Order Code RL34314
China’s Holdings of U.S. Securities:
Implications for the U.S. Economy
January 9, 2008
Wayne M. Morrison
Specialist In International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Marc Labonte
Specialist in Macroeconomic Policy
Government and Finance Division
China’s Holdings of U.S. Securities: Implications for the
U.S. Economy
Summary
Given its relatively low savings rate, the U.S. economy depends heavily on
foreign capital inflows from countries with high savings rates (such as China) to help
promote growth and to fund the federal budget deficit. China has intervened heavily
in currency markets to limit the yuan’s appreciation. As a result, China has become
the world’s largest and fastest growing holder of foreign exchange reserves (FER),
which totaled $1.4 trillion as of September 2007. China has invested a large share
of its FER in U.S. securities, which, as of June 2006, totaled $699 billion, making
China the 2nd largest foreign holder of U.S. securities (after Japan). These securities
include Treasury debt, U.S. agency debt, U.S. corporate debt, and U.S. equities.
U.S. Treasury securities are issued to finance the federal budget deficit. Of the
public debt that is privately held, about half is held by foreigners. As of October
2007, China’s Treasury securities holdings were $388 billion, accounting for 16.8%
of total foreign ownership of U.S. Treasury securities and making China the second
largest foreign holder of U.S. Treasuries after Japan. From March to October 2007,
China’s Treasury holdings declined by about 8%.
Some U.S. policymakers have expressed concern that China might try to use its
large holdings of U.S. securities, including U.S. public debt, as leverage against U.S.
policies it opposes. For example, various Chinese government officials are reported
to have suggested that China could dump (or threaten to dump) a large share of its
holdings to prevent the United States from implementing trade sanctions against
China’s currency policy. Other Chinese officials have reportedly stated that China
should diversify its investments of its foreign exchange reserves away from dollar-
denominated assets to those that offer higher rates of returns.
A gradual decline in China’s holdings of U.S. assets would not be expected to
have a negative impact on the U.S. economy (since it be matched by increased U.S.
exports and a lower trade deficit). However, some economists contend that attempts
by China to unload a large share of its holdings U.S. securities holdings could have
a significant negative impact on the U.S. economy (at least in the short run),
especially if such a move sparked a sharp depreciation of the dollar in international
markets and induced other foreign investors to sell off their U.S. holdings as well.
In order to keep or attract that investment back, U.S. interest rates would rise, which
would dampen U.S. economic growth, all else equal. Other economists counter that
it would not be in China’s economic interest to suddenly sell off its U.S. investment
holdings. Doing so could lead to financial losses for the Chinese government, and
any shocks to the U.S. economy caused by this action could ultimately hurt China’s
economy as well.
The issue of China’s large holdings of U.S. securities is part of a larger debate
among economists over how long the high U.S. reliance on foreign investment can
be sustained, to what extent that reliance poses risks to the economy, and how to
evaluate the costs associated with borrowing versus the benefits that would accrue
to the economy from that practice. This report will be updated as events warrant.
Contents
China’s Foreign Exchange Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
China’s Holdings of U.S. Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
China’s Ownership of U.S. Treasury Securities . . . . . . . . . . . . . . . . . . . . . . 6
U.S. Concerns Over China’s Large Holdings of U.S. Securities . . . . . . . . . . . . . . 7
What If China Reduces its Holdings of U.S. Securities? . . . . . . . . . . . . . . . . . . . . 9
Concluding Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
List of Figures
Figure 1. Breakdown of China’s Holdings of U.S. Securities as of June 2006 . . 6
List of Tables
Table 1. China’s Foreign Exchange Reserves: 2001-2006 and
Estimates for 2007 and 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Table 2. Top 5 Holders of Foreign Exchange Reserves and
Changes to Holdings From December 2006-September 2007 . . . . . . . . . . . . 3
Table 3. Top Five Foreign Holders of U.S. Securities as of June 2006 . . . . . . . . 5
Table 4. Major Foreign Holders of U.S. Treasury Securities:
March 2007 and October 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
China’s Holdings of U.S. Securities:
Implications for the U.S. Economy
Because of its low savings rate, the United States borrows to finance the federal
budget deficit and its capital needs in order to enjoy healthy economic growth. It
therefore depends on countries with high savings rates, such as China, to invest some
of its capital in the United States.
