Why China and Japan are praying the US won't default

Hong Kong CNN

The world's third and second largest economies watch in horror as the clock counts down to an unprecedented US default.

China and Japan are two of the biggest foreign investors in American Government Debt. They own more than a quarter of the US Treasury Securities held by foreign nations, or $2 trillion.

Beijing began to increase its purchases of US Treasuries when the United States endorsed China's entrance into the World Trade Organization in 2000. This triggered an export boom. China needed to store the huge amounts of money it generated.

US Treasury bonds are regarded by many as the safest investment on Earth. China's holdings in US government debt grew from $101 million to $1.3 trillion at its peak in 2013.

China has been the United States' largest foreign creditor for over a decade. Beijing's holdings were reduced in 2019 as tensions escalated with the Trump Administration. Japan overtook China that year to become the largest creditor.

Tokyo holds $1.1 trillion compared to China's 870 billion. This heavy exposure makes both countries vulnerable to the potential crash of US Treasuries in the event that the doomsday scenarios for Washington unfold.

The large Treasury holdings of Japan and China could be detrimental to them if Treasuries' value plummets. This is according to Josh Lipsky and Phillip Meng from the Atlantic Council GeoEconomics Center.

A fall in the value of Treasury bonds would cause a decline in Japan's and China's reserves. This would mean that they'd have less money to pay for imports essentials, service foreign debts or support their national currencies.

They said that the real risk is the economic impact on the world and the likely US recession which could result from a default.

Lipsky and Meng stated that 'this is a serious problem for all countries, but poses a special risk to China's fragile recovery'.

China's economy has slowed down after an initial surge in activity that followed the sudden lifting of pandemic restriction late last year. This is due to a slowdown in consumption, investment, and industrial production. The deflationary pressures have increased as the consumer prices barely changed in recent months. The high unemployment rate among young people is another major concern. It reached a record of 20,4% in April.

Japan's economy is only just beginning to show signs of recovery from the stagnation and deflation that have plagued it for decades.

Devastating impact

Even if US government runs out money and takes extraordinary measures to pay its bills - a scenario Treasury Secretary Janet Yellen said could occur as soon as June 1 - the probability of a US default is still low.

Some US legislators have proposed that the largest bondholders receive priority in the payment of bonds' interest.

Alex Capri said that this would mean cutting back on other obligations such as the payment of salaries and pensions for government employees. However, it would prevent major defaults in countries like Japan and China.

Investors could, in the absence of a clear alternative to market volatility, swap short-term bonds for long-term debt. According to Lipsky & Meng of the Atlantic Council, this could be beneficial for China and Japan because they have a concentration in US Treasuries with a longer term.

The greater threat is the financial contagion that could spread to other countries and the economic recession.

Marcus Noland is executive vice president at the Peterson Institute for International Economics and director of studies. He said that a US debt default would result in a drop in US Treasury prices and a rise in US interest rates. It would also mean a decline in the value and volatility of the US dollar.

It would likely also be accompanied with a decline in the US stock exchange, increased pressure on the US banking system, and increased strain on the real estate market.

This could also cause the global economy and financial market to fall apart.

China and Japan depend on the largest economy in the world to support their companies and create jobs. Exports are especially important to China as other economic pillars, such as the real estate sector, have been struggling. Exports account for a fifth of China’s GDP, and provide employment to around 180 million people.

The United States is still China's largest trading partner, despite rising geopolitical tension. Japan is also its second-largest trading partner. US-China trade reached a record of $691 billion in 2022. In 2022, Japan's exports increased by 10% to America.

Noland said that as the US economy slowed down, it would have a negative impact on trade. This could lead to lower Chinese exports into the US and a global economic slowdown.

Deep Concerns

Kazuo Ueda, the Governor of Bank of Japan, expressed concern last Friday. He warned that a US default on its debt would lead to turmoil in different markets and serious consequences for global economics.

According to Reuters, he said that the Bank of Japan would strive to maintain stability on the market based on their pledge to react flexibly, keeping an eye on price, economic and financial developments.

Beijing has so far been quiet about the issue. The Foreign Ministry said Tuesday it hoped the United States would 'adopt a responsible fiscal and monetary policy' and refrain from 'passing on risks' around the world.

Earlier this month, the Chinese state news agency Xinhua wrote a column highlighting the symbiotic relationships the two countries share in the US Bond Market.

It said that if the United States defaults, not only will it discredit them, but it would also cause real financial losses for China.

Tokyo and Beijing have little to do but wait and hope.

Capri stated that dumping US debt quickly would be a'self-defeating' move, since it would cause the Japanese yen and the Chinese yuan to rise significantly against the dollar. This would increase the price of their exports, which would 'go through roof'.

Longer-term benefits?

Some analysts believe that a possible US default would push China to speed up its efforts to create a financial system less dependent on dollars.

China has already signed a number of agreements with Russia, Saudi Arabia and France in order to expand the use of yuan for international trade and investments. Last year, a Russian legislator said that the BRICS nations, namely China. Russia. India. Brazil and South Africa are looking into the creation of a currency to facilitate cross-border trading.

Capri stated that this will serve as a catalyst to China's efforts to internationalize the yuan and to Beijing's efforts to include its trading partners in the recently announced "BRICs Currency" initiative.

China still faces serious challenges, including the controls placed on how much money it allows to enter and leave its economy. Analysts claim Beijing has not shown a willingness to fully integrate into global financial markets.

Derek Scissors is a senior fellow at American Enterprise Institute. He said that if there was a serious push to de-dollarize, the yuan would trade much more volatilely.

SWIFT, the international payment system, reported that in March the yuan accounted for 4.5% of global trade finance. The dollar was responsible for 83.7%.

Lipsky and Meng stated that there is still a way to go until a credible alternative currency to the US Dollar can be developed.