China’s View of the US Debt Crisis

China’s got its own version of Moody’s. Its private credit rating agency is called Dagong, and over the past year, it’s downgraded the US debt rating twice, down to A+.

Dagong Chairman Guan Jianzhong says the US is cruising for a “D” if it defaults on its debt. He says he can’t believe the Democrats and Republicans are still playing chicken this close to the deadline.

“I’m honestly surprised. This wouldn’t happen in China,” Guan says, neatly sidestepping the fact that it wouldn’t happen in China because China is a one-party authoritarian state. “The two parties are still arguing over a life-and-death decision, just to protect their own party interests. This is hard to understand.”

Guan is also dismayed that the US government has essentially been printing money in recent months to devalue the dollar, in a process called “quantitative easing.”

“This is already a kind of defacto default,” he says. Dagong estimates that China will lose about a quarter of the value of its investments in US Treasuries through this depreciation – about $300 billion out of almost $1.2 trillion.

An obvious response is to avoid further pain of this sort, and already, there are indications that China is putting new foreign currency reserves – about $350 billion so far this year alone – elsewhere. The Euro and Japanese yen carry their own risks, but Guan believes US debt is now riskier than Europe’s, because Europe is at least calling it what it is. He wishes the three main credit ratings companies would do the same for US debt.

“We can see the US is in a terrible debt situation,” Guan says. “And its ability to pay down its debt is no better than the indebted European countries. Without its right to issue the dollar, the international currency, it would have been in crisis long ago.

Yet the three credit rating agencies still give the US a AAA rating. It’s clear they’re looking from the perspective of the debtor country, while we at Dagong are more reliable, because we’re looking from the perspective of creditors.”

But China’s not exactly a creditor, in the usual sense, says Michael Pettis, a former Wall Street executive who now teaches finance at Peking University.

“The whole issue of Chinese purchases of US Treasuries is one of the most misunderstood issues in current affairs,” Pettis says. “The decision to buy US Treasuries was not a banking decision; it wasn’t a discretionary decision in which China decided whether or not we’re going to lend to the US. If you run a current account surplus, you have no choice but to recycle the money and where you recycle the money determines who runs the equivalent trade deficit.”

In other words, China has to put its foreign currency reserves somewhere if it’s going to buy them to keep its own currency low, and its exports cheap. But China has another option. It could move from its long-time reliance on exports and capital spending to drive growth – to an economy that relies more on domestic consumption. That’s a current government goal, says Yu Bin, director-general of macroeconomic research for China’s State Council.

“We do believe that now is the time to restructure China’s economy,” he says. He admits it’s a daunting task. Already, to hold down inflation, the People’s Bank of China has raised interest rates five times in 10 months, and has raised the reserve requirement for banks nine times.

Without easy credit, and with international demand down, China’s manufacturing sector is contracting, and state-owned factories are begging for relief. Yu Bin thinks the market should decide.

“Some argue we should step in, to stop so many small and medium enterprises from going bankrupt,” says Yu Bin. “But we disagree. We think outdated and less competitive enterprises should be phased out through competition.”

Meanwhile, Yu Bin says, wages need to rise to put more money in consumers’ pockets. China now has one of the world’s highest savings rates and lowest rate of consumption – and that’s not a good thing for China’s economy.

Michael Pettis says it’s gotten this way because the government has stacked the deck to favor heavy industry and infrastructure investment over consumers.

“Chinese businesses, like businesses anywhere in the world, evolve to whatever is the most profitable set of outcomes for them,” Pettis says. “And when you have an undervalued exchange rate and extremely low interest rates, and very sluggish wage growth, it’s natural to focus on areas that take advantage of those things. So, Chinese companies naturally gravitated toward capital-intensive growth, because it was the most profitable. When you’re getting basically free capital, you might as well use as much of it as you can.”

That’s meant investing in more infrastructure – like high-speed trains – even when they’re not really needed. Much of China’s growth last year came from capital investment, channeled through state enterprises. China’s services sector is lagging behind. And its factories are finding that inflation and rapidly rising wages mean they can no longer beat everyone else on price.

All this suggests it’s time for a change – time for China to shift to a more durable economic model that favors the Chinese consumer. Without that shift, Chinese policymakers are beginning to realize, China risks its own turn at economic distress down the line.