China’s central bank is a major purchaser of U.S. assets, largely because of its
exchange rate policy. In order to mitigate the yuan’s appreciation against the dollar,
China’s central bank must purchase U.S. dollars.1 This has led China to amass a
significant level of foreign exchange reserves (FER); these totaled $1.4 trillion as of
September 2007. Rather than hold dollars, which earn no interest, the Chinese
central government has converted some level of its FER holdings into financial
securities. Since foreign exchange holdings facilitate trade and prevent speculation
against their currency, the central bank also holds securities from other foreign
countries. The United States is a major destination of China’s overseas investment.
China is the second largest holder of U.S. securities, which include U.S. Treasury
securities that are used to finance the federal budget deficit. Some U.S. policymakers
have expressed concern that China’s large holdings of U.S. securities may pose a risk
to the U.S. economy should China stop purchasing those securities or attempt to
divest itself of a large share of its holdings. In addition, China’s FER are expected
to continue to grow rapidly in the near future, potentially continuing (and possibly
increasing) China’s role as a major buyer of U.S. securities.
This report examines the importance to the U.S. economy of China’s investment
in U.S. securities, as well as U.S. concerns over the possibility that China might
unload a large share of those holdings, the likelihood that this would occur, and the
potential implications such action could have for the U.S. economy. The report
concludes that a large sell-off of Chinese Treasury securities holdings could
negatively affect the U.S. economy, at least in the short-run. As a result, such a move
could diminish U.S. demand for Chinese products and thus could lower China’s
economic growth as well. The issue of China’s large holdings of U.S. securities is
part of a broader question that has been raised by many economists: What are the
implications of the heavy U.S. reliance on foreign investment to maintain healthy
economic growth and to finance the budget deficit?
1 China’s accumulation of foreign exchange reserves has also occurred because of large
annual current account trade surpluses, high levels of foreign direct investment in China,
and inflows of “hot money” from overseas investors who anticipate that the Chinese
government will appreciate the yuan in the near future. For additional information, see CRS
Report RL32165, China’s Currency: Economic Issues and Options for U.S. Trade Policy,
by Wayne M. Morrison and Marc Labonte.
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China’s Foreign Exchange Reserves
As indicated in Table 1, China’s foreign exchange reserves have increased
sharply in recent years, both in absolute terms and as a percent of gross domestic
product (GDP). Those reserves rose from $216 billion in 2001 to nearly $1,069
billion in 2006.2 China’s reserves as a percent of GDP grew from 18.1% in 2001 to
38.6% in 2006. According to Global Insight, China’s FER may have hit $1,540
billion in December 2007, which would equal about 47.3% of China’s estimated
GDP in 2007. By year-end 2010, China’s FER are projected to reach $1,865 billion.3
Table 1. China’s Foreign Exchange Reserves: 2001-2006 and
Estimates for 2007 and 2010
Year
Billions of U.S. Dollars
As a % of Chinese GDP
2001
215.6
18.1
2002
291.1
22.1
2003
403.3
28.1
2004
609.9
31.5
2005
818.9
35.5
2006
1,068.5
38.6
September 2007
1,433.6
N/A
Projection for 2007
1,539.9
47.3
Projection for 2010
1,865.0
32.1
Source for actual data: International Monetary Fund (IMF) and People’s Bank of China.
Source for 2007 and 2010 projections: Global Insight, Country Intelligence, China,
October 2007.
Note: Year-end or month-end values.
A listing of the world’s top five holders of FER at the end of September 2007
is shown in Table 2. Not only was China the world’s largest FER holder, its reserves
grew much faster than those of any other country from December 2006-September
2007; these rose by $365 billion, hitting $1,434 billion (as of September 2007).
China overtook Japan in 2006 to become the world’s largest holder of FER, and
China’s reserves were 55.4% larger than Japan’s reserves as of September 2007.
