to buy US government bonds.

Oil purchasing is a second reason why China maintains a strong position in dollars. Most oil transactions globally are settled in US dollars. China is the second largest economy in the world. The country therefore needs a great many dollars to buy oil.

Foot on the brake

China has already taken steps in recent years to reduce its exposure to US debt instruments to some extent. While China had more than USD 1,300 billion in US bonds in 2013, it is currently moving to within the range of approximately USD 1,050 to 1,100 billion. At the same time, China is also attempting to get rid of the need for oil dollars by breaking the grip of the US dollar on the oil market. Although still on a very limited scale, the country is doing so by linking some oil deals to its own currency (yuan) rather than dollars. Oil futures are already traded in yuan on the Shanghai Stock Exchange.

Relationship status: It's complicated

China's relationship with the US dollar is a love-hate one. Hate because China wants to promote the yuan as a global currency and prefers to buy oil in yuan rather than dollars. Love because US bonds help the Chinese economy grow. Demand for USD government bonds actually increases the value of the dollar against the yuan. This makes Chinese exports cheaper than US manufactured goods, increasing sales of Chinese products.

However, the fact that China is sitting on such a mountain of US government debt is also a good thing for the US. China's demand for government paper is helping to keep interest rates low in the US. This means the US government can borrow more at lower interest rates. The US government can then increase federal spending, which in turn stimulates economic growth.

What if … ?

China's position as "America's banker" gives the country both political and economic clout, as evidenced by the trade friction between China and the US under Trump. Republicans at the White House floated the idea in April 2020 of never repaying China the more than USD 1,000 billion in debt. In response, China threatened to dump US bonds. Fortunately, it was limited to some muscle flexing and posturing.

However, the incident also raised some real questions. What if China reclaimed all this lending and dumped the mountain of US bonds onto the market? In that case, interest rates and prices in the US would rise, putting the brakes on economic growth in the US. According to some economists, this would push down demand for the dollar and disrupt the international markets even more than the 2008 financial crisis. However, this would affect the entire global economy – including China. Dumping all that government paper is a trigger that China could pull, but they would also be shooting themselves in the foot. There is therefore little likelihood of China choosing this nuclear option.

Slowly but surely?

In addition, various economists argue that other countries would quickly pick up the dumped government paper. Generally speaking, US debt instruments are an asset that is in demand. They are relatively safe and simple. As a reserve currency, the US dollar is used extensively in international transactions. Commodities are often priced in dollars and thanks to the high level of demand, dollars can easily be cashed in. Moreover, the US government has always honoured its debts.

If China ever decided to reclaim its debt, it would likely start selling US Treasuries slowly. However, this would need to be done very cautiously, or it would hurt China's competitiveness because the yuan would appreciate against the dollar (at a certain price point US consumers would then buy US products). China will not be in a position to initiate this process until it has further expanded its exports to other Asian countries and boosted domestic demand. Definitely to be continued!

This article does not contain any investment advice or recommendation, nor a financial analysis. Nothing in this article may be construed as information with a contractual value of any sort whatsoever. This article is intended for information only and does not constitute in any way a commercialization of financial products. Keytrade Bank cannot be held liable for any decision made based on the information contained in this article, nor for its use by third parties. Every investment entails risks such as a possible loss of capital. Before investing in financial instruments, please inform yourself properly and read carefully the document "Overview of the principal characteristics and risks of financial instruments" that you can find in the Document centre.

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