How a Debt Default Might Be Viewed in China

07/28/2011 10:45 am ET | Updated Sep 27, 2011

Like most summer blockbusters, we're all pretty sure we know how this is going to end.

Choose your hero: the noble Mr. President, or the brave Mr. Boehner. Contemplate the danger: the shameful triumph of the rich and powerful, or a pathetic capitulation to big government. Now savor the predictable ending -- a high-stakes finale, followed by a last-minute victory over the forces of evil. It's as if Washington hopes to compete with Captain America for next weekend's box office returns.

Our politicians urge us to take this all seriously. But I think most Americans know the debt ceiling "crisis" is no crisis at all -- it's an elaborate political drama, a self-created disaster, a script. We assume the politicians will play their parts and then create a solution. Everything will work out in the end. But consider that whether or not Washington pulls this off, the debacle itself has made an impression on our creditors overseas -- especially China. How might this affect U.S. relations with Beijing?

First, a quick review of the economics. The federal government probably owes about $14.3 trillion (with a T), extrapolating out from March 2011 statistics. Foreign creditors hold about $4.5 trillion. In general, that high number of foreign creditors is an indicator of trust and confidence in the U.S. economy, and in the commitment of the U.S. government to pay its debts. That trust has serves us well; holding a AAA credit rating is a little like being able to walk up to anyone on the street and borrow a thousand dollars. It's an economic parachute; if we need more credit, we simply issue more bonds. Or at least, that's the way it's been.

China is our largest foreign creditor. It currently holds 25% of our total foreign debt, about $1.16 trillion. It's not because they like us. It's because they've earned so much foreign currency through trade that there's basically nowhere else (safe) to put it. When you have that much cash, you can sit on it, you can invest it, or you can buy stuff. Since Beijing values security, and the only stuff left to buy are things we refuse to sell (high-tech products with military applications), U.S. securities are the natural alternative.

But bond purchases also serve another purpose: they keep the value of the Chinese yuan artificially low. This is advantageous for trade because it makes exports more affordable -- and export-driven trade is how Beijing plans to build the China of tomorrow. The yuan is allowed to "float" against the dollar, but only within a narrow range set by the Chinese government. If it floats too much in the wrong direction-- that is, toward its market-derived value -- Beijing's central planners get a chance to regain control. They do this in part by buying U.S. securities. But if these securities are no longer considered safe, their associated value decreases and the yuan comes under increasing pressure to appreciate. Sure enough, on Wednesday Bloomberg reported that the yuan hit a 17-year high against the dollar. In short, we are ruining the party.

So perhaps you can understand why they're a little displeased right now with this extended round of economic chicken. A Foreign Ministry spokesman was sent out a few weeks ago to make a statement, saying, ''We hope that the U.S. government adopts responsible policies and measures to guarantee the interests of investors.'' This roughly translates to "WHAT THE HELL ARE YOU DOING?! STOP! STOP!" Chinese diplomacy can sometimes be understated. In response, we sent Secretary of State Clinton to Asia to reassure everyone that these are just wacky comic-relief scenes in the drama of American democracy. It's not clear the Asians were impressed.

So where does this all lead us? A default on August 2 would not immediately threaten China's holdings, but it would further erode confidence in the United States and threaten a downgrade in our credit rating-- affecting interest rates, economic opportunity, and inflation. But putting aside all the complex economic variables, a default would also affect the overall Chinese perception of America-- as a country, as a competitor, as a concept. In particular:

It could tip the scales in the ongoing debate over American global leadership. China has long advocated for a "multipolar world," which is a polite way of saying a world in which the U.S. can't just do whatever it wants. China naturally sees itself as one of the future "poles," and figures that U.S. supremacy has an expiration date like any other empire. Thus, it eyes the U.S. carefully for signs of decline -- not so much to fill shoes left empty, but to be prepared for an impending shift in the global order. Many Chinese scholars already believe that U.S. power is on the wane: first the Iraq war, then the 2008 subprime mortgage crisis, and now this. One more solid knock that damages America's reputation would push such arguments to the fore -- potentially increasing the chance for conflict as China's leaders perceive their influence on the rise.

It would reaffirm the Chinese narrative about the dangers of Western democracy. For years, China's propaganda ministers have warned its citizens about the dangers of "Western-style" democracy -- elected leaders, separation of powers, freedom of the press, and all that. At best, says Beijing, it is simply "unsuited" for China's unique conditions; at worst, it is part of a complex conspiracy to undermine China's political system and thwart its rise to greatness. But the outcome is the same, they emphasize: chaos. Well, on August 2, the Propaganda Department would get a freebie -- they wouldn't even need to spin it. "Look," they would say, "you want this? You want to have your country ruled by a bunch of petty partisans willing to wreck the ship just to score a political point, with no central control?" (In fairness, China's own record on this is not great -- but they're not likely to mention that.)

It would give China added leverage in acquiring U.S. businesses -- including sensitive knowledge and technology. China is already in the midst of what some analysts term a "foreign takeover offensive," propelled by the stronger yuan and concern over the debacle in Washington. Chinese-driven mergers and acquisitions increased 29 percent so far this year, according to one firm -- still a fraction of Chinese debt holdings, but a significant change in itself. There is already a powerful economic incentive to finesse U.S. export controls; in many cases both the Chinese and U.S. firm favor the sale, with only the U.S. government standing in the way. In the wake of a default, however, Washington would face increasing pressure from all sides to ease restrictions and facilitate Chinese investment, in order to ease the pain of the credit crunch.

None of these things in themselves equal the end of American supremacy. But it's worth remembering that economics is a lot about perception -- and right now, the world is watching. It's not just about whether or not we pull the thing off at the last minute, Hollywood style. It's about whether the rest of the world wants to see the sequel.

(Other implications? Corrections to my economics? Feel free to comment.)

This post has been modified since its original publication.