According to the IMF, as of June 2007, China accounted for 23.3% of the world’s
FER.4
2 All data on foreign exchange reserves are year-end unless otherwise specified.
3 Global Insight, Country Intelligence: China, October 2007.
4 Total reserves for all countries were $5,710 billion and China’s reserves were $1,333
billion. Worldwide, 43% of reserves were held in dollar-denominated assets. Source: IMF,
International Financial Statistics, November 2007; and IMF Currency Composition of
(continued...)
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Table 2. Top 5 Holders of Foreign Exchange Reserves and
Changes to Holdings From December 2006-September 2007
Country
Reserves (billions of U.S. dollars)
December
September
Dollar Change: December
2006
2007
2006 to September 2007
China
1,068.5
1,433.6
+365.1
Japan
879.7
922.5
+42.8
Russian Federation
295.6
310.0
+14.4
Taiwan
266.1
262.9
-3.2
South Korea
238.9
257.2
+18.3
Sources: EIU Database and IMF, International Financial Statistics.
Note: Ranked according to total holdings as of September 2007.
China’s Holdings of U.S. Securities5
China’s central bank is a major purchaser of U.S. financial securities because
of its exchange rate policy. In order to mitigate the yuan’s appreciation against the
dollar, the central bank must purchase dollars. Rather than hold dollars, which earn
no interest, the Chinese central government has converted some level of its foreign
exchange holdings into financial securities. Since foreign exchange holdings
facilitate trade and prevent speculation against their currency, the central bank also
holds securities from other foreign countries.
There are no official estimates of what share of China’s foreign reserves are held
in dollar-denominated assets (assets that were bought with dollars and are cashed in
dollars), but the Treasury Department conducts an annual survey of foreign portfolio
holdings of U.S. securities by country, and reports data for the previous year as of the
end of June.6 The report does not distinguish between government and private
holdings of U.S. securities. U.S. securities include long-term (LT) U.S. Treasury
4 (...continued)
Official Foreign Exchange Reserves (COFER), September 28, 2007.
5 For additional information on foreign ownership of U.S. securities, see CRS Report
RL32462, Foreign Investment in U.S. Securities, by James K. Jackson.
6 Note, Treasury’s annual survey does not include data on foreign direct investment (FDI)
in the United States, which measures foreign ownership or investment in U.S. businesses.
China’s total FDI in the U.S. at the end of 2006 was $554 million (on a historical cost basis),
according the U.S. Bureau of Economic Analysis. Since these types of assets cannot be
liquidated rapidly, they are not included in this report.
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securities, LT U.S. government agency securities,7 LT corporate securities (some of
which are asset-backed), equities (such as stocks), and short term debt.8 According
to the latest Treasury survey (released in May 2007), China’s total holdings of U.S.
securities at the end of June 2006 were $699 billion.9 From June 2005 to June 2006,
China’s U.S. securities holdings increased by $172 billion, a far larger amount than
any other country, and China’s holdings more than doubled from June 2004 to June
2006.10
As indicated in Table 3, China was the second largest foreign holder of U.S.
securities, after Japan. China’s main holdings were in LT Treasury securities and LT
government agency securities (see Figure 1).11 This likely indicates that a large share
of China’s holdings of U.S. securities are controlled by the Chinese government and
that it has been pursuing a relatively low-risk investment strategy.12 China’s holdings
of LT U.S. securities (excluding short term debt) accounted for 9.0% of total foreign
holdings of LT U.S. securities as of June 2006. In terms of total (domestic and
foreign) holdings of all U.S. LT securities ($42.8 trillion), China’s share was 1.6%.
7 Agency securities include both federal agencies and government-sponsored enterprises
created by Congress (e.g., Fannie Mae and Freddie Mac) to provide credit to key sectors of
the economy. Some of these securities are backed by assets (such as home mortgages).
8 LT securities are those with no stated maturity date (such as equities) or with an original
term to maturity date of more than one year. Short-term debt includes U.S. Treasury
securities, agency securities, and corporate securities with a maturity date of less than one
year.
