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R.MPCIR.T
TO CSiVGRESS
Assessment of the National seeurity Risl<s
Fosed fo ttrre united States as a Result of the
U.S. Fedenal llebt Owed to China as a
Creditor of the [J.S" Governmemt
Office of the Secretary of Defense
IuIy 2012
Preparation of this reporUstudy cost
the Department of Defense a total of
approximately $4,500 for the 2012
Fiscal YearGenerated on 2012Jun06 1725 ReflD: 5B3A274F
The Conference Report accompanying the National Defense Authorization Act for Fiscal year
2012 (House Report lI2-329,pages 742-3) requests that the Secretary of Defense "provide an
assessment of the national security risks posed to the United States as a result of the United
States federal debt owed to China as a creditor of the United States Government and the
implications of that debt for the United States military. The assessment shall include a
description of the United States federal debt liabilities owed to China as a cred.itor of the United
States and a discussion of any options available to China for detening United States military
freedom of action in the westem Pacific as a result of this debt.,'
U.S. FEDERAL DEBT LIABILITIES OWED TO CHINA AS A CREDITOR OF THE
UNITED STATES
The Treasury International Capital System repofis data on foreign holdings of U.S. Treasury
securities. At the end of March2012, total foreign holdings of U.S. Treasury securities Uy bnina
were $1.170 trillion, or 7.5 percent of total pubiic debt. All but $3.9 billion tf Chiou', holdings
were long-term (maturing in more than a year),
WHY DOES CHINA HOLD U.S. TREASURY SECURITIES?
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Available in quantity in both domestic and international financial markets, IJ.S. Treasury bills,
notes, and bonds (henceforth "Treasudes") are the prefened instruments for many large-scale
sovereign and private investors seeking a safe and Iiquid harbor for their holdings. As such, U.S.
Treasuries are an attractive investment vehicle for China, which has significant foreign exchange
holdings.
Over the past decade, China has consistently run substantial net trade and cunent income
sutpluses with the rest of the world, and also has typically been the recipient of large net capital
inflows, such as from foreign direct investment. At the same time, China has closely managed
the value of its exchange rate against the U.S. dol1ar, including pegging the value of its cunincy
against the dollar rurtil July 2005, and again from mid-2008 until June 2010. When firms,
institutions, and individuals in China exchange their foreign curency, such as U.S. dollars, for
Chinese cuffency (the "renminbi," or RMB), this demand for RMB creates market pressure for
the value of the RMB to rise. As a result, the net inflows of foreign currency into China's
economy from its trade and capital surpluses with the rest of the world put market pressure on
China's exchange rate for its currency to appreciate.
Llnder these circumstances, if China wants to limit the RMB's appreciation against the U.S.
dollar, the People's Bank of China (PBOC), China's central bank, must intervene in the currency
market in China and be willing to purchase U.S. dollars in whatever amounts necessary to keep
the RMB from rising beyond what the PBOC and the Chinese Government are willingto accept.
Due to this foreign exchange market intervention, much of the large net inflow of U.S, dollars
and other foreign exchange into China over the past decade has been absorbed by the PBOC,
becoming part of China's official foreign exchange reserr/es. As a result, the PBOC's official
foreign exchange resewes totaled more than $3.3 trillion as of the end of March 2012. If
Chinese authorities were to try to sell their holdings of foreign exchange resewes in any quantity,
the immediate consequence would be a substantial appreciation of the RMB, as demand for
RIVIB would exceed the available supply. Thus, China cannot reduce its holdings of foreign
exchange reseryes without giving up its objective of limiting RMB appreciation, a policy ihe
United States has long urged China to abandon.
Like other central banks, the PBOC, in order to eam at least a modest retum as well as
preserving the real value of principie, invests in a variety of assets, including U.S. Treasuries,
rather than simply hold reserves as cash. China's other investment options could include
altematives such as converling its dollars into other currencies and purchasing securities in that
currency, investing in asset-backed securities or equity markets, or purchasing physical assets
such as gold. These other investments may attimes offer higher retums, but also carry gteater
risk than U,S. Treasuries, so China, like other large reserve managers, likely has chosen to
include a heavy weight on safe, liquid and stable assets such as U.S. Treasuries as the core of a
diversified mix of assets.
