Congressional Research Service, “China’s Holdings of U.S. Securities: Implications for the U.S. Economy,” January 9, 2008

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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.

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