The U.S. is deeply in debt, and it maintains a Rolodex of creditors at home and abroad – friends and foes alike. Over the last decade, China and Japan have routinely swapped the top spot as the largest foreign holder of Treasury debt. Both nations each possess more than $1 trillion in American bonds, and if either Tokyo or Beijing were to unleash a fifth of its holdings onto global financial markets, it would be a day of reckoning. But what if Washington were to take advantage of the Coronavirus pandemic and not pay its obligations to the Chinese government? As we have learned over the last couple of months, we are living in an environment where anything can happen. You can potentially add a monumental debt default to the list of crazy things to transpire in 2020.
Tariffs or Defaults?
President Donald Trump recently told reporters that the United States has endured "the worst attack" the nation has ever witnessed, describing the pandemic as worse than Pearl Harbor and the September 11 terrorist attacks. He believes the public health crisis could have been stopped in China, and "it should have never happened." The president and his administration are now reportedly examining ways to penalize China for its mishandling of the COVID-19 outbreak, which could include slapping new tariffs on the world's second-largest economy.
While this would produce consequences, the other primary consideration would trigger massive ramifications for both countries.
According to various media reports in the U.S. and China, the White House is mulling a plan that would see the federal government canceling all or part of the $1.1 trillion debt owed to Beijing. Reuters reports that the U.S. might choose to initiate "a synthetic default" that would target specific debtholders, which would involve President Trump demanding "that banks halt any payments of interest or principal to any account held by a Chinese government counterparty."
Analysts have already named this move the "nuclear option" since it would have long-lasting effects.
The consensus is that the Trump administration is unlikely to take this drastic action. Local media are reporting that China may be considering its options, including cutting its holdings of Treasury securities by allowing them to expire and not be replaced by new ones. This would somewhat help mitigate risks should the president invoke the International Emergency Economic Powers Act (IEEPA). This four-decade-old policy would legally allow Trump to tear up its debts to America's fair-weather friend.
Consequences
Global financial markets suffered severe cases of whiplash and migraines during the 18-month U.S.-China trade dispute. But if you thought a spat over tariffs and import restrictions was horrendous for the Dow Jones Industrial Average, you can only imagine the turmoil that would unfold in China and the U.S. if Uncle Sam defaulted on its obligations.
Let's say Washington threw up its hands and informed President Xi Jinping that it would not repay 25% of the $1.1 trillion. What happens?
The Treasury Department would be in a tough spot because it is issuing $2.999 trillion in debt to help cover the cost of its Coronavirus stimulus and relief spending. By defaulting on even a portion of its liabilities, investors' faith in the guaranteed nature of the U.S. government to cover its bills would be destroyed. In the immediate fallout, interest rates would skyrocket, making borrowing more expensive for the government, businesses, and consumers.
The dollar could crater, bond prices would be pushed down, and an economic calamity would occur. China would be harmed in either event – America defaulting or Beijing cutting its holdings. It might even choose to impose a new round of tariffs on U.S. goods and services. It might also be the catalyst for an aggressive de-dollarization push and allow China to diversify its $3 trillion in foreign exchange reserves, something that internal officials and regional allies have been pushing for several years.
In March, China sold approximately $30 billion to shield the yuan's value from the spike in the greenback's appreciation. Since March 2019, China's holdings have decreased from $1.12 trillion to around $1.065 trillion. Japan has increased its stake in U.S. debt, raising its holdings from $1.078 trillion to $1.268 trillion in the same period.
Cliff Tan, the East Asian head of global markets research at Japan's MUFG Bank, was blunt in his assessment of the tactic in an interview with South China Morning Post:
"It's such a crazy idea that anyone who has made it should really have their fitness for office reconsidered. We view this as largely a political ploy for [Donald Trump's] re-election and a cynical one because it would destroy the financing of the U.S. federal budget deficit."
IOU
Following the Second World War, the United States gained its superpower status through military might and a strong currency. In this century, China has attained incredible influence worldwide by investing in many pockets of the globe, whether it is parking money in foreign assets or flooding the international marketplace with cheap goods. Countries including the U.S. have become beholden to China due to the staggering level of IOUs the government has scooped up over the years. What if a multitude of nations banded together and refused to repay Beijing, citing COVID-19? If there is anything the Coronavirus has taught us, it is that anything can happen. Nobody knows what the heck is going on anymore. Trade war, military combat, and economic warfare – all options are on the table.
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Read more from Andrew Moran.
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