World Crisis Online

By Scott Zhou, Shanghai In a joint statement from the present round of the China-US Strategic and Economic Dialogue (S&ED), China takes the stance of the US’s largest creditor, while the US promises that it will pursue the sustainability of its public finances and set out specific measures as soon as possible

The European debt crisis triggered by the “Greek tragedy” may well be the opening of a developed-country government debt crisis. There are the European PIIGS(Portugal, Ireland, Italy, Greece, and Spain), while Japan’s government debt is the most serious, and the ratio of US government debt to GDP is approaching a critical point. China holds US government bonds worth hundreds of billions of dollars and is naturally worried about the status of that debt and whether that increasingly heavy debt will affect US economic prospects.

The joint statement contains pledges to strengthen dialogue and coordination on financial, monetary and structural reforms. China shows its greatest concern over when and how the focus of US fiscal policy will turn from maintaining aggregate demand and supporting employment to reducing medium-term federal budget deficits and ensuring long-term financial sustainability. To some eyes, US government debt levels have already demonstrated unsustainability.

In their latest book, This Time Is Different: Eight Centuries of Financial Folly, University of Maryland economist Carmen Reinhart and Harvard University professor and former IMF chief economist Kenneth Rogoff found that in developed economies, sovereign debt accounting for 90% of GDP is a critical point. If it passes this point, they say, the growth rate will go two percentage points lower than the economy. Currently, the ratio of US government debt to GDP, 84%, is approaching that point. Even besides Europe’s PIGS (Portugal, Italy, Greece, Spain), the ratio of many EU countries is around the critical point. As the problem of aging in Europe brings increasing pressure on government finances, and with the US social security system finances unsustainable in the long run, most developed countries (except, perhaps, the Nordic countries) are “Japan”-izing, meaning with this financial crisis and large-scale government intervention, the debt-burden is shifting from private institutions to public finance, from families and financial institutions to state finances, with the danger of long-term Japanese-style anemia and low growth.

Another critical point comes from the rating agencies. Interest payable by the federal government rises to 20% of revenue rather than expenditure. Taking into account paying debt principal and interest is prior all other matters of government spending, 20% is an acceptable limit for rating agencies. When will the US reach this threshold? The Congressional Budget Office (CBO) shows it may occur within ten years. The proportion of interest payable in expected revenue will rise up from 8.9% last year to 9.9% this year, 14.8% in 2015, 19.8% in 2019 and 20.8% in 2020.

Is it possible that the US may lose its solvency in the not too distant future? The Chinese government has ample reasons to worry. When the European debt crisis broke out, China was willing to hold more US government bonds. It increased its holdings of US treasuries by US$17.7 billion in March, its first increase after reducing US debt during the previous four months. Now China’s total holdings of US treasuries is US$895.2 billion. But risk is looming. If ratings agencies downgrade the US rating, values will drop dramatically, resulting in a substantial shrinkage of China’s sovereign wealth fund assets, not to mention a major upheaval in world financial markets.

China hopes to see the US take action to stabilize and gradually reduce government debt levels. In the statement, the US stressed that Obama has put forth specific budget measures, cutting 1 trillion dollars in deficit in the coming decade through the implementation of historic financial restrictions. These measures include: freezing non-security discretionary spending within three years; requiring the financial services industry to repay the cost of the TARP; allowing a tax cut from 2001-2003 for families with annual income over $250,000 to lapse after its expiration; removing subsidies for inefficient fossil fuel. Congress has passed a bill, requiring Congressional increases in non-emergency expense or tax reductions to be met with expenditure cuts in other areas by the same amount. Once the US economy recovers, the National Commission on Fiscal Responsibility and Reform will develop policies to respond to financial risk, and keep the debt-to-GDP ratio at an acceptable level.

The US side also stresses its launch of reform on slowing medical cost growth to address that long-term financial threat. In addition, it is looking for incentives for private savings through retirement savings based on employment expansion.

Developed countries owe huge amounts of debt to other governments, private sectors, and institutions, and their ability to repay has come under doubt. American economist Nouriel Roubini says governments that aid private sectors are in trouble. Who will then help them? The global debt mechanism has become more and more like a Ponzi scheme.

While it continues to lend to the US, China is paying close attention to US spending and deficit reduction behavior and solvency. The Sino-US SED is a good mechanism for China to strengthen “due diligence” on the US.