Not wanting to "take the fall", Washington's two major creditors are hoping; Is the Yuan stepping up its efforts?

As the largest foreign investors in US government debt, China and Japan are “nervously” watching developments in debt ceiling negotiations.

China and Japan 'nervously' watch debt ceiling negotiations in the US. (Source: NBC News)

On May 27, US media reported that President Joe Biden and Republican lawmakers had reached a preliminary agreement on raising the public debt ceiling. According to informed sources, the White House and negotiators reached an agreement in principle to prevent default.

If approved by Congress, the deal would help the United States avoid default before the Treasury runs out of money to cover its expenses on June 5.

Why are Japan and China worried?

China and Japan own $2 trillion — more than a quarter — of the $7.6 trillion in foreign holdings of U.S. government bonds. Beijing began ramping up its purchases in 2000, when the U.S. effectively backed China’s entry into the World Trade Organization (WTO), sparking a massive export boom. That created a flood of dollars for China, which needed a safe place to park them.

US government bonds are widely considered one of the safest investments in the world, and the value of US bonds held by China soared from $101 billion to a peak of $1.3 trillion in 2013.

China has been the largest foreign creditor of the United States for more than a decade. However, escalating tensions with the administration of former US President Donald Trump in 2019 caused Beijing to reduce its holdings of US bonds, and Japan overtook China to become the top creditor of the United States that year.

Tokyo currently holds $1.1 trillion in US bonds, compared with $870 billion held by China, meaning both countries are vulnerable to a potential collapse in the value of US government bonds if a US default were to occur.

Josh Lipsky and Phillip Meng, analysts from the Atlantic Council's Economic Center, a research and analysis organization on international issues in the US-Atlantic region, said: "The fact that Japan and China hold a lot of US government bonds could hurt these countries if the value of the bonds falls sharply.

Because falling bond values will lead to a decline in foreign exchange reserves in Japan and China. That means they will have less money to pay for essential imports, repay foreign debts or support their national currencies."

However, Mr. Lipsky and Mr. Meng say the real risks come from a global economic recession and the possibility of a US crisis triggered by a debt default.

“It is a serious concern for all countries but poses a particular risk to China’s fragile economic recovery,” they said.

After an initial boom following the sudden lifting of Covid-19 restrictions late last year, China's economy is now struggling as consumption, investment and industrial output all show signs of slowing.

Deflationary pressures have worsened as consumer prices have barely changed in recent months. Another major concern is China's soaring youth unemployment rate, which hit a record 20.4% in April 2023.

Meanwhile, Japan's economy is only just showing signs of emerging from the stagnant economic growth and deflation that has haunted the country for decades.

The big threat

Even if the US government runs out of money and all extraordinary measures to pay all its bills – a scenario that Treasury Secretary Janet Yellen has said could happen as early as June 1 – the chances of a US default remain low.

Some US lawmakers have proposed prioritizing bond interest payments to the largest bondholders.

This would be done by drawing on other funds, such as government pension payments and government employee salaries, but would prevent major defaults for countries like Japan and China, said Alex Capri, senior lecturer at NUS Business School.

And in the absence of a clear alternative, investors could swap shorter-dated bonds for longer-dated ones to counter the increased market volatility. That could benefit China and Japan, because they concentrate their holdings of long-dated US bonds.

That said, the spread of financial instability and economic recession is a much bigger threat.

“A default on US debt would mean falling government bond prices, rising interest rates, a falling value of the dollar and increased volatility,” said Marcus Noland, vice president and director of research at the Peterson Institute for International Economics.

It could also be accompanied by a decline in the US stock market, increasing stress on the US banking sector and increasing stress on the real estate sector. That could also cause a break in the connection between the global economy and financial markets."

China and Japan are relying on the world's largest economy to support businesses and jobs at home. Exports are particularly important for China as other pillars of the economy - such as real estate - have faltered. Exports generate a fifth of China's GDP and provide jobs for about 180 million people.

Despite rising geopolitical tensions, the US remains China's largest trading partner. It is also Japan's second-largest trading partner. In 2022, total US-China trade reached a record high of $691 billion, while Japan's exports to the US increased by 10% over the same period.

“As the US economy slows, it will be reflected in trade, for example by reducing Chinese exports to the US and contributing to a global economic slowdown,” Mr. Noland stressed.

At the moment, there is little Tokyo or Beijing can do but wait and hope for the best.

Analysts say a rush to sell US government bonds would be “self-defeating” because it would significantly increase the value of the yen or yuan against the dollar, causing the two countries’ export costs to skyrocket.

Yuan 'reaps' benefits?

In the long term, some analysts say, the possibility of a US default could prompt China to accelerate efforts to create a global financial system less dependent on the US dollar.

The Chinese government has reached a series of agreements with Russia, Saudi Arabia, Brazil and France to increase the use of the yuan in international trade and investment.

The BRICS group of leading emerging economies, comprising China, Russia, India, Brazil and South Africa, is considering creating a common currency for cross-border trade, a Russian lawmaker said.

Analysts say this will certainly act as a catalyst for China to continue pushing for the internationalization of the yuan and for Beijing to redouble its efforts to bring its trading partners into the newly announced “BRICs Currency” initiative.

However, China faces some serious obstacles, such as the controls it imposes on the amount of money that can flow in and out of its economy.

Beijing is showing less willingness to fully integrate with global financial markets, analysts say.

“A serious push for de-dollarization would make renminbi transactions much more volatile,” said Derek Scissors, a senior fellow at the American Enterprise Institute.

Recent data from the international payment system SWIFT shows that the RMB's share of global trade finance was 4.5% in March 2023, while the USD accounted for 83.7%.

“There is still a long way to go before a credible alternative to the US dollar can emerge,” Josh Lipsky and Phillip Meng stressed.

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