As the clock ticks down toward an unprecedented US debt default, the world's second- and third-biggest economies are watching in fear.
China and Japan are the largest foreign investors in American government debt. Together they own $2 trillion — more than a quarter — of the $7.6 trillion in US Treasury securities held by foreign countries.
Beijing started to ramp up buying of US Treasuries in 2000, when the United States effectively endorsed China's entry into the World Trade Organization, triggering an export boom. That generated vast amounts of dollars for China and it needed a safe place to stash them.
US Treasury bonds are widely regarded as one of the safest investments on Earth, and China's holdings of US government debt ballooned from $101 billion to peak at $1.3 trillion in 2013.
China was the largest foreign creditor to the United States for more than a decade. But an escalation of tensions with the Trump administration in 2019 saw Beijing pare back its holdings, and Japan surpassed China as the top creditor that year.
Tokyo now holds $1.1 trillion, to China's $870 billion, and that heavy exposure means both countries are vulnerable to a potential crash in the value of US Treasuries if the doomsday scenario for Washington were to unfold.
"Japan and China's large Treasury holdings could hurt them if the value of Treasuries plummets," said Josh Lipsky and Phillip Meng, analysts from the Atlantic Council's GeoEconomics Center.
The falling value of Treasuries would lead to a drop in Japan and China's foreign reserves. That means they would have less money available to pay for essential imports, service their own foreign debts, or prop up their national currencies.
Nevertheless, the "real risk" comes from the global economic fallout and likely US recession that could follow from a default, they said.
"That is a serious concern for all countries but poses a particular risk to China's fragile economic recovery," Lipsky and Meng said.
After an initial burst in activity following the abrupt lifting of pandemic restrictions late last year, China's economy is now sputtering as consumption, investments, and industrial output all show signs of slowing. Deflationary pressure has worsened as consumer prices barely moved during the past few months. Another major concern is the soaring unemployment rate for young people, which hit a record level of 20.4% in April.
Japan's economy, meanwhile, is just showing signs of emerging from stagnation and deflation, which have haunted the country for decades.
Devastating impact
Even if the US government runs out of money and extraordinary measures to pay all its bills — a scenario that Treasury Secretary Janet Yellen has said could happen as early as June 1 — the likelihood of a US default may still be low.
Some US lawmakers have proposed prioritizing the payment of interest on bonds to the biggest bondholders.
This would be done at the expense of other obligations, such as payment of government pensions and salaries to government employees, but would stave off major debt defaults to the likes of Japan and China, said Alex Capri, senior lecturer at NUS Business School.
And without a clear alternative, in response to rising market volatility investors could swap shorter term bonds for longer term debt. That could benefit China and Japan, because their holdings are concentrated in longer-term US Treasuries, according to Lipsky and Meng from the Atlantic Council.
That said, broader financial contagion and economic recession are a much bigger threat.
"A debt default in the US would mean a fall in US Treasury prices, a rise in interest rates, a fall in the value of the dollar, and increased volatility," said Marcus Noland, executive vice president and director of studies at the Peterson Institute for International Economics.
"It would also likely be accompanied by a fall in the US stock market, increased stress on the US banking sector, and increased stress on the real estate sector."
That could lead the interconnected global economy and financial markets to stumble, too.
China and Japan are dependent on the world's biggest economy to support companies and jobs at home. The export sector is especially crucial to China, as other pillars of the economy — such as real estate — have faltered. Exports generate a fifth of China's GDP and provide jobs for around 180 million people.
Despite rising geopolitical tension, the United States remains China's single largest trading partner. It's also the second largest for Japan. In 2022, US-China trade hit a record high of $691 billion. Japan's exports to America increased by 10% in 2022.
"As the US economy slowed, the impact would be transmitted through trade, depressing Chinese exports to the US, for example, and contributing to a global slowdown," said Noland.
Deep concerns
Bank of Japan Governor Kazuo Ueda expressed concerns last Friday, warning that a US debt default would cause turmoil in various markets and have serious consequences for the global economy.
"The Bank of Japan will strive to maintain market stability based on its pledge to respond flexibly with an eye on economic, price and financial developments," he told parliament, according to Reuters.
Beijing, so far, has been relatively quiet on the matter. The foreign ministry commented Tuesday that it hopes the United States will "adopt responsible fiscal and monetary policies" and "refrain from passing on risks" to the world.
Chinese state news agency Xinhua published a column earlier this month, highlighting the "symbiotic relationship" the countries have in the US bond market.
"If the United States defaults on its debt, it will not only discredit the United States, but also bring real financial losses to China," it said.
There's nothing much Tokyo or Beijing can do, other than wait and hope for the best.
Hastily dumping US debt would be "self-defeating," Capri said, as it would significantly drive up the value of the Japanese yen or the Chinese yuan against the dollar, causing the cost of their exports to "go through the roof."
Longer-term benefits?
In the longer term, some analysts say a potential US default could push China to accelerate its drive to create a global financial system that is less dependent on the dollar.
The Chinese government has already struck a series of deals with Russia, Saudi Arabia, Brazil, and France to increase the use of yuan in international trade and investment. A Russian lawmaker said last year the BRICS countries, namely China, Russia, India, Brazil, and South Africa, are exploring the creation of a common currency for cross-border trade.
"This will certainly serve as a catalyst for China to continue to push the internationalization of the yuan, and for Beijing to double down on its efforts to bring its trading partners into the newly announced 'BRICs Currency' initiative," Capri said.
However, China faces some serious obstacles, such as controls it applies to how much money can flow in and out of its economy. Analysts say Beijing has shown little willingness to fully integrate with global financial markets.
"A serious push for de-dollarization would see ... much more volatile yuan trading," said Derek Scissors, senior fellow at the American Enterprise Institute.
Recent data from international payments system SWIFT showed that the yuan's share of global trade financing was 4.5% in March, while the dollar accounted for 83.7%.
"There is still a long way to go before a credible alternative to the US dollar can emerge," Lipsky and Meng said.