By Ker Zheng
These days it’s not uncommon to see news headlines saying that our public debt to China has risen to some astronomical amount and that each American household owes thousands of dollars to China. Now, you may be asking yourself, “What does this mean? I never borrowed money from China!” Well, to clear things up, the debt we owe to China is actually US government debt, a.k.a. US Treasury bonds that China’s central bank has bought up. Today, China owns a disproportionately large amount of US government debt, currently amounting to just over $1 trillion.
To understand this problem (and explain why it is a problem), we have to backtrack a little bit. Consider the fact that the Chinese currency, the yuan or renminbi, was pegged to the US dollar at a relatively low rate throughout the latter half of the 1990s and much of the last decade. This is what pundits mean when they say the Chinese currency is artificially undervalued; the currency is deliberately set at a cheaper foreign exchange rate to the US dollar in order to make Chinese goods and labor cheaper for foreigners. Also, the central bank may engage in open market operations and deliberately buy up US dollars and/or sell renminbi, increasing the Chinese money supply and keeping the value of the Chinese currency low. This is in contrast to other currencies whose values are set by the free market rather than by the government.
With an artificially cheap Chinese currency, Chinese labor is cheaper and American firms have more buying power in the form of a strong dollar. This creates an incentive for American firms to set up their own export-processing factories in China OR to simply outsource manufacturing to Chinese contract manufacturers. For example, many of the products produced by Apple and Nike are produced in China by contract manufacturers. Because labor in China is cheaper, Chinese-made goods are cheaper, which has caused US consumers to flock to Chinese-made goods throughout the last few decades.
Naturally, this results in a trade deficit between China and the US: China exports more to the US than the US exports to China. This creates a problem; when US consumers spend money on Chinese-made goods, large amounts of US dollars flow to Chinese companies and thus enter China. However, since US dollars cannot be used in China, these companies must exchange them for local renminbi currency at their banks, which in turn exchange them for renminbi with the Chinese central bank, the People’s Bank of China. As a result, the central bank has to print more and more renminbi to keep up with the inflows of US dollars coming in. This increases the Chinese money supply and spurs inflation, an issue that China has been consistently battling. Additionally, the Chinese government still maintains restrictions on what Chinese investors can invest in outside of China, so it can be difficult for renminbi to leave the country.
Lastly, the central bank accumulates large amounts of US dollars. Because it is a central bank and typically must invest in safe assets, the People’s Bank of China has used these reserve dollars to invest in what is considered to be one of the world’s safest asset classes: US Treasury bonds. Why? Because the US government is least likely to default on its debt; the US is the premier economic power in the world and the US dollar is used regularly as a medium of trade throughout the world. Therefore it is highly unlikely that the US government will be unable to pay back its borrowers. Thus, US Treasury bonds have what we call low default risk. The Chinese currently own approximately $1 trillion in US Treasuries. Now, circling back to our original question, this is what it means when people say that the US owes China money.
Questions? Comments? Feel free to contact us at the Tufts Economics Society at firstname.lastname@example.org.