9 Data on China’s holdings of U.S. securities exclude holdings by Hong Kong ($110.1
billion) and Macao ($1.4 billion), which are reported separately by Treasury.
10 U.S. Treasury, Report on Foreign Portfolio Holdings of U.S. Securities as of June 30,
2006, May 2007, p. 9.
11 China was the largest foreign holder of LT U.S. agency securities, accounting for 54% of
total foreign holdings of these type of securities.
12 It is not clear, however, to what extent these investments have gone into U.S. sub-prime
mortgage securities, but they may be extensive. For example, the Bank of China reported
in October 2007 that it held $7.5 billion in sub-prime U.S. asset backed securities as of
September 2007. As of June 2006, China held $15 billion in corporate asset backed
securities; if China held any sub-prime mortgage backed securities, they would likely be
included in this category.
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Table 3. Top Five Foreign Holders of U.S. Securities as of June
2006
($ billions)
LT
LT
LT
Short
Total
Government
Equity
Treasury
Corporate
Term
Agency
Japan
1,106
535
184
108
195
85
China
699
364
255
59
4
17
United
640
47
28
249
300
16
Kingdom
Luxembourg
549
52
38
233
193
32
Cayman
485
19
50
111
178
31
Islands
World Total
7,778
1,727
473
2,021
2,430
615
China’s
Holdings as a
% of World
Total
9.0%
21.1%
53.9%
2.9%
0.2%
2.8%
Source: U.S. Treasury Department, Report on Foreign Portfolio Holdings of U.S. Securities as of
June 30, 2006, May 2007, p. 8.
Note: LT securities are those with no stated maturity date (such as equities) or with an original term
to maturity date of more than one year. Short term securities have a maturity period of less than one
year.
Although the Chinese government does not make public the dollar composition
of its foreign exchange holdings, many analysts and the Chinese media estimate this
level to be around 70%.13 If this estimate is correct, it implies that China’s holdings
of U.S. securities may have reached $1 trillion as of September 2007.
13 See testimony of Brad Setser, Senior Economist, Roubini Global Economics and Research
Associate, Global Economic Governance Programme, University College, Oxford, before
the House Budget Committee, Foreign Holdings of U.S. Debt: Is our Economy Vulnerable?,
June 26, 2007, p. 11. In addition, the People’s Daily Online (August 28, 2006) estimated
China’s dollar holdings to total FER at 70%. A rough estimate can be made by taking the
value of China’s holdings of U.S. securities ($699 billion at the end of June 2006) and
dividing it by China’s foreign exchange reserves ($941 billion at the end of June 2006).
Using these data, China’s foreign exchange reserves in dollar asset holdings at most would
be 74.3% as of June 2006. Some analysts note that China’s official FER data exclude $66
billion in FER that have been used to recapitalize state banks and insurance companies. If
this figure is factored in, China’s FER in dollar holdings would equal 69.4%.
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Figure 1. Breakdown of China’s Holdings of U.S.
Securities as of June 2006
Source: U.S. Treasury Department.
Note: LT stands for long-term debt.
China’s Ownership of U.S. Treasury Securities14
U.S. Treasury securities are the main vehicle the U.S. government uses to
finance the federal debt, which totaled $9 trillion as of September 2007. Of this
amount, 53% was held by U.S. government trust funds and 47% was privately held.
Of the total level of privately-held U.S. Treasury securities ($4.3 trillion), foreigners
owned 52.6% of the total.15 China’s holdings as a share of total private holdings
(including foreign governments and citizens) of U.S. Treasury securities were 9.3%.16
Over the past few years, China has become a major purchaser of Treasury
securities. From December 2001 to December 2006, China’s share of total foreign
holdings of U.S. Treasury securities rose from 7.6% to 18.8%. As of October 2007,
it had the second largest foreign holdings of such securities, after Japan.
14 For a general discussion of foreign ownership of U.S. debt, see CRS Report RS22331,
Foreign Holdings of Federal Debt, by Justin Murray and Marc Labonte.
15 U.S. Treasury Department, Financial Management Service, Ownership of Federal
Securities, available at [http://www.fms.treas.gov/bulletin/index.html].
