G20 economists and other observers have described the ongoing Eurozone crisis as a drag on global, and particularly American, growth (Guerrieri, 2012). It seems to some that leaders of European Monetary Union countries are unable to move beyond monetary union into a full fiscal union (Habermas, 2012). In this view, this inability has kept the Eurozone in the grip of conflicts stemming from nationalism on the one hand, and austerity fundamentalism, on the other hand (Bastasin, 2012, 100-109). Similarly, American critics have described Europeans as “moral hazard fundamentalists,” as incapable of living up to their global responsibility of stabilizing financial markets and as willing to sacrifice the economic strength of the continent, and indeed global markets, for stubborn austerity policies (Geithner, 2014, 445-450). At the same time, other critics have described the Eurozone crisis as a merely European problem.
I maintain that the Eurozone crisis, far from being solely a European phenomenon, allows inferences beyond that continent’s institutions. It allows one to draw larger conclusions about financial market mechanisms—particularly the duality of sovereign bonds as a fiscal instrument and an asset class. This dualism can be found in the empirical context of Sino-American relations, which have long been characterized by conflict-ridden cooperation stemming from significant investments by Chinese Sovereign Wealth Funds in United States Treasury securities. Since the structural integrity of the American financial system and hence of Chinese exports depend on this cooperation, the Eurozone crisis is of interest to U.S. foreign policy and international political economy analysts alike.
The ongoing European financial instability has highlighted the role of seemingly arcane financial technicalities in shaping policy. This is particularly the case for sovereign bonds—assets issued by governments and purchased by financial market participants, who thereby lend money to the offering nation (Eaton 1993; Lo Conte 2009). Bonds of this kind yield little interest compared to other possible investment instruments. Instead, their main selling point is that the sovereign involved can require its citizens to contribute funds toward repayment via taxation, virtually guaranteeing repayment (Mundell 1996).
Investors purchase sovereign bonds to stabilize their international portfolios precisely because they are considered exceptionally stable. In regulatory terms, this makes these offerings tier 1 capital (BIS 2013), the reserve a financial institution holds that constitutes its basis for leverage borrowing (Epstein and Habbard 2013, 330). For example, at a leverage ratio of five, if a bank or fund holds sovereign bonds valued at $100, it will be legally allowed to lend money from other financial businesses up to a total volume of $500, funds the bank or fund can use for its own operations despite only $100 being genuinely its own.
This fact implies that any changes in the value of sovereign bonds can have significant consequences for the businesses holding them. If the value of the government paper in the above example was to fall by $10, for example, the portfolios of firms that contain it would decline by $50. Assuming that financial actors hold more than one such asset and that their leveraging ratios are often higher than five and that sovereign bonds trade for significant sums, a decline in the value of these instruments can create significant difficulties for entities holding them. Moreover, the effects of this reality ripple outward, as other businesses, to which the firm in this example lent for its leveraged transaction, will demand repayment if they begin to question their loan’s viability.
Many European banks held other Eurozone governments’ bonds prior to the region’s recent crisis and that exposure proved to be one key precipitating factor of those events. For example, French banks were exposed to Greek sovereign bond deterioration to a significant extent in 2010 (Lucarelli 2011, 208). Rapid French and other European bank sell-offs of that paper reduced the value of Greece’s offerings in the region’s sovereign bond markets, threatening their asset function and thereby stimulating further sell-offs (Shambaugh 2012, 159). In turn, the fiscal function of sovereign bonds was threatened as sell-offs reduced buyer demand and drove up interest rates. This combination negatively affected state finances, resulting in marked deterioration in the fiscal status of several countries (Botta, 2013, 419-420). The workings of sovereign bond markets thus became vitally important to European policy-makers.