OPTIONS AVAILABLE TO CHINA
Occasional commentary reported in China's media advocates selling U.S. Treasury securities in
response to lJ,S, policies with which China disagrees. In a February 8, 2010 interview published
'."-"'"in"-Uu1[otit Wb-eftiy""milgarti€;-a-efir"no6o'lengue"ge'Fu'blieation'of-eh'ina'sotTiCief'Xififiud'news
agency, People's Liberation Army academic advisors Major General Luo Yuan, Major General
Zhu Chenghu and Senior Colonel Ke Chun.riao called on China to "dump" U.S. Treasuries as
punishment for the Obama Administration's notification to Congress that it would provide a
package of arms to Taiwan. Mr. Ding Gang, a senior editor with China's People's Daily, wrote
in an editorial in August 2011 that China should directly link the amount of U.S. Treasury
hcldings with U.S. arms sales to Taiwan, stating that "now is the time for China to use its
'financial weapcn' to teach the United States a lesson if it moves forward with a plan to sale (sic)
arms to Taiwan,"
There is no evidence that Chinese authorities have acted on these recommendations; on the
contrary, China has continued purchasing large quantities of U.S. Treasury securities. Officials at
China's State Administration of Foreign Exchange (SAFE), which manages China's ofhcial
foreign exchange reserves, have repeatedly stated that they base the operation and management
of foreign exchange reserves on the principies of safety, liquidity, and potential revenue.l '\)Ve
have no indication that, over the last two decades, China has changed materially its holdings of
international reserves in response to stress in the U.S.-China relationship.
The market for U.S. Treasuries is the deepest and most iiquid in the world. It maintains a diverse
pool of investors, both domestic and foreign, and is not dependent on any single investor.
China's holdings of U,S. Treasury securities at the end of March 20L2were 11 percent of federal
debt held by the public, 7.5 percent of total public debt, and only slightly more than2 percent of
total U.S. credit market debt estimated by the Federal Reserve's Flou' of Funds data. As these
figures indicate, the ability of China to affect the market for Il.S. Treasuries, and U.S. financial
markets more broadly, is limited.
1
See
for example, http://usa.chinadaily.com.cn/business/2012-03/12lcontent
14813810.htn
Should China decide to reduce its holdings of U.S. Treasuries suddenly and significantly, this
could cause short-term disruptions in the secondary market, and lead to an inciease in the interest
rate required by the market for debt issued by the Treasury Department. This dramatic option,
howevet, also would impose significant costs on China. By abruptly attempting to sell o?f 1*g.
quantities of I.I.S. Treasuries, China would dramatically increase the supply of U.S. Treasuries on
the secondary market, and the value of U.S. Treasuries on the secondary market could fall
sharply. If this occutred, China's own holdings of U.S. Treasuries would fall in value, causing
direct financial losses for China. In addition, if it determined it necessary to achieve its inflation
and employment mandates, the Federal Reserve is fully capable of purchasing U.S. Treaswies
dumped on the market by China, reducing the economic impact to the United States, Finally, as
well as undermining the value of its own holdings, a policy decision by China to reduce suddenly
and significantly its holdings of U,S, Treasuries would fundamentally change the international
finance and business community's perception of China as a reliable and respected economic and
financiai partner.
Aside from the aggressive option of a large-scale sell-off China has other options that are less
provocative and would have even less effect on the United States, but are equally problematic for
China itself. China could annource a decision not to purchase U.S. securities in the future,
which could result in some mild upward pressure on interest rates for new issuances of U.S.
adapt quickly, and it would not affect the U,S, Treasury's ability to issue debt, The reputational
ccst to China for pursuing this type of antagonistic economic approach to one of its major trading
partners could also he significant.
Even if Chinawere to choose to sell off existing holdings or renounco future purchases of U.S.
Treasuries, it would face the difficult predicament of finding alternate investments in which to
put the doliars accumulated from its currency intervention in the context of significant trade and
capital surpluses. China could attempt to diversi$i holdings significantly into a basket of
developed aountry debt, but no other market offers the same levels of depth, liquidity, and safety
as the market for U.S. Treasuries. Investing in developing country debt offers the potential of
higher teturns, but al much higher risk with very limited liquidity and volume. Ultimately, China
has few attractive options for investing the bulk of its large foreign exchange holdings outside of
U. S. Treasury securities.
ASSESSMENT OF'NATIONAL SECURITY RISKS POSED TO THE UNITED STATES
As described above, attempting to use U.S. Treasury securities as a coercive tool would have
limited effect and likely would do more harm to China than to the United States. As the threat is
not credible and the effect would be limited even if carried out, it does not offer China deterrence
options, whether in the diplomatic, military, or economic realms, and this would remain true both
in peacetime and in scenarios of crisis or war. Moreover, in times of military crisis or war, the
threshold for what might deter the United States also rises.
During his confirmation hearing in May 2011 before the Senate Foreign Relations Committee to
become U.S. Ambassador to China, Gary Locke, in response to a question on the issue, stated
that China's holdings of U.S. Treasurl' securities did not
policy."
"in any way influence U.S, foreign