US' cheap financing coming to an end

The dumping of US government debt by foreign investors heralds the end of the era of cheap financing for the United States. According to the US Treasury Department, overseas investors sold a record $54.5 billion in long-term US debt in April, with China slashing its holdings by $5.4 billion.

As it stands, the US government holds roughly 40 percent of its debt through the Federal Reserve and government agencies such as the Social Security Trust Fund, while US and foreign investors each hold 30 percent. Emerging economies many of which use large trade surpluses to drive GDP growth and supplement their foreign-exchange reserves with resulting capital inflows are leading buyers of US debt.

Over the last decade, these countries' foreign-exchange reserves have swelled from $750 billion to $6.3 trillion more than 50 percent of the global total providing a major source of financing that has effectively suppressed long-term US borrowing costs. With yields on US ten-year bonds falling by 45 percent a year on average from 2000 to 2012, the US was able to finance its debt on exceptionally favorable terms.

But the ongoing depreciation of the US dollar which has fallen by almost half since the Bretton Woods system collapsed in 1971 together with the rising volume of US government debt, undermines the purchasing power of investors in US government securities. This diminishes the value of these countries' foreign-exchange reserves, endangers their fiscal and exchange-rate policies, and undermines their financial security.

Nowhere is this more problematic than in China, which, despite the recent sell-off, remains by far the US' largest foreign creditor, accounting for more than 22 percent of the US' foreign-held debt. Chinese demand for US Treasuries has enabled the US to increase its government debt almost threefold over the last decade, from roughly $6 trillion to $16.7 trillion. This, in turn, has fueled an average annual expansion in China's foreign exchange reserves of roughly 28 percent.

China's purchases of US debt have effectively transferred the official reserves gained via China's trade surplus back to the US market. In early 2000, China held only $71.4 billion of US debt and accounted for 8 percent of total foreign investment in the US. By the end of 2012, this figure had reached $1.2 trillion, accounting for 22 percent of inward foreign investment.