These findings can be generalized beyond the Eurozone in two ways. First, and well illustrated in the recent European scenario, are the fiscal constraints imposed on nation-states by financial market practices. In lieu of levying taxes—an option in popular disrepute since the late 1970s—governments throughout the Western world have often financed their expenditures by issuing bonds at market interest rates (Schäfer and Streeck 2013). As a result, debt service prioritization—austerity—had become a permanent condition for many nations long before the Eurozone crisis (Pierson 2002). Secondly, by issuing debt, states provide assets for international investor portfolios and thereby serve a securitization function in international finance (Lo Conte 2009). In this way, government finances have become a sui generis form of international relations.
Sino-American relations exemplify this turn in international politics. U.S. sovereign bonds (Treasury securities or Treasuries) are widely considered a ‘safe haven’ asset and are therefore employed as debt securities in a range of international portfolios (Noeth and Sengupta 2010). Interestingly, however, to a significant extent, their price stability—which allows them to perform their financial steadying function—stems from ongoing Chinese investment in them. As of June 2015, Chinese Sovereign Wealth Funds held $1.3 trillion in American sovereign debt (U.S. Treasury 2015). Japan holds a similar amount. China employs this strategy to lower the relative value of its currency, keeping its products cheap vís-a-vís the American Dollar and strengthening its export capacities to the U.S. (Liang 2012). Simultaneously, this investment in United States Treasuries allows these assets to serve as portfolio stabilizers for American financial businesses. Those firms extend credit to U.S. consumers based on the security provided by ongoing high Treasury prices, who then often use it in turn to purchase Chinese goods (Cohen and DeLong, 2010, 15-34).
The Chinese stock market correction that occurred from June through August 2015 provides an example of the implications of this structure and its associated dynamics. As investors worked to reduce their exposure to China’s stocks in their portfolios, they sought safety in U.S. Treasuries, raising the initial price of those offerings and reducing their interest rates. Between June and August 2015, the return associated with U.S. two-year, five-year and ten-year Treasury notes decreased by a third, a fifth, and a fifth, respectively, as demand for them increased. At the same time, the Dollar increased in value relative to the Chinese Yuan (Bloomberg 2015).
Despite their minuscule appearance, these fluctuations have had notable economic and political effects. First, U.S. exports have become more expensive because of the rise of the value of the Dollar, potentially decreasing their volume and threatening domestic employment. Secondly and simultaneously, American purchasing power for goods produced in China has increased as available credit has expanded. Maintaining a balance between these two forces has emerged as a primary challenge of Sino-American relations for the foreseeable future.
The Eurozone crisis has yielded insights into these dynamics that can help American and Chinese leaders respond more effectively to this turn. Just as in Europe, U.S. domestic economic policy inevitably has consequences for other nations. For America, maintaining an economic environment favorable to Chinese purchases of U.S. Treasury Securities is essential if the nation is to ensure continued availability of credit to American businesses and consumers. Debt ceiling standoffs of the kind that occurred in Washington in 2011 and 2013 are thus not likely to be isolated American affairs any more. More positively, U.S. economic aims could also be achieved through bilateral efforts, as increasing Chinese (and other) investments in Treasury Securities raises the price of those offerings and thereby increases the lending leverage available to American financial businesses. In all of these cases, examining the Eurozone crisis carefully with an eye toward the implications of internationally integrated capital markets for domestic policy allows analysts to abandon the dangerous assumption that the United States is an isolated hegemon—and to pay more attention to just how much its economic strength owes to its fruitful relations with China and other nations.
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Sascha Engel is a doctoral candidate (ABD) in the ASPECT (Alliance for Social, Political, Ethical, and Cultural Thought) program at Virginia Tech where he teaches in the Department of Political Science. Sascha received his M.A. in Political Theory from Goethe University Frankfurt (Germany) and Darmstadt University of Technology (Germany), as well as a B.A. in Political Science and Fundamentals of Economics from the Martin Luther University Halle-Wittenberg (Germany). He has published in Fast Capitalism and New Political Science and has forthcoming articles in the Journal of Economic Issues as well as New Perspectives. Sascha’s research focuses on the Eurozone crisis, sovereign debt and international financial governance.