How Owning U.S. Debt Makes China Vulnerable

Timothy Beardson founded, majority-owned, and ran the largest independent investment bank in the Far East. He chairs the China Oxford Scholarship Fund -- supporting talented Chinese students pursuing postgraduate work at Oxford University -- and enjoys coaching young entrepreneurs. Today he joins the Fool to discuss his book, Stumbling Giant: The Threats to China's Future.

China owns $3.5 trillion in foreign exchange, including a significant portion of the U.S. public debt. While some argue that this places the Asian country in a position of power, Beardson points out the other side of the coin, in the form of local currency debt.

A full transcript follows the video.

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Brendan Byrnes: I think a lot of people in the United States say China "owns" the United States because they own such a large amount of U.S. Treasuries. Could you talk about the dynamic there? First of all, do you think that's an accurate statement, and second of all, how does that affect China, going forward?

Timothy Beardson: Well, China of course does have $3.5 trillion of foreign exchange. A lot of it's in America. They own something like 8% of all U.S. public debt, which makes it one of the larger holders.

But, nobody ever really looks at how China got to buying $3.5 trillion of foreign assets. It got it by borrowing at home -- domestic currency -- either because banks operating in China have to place deposits with the Central Bank in proportion to their balance sheets, or because the Central Bank issues bonds to insurance companies and banks, domestically.

All of this is borrowed money in local currency, which has been used through the foreign exchange markets to accumulate foreign currency because China's stabilizing the foreign exchange markets or, as some people in Washington like to say, "manipulating the foreign exchange markets." But the action is mostly selling Chinese currency and buying foreign currency.

At the end of a year, they're accumulating all the time foreign exchange assets, but nobody ever looks at the balance sheet and says, "Well, actually, they also owe $3 trillion of local currency." For me, that position is not one of strength. It's one of vulnerability because any mismatch in currency movements -- any 10% rise in the Chinese currency, they lose $300 billion on their foreign exchange assets.

They're also getting a mismatch on interest rates between what they get on U.S. Treasuries, which is nothing, and what they're paying to domestic investors, which is rather more. They could be losing $66 billion a year on some forecasts.

This is a position of vulnerability, not a position of strength.

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