China Watches As Washington Debates Debt

The U.S. debt stalemate is of particular concern to China, the largest single holder of U.S. government debt. Guest host Linda Wertheimer talks with Eswar Prasad, former head of the International Monetary Fund's China division.

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LINDA WERTHEIMER, host: Across the Pacific, China is keeping a close eye on debt negotiations in Washington. China holds nearly two trillion dollars of American government debt. It is the largest foreign holder of U.S. treasuries, so if there should be a default or if the U.S. bond rating is downgraded, what would China do?

Eswar Prasad is a professor of economics at Cornell University and the former head of the China Division at the International Monetary Fund. And he joins us now to talk about the U.S. and China's intertwined economic fates. Welcome to the program.

ESWAR PRASAD: Thank you for having me on.

WERTHEIMER: I wonder if you could talk to us about why U.S. debt, U.S. in particular, is so important to China.

PRASAD: The Chinese have had this policy of trying to maintain their currency at a level that doesn't appreciate very fast. If their currency appreciated it would make their exports more expensive and less competitive. So the way they've been dealing with that is by recycling the money that flows into their economy and buying up U.S. debt with it.

WERTHEIMER: Would a downgrade from the AAA rating that U.S. treasuries now have, would a downgrade affect China's plans? Would China do anything differently?

PRASAD: The Chinese can threat and fume about what's happening in Washington. But the reality is that they can't do very much. They've accumulating $152 to $250 billion every quarter. So there really isn't any other market out there that can absorb this amount of money. So what can the Chinese do if there is a downgrade?

What's going to happen if there is a downgrade is that the interest rates in the U.S. are going to rise, which means that bond prices will fall. And this should in principle hurt the market value of the Chinese holdings of U.S. government debt. But the Chinese point of view is that they don't really care, because they don't need me to use these bonds anytime soon for their own financing. So, so long as they get their principal and their interest, they're happy.

WERTHEIMER: I understand that China also has a lot of money invested with other countries, as well - money in euros, money in Japan. Presumably that's because they have so much money that they've got to somehow put somewhere. But does it also create some kind of a hedge in terms of the United States' economy?

PRASAD: They've been desperately trying to diversify their foreign exchange reserves. But if you're looking for safe assets around the world, there really isn't very much other places to go. And they can put some money in other emerging markets. They can buy a bit of gold. But all of that really doesn't add up to very much when you're trying to invest $200 billion every quarter.

WERTHEIMER: How do you see the debt ceiling standoff between the Congress and the president, and among the members of Congress? How will that affect the economic relationship between the U.S. and China going forward? Or will it?

PRASAD: You know, it's going to have one very important effect within China itself, because the U.S. has been telling China to open up its financial markets, to allow its currency to appreciate. And now the Chinese can see the mess that the U.S. government is in. So those in China who are opposed to the funds are going to say, look, the U.S. is making such a mess of itself, why should we take their advice to reform and liberalize?

WERTHEIMER: Eswar Prasad is a professor of economics at Cornell University and a former head of the China Division at the International Monetary Fund. He's also a senior fellow at the Brookings Institution, and he joined us from their studios in Washington, D.C.

Professor, thank you very much.

PRASAD: My pleasure.

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