Will United States Debt Holders Bail on Treasuries?

Since the mid-1990s, China and a host of other foreign governments have quietly acquired one-third of all United States public debt. Foreign holders of United States debt held more than $5.6 trillion in Treasury securities as of August 2013.

But continued debt-ceiling drama in the United States is starting to change that.

That's because the United States once again waited until the last minute to do something about its debt limit and, instead of coming up with a long-term solution, simply delayed another decision until early February.

"Avoiding default was clearly in everyone's interest, both in the U.S. and overseas," says Richard Grossman, author of the new book Wrong: Nine Economic Policy Disasters and What We Can Learn About Them. "That said, while the deal calmed the market, it has only just kicked the can down the road a few months. The great fear is that we could have a rerun when the current deal expires."

Overseas investors already started dumping U.S. debt earlier this year, with June seeing record outflows of $40.8 billion from U.S. Treasuries – the highest since August 2007.

Even with the deal between U.S. President Barack Obama and Congressional Republicans extending the debt ceiling, economists predict that U.S. debt will become less attractive to investors. U.S. debt holders may worry that Congress will fail to reach compromise before the extension on federal borrowing power expires.

"The politicians have to recognize that if the world loses confidence in the U.S.'s willingness to make its debt payments, that loss in confidence will get any country to start thinking about how it can diversify its holdings in other sovereign bonds," says Jerry Webman, chief economist at OppenheimerFunds. "Over time that will erode confidence and weaken the U.S. debt market."

Who Holds the U.S. Debt?

China is the biggest holder of U.S. debt – outside the federal government. China now owns $1.3 trillion in Treasury securities, an astounding increase since 1994, when it had just $17.2 billion, according to U.S. government data.

Japan – the second largest U.S. debt holder – has $1.1 trillion in Treasury securities, compared to $127.7 billion two decades ago.

The next three largest holders of the $16.7 trillion U.S. debt are Caribbean banking centers, where many hedge funds are located, with $287.7 billion; oil exporters like Ecuador, Venezuela, and Saudi Arabia, with $257.7 billion; and Brazil, with $256.4 billion.

Foreign entities have steadily been purchasing U.S. government-issued debt for several reasons.

First and foremost, Treasuries were considered a safe, liquid investment. Collectively, they now own $5.6 trillion – 33% – of all Treasury securities outstanding.

"The biggest and most liquid financial market in the world is the U.S. Treasury market," says Grossman, an economist at Wesleyan University. "No matter what has gone wrong in the U.S. – up until now – the market for Treasuries has been strong."

The U.S. trade deficit also contributed to foreign ownership of U.S. debt. As export-rich countries like China accumulate foreign currency reserves, they hold most of that surplus money in dollars and invest it in the U.S. bond market.

"It's just the nature of buying a gallon of gas or a t-shirt or a car," says Webman. "You end up putting dollars in foreign accounts, and people will want to hold them in securities."

With the dollar's "exorbitant advantage" as the world's reserve currency – as former French President Valéry Giscard d'Estaing once termed it – every country in the world that engages in international trade needs to hold dollars, which are typically invested in Treasuries.

Not Just Foreigners Hold United States Debt

While foreign ownership of U.S. debt skyrocketed over the past couple decades, a steady staple in the Treasury market has been the U.S. government itself.

The Social Security Trust Fund holds the largest percentage of Treasury securities – 16.7%. The U.S Civil Service Retirement Fund and the U.S. Military Retirement Fund also own sizeable portions of the public debt.

These government entities became holders of the public debt because federal law requires that they invest their surplus funds in Treasury securities.

"You wouldn't want the Federal Airport Trust Fund to go and out start buying stocks and bonds," Grossman says. "If the government put the surpluses in something that crashed, we'd all be bleeding."

Among the remaining debt owners are American investors, banks, insurance companies, mutual funds, and state and local governments, which together hold 30% of the nation's debt. The U.S. Federal Reserve accounts for 10.8% of the government debt.

But with the United States failing to keep its debt at a reasonable level – and failing to agree on a way out – investing in U.S. debt is going to change…