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Is the U.S. in Hock to China—And Should We Worry?

Is the U.S. in Hock to China—And Should We Worry?
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Notwithstanding its current economic slowdown, China is still one of the largest foreign holders of U.S. debt. In this week’s episode, we debunk fears about China’s hold over the U.S.

Click to show the transcript

RICK KARR:

China already holds more than a trillion dollars’ worth of U.S. Treasuries. Some people find that fact scary. They don’t like being in hock to another country, and think we may be dependent on a potential rival or burgeoning superpower. 

You’re listening to the Insights & Ideas podcast, brought to you by Charles Schwab. I’m Rick Karr. Recently, China devalued its currency, which caused a spike in global market volatility. But while its economy is not as robust as it once was, China is still a major holder of U.S. debt. So the question—should we worry about China?—is still worth asking.

Concern over this country’s dependence on a nation that does not necessarily have our best interest at heart is something that my guest also heard back in the 1980s. The difference then was that Japan seemed to be the potential threat. Japan still holds U.S. debt, in fact the country holds more than any other nation, including China, which is second on the list.

But Japan’s initial reason for buying U.S. debt was the same as China’s is today, according to Kathy Jones. She’s senior vice president and fixed income strategist at Charles Schwab. And Kathy, safe to say, it all starts with the fact that we American consumers like a bargain?

KATHY JONES:

Well, yeah, you could put it that way I think. We run a large trade deficit currently with China. And that’s because we like to buy inexpensive consumer goods, and China has established itself over the last couple of decades as a manufacturer and producer of inexpensive goods because they’ve had inexpensive labor. And so because we run this trade deficit with China, they end up with a lot of U.S. dollars. And they invest those U.S. dollars in Treasuries.

RICK KARR:

And the same was true of Japan in the ’80s?

KATHY JONES:

Absolutely. We had a big deficit with Japan in the ’80s if you remember. We imported a lot of cars from Japan in the ’80s.

RICK KARR:

So why does that trade deficit turn into them buying Treasuries?

KATHY JONES:

So what happens is, when we buy a lot of goods from China, they acquire U.S. dollars in the transaction. Since they have a trade surplus, they have to do something with all those dollars. Most goods that are traded in the world are traded in U.S. dollars. So things like wheat and oil and soy beans—you name it—it gets traded in U.S. dollars. So they tend to hold the dollars, because they’re going to turn around and use them for another transaction somewhere. Or they’re expecting that they have to put those dollars somewhere.

And the easiest place for them to put those dollars is in U.S. Treasuries, because it’s a large and liquid market. They know they can get their money back out when they need it, and that they’re not at risk of default or someone not paying them on those dollars.

RICK KARR:

So it sounds like this is actually a good thing. The federal government needs to borrow the money, it’s better that we get the dollars back than they sit on them there. I mean, doesn’t this work out great for everybody in the long run?

KATHY JONES:

Well—you know, in a perfect world it’s just recycling the dollars through trade. So, yeah, when trade works properly, and when there’s not a lot of political interference between the two countries conducting it, it works perfectly fine. It continues to work.

RICK KARR:

One of the arguments you commonly hear against borrowing so much from China starts with the fact that at some point China might decide to inflict some damage on the United States, and the Treasuries it owns could be the weapons it uses. It could just dump them off all at once, causing the price to crash. Wouldn’t that cause serious damage to our economy?

KATHY JONES:

Yeah, it undoubtedly would. It would cause interest rates to spike up. That spike in interest rates would hurt the economy, could send us into recession again. It would send the value of the dollar down. So it would definitely be very negative. What you have to consider, though, is it also hurts China. So as they’re trying to sell…

RICK KARR:

Mutually assured destruction?

KATHY JONES:

Yes, exactly. And they’d really be shooting themselves in the foot. They would be causing the value of their own assets to go down as they sold those Treasuries, so they’d go down in value. And they’d be hurting their best customer. So we buy a lot of consumer goods from China, a lot of equipment, a lot of goods from them, and if we went into recession and our dollar went down, our ability to buy from them would decline. And it would probably hurt their economy as well.

RICK KARR:

And it sounds if I’m hearing you right, because so many of the other things that China and every other country’s buying—whether it’s oil or steel or wheat—are bought and sold in dollars, that is good for us, isn’t it? I mean, it’s because it makes the whole world take an interest in keeping the dollar stable?

KATHY JONES:

Right. And that is partly an outgrowth of the fact we have what’s called the world’s reserve currency. It’s the currency that people transact in, it’s a currency that other central banks are willing to hold to conduct those transactions. And we get a bit of a privilege of having that. Because everybody wants to hold them, it helps keep our interest rates down, because we have the world’s reserve currency.

RICK KARR:

Does this matter to the individual investor? Does this have an impact on their investments?

KATHY JONES:

I would say that the impact on the individual investor is the impact on interest rates. So as long as the rest of the world is willing to hold U.S. Treasuries and buy them and hold them at low rates, it keeps interest rates down. If something were to change, then it would probably send interest rates up. But the direct impact is small right now, unless something changes. The indirect impact is it helps hold down U.S. interest rates.

RICK KARR:

Why has Japan suddenly passed China up again? Is it the same situation with Japan as Japan faced in the 1980s, they’ve got a big trade surplus?

KATHY JONES:

It’s a little bit different now for Japan. They do indeed run a trade surplus. And they also are in the process of trying to boost their economy with quantitative easing. And that means with a big bond-buying program, to hold down their interest rates and fight deflation.

So they’ve been out buying not only their own bonds, but they’re acquiring bonds all over the world. And so with Japan, between the trade surplus and the quantitative easing program, they’ve acquired a whole lot of U.S. Treasuries along the way as well.

RICK KARR:

And so demand for Treasuries is strong, which means the price is solid, right? I mean, isn’t this basically a supply and demand thing?

KATHY JONES:

Yeah, it’s sort of ironic, because the world is flooded with debt, and yet for some investors who have to hold sovereign bonds—bonds issued by major countries—they’re having trouble getting as much as they want. So the natural buyers of those are pension funds, some banks, insurance companies. They’re really required to hold this kind of debt. And because the central banks—between the European Central Bank and the Bank of Japan and the Fed—hold about 10 trillion of those bonds, some of the rates are so low, these pension funds and insurance companies are actually having trouble getting a decent rate of return on those investments.

RICK KARR:

So it sounds to me as though we should not really be concerned? This is a net positive for the U.S. economy. The fact that the Chinese government is willing to sit there and say, ‘We need Treasuries.’ Japan is saying the same thing. This is not a problem?

KATHY JONES:

In and of itself, it’s not a problem. Obviously if something really drastic happened in the world, and China or Japan suddenly became an enemy of ours for some reason, and wanted to inflict damage on themselves as well as us, in theory I supposed they could. But in and of itself, this is just the way currency and interest rate markets work.

RICK KARR:

Why do you think that people are so bent out of shape about it, then?

KATHY JONES:

I think there’s a fear that a foreign government could have influence on our markets, or influence maybe on our politics. And so there’s a fear of being beholden to anyone outside the United States.

RICK KARR:

Kathy, thank you for joining us. Kathy Jones works for Charles Schwab following interest rates and international finance. If you want to follow her on Twitter, her handle is @KathyJones, all one word. Kathy spelled with a K, so that’s K-A-T-H-Y-J-O-N-E-S.

That’s it for this installment. The Insights & Ideas podcast is brought to you by Charles Schwab. You can find us on iTunes, or go to insights.schwab.com. Our producer is Matthew Nelson. I’m Rick Karr. Thanks for listening. 

Important Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. 

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