16 Although yields on U.S. Treasury securities are relatively low compared to other types of
investment, they are also considered to be relatively low in risk. Thus they are viewed by
many central banks to be a safe investment for their FER.
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As indicated in Table 4, China’s Treasury holdings peaked at $421.1 billion in
March 2007, but have since declined to $388.1 billion (a 7.8% drop) as of October
2007. China’s holdings of U.S. Treasuries as a share of total foreign holdings has
declined to 16.8%.17 Japan’s holdings over this period decreased as well, but the
holdings of the United Kingdom, major oil exporters, and Brazil increased. As a
result, total foreign holdings of U.S. Treasury Securities increased by $103.0 billion
over this period.18
Table 4. Major Foreign Holders of U.S. Treasury Securities:
March 2007 and October 2007
($ billions)
Holdings as a
March-October
Share of Total
March
October
2007 Change in
Foreign
2007
2007
the Value of its
Holdings as of
Holdings
October 2007
(%)
Japan
611.2
591.8
-19.4
25.6
China
421.1
388.1
-33.0
16.8
United Kingdom
148.8
296.5
147.7
12.8
Oil Exporters*
112.3
130.3
18.0
5.6
Brazil
69.7
112.8
43.1
4.9
Total Foreign
Holdings
2,206.5
2,309.5
103.0
—
Source: Department of Treasury, Major Foreign Holders of Treasury Securities Holdings, December
17, 2007.
*Oil exporters include Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar,
Saudi Arabia, the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria.
U.S. Concerns Over China’s Large Holdings of
U.S. Securities
Some U.S. policymakers have expressed concern over China’s large holdings
of U.S. securities, including Treasury securities, contending that China could use it
as a political tool against the United States. To illustrate, an August 7, 2007 article
17 It is still too early to tell whether or not the recent decline in China’s holdings of U.S.
Treasury securities is an indicator that China plans to gradually reduce a large share of its
Treasury holdings in favor of other types of investment.
18 Department of Treasury, Major Foreign Holders of Treasury Securities Holdings,
December 16, 2007, available at [http://www.treasury.gov/tic/mfh.txt].
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in the Telegraph (an online British newspaper) cited interviews with officials from
two leading Chinese government think tanks who reportedly stated that China had
the power to make the dollar collapse (if it chose to do so) by liquidating large
portions of its U.S. Treasury securities holdings if the United States imposed trade
sanctions to force a yuan revaluation, and that the threat to do so could be used as a
“bargaining chip.”19 The article prompted concern among many U.S. policymakers,
including Senator Chuck Grassley, who, in an August 9, 2007 letter to the Chinese
ambassador to the United States (Zhou Wenzhong), called the comments
“dangerous” and a factor in why the United States “is right to be concerned with
China’s currency practices.” The letter asked the Chinese government to confirm
that “the comments do not reflect the official position of the Chinese government.”20
In response, the Chinese ambassador wrote to Senator Grassley on August 13, 2007,
that “China does not have a plan to drastically adjust the structure of its foreign
reserves.”21 In addition, China’s Xinhua News Agency on August 13, 2007, quoted
an unnamed official at the People’s Bank of China as stating that “dollar-
denominated assets, including U.S. government securities, are an important
component in China’s foreign exchange reserve investment portfolio,” and that China
was “a responsible investor.”
Numerous reports have appeared in the media citing various Chinese officials
who claim or hint at government plans to reduce its holdings of U.S. Treasury
securities for economic reasons. For example, on September 29, 2007, the Chinese
government officially launched the state-owned China Investment Corporation,
which Chinese officials state was created to better manage its foreign exchange
reserves. It reportedly will initially manage over $200 billion of China’s reserves,
making it one of the world’s largest sovereign wealth funds. Some contend the
creation of this entity could signal Chinese plans to diversify away from relatively
low-yielding assets, such as Treasury securities, and perhaps dollar denominated
assets in general.22 On November 7, 2007, Cheng Siwei, the vice chairman of the
Chinese National People’s Congress, reportedly made remarks that the Chinese
government “will favor stronger currencies over weaker ones, and will readjust
accordingly.” The media claimed that his remarks were a major factor in sparking a
sharp decline of the dollar against the euro in international currency markets that
day.23 However, on November 14, 2007, Yi Gang, assistant governor of the People’s
Bank of China, was quoted as saying that “the U.S. dollar is the main currency in our
