Excerpts from
The Congressional Research Service Report

China’s Holdings of U.S. Securities: Implications for the U.S. Economy

The complete report can be found here. http://www.fas.org/sgp/crs/row/RL34314.pdf

Growing Bilateral Tensions over the U.S. Public Debt

Since the beginning of the global financial crisis in 2008, U.S. government officials have increasingly sought to offer assurances to Chinese officials regarding the safety of China’s holdings of U.S. government debt securities and to encourage China to continue to purchase U.S. securities. For example, during her first visit to China on February 21, 2009, Secretary of State Hillary Rodham Clinton was quoted as saying that she appreciated “greatly the Chinese government's continuing confidence in the United States Treasuries,” and she urged the government to continue to buy U.S. debt.26 However on March 13, 2009, Chinese Premier Wen Jiabao at a news conference stated: “We’ve lent a huge amount of capital to the United States, and of course we’re concerned about the security of our assets. And to speak truthfully, I am a little bit worried. I would like to call on the United States to honor its words, stay a credible nation and ensure the safety of Chinese assets."27 On March 24, 2009, the governor of the People’s Bank of China, Zhou Xiaochuan, published a paper calling for replacing the U.S. dollar as the international reserve currency with a new global system controlled by the IMF.28

The recent contentious U.S. debate over raising the debt ceiling and over how to address long- term U.S. debt issues, along with the downgrade of the long-term sovereign credit rating of the United States from AAA to AA + by Standard and Poor’s in August 2011, appear to have intensified China’s concerns over its U.S. debt holdings.29 Several government-controlled Chinese newspapers issued sharp criticism of U.S. economic policies (as well as the U.S. political system). For example:

• A July 28, 2011, Xinhua News Agency (Xinhua) editorial stated: “With its debt approximating its annual economic output, it is time for Washington to revisit the time-tested common sense that one should live within one's means.”

• An August 3, 2011, a Xinhua editorial stated: “Should Washington continue turning a blind eye to its runaway debt addiction, its already tarnished credibility will lose more luster, which might eventually detonate the debt bomb and jeopardize the well-being of hundreds of millions of families within and beyond the U.S. borders.”

• A Xinhua August 6, 2011, editorial said: “The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone. International supervision over the issue of U.S. dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country.”

• A Xinhua editorial on August 8, 2011, stated: “The days when the debt-ridden Uncle Sam could leisurely squander unlimited overseas borrowing appeared to be numbered as its triple A-credit rating was slashed by Standard & Poor's (S&P) for the first time on Friday. China, the largest creditor of the world's sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China's dollar assets.”

Some analysts contend that China’s main concern is not a possible U.S. default on its debt, but rather U.S. monetary policies that have been utilized by the Federal Reserve in recent years to stimulate the economy, namely the purchases of U.S. Treasury securities, agency debt, and agency mortgage-backed securities. Such measures, often referred to as “quantitative easing” (QE), have led the Federal reserve to purchase over $2 trillion in U.S. securities since March 2009 in an effort to lower long-term interest rates.32 An August 25, 2011, editorial in China Daily stated that

“China is not worried that Standard & Poor's has downgraded the U.S. credit rating from AAA to AA+. Rather it is concerned about the Fed announcing QE3. If the U.S. administration chooses to make the irresponsible choice of devaluating the dollar further, China would not only stop buying U.S. debt, but also gradually decrease its holdings, which would certainly not be in the interests of the U.S.”

Chinese officials have expressed concerns that actions by the Federal Reserve to boost the U.S. money supply will undermine the value of China’s holdings of U.S. dollar assets, either by causing the dollar to depreciate against other major currencies or by significantly increasing U.S. Inflation.

Some Chinese analysts have argued that the debt problems in Europe and the United States will decrease their demand for Chinese products, and that a depreciating dollar will lower the value of Chinese dollar assets. Thus, they argue, China will need to accelerate its economic reforms in order to boost domestic consumption (including increased imports), lower its dependency on exporting for economic growth, and slow or reduce China’s FX reserves and holdings of U.S. securities. If China consumed more and saved less, it would have less capital to invest overseas, including in the United States. Thus, if the United States did not reduce its dependence on foreign savings for its investment needs (and borrowing for deficit spending), and China reduced its U.S. investments, the United States would need to obtain investment from other countries, and the overall U.S. current account balance would likely remain relatively unchanged but U.S. interest rates would be expected to rise.

A potentially serious short-term problem would emerge if China decided to suddenly reduce their liquid U.S. financial assets significantly. The effect could be compounded if this action triggered a more general financial reaction (or panic), in which all foreigners responded by reducing their holdings of U.S. assets. The initial effect could be a sudden and large depreciation in the value of the dollar, as the supply of dollars on the foreign exchange market increased, and a sudden and large increase in U.S. interest rates, as an important funding source for investment and the budget deficit was withdrawn from the financial markets.

Many analysts argue that heavy U.S. reliance on foreign savings is not sustainable and may undermine U.S. economic interests over time.