By Sunanda Natrajan
The post-Cold War scenario paved the way for a new world ordera world where the US is the ultimate hegemon around whom the global economy functions. With the USD still retaining its standing as the universal currency, the US economy and its workings undoubtedly have an impact on the rest of the world. Everyones perceptions of the financial markets are wedded to the notion of the US being the sole economic, political and military superpower. Sovereign nations, as well as independent investors, have great faith in the American economy and this faith is being testified by their share in the US Treasury holdings.
According to latest official data, Indias holdings of US government securities rose to a sharp high of 144.7 billion USD at the end of 2017. Having preserved the 12th rank in being the largest overseas holder of US debt, the US Treasury Department has compiled data that reveal that Indias holdings of such securities increased from 118.2 billion USD in 2016 to a little over 26 million USD over a span of one year. In 2017, China was the largest holder of USAs government securities, claiming ownership to the tune of 1.18 trillion USD. This was followed by Japan in the second position at 1.06 trillion USD and Ireland in the third position at 326.5 billion USD respectively. Moreover, amongst the BRICS nations, India is the third largest owner of US government securities while Russia has a lower exposure at 102.2 billion USD.
Why do nations hold foreign government debt?
The way corporate enterprises and MNCs float their stocks and corporate debentures to raise money, sovereign governments of various nations use bonds as a mechanism to raise funds. Governments usually have taxes as the prime source of funds to undertake their welfare operations. However, when taxes are not enough to cover their expenditures, they usually resort to foreign borrowings and open market operations. Open market operation is the buy/selling of government securities to citizens domestically whereas foreign borrowings are made by selling legal government bonds to other nations in exchange for money. This is mostly done to finance imports and exports because international trade requires payments to be made in foreign currencies.
Besides facilitating cross-country trade, foreign government debt is held by nations as an important asset for their economy. International financial markets are riddled with frequent fluctuations which influence the exchange rate of currencies. A mere 0.5 percent fall in the exchange rate of the rupee with the US dollar has the potential to disrupt trade between the two nations and even spread shock waves in neighbouring economies. In a nutshell, the interconnectedness of foreign currency and global trade necessitates countries to hold a proportion of their assets in the form of foreign exchange reserves. By doing so, if the exchange rate increases over a period of time, the owner nation can release their forex holdings in the international money market and drive down the rates in their favour since an increase in supply decreases the prices.
However, borrowing in a foreign currency also has its downside because it exposes the borrower nation to the risks of exchange rate fluctuations, which forms a major cause for concern in the context of repayment of the debt. If the local currency drops in value, the nation will have to pay more to honour the loan and that becomes taxing for the borrowing nations economy. Coined as the original sin by many economists, this problem came to the forefront during the 1980s and 1990s when many emerging economies suffered from weakening local currencies and consequentially had a difficulty in servicing their foreign-denominated debt.
The case of India and China
China, like most other countries, possesses US Treasury bonds with an aim to create a safety net against the harsh blows of impending economic crises. After the Asian crisis of 1997, China actively started building up its foreign reserves in order to cushion the impact of large cash outflows due to trade and investment. However, that was a long time ago. Right now, a mass sell-off of the Chinese holdings of US government securities will have a graver impact for China than for the US. China has large trade surpluses with the US and it invests the excess dollars into the securities which help keep its inflation and other macroeconomic fundamentals in check. This is primarily because US bonds are the most sought-after asset due to their low risk and guaranteed return. Additionally, with the exchange rates being at an all-time low, the benefits are felt on the exports and imports of the Chinese economy. Therefore, a total sell-out is not an option presently.
However, it must also be noted that China and the US are major trade partners in the current scenario and a few believe that China holding so much of the American bond is more an aggressive measure rather than a defensive one. China and the US have been at loggerheads in terms of the universal currency for a while now and a true, absolute release of all its US debt holdings could very well trigger a wave of negative shocks to the US economy, along with ripple effects for other nations. The country alone claims 20 percent of the total foreign debt of the United States and if it sells that off, there might be a surge in panic selling by all other sovereign investors driving down the US dollar to its lowest. Interest rates would spike up, the dollar would gravely depreciate and imports would become severely expensive.
Even though back in 2015 China did reduce its holdings by about 180 billion USD, it did not have a significant impact on the US economy and neither did it benefit the Chinese Yuan. In the last couple of years, China has been unloading a proportion of its reserves but only by small margins. In fact, in January 2018, Chinese officials have denied news reports stating that theyll move away from US debt, calling it fake news making the latter reason of attacking the dollar to make way for Yuan to become the universal currency more legitimate.
As for India, the situation has more to do with the advent of liberalization and globalization in the world economy. According to Yilmaz Akyuzs book, Playing with Fire, US monetary policy has followed a tradition of lowering interest rates after every crisis in order to regain the momentum in the financial market. This increases third world debt because developing nations, in an attempt to integrate with other powerful, developed nations, liberalize their economies and open their capital accounts to foreign debt. Governments in these countries have a myopic view of the future and therefore, in the pretext of lower rates and attractive returns, tend to accumulate more and more of foreign debt in order to reduce their vulnerability to external financial shocks. That is why, most developing nations, except Latin America, allow a huge proportion of their reserves to be occupied by foreign debt. India is inclined towards following the same trend. The RBI, as of now, has no intention of reducing or selling off its US bonds so this seems to be their mechanism to prevent the economy from the influence of exchange rate uncertainties.
The future of the US and the world
The US is heavily dependent on issuing government-backed securities to finance its deficit and at present, that is the mainstay of the American economy. US debt has been attractive to investors and nations for long enough but the future seems quite bleak. Tensions have already started brewing between nations since Donald Trump has come to power and the political stability of the nation is being viewed with an air of suspicion. The Presidents recent open declaration of trade wars are good and other controversial tweets seem to be increasing the disapproval and lack of confidence of the nations worldwide and is anticipated to have a negative impact on the American dollar soon enough. If the expectation comes true and the effects fall out as predicted, we could be witnessing a transformation of the world order in this century.
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