Monthly Article

January 2017 Monthly Article – Japan and US Debt

By Jerry Pacheco            

The more things change, the more they remain the same? It sure seems like it. In the 1980s, many politicians and American citizens were anxious because Japan seemed to be beating the U.S. in producing consumer and manufactured goods at every turn. On top of this, it became the largest holder of U.S. Treasury securities, thus making the country the largest holder of U.S. debt. Many U.S. officials accused Japan of not playing fair when it came to trade, and viewed it as flooding the U.S. market with its products, while severely restricting its own market to American-made products. I remember watching television reports of events during this time period held by U.S. politicians where frustrated members of the public were invited to take their turn smashing a Japanese-made car with a sledgehammer. Japan was vilified in the U.S. as a country that was unfairly taking U.S. jobs while holding U.S. debt over our heads as a threat. Sound familiar?

By the mid-1990s, it was clear that Japan’s economic strategy was no longer working. Under its export-based economic approach, which it had used since its rebuilding after World War II, the government selected favored sectors to support and promote in foreign markets. This strategy was very successful for several decades until Japanese companies started relying too much on the safety net, and competitiveness and innovation suffered. A boom developed in Japan’s real estate market, and places such as Tokyo accounted for the most expensive real estate in the world. Japanese consumers and companies invested in Japanese stocks, creating a dangerous bubble in the stock market. Eventually, this entire system came crashing down and Japan went through years of near zero growth in its economy. It got to the point that Bank of Japan interest rates were essentially at negative rates.

About this time, China took over as the new economic star in Asia, a role which it still occupies today as the world’s second largest economy behind the U.S. As with Japan, China often is looked upon as a threat to U.S. economic interests. And like Japan, China eventually became the number one holder of U.S. debt by acquiring U.S. government securities. However, this situation changed in the final quarter of 2016, as Japan was reported holding $1.13 trillion of U.S. securities compared to China’s $1.12 trillion, again making Japan the largest holder of U.S. debt.

In times of uncertainty in the world economy, putting money into U.S. government-backed securities is a popular method to hedge risk while earning interest on your investment. This certainly is the case now, but an interesting situation is brewing within China that is driving down that country’s holdings of U.S. securities.

In 2016, China’s currency, the yuan, depreciated by about seven percent against the U.S. dollar. After years of booming economic figures, along with investment opportunities, returns in China’s real estate, stock market, and government-backed securities have leveled off. Many Chinese investors have discovered investment opportunities outside of China that will offer them higher returns. Thus, they are choosing to invest their Chinese capital abroad, which puts pressure on the yuan to lose value. A depreciated yuan is not necessarily a bad thing for China, as it makes Chinese exports cheaper in countries such as the U.S. However, it also makes the importation of production inputs more expensive for the country’s large manufacturing base. The Chinese government doesn’t want the yuan to be completely subject to market forces, especially those that are generated internally, therefore, it is selling liquid assets, in this case U.S. securities, to prop up the yuan on world markets. In this manner, the Chinese government is attempting to manage the yuan’s depreciation within acceptable target levels.

China’s economy continues to grow, but as it matures and its investors have better- looking opportunities abroad, it is going to have to artificially support the yuan in the world market going forward. Given the fact that friction between the U.S. and China has increased during the past few years, due to territorial disputes in Asia and China’s inclination to flex its muscles throughout the world, does the U.S. feel more comfortable with Japan reassuming its place as the number one holder of U.S. debt? Based on President-elect Donald Trump’s tweets on China’s maritime disputes with the U.S., and his threat to slap tariffs on Chinese-made goods, the U.S.’s relationship with China appears be continuing on the path of contentiousness going forward.

In the future, the U.S. will continue to need Japan as a close ally in Asia, particularly in this era of uncertainty. How interesting that having Japan again become the largest holder of our debt would seem surprisingly comforting at this time.