The 2 Trillion Dollar Hole in the Chinese Economy

Do you remember the Article titled "S & P Downgrades US Credit Rating"? I had mentioned in that article that China is the largest holder of US Debt. They hold over $ 1 Trillion worth of US Treasury Bills. With the World Economy moving at a sluggish pace and Major economies like US and European Union reeling under pressure, Growing Economies like India & China are significantly affected. This article is an Analysis of the Current Soup that China finds itself in!!!

Chinese Economy - A Quick Refresher

The People's Republic of China (PRC) is the world's second largest economy after the United States. It is the world's fastest-growing major economy, with growth rates averaging 10% over the past 30 years. China is also the largest exporter and second largest importer of goods in the world. They Exports Goods value at around US$ 1.9 Trillion every year to countries around the Globe. USA is the largest consumer of stuff exported by China. A little over 20% of all goods produced by China end up in USA.

Experts feel that, if China can grow at the current rate it could overtake USA as the Largest Economy in the World in the next 10 to 15 years.

China - The Single Largest Holder of US Treasury Debt

China is considered the Single Largest Lender/Creditor to the United States. Nearly 21% of US Treasury Debt is held by China. They hold around $1.1 Trillion worth of Treasury Bills issued by the United States of America. This effectively means that

"The United States of America owes the People’s Republic of China more than US$ 1 Trillion in Debt and has to pay both Interest & Principal on the Same"

What Does China Holding $1 Trillion in US Treasury Bills Got to do with this Article?

Did you think of this my friend? Well, to Answer your question "EVERYTHING"...

China holds close to US $ 3.3 Trillion worth of Forex Reserves. As suggested in the previous paragraph, roughly one-third of it is in US Treasury Bills. Apart from this China also holds hundreds of billions of dollars’ worth of foreign currency - Especially the US Dollar. So, around 60% of all their foreign exchange holdings is in United States Dollar (Roughly around 2 Trillion). So, with the United States Economy being as volatile as it is, the value of the Dollar has come to Question. So, at this Juncture, the price movement of the United States Dollar can make or break the Chinese Economy.

Now, go back to the paragraph heading and ask yourself the Question again "What Does China Holding $1 Trillion in US Treasury Bills Got to do with this Article?"

How Will the De-Valuation of the US Dollar Affect China?

As of the Writing of this article 1 USD (United States Dollar) = 6.3 CNY (Chinese Yuan Renminbi). So, USD 2 Trillion in Dollar denominated assets works out to CNY 12.6 Trillion in their local currency.

Let us say due to some problems in the US Economy, the value of the USD Falls and goes to 1 USD = 5 CNY, the value of this $ 2 Trillion Forex Reserves comes down to only CNY 10 Trillion in their local currency. Practically speaking, the Chinese Government stands to lose a hefty amount of their investment if the US Dollar depreciates...

Repayment Risk or Default Risk

On top of the Dollar getting Devalued there is one more, even bigger problem "Default Risk"

Default Risk is the risk that you face when you lend money to someone and the other party fails to repay the same. In this case, if the US Government fails to honor the Interest or Principal repayment on these Treasury Bills China stands to lose $1.1 Trillion.

Before we go any further, 1 Trillion = 1,000,000,000,000. and 1 Trillion USD = INR 53 Lakh Crores. This is a loooooooooottttttttttttttttttttttttttttt of Money. Isn’t it???

A Real Life Example:

If the above explanation wasn't too clear, think this way. Let us say, you bought a House in Chennai, India last year for INR 50 lakhs. Now, it is found that, due to dumping of poisonous chemicals in the ground by a neighboring factory, the ground water is heavily contaminated. As a result, people are avoiding that locality and the property prices have plunged in the past one year and the value of your house is roughly around INR 25 lakhs. Here, with no mistake of yours, the value of your investment (House) has come down and you will lose a lot of money if you sell the house now.

This is China's Situation. Because of Problems in the US Economy, if the value of the US Dollar goes down, the value of their investment will go down and they will lose a lot of money...

Has China done anything to reduce its Forex Exposure to US Dollar?

The answer is YES. But, sadly, China has tried practically every trick known to get into non-dollar assets. It has set up a $300 billion sovereign wealth fund to invest excess foreign reserves in foreign companies. It has encouraged state-owned companies to acquire assets abroad, such as natural resources and firms. It has launched an experimental scheme to settle foreign trade in the Renminbi, instead of the dollar. It has dabbled in purchasing distressed European sovereign debt. The list goes on.

Unfortunately, these efforts to diversify Forex holdings have yielded disappointing results. Chinese attempts to acquire natural resources have met with strong resistance in most parts of the world (except in Africa). China’s sovereign wealth fund’s investments overseas haven’t been successful either, mostly due to political opposition. Chinese state-owned firms seem to have done better. But the tens of billions of dollars they have spent on projects may not generate economic benefits. Expanding the use of the Renminbi to settle trade reduces currency risks, but does little to restrain the growth of China’s dollar holdings. In the two years since China began this experiment, Chinese Forex holdings grew more than 50 percent.

A Trillion Dollar Question!!!

US Treasury Bills are debt obligations that the United States promises to settle when redeemed. So, if today China surrendered its over 1 Trillion dollars’ worth of US T-Bills and asked the US to pay up, what will happen?

The answer is very simple.

"The United States of America will most probably declare Bankruptcy"

Anyways, the chances of that happening are very very remote. Because:

1. China has invested nearly 6 Trillion worth of their Currency in this US $ 1 Trillion worth of T-Bills. If they surrender their investments, the value of the US Dollar will crash and their investment may not be worth even 50% of what they invested (If you don't understand this, go back to the house buying example a few paragraphs away. Will you do anything to diminish the value of your house??)
2. If such an event happens, US will stop importing goods from China (They won’t have money to pay for it), and China can’t sell that much stuff to any other country. So, their economy will be crippled beyond repair.

So, considering the impact this will have on the Chinese Economy, I personally do not think that China can afford to take this drastic step. However, they can definitely use this 1 Trillion Dollar leverage as a bargaining chip during negotiations!!!

Contrary to the fears harbored by many Americans that China would use its mammoth Treasury holdings as a financial weapon of mass destruction against the United States, China is being taken to the equivalent of the financial cleaners in the US debt scenario.

The 2 Trillion Dollar Sized Hole in the Chinese Economy

For the moment, China finds itself in a $2 trillion hole it has dug for itself over the last decade. It watches the political situation in Washington and the resulting economic uncertainty in complete helplessness. All they can do is "Wait and Watch" and hope that the Financial Scenario in the United States Improves.


China's Economic Future

It’s easy to accuse the Americans, of behaving recklessly with their Finances. But for Beijing, the more meaningful thing to do is to figure out how to get out of its $2 trillion mess it is in right now. Allowing a more rapid pace of revaluation of the Renminbi is clearly one. Diversify the Forex Portfolio is another... The list is long and I am sure the Chinese policy makers are scratching their heads trying to find the right cure for their problem…

Since China has strong fundamentals in terms of Manufacturing & Production, the near-term impact will be minimal. However, how the Political & financial scenario in the United States pans out in the forthcoming months will have significant impact on the Chinese Economy in long-term.

So, just like the Chinese, all we can do is "Wait and Watch"...