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What does the US debt crisis have to do with China's role in Sri Lanka?

An article by Professsor Minxin Pei in The Diplomat provides some answers.

Much of the world has been watching the debt crisis in the United States with trepidation in recent weeks, but one actor has been particularly nervous: China.

Why? China is the world’s biggest lender to the US. Prof Pei writes:

“China is the largest single holder of US Treasury debt (roughly $1.1 trillion). In a nightmarish scenario of an American debt default, the prices of the Treasury bonds China has accumulated are bound to decline significantly.

“[Furthermore,] 60 percent of China’s $3.2 trillion in foreign exchange reserves consists of dollar-denominated assets (in addition to Treasury bonds, China has bought hundreds of billions of dollars in [US] mortgage-backed securities)

“The paper losses from the price declines of dollar-denominated bonds, and the depreciation of the dollar itself, will likely be in at least the tens of billions of dollars.”

“To Beijing’s credit, the Chinese government has kept relative silence [on the debt crisis]. .. China has maintained an ultra-low profile out of self-interest.  It will only hurt itself more if it raises alarm about a possible US default and spooks the financial markets.”

As Prof. Pei points out, one obvious question, given the massive risks of holding trillions of dollars in US debt, shouldn't Beijing have diversified its forex investments? Why not invest in assets not denominated in the US dollar?

“The answer is, sadly, China has tried practically every trick known to get into non-dollar assets. It has set up a $300 billion sovereign wealth fund to invest excess foreign reserves in foreign companies. It has encouraged state-owned companies to acquire assets abroad, such as natural resources and firms. It has launched an experimental scheme to settle foreign trade in the renminbi, instead of the dollar. It has dabbled in purchasing distressed European sovereign debt. The list goes on.”

So perhaps it is not surprising that in recent years, China has been happy to lend to, and invest in Sri Lanka, too.

China has famously bankrolled the new Hambantota harbour and other infrastructure projects.

To be more precise, China lends to Sri Lanka, which in turn pays Chinese contractors to build.

Whether these projects contribute to Sri Lanka or not, the contractors get paid immediately, and indebted Sri Lanka repays China over the coming years.

A smart way to offset some of the risk.

Interestingly, Sri Lanka is one of the countries participating in China’s experimental scheme to settle trade in the renminbi (see here).

Meanwhile, how have China’s efforts vis-à-vis the dollar worked out? Prof. Pei, again:

“Unfortunately, these efforts to diversify forex holdings have yielded disappointing results. Chinese attempts to acquire natural resources have met with strong resistance in most parts of the world (except in Africa).

China’s sovereign wealth fund’s investments overseas haven’t been successful either, mostly due to political opposition. Chinese state-owned firms seem to have done better. But the tens of billions of dollars they have spent on projects may not generate economic benefits.” 

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