Looming peril

The United States federal government has run deficits for 23 consecutive years from 2002 to 2024, with its debt-to-GDP ratio surging from 57.2 percent to 124.3 percent. In fiscal year 2024, the federal deficit amounted to $1.83 trillion, pushing total federal debt past $36 trillion. This accounted for over 37 percent of the global sovereign debt balance, a percentage much higher than the US share of the global GDP.

The US' fiscal imbalance has not improved since the start of Donald Trump's second presidential term. In the first seven months of the fiscal year 2025, the federal government recorded a deficit of $1.05 trillion. Today, the size of the US federal debt and its spillover effects have become a prominent risk to the global economy and international financial markets.

The growing deficit is weakening Washington's fiscal maneuvering ability and stoking inflationary pressures. With interest rate hikes in the past few years, a growing share of the federal budget is being swallowed by interest payments, reaching 13.2 percent in the fiscal year 2024. Meanwhile, the share of expenditures that stimulate economic growth has fallen sharply to 24.5 percent from 34.4 percent at the turn of this century, dampening the fiscal multiplier effects.

At the same time, with a change in the structure of investors, the Federal Reserve and domestic financial institutions have become the major US Treasury holders. When the Fed purchases Treasuries, it effectively monetizes fiscal deficits, which means an increase in supply of the base currency, thus heightening inflationary pressures. US financial institutions, on the other hand, view Treasuries as risk-free assets and use them for credit creation via operations like repurchase agreements. This further increases the money multiplier, and contributes to inflation pressures.

Continuous government borrowing has generated sustained global demand for US Treasuries, contributing to an overvalued dollar. The dollar overvaluation, rising domestic prices and production costs have undermined the competitiveness of US exports and accelerated the offshoring of manufacturing. As a result, the US has maintained a long-standing current account deficit. In the long run, the twin pressures of fiscal and current account deficits will ultimately weaken the underlying credibility of the dollar.

Long regarded as one of the world's safest assets, US government debts remain a cornerstone of central bank reserves and private sector portfolios worldwide. However, with a fast rise in federal deficits and growing uncertainties about the government's long-term debt servicing capability, major credit rating agencies have downgraded the ratings of US sovereign debts.

US Treasuries are the most important credit enhancement collateral in global financial markets. As yields rise, the resulting repricing of dollar-denominated assets will push up interest rates in other advanced economies, including the eurozone and Japan. This will also raise borrowing costs for emerging and developing economies, increasing the likelihood of sovereign debt default in developing countries.

As a widely held reserve asset, the rising scale and potential unsustainability of US federal debts pose significant risks to the economic and financial stability of the US and the world as a whole. China, too, is increasingly exposed to the spillover effects from the US' mounting fiscal deficits in the following ways.

First, the inverted yield spread between Chinese and US bonds is fueling short-term capital outflows from China. In early 2022, the yield on China's 10-year government bond exceeded its US counterpart by 120 basis points. By May 2025, that had reversed to a negative 274 basis points. This inversion has encouraged the outflow of cross-border capital to the US, and was also a factor that caused downward pressures on the renminbi exchange rates and domestic equity markets.

Second, the tightening US dollar liquidity is expected to increase the financing costs for Chinese entities issuing US dollar debts. As of the end of May 2025, Chinese issuers had a total of $634.6 billion in outstanding dollar bonds, primarily in the urban infrastructure, finance and real estate sectors. Rising US Treasury yields are pushing up refinancing costs for these borrowers. These strains may spill over into China's domestic capital markets through channels such as cross-default risk.

At the end of 2024, China's banking sector held $815.3 billion in dollar-denominated assets against $339.2 billion in liabilities. As dollar credit quality weakens, its liquidity tightens, leading to rising offshore financing costs and liquidity stress for some Chinese financial institutions.

Third, US tax cuts are undermining China's appeal to foreign investors. The US' fiscal imbalance is partly due to stronger corporate tax reductions and industrial subsidies designed for the reshoring of advanced manufacturing. If Trump succeeds in making these cuts permanent during his second term, the US will become even more attractive to global capital, especially investments in high-end manufacturing. Combined with shifting geopolitical dynamics and the Trump administration's protectionist tariffs policy, the global supply chains are expected to recalibrate, leading to a more complex and competitive environment for China to attract foreign direct investment.

Fourth, declining confidence in the dollar could jeopardize the safety of China's overseas assets. As of the end of May, China's foreign exchange reserves totaled roughly $3.29 trillion, with US Treasuries representing the largest asset class. Any deterioration in Treasury creditworthiness would directly threaten the security of China's foreign exchange reserves.

Moreover, many developing economies rely heavily on dollar-denominated debt to fund their growth. China has emerged as the largest bilateral creditor to these developing nations, with most loans denominated in US dollars. Soaring US fiscal deficits are likely to push up the costs of dollar financing, making it harder for developing countries to service their sovereign debt and potentially putting at risk the value of China's lending to those nations.

Given these risks, Chinese institutions must closely monitor the evolving US debt landscape and its global spillovers. Macroeconomic and financial stability policies should incorporate contingency plans for handling the spillover effects from US policy shifts. China should strengthen the monitoring of the debt structure and risk exposure of dollar-denominated debt and cross-border assets. Full-coverage macroprudential management of cross-border financing needs to be enhanced. Regulatory tools, such as the countercyclical capital buffer, foreign exchange reserve requirements and foreign currency risk reserve deposits, should be adjusted as needed.

Moreover, China should diversify its reserve assets portfolio and optimize the asset structure by expanding holdings of critical and strategic resources such as gold, energy and food. It is also important to deepen regional monetary collaboration to reduce overreliance on the US dollar. Financial cooperation frameworks with developing countries need to be improved to help them enhance debt management and better support their economies, leading to a virtuous cycle of debt and growth.

The author is director of the Research Institute of Bank of China. The author contributed this article to China Watch, a think tank powered by China Daily.

Contact the editor at editor@chinawatch.cn.