December 27, 2008

What will happen if China wants its money back??

I'm sure many of you are well aware that the USA owes China some money. Many people seem to believe that a majority or very large portion of our national debt is owed to the Chinese. This is not true actually. As I discussed previously in the article, Myth: We Owe All Our Debt to China, the US government owes less than $600B to China. That is around 6% of the total US national debt which is owed to China. That is still a large amount of money. Its not good in general to be heavily in debt to a party and be so obligated to them.

So this raises the question: What will happen if China wants its money back?

The very short answer is : They won't so don't worry about it.

I'm serious. Maybe this seems flippant but it isn't really. So I'll explain..

First of all Chinese officials have publicly said they have no plans to drastically or abruptly reduce their investment in the US. The Chinese ambassador wrote in 2007 to US Senator Chuck Grassley to say “China does not have a plan to drastically adjust the structure of its foreign reserves.” Then assistant governor of the People’s Bank of China, was quoted as saying that “the U.S. dollar is the main currency in our reserves and that policy remains very firm” and said statements to the contrary were "opinions".

The US government loans people money in the form of bonds. These are contracts to loan money. You can't just simply call up the government and demand your money back. Contractually and legally there isn't a way for someone to just demand their money back from the US treasury. So basically China can't just take its money back. They could ask for it back or they could sell it. If they asked for it back theres nothing that would require us to return repay the debts outside the normal terms of the loans. They could sell their bonds to someone else on the open market if they wanted to. That wouldn't hurt the US though. The US government debt owed to China is just like any other loan you might have. Thinking the Chinese will abruptly demand their loan back is like thinking your bank will call tomorrow and demand you repay your mortgage.

But they generally wouldn't want to. Individuals, businesses and governments loan money to the US because they know it is the safest investment in the world. People don't buy treasury bonds because they are high interest, and in fact since the risk is so low the treasury can loan money at very low interest rates. Over time this could change. People may decide the US government is no longer stable or worthy of loaning money to. That isn't happening and isn't going to happen any time soon. Given the current economic situation it might seem as if the US government is on the verge of collapse, but this is far far from the truth. In fact during the current economic crisis people are more willing to buy treasury bonds because even now the US government is considered a safe harbor.

Contractually China has no way to demand their money back. Economically China would have no reason to do so. These reasons alone should be justification enough to not worry about China pulling the economic rug out from under our governments debt.

But what if China for whatever reason decided to challenge the contracts of the treasury bonds or otherwise demand their money back? That is possible but it would strongly irritate relations between the USA and China. Politically China would risk heavy economic repercussions from the USA if they chose to demand early repayment of our loans. The USA is a big customer of Chinese goods. In just the first 9 months of 2008 the US has imported over $250B in goods from China. If China chose to play economic 'hard ball' with the USA for some reason then it would be highly likely that the US government would respond by reducing or taxing imports from China. The USA wields a lot of political power around the world. China has no motivation to risk making USA a serious political enemy.

If China sold off its treasury securities abruptly they would lose a lot of money in the process. You can't just dump a large amount of anything on a market and get full price. If they sold our treasuries they'd take a loss in the sale.

A sharp or drastic reduction in Chinese investment in the US would have negative economic impact on the US. This would hurt our economy which would in turn hurt the Chinese economy.

China lacks any real motivation to prematurely demand loan repayment. It has been speculated that they could do so as a retaliatory measure or as leverage over a political point. However China has no realistic incentives to reduce investment in the US and significant downsides if they did so.

So as I said originally: it won't happen so don't worry about it.

Report to congress: China’s Holdings of U.S. Securities: Implications for the U.S. Economy

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