19 The Telegraph, China Threatens ‘Nuclear Option’ of Dollar Sales, August 7, 2007.
20 See text of letter at [http://grassley.senate.gov/public/].
21 Letter reprinted in Inside U.S. Trade, August 13, 2007.
22 Others are concerned that China will attempt to use the fund to purchase major U.S.
companies. See the New Yorker, Sovereign Wealth World, November 26, 2007. According
to the article, “were China’s fund so inclined, it could buy Ford, G.M., Volkswagen, and
Honda, and still have a little money left over for ice cream.”
23 Bloomberg News, November 8, 2007.
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reserves and that policy remains very firm,” and said that statements by other
officials to the contrary were “opinions.”24
What If China Reduces its Holdings of U.S.
Securities?25
As the previous data illustrate, China has accumulated large holdings of U.S.
assets in recent years. These accumulations are the result of U.S. borrowing to
finance its large trade deficit with China (the gap between U.S. exports and Chinese
imports). All else equal, Chinese government purchases of U.S. assets increases the
demand for U.S. assets, which reduces U.S. interest rates.
If China attempted to reduce its holdings of U.S. securities, they would be sold
to other investors (foreign and domestic), who would presumably require higher
interest rates than those prevailing today to be enticed to buy them. One analyst
estimates that a Chinese move away from long-term U.S. securities could raise
interest rates by as much as 50 basis points.26 Higher interest rates would cause a
decline in investment spending and other interest-sensitive spending. All else equal,
the reduction in Chinese Treasury holdings would cause the overall foreign demand
for U.S. assets to fall, and this would cause the dollar to depreciate. If the value of
the dollar depreciated, the trade deficit would decline, as the price of U.S. exports fell
abroad and the price of imports rose in the United States.27 The magnitude of these
effects would depend on how many U.S. securities China sold; modest reductions
would have negligible effects on the economy given the vastness of U.S. financial
markets. For example, Japan gradually reduced its Treasury holdings from $699.4
billion to $582.2 billion from August 2004 to September 2007, a decline of $117.2
billion. This shift appears to have had little noticeable impact on the U.S. economy.
Since China held $699 billion of U.S. assets as of June 2006, any reduction in
its U.S. holdings could potentially be large. If there were a large reduction in its
holdings, the effect on the U.S. economy would still depend on whether the reduction
24 China Daily, November 15, 2007.
25 From the perspective of the macroeconomic effects on U.S. investment, interest rates, and
so on, it does not matter what type of U.S. security is purchased when foreign capital flows
to the United States. Thus, Chinese purchases of all types of U.S. securities (not just
Treasury securities) should be considered when attempting to understand the impact China’s
investment decisions have on the U.S. economy.
26 Testimony of Brad Setser before the House Budget Committee, Foreign Holdings of U.S.
Debt: Is our Economy Vulnerable?, June 26, 2007. Brad Setser is Senior Economist,
Roubini Global Economics, and Research Associate, Global Economic Governance
Programme, University College, Oxford. Setser does not detail how much U.S. debt he
assumes China would sell to reach his estimate.
27 The extent that the dollar declined and U.S. interest rates rose would depend on how
willing other foreigners were to supplant China’s reduction in capital inflows. A greater
willingness would lead to less dollar depreciation and less of an increase in interest rates,
and vice versa.
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were gradual or sudden. It should be emphasized that economic theory suggests that
a slow decline in the trade deficit and dollar would not be troublesome for the overall
economy. In fact, a slow decline could even have an expansionary effect on the
economy, if the decrease in the trade deficit had a more stimulative effect on
aggregate demand in the short run than the decrease in investment and other interest-
sensitive spending resulting from higher interest rates. Historical experience seems
to bear this out — the dollar declined by about 40% in real terms and the trade deficit
declined continually in the late 1980s, from 2.8% of GDP in 1986 to nearly zero
during the early 1990s. Yet economic growth was strong throughout the late 1980s.
