SYDNEY: 5 November 2013 - America has avoided defaulting on its debt until at least February. 

China is America’s largest creditor. It currently owns almost a quarter of the U.S. Treasury bonds held abroad, some $1.28 trillion as of July this year.

During America’s recent debt ceiling crisis, China’s Vice Minister of Finance, Zhu Guangyao, said “We demand that the U.S., as the issuing country of the major reserve currency … undertake its due responsibility … to uphold and develop the stability of international financial markets.” He went on to criticise “the attitude of the Tea Party.” 

The Republican response was predictable. “They need to stay out of our politics,” said Representative Blake Farenthold. Ted Yoho, another Tea Party Republican Congressman, said “For them to say something derogatory about the Tea Party, I take offense to that.”

According to a Pew Centre poll in early 2011, 34% of Tea Party Republicans viewed China as an adversary, while only 17% of other Republicans saw China this way.

Come February the world will once again endure the whole debt ceiling circus, and it may be that the outcome then will play right into China’s hands.   

In 2009, China announced it did not want the U.S. dollar to remain the only global reserve currency. Ever since, China has been establishing swap agreements with Australia, Brazil and many other countries, so its trade with these countries can be denominated and settled in the currency of the trading partner or of China. Historically trade with China has been in U.S. dollars. China is working steadily toward the day when most trade will be denominated in either its own or its trading partner’s currency. This is part of its push for a world with a basket of reserve currencies, not merely one.

If the U.S. government defaults on its Treasury Bonds, it will have taken the first major step in the dethronement of the U.S. Dollar as the global reserve currency. Yet America has benefitted enormously from the dollar being both its money, and the world’s money. America today consumes and invests a trillion dollars more each year than it produces simply because central banks and other foreign investors have a voracious appetite for U.S. dollars that America effectively prints for free. This has been rightly described by Professor Barry Eichengreen as America’s “exorbitant privilege.”

If the U.S. Dollar is not the global reserve currency, the U.S. will no longer be able to import some $1 trillion more of goods and services each year than it exports. U.S. living standards will fall significantly.

There is an alternative to the U.S. dollar as the global reserve currency. A basket of currencies could perform this role, probably the dollar, euro, renminbi and yen. Such an arrangement would share the privilege of one’s currency being used globally as well as in one’s own country.

Some within the Republican Party are prepared to risk the enormous benefit America gains from printing the world’s reserve currency. They have damaged the currency’s status already with the latest round of brinksmanship. A default is a possibility come February.

Will the U.S. give China a massive present by failing to lift the debt ceiling and defaulting on its debt? Even another round of damaging uncertainty will hasten the day when the world moves to a basket of reserve currencies.

Some U.S. Republicans this time around said that a U.S. default would not be catastrophic. They claimed it would, somehow, merely be “technical.” Financial markets don’t work like that. A default is a default, even when the party in default has the means to pay. If the U.S. fails to repay its Treasury bonds in February, the impact on global financial markets will be cataclysmic and make 2008 look like a picnic. The short term damage to economies around the world, particularly America’s, will be very substantial indeed.

But it is the longer term impact that will be more profound and far-reaching.  

For the exquisite irony is that while a U.S. debt default would be bad news for China in the short term, as its U.S. Treasuries would fall sharply in value, in the longer term it would be for them a wonderful gift. A cynic might even suspect that China is speaking out on this issue believing the Republican Party is likely to do the opposite of whatever China tells it to do.

Most Americans outside the Tea Party understand a debt default shoots the country in the foot. However, how many understand that in the long term a debt default would be more like America blowing away both its kneecaps with a shotgun?

Ross P. Buckley is CIFR King and Wood Mallesons Professor of International Finance and Regulation, University of New South Wales.