Neither a borrower nor a lender be...

February 5, 2009 11:13 PM

Speak to me of deficits. If a country goes into deficit by selling bonds to other countries' foreign banks, is that debt ever used as a geopolitical bargaining chip? Why/why not?

For example, say China and the US had some kind of diplomatic squabble: couldn't China just wave a hand at its giant pile of US treasury bonds and say, "Hmm. So you don't want us building a new military base in the Pacific, huh? You sure? Huh. Guess we'll have to start recalling that $681 billion you owe us- Oh, what's that...you changed your mind?"

I'm not specifically concerned about the above situation, in fact I'm sure it's extremely unlikely, not least because of the US's military power. I'm just curious about why, when so much of geopolitics depends on the complex power ratios between state actors, foreign debt is rarely mentioned as part of the equation. Will the GFC change that? Or have I missed something?

Enlighten me, hive mind.

posted by [ixia] to law & government (11 comments total)

Oh, and I'm aware that most countries' central banks are supposed to be independent. But countries do all sorts of other nasty things when they disagree - what's a little central bank fiddling between enemies?
posted by [ixia] at 11:16 PM on February 5

How did China end up with all those US treasuries?

By running a trade surplus with us. China's economy is based on exports, and China's currency is pegged to the dollar. If China dumps those treasuries, it'll cause the dollar to collapse, the US economy to collapse, and China's economy to collapse because they won't have their biggest market any longer. (Even if they unpeg their currency.)

In terms of balance of power, the ironic situation is that if one country holds a lot of debt from another country, the debtor has much more power than the creditor, because whatever relationship it was that resulted in the creditor holding all that debt continues.

The world needs the US economy to be healthy. Anyone trying the kind of blackmail you're talking about effectively is talking about burning the entire world economy down.

For the last hundred years, the US has led the world out of every world recession. Recovery always started here first. No one out there wants to kill us off; it would effectively be economic suicide.
posted by Chocolate Pickle at 11:35 PM on February 5

You can't recall a bond. Bonds have set dates when interest is paid, and a set date when the principal is paid. So there's no scope for exercising power that way.

However, you can stop buying bonds you used to buy, either refraining from buying them at all, or demanding a higher interest rate.

This plays out differently depending on the scale of the countries involved. For example, in my country (New Zealand) we have for various reasons offered higher interest rates than larger more stable countries. (Google up "carry trade" to learn more about this). So lots of people from countries where central banks offer lower rates have bought bonds from my country. Now, our central bank has lowered its interest rate, and also, people are worried about our economy's stability, since we are even more dependent on exports than most countries. And so demand for our bonds is dropping, hence demand for our currency is dropping, and suddenly books from Amazon cost me half as much again as they used to.

One can imagine China refraining from buying US Treasury bonds. The practical upshot would be the US dollar devaluing vs Chinese currency. China doesn't really want that to happen, because all the US dollar-denominated assets they own would be worth less in terms of Chinese currency. So there's a stand-off.

Military power doesn't really come into it, unless a country is so destabilised by having a rooted economy that it starts waging war for whatever wacky reasons. Of course, to an outside observer of the US, this may have already started to happen.
posted by i_am_joe's_spleen at 11:41 PM on February 5

Hmm, interesting. I wonder if the US-China example is too loaded with other variables. Would the answers be different if the two countries were less important players in the global economy? What if Zambia was in enormous debt to Senegal?

Sorry for using you as examples, Zambia and Senegal - you're awesome and I'm sure you're debt levels are just fine
posted by [ixia] at 11:54 PM on February 5

Russia's forgiveness of some debt, acceptance of land in lieu of cash on some debt, and agreement to make favorable loans to Kyrgyzstan are thought to have influenced the decision of the Kyrgyz president to push for closing of the American military base there.

I assume that fiscal considerations including the PRCs vast T-bill holdings play a role in all of the USAs policy decisions regarding the PRC.

One thing to consider with respect to this issue is that a country's holdings of a foreign securities are different than foreign currency reserve holdings. That is to say,
posted by McGuillicuddy at 11:59 PM on February 5

Between countries, it is the creditor who is usually in the vulnerable position. They have delivered goods (by running a trade surplus) but are awaiting payment in the form of a trade deficit. There are a number of ways the debtor can not honor the agreement: default outright or accept the bonds in exchange for newly printed money, which drives up prices and makes them worth less.

There is effectively one threat that works against the debtor (apart from military action) which is that any country that pulls such a stunt would be denied access to global capital markets for a long while. For a practical example, see Argentina (2002). When they defaulted, foreign funds dried up. This was considered so bad that bondholders eventually got (part of) their money back.
posted by thijsk at 1:21 AM on February 6

a good story related to this question from the Atlantic:
Be Nice to the Countries That Lend You Money
posted by originalname37 at 3:14 AM on February 6 [1 favorite has favorites]

Yeah, i_am_joe's_spleen is right: creditors can't "call" bonds.

The reason foreign debt is mentioned so infrequently in scenarios like this is that it's exceptionally rare for any single nation or group of nations to own a significant percentage of another single nation's debt. The federal debt is currently between $11-12 trillion. People are always saying how much of our debt China owes. Well at the moment, only 28% of the federal government's outstanding debt is owned by foreign governments, and China only holds 22% of that, or about 6% of the total. That's just not all that much leverage. Even if China, Japan, and the UK banded together they'd only be holding about 15% of the total.

Another reason is because, as indicated by others, the US defaulting on its debt would be the economic equivalent of the End of the World. Not only would investors be out about $5 trillion, but the government itself, which holds about 50% of the debt (ever wonder where that Social Security "surplus" went?) would immediately tank. This is widely recognized as a Bad Thing. Welcome to the MAD equivalent of the 21st century.
posted by valkyryn at 4:22 AM on February 6

The money's already lent. the other problem is that banks buy government securities because they are an excellent, safe investment. They have the highest ratings because a country isn't going anywhere. This means that if the Chinese banks do not purchase the debt, other investors will and the Chinese will be shut out of the market.
China could decide to buy less bonds for political reasons but the hurt would be that the US would have to raise their rates of return only.

The political pressure really only comes into play when a nation cannot pay. In this case, organizations like the IMF and the World Bank make demands on smaller countries to change the way they do business by requiring transperency meausures, democratization, etc.
posted by Ironmouth at 6:10 AM on February 6

China can't demand immediate repayment of its Treasuries, sure, but that's really besides the point. China can sell its Treasuries (and also its holdings in Agency MBS, which are also massive), and that's the scary thing. We take for granted the historical liquidity of the market for US Treasuries--but if China launches a fire-sale, that liquidity situation would probably change drastically. It would be a fire-sale of off-the-run assets, which are already less liquid than on-the-run Treasuries. On top of that, it would be a signal that China will no longer be a buyer of future US Treasuries issuances and that would be another huge blow to the market.

In short, it would be a disaster. Thankfully it's a bit like MAD--if China can't finance the world's consumption, factories shut down and people start rioting.
posted by mullacc at 7:37 AM on February 6 [2 favorites has favorites]

Thanks, all. You're brilliant!
posted by [ixia] at 8:52 PM on February 6