Why does everybody lend money to the US government?

The US government borrows a lot of money. Currently, they owe roughly $29 trillion—roughly 100% of their GDP.  And a big chunk of this—Almost $7 trillion comes from other foreign countries. But here’s the interesting bit. Even India features on this list and as it stands, the US owes us about $216 Billion. So the question is simple — Why are the likes of India lending money to the US and why isn’t anybody talking about it?

The Story

It almost seems as if the world is doing US a favour. However, things are a bit more complicated. For instance, imagine you’re running a country. You want to park your money someplace, redeem it in a few years and you want to see it appreciate quite a bit by then. And if you want access to higher yields (higher returns) you will sometimes have to look beyond your borders. Consider for instance the biggest lender of them all — Japan. As of April 2020, the country held $1.266 trillion worth of US Debt. But they aren’t doing it out of some misplaced sense of benevolence. They’re doing it because it’s in their best interest to do so.

Here’s an example — Right now you could buy a 1- year Japanese T-Bill in the hopes of making some money.

Think of T-Bills as promissory notes issued by a government in exchange for money. Technically they aren’t promissory notes. But T-bills do make a promise. So we’ll just go ahead with that definition for now. Anyway, when a government issues a T-Bill, they’ll tell you something like this — You lend ¥99 today and we promise to pay you back in full with an extra ¥1 on top. The effective yield, in this case, is 1/99=1.01%. That’s what you’re expected to make if you hold a 1-year T-Bill for 1 year (until maturity that is). But this is a fictional example. In the real world, if you lend ¥99 to the Japanese government by buying one of these T-Bills, they won’t even return the principal. They’ll actually give you something like ¥98.88. So if you’re an investor in Japan trying to make some money, you have to look elsewhere. And your best option is to buy a US T-Bill — that is, you could lend money to Uncle Sam.

It’s safe. It offers better returns than your own government. And the promise is etched in stone. Not literally, but the US government has never defaulted on its obligations. So they’ll almost certainly pay you. And countries like Japan have every incentive to park their money here. But that’s not the only reason. China for instance has another motive.

The country exports a lot of goods to the US and the US pays for it in its own currency — Dollars. But China doesn’t import as much. So they don’t have avenues to spend these dollars. So if you’re a trader in mainland China, you won’t know what to do. You need your own currency, not the USD. And at this point, the Central Bank of China will intervene. They will print the Chinese currency and swap it for the dollars. And if they don’t mop up the excess dollars, you will start seeing the dollar tumble in value, especially when compared to the Chinese Yuan. This isn’t in China’ best interests. After all, people abroad buy Chinese goods because it’s cheaper to do so. And if the Yuan starts becoming more expensive, relative to the dollar, it’ll hurt the country’s export engine. So this way the Chinese central bank starts accumulating a lot of dollar reserves.

And once they have access to these dollar reserves they can lend them back to the US government so that country can keep importing from China. It’s a win-win for everyone involved. India, much like China has similar reasons to buy US treasuries. The Reserve Bank of India invests in US T-Bills because

a) It’s safe

b) They can exchange it for dollars whenever they want

This exchange program helps when the value of the Indian currency starts fluctuating. Imagine the value of the rupee starts tumbling because of economic uncertainties. The RBI then has to exchange the US Dollars for the Indian currency. Ergo, if they keep mopping up the excess Rupees floating in the system, they could ensure the value of the rupee doesn’t capitulate. And so long as the value of the rupee remains stable, prices of commodities will follow suit.

Bottom line — Countries don’t hold US Debt because they are trying to help the US. They are doing it to help themselves.

Until next time...

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Correction: In an earlier version of the article, the Chinese motive for hoarding dollars wasn't explained accurately. The article has been modified to better reflect the actual idea.