U.S. Debt Default To Mangle China's Economy, Expert Says

The big political drama in Washington over the next few months will be the fight over the federal debt ceiling. The worst-case scenario is that Congress refuses to raise the ceiling and the US Treasury defaults on its debt.

Photo Insert: China's debt has soared to nearly 300 percent of GDP.

Since US Treasury debt powers the entire world financial system, the result could be a massive global economic crisis, Arthur R. Kroeber, managing director of GaveKal Dragonomics and editor of its China Economic Quarterly, wrote for Foreign Policy.

The good news is that a US default is improbable. As in 2008-2009, a global economic meltdown would hurt China a lot. It would fare slightly better than most other countries because it runs a closed-off financial system that relies mainly on domestic savings and is protected from the ups and downs of global financial instability by capital controls.

In 2008-2009, the loss of trade finance and collapse in demand sent China’s exports plummeting by nearly 20% and more than 20 million workers lost their jobs.

Fifteen years ago, China’s government could respond by unleashing a massive debt-financed economic stimulus program because the country’s debt level, at 140 percent of GDP, was relatively low and it still had significant needs for infrastructure and housing.

Today, debt has soared to nearly 300 percent of GDP, and both infrastructure and housing are seriously overbuilt. Whatever pain the Chinese people were forced to suffer could rightly be blamed on outside forces.

The government could still support a minimum level of growth by adding to its debt pile, since it would be borrowing from its own future, not from foreign creditors.

This leads us to the second question. If the US defaults, could China create a substitute system built around the renminbi? The answer is no. The US Treasurys market is huge. There is $23.9 trillion in Treasury bonds outstanding; foreigners hold $7.5 trillion, or 31 percent, of that pile. Daily trading last year averaged $600 billion.

The total value of Chinese government bonds on issue—$3.3 trillion—is less than half the value of US Treasurys held by foreigners.

Foreign holdings of Chinese government bonds are a mere $340 billion, or 5% of the country’s Treasury holdings. The daily turnover of China’s government bond market is $30 billion, about 5 percent of the Treasury's market average.

And since China practices capital controls, bondholders could not take their money out and park it elsewhere.

Only After the 2008-09 crisis, because it decided it was too dependent on the dollar-driven global financial system, China tried hard to internationalize the renminbi. Its efforts have borne little fruit.

The renminbi accounts for just 2.8 percent of global official central bank reserves (compared with 60 percent for the US dollar and 20 percent for the euro), a figure that has not changed much in the past several years. Similarly, it makes up just 2.4 percent of global trading in foreign exchange.

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