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. The dollar depreciation
would not cause a recession since it would ultimately lead to a trade surplus (or
smaller deficit), which expands aggregate demand.28 (Empirical evidence suggests
that the full effects of a change in the exchange rate on traded goods takes time, so
the dollar may have to “overshoot” its eventual depreciation level in order to achieve
a significant adjustment in trade flows in the short run.)29 However, a sudden
increase in interest rates could swamp the trade effects and cause a recession. Large
increases in interest rates could cause problems for the U.S. economy, as these
increases reduce the market value of debt securities, cause prices on the stock market
to fall, undermine efficient financial intermediation, and jeopardize the solvency of
various debtors and creditors. Resources may not be able to shift quickly enough
from interest-sensitive sectors to export sectors to make this transition fluid. The
Federal Reserve could mitigate the interest rate spike by reducing short-term interest
rates, although this reduction would influence long-term rates only indirectly, and
could worsen the dollar depreciation and increase inflation.
Some U.S. officials have expressed doubts that a Chinese sell-off of U.S.
securities would cause liquidity problems or have much of an impact on the U.S.
economy. In January 2007, Secretary of Treasury Henry Paulson was asked at a
Senate Banking Committee hearing whether or not he was concerned over China’s
large ownership of U.S. debt. Paulson stated that the daily volume of trade in
Treasury securities was larger than China’s total Treasury securities holdings and
concluded: “given the size of our debt outstanding and the way it trades and the
28 A sharp decline in the value of the dollar would also reduce living standards, all else
equal, because it would raise the price of imports to households. This effect, which is
referred to as a decline in the terms of trade, would not be recorded directly in GDP,
however.
29 Since the decline in the dollar would raise import prices, this could temporarily increase
inflationary pressures. The effect would likely be modest, however, since imports are small
as a share of GDP and import prices would only gradually rise in response to the fall in the
dollar.
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diversity and so on, that’s not at the top of the list.”30 According to the Treasury
Department, gross foreign purchases and sales of U.S. marketable Treasury bonds
and notes in 2006 were $11.0 trillion and $10.8 trillion, respectively.31 In addition,
the average daily trading volume by primary dealers of all U.S. Treasury securities
sold in the U.S. in 2006 was $524 billion.32
In March 2007, Federal Reserve Chairman Ben Bernanke reportedly stated in
a letter to Senator Shelby that “because foreign holdings of U.S. Treasury securities
represent only a small part of total U.S. credit market debt outstanding, U.S. credit
markets should be able to absorb without great difficulty any shift of foreign
allocations.” He also reportedly stated that “even if such a shift were to put
undesired upward pressure on U.S. interest rates, the Federal Reserve has the
capacity to operate in domestic money markets to maintain interest rates at a level
consistent with our economic goals.”33
The likelihood that China would suddenly reduce its holdings of U.S. securities
is questionable because it is unlikely that doing so would be in China’s economic
interests. First, a large sell-off of China’s U.S. holdings could diminish the value of
these securities in international markets, which would lead to large losses on the sale,
and would, in turn, decrease the value of China’s remaining dollar-denominated
assets. This would also occur if the value of the dollar were greatly diminished in
international currency markets due to China’s sell-off.34
Second, such a move would diminish U.S. demand for Chinese imports, either
through a rise in the value of the yuan against the dollar or a reduction in U.S.
economic growth (especially if other foreign investors sold their U.S. asset holdings,
and the United States was forced to raise interest rates in response).35 The United
States purchases about 30% of China’s total merchandise exports. A sharp reduction
of U.S. imports from China could have a significant impact on China’s economy,
30 Congressional Transcripts, Congressional Hearings, Senate Banking, Housing and Urban
Affairs Committee, Hearing on U.S.-China Strategic Economic Dialogue, January 31,
2007.
31 These figures include purchases of newly issued securities, as well as transactions
executed in the United States (buying, selling, and redeeming) of outstanding long-term U.S.
Treasury securities (excluding nonmarketable Treasury bonds), as reported by banks,
securities brokers and dealers, and other entities in the United States. See Treasury
Department, Financial Management tables on capital movements at
[http://www.fms.treasury.gov/].
32 Source: Securities Industry and Financial Services Association.
33 Reuters, Bernanke-China Holdings of US Debt Not Problematic, March 26, 2007.
34 Selling off U.S. dollar assets could cause the yuan to appreciate against the dollar, which
would lower the value of remaining U.S. assets since the assets are dollar-denominated.
35 In addition, if a “dollar collapse” occurred, U.S. imports from other major trade partners
would decline, which could slow their economies. This in turn could weaken their demand
for Chinese products.
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which heavily depends on exports for its economic growth (and is viewed by the
government as a vital source of political stability).36
Finally, any major action by the Chinese government that destabilized the U.S.
economy (whether deliberate or not) could provoke “protectionist” sentiment in the
United States, and could lead to the enactment of new legislation that takes a harder
line against Chinese economic policies deemed to be unfair (such as its currency
policy). Since a downturn in the U.S. economy would hit other countries as well,
Chinese actions that destabilized the U.S. economy could diminish China’s standing
as a “responsible stakeholder” in the global economy.
Concluding Observations
Many economists argue that concerns over China’s holdings of U.S. securities
represent part of a broader problem for the U.S. economy, namely its dependence on
foreign saving to finance its investment needs and federal budget deficits.37 The large
U.S. current account deficit (the manifestation of the high U.S. saving/investment
gap) cannot be sustained indefinitely because the U.S. net foreign debt cannot rise
faster than GDP indefinitely.38 Some economists argue that at some point foreign
investors may view the growing level of U.S. foreign debt as unsustainable or more
risky, or they may no longer view U.S. securities as offering the best return on their
investment, and shift investment funds away from U.S. assets, thus forcing U.S.
interest rates to rise to attract needed foreign capital. This would result in higher
interest rates and lower investment rates, all else equal, which would reduce long-
term growth.39 Other economists contend that, although the low U.S. savings rate is
a problem, the U.S. current account deficit and high levels of foreign capital flows
to the United States are also reflections of the strength of the U.S. economy and its
36 Although a falling dollar may harm China’s short-term growth via reduced Chinese
exports (and export sector-related employment), it would also improve China’s terms of
trade with the United States, raising China’s overall consumption since it could now spend
less to acquire the same amount of American goods (which would also create jobs in other
sectors of the economy because of increased consumer purchasing power).
37 Nations (such as the United States) that fail to save enough to meet their investment needs
must obtain savings from other countries with high savings rates (such as China). By
obtaining resources from foreign investors for its investment needs, the United States is able
to enjoy a higher rate of consumption than it would if investment were funded by domestic
savings alone. The inflow of foreign capital to the United States is equivalent to the United
States borrowing from the rest of the world. The only way the United States can borrow
from the rest of the world is by importing more than it exports, which produces a trade (and
current account) deficit.
38 The current account deficit rose from $389.4 billion in 2002 to $811.5 billion in 2006, and
as a percent of GDP, it increased from 4.4% to 6.1%, respectively.
39 See CRS Report RL33186, Is the U.S. Current Account Deficit Sustainable?, by Marc
Labonte.
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attractiveness as a destination for foreign investment, and therefore discount the
likelihood that foreign investors will suddenly shift their capital elsewhere.40
The United States continues to press China to make its currency policy more
flexible so that the yuan will appreciate more significantly against the dollar and to
adopt policies that promote domestic consumption as a major source of China’s
economic growth (as opposed to export and fixed investment-led growth that has
resulted from China’s currency policy). This is viewed as a major step towards
reducing global trade imbalances, including the large U.S.-China trade imbalance.
However, in order for that to occur, the United States must also boost its level of
savings. 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 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.
40 See Council of Economic Advisors, Economic Report of the President, The U.S. Capital
Surplus, February 2006, p. 144.