What are the stakes in the U.S.-China tussle over yuan?

Theoretically, the cost of Chinese-made products would rise for consumers around the world. If prices rise sufficiently, other countries' goods might be substituted for those China now makes. Some in the United States hope that domestic firms that now say they cannot compete might decide that they can boost their share of export markets, in turn cranking up production and hiring. If Chinese consumers were empowered with a stronger currency, they might become more aggressive importers, perhaps even swinging China's trade surplus to deficit.

In practice, though, the yuan's 21 percent rise from 2005-2008 barely registered on the price tags of Chinese goods abroad, as buyers — often foreign firms like Wal-Mart — demanded that costs be kept down and their suppliers were able to oblige, thanks in part to productivity gains.

Economists often describe China's trade surplus as structural, referring to the country's cheap capital and over-investment, which generate excess production that is cleared through exports. The implication is that deeper reforms to China's economy such as building up a social safety net, and not just yuan appreciation, are necessary to stimulate domestic demand and rein in its yawning trade surplus.

Would China Seriously Consider Dumping Its Holdings Of U.S. Treasury Securities?

China has amassed US$2.27 trillion of foreign exchange reserves, the world's largest stockpile. The vast majority (analysts think about two-thirds) is invested in dollar-denominated assets. China is the single biggest holder of U.S. Treasuries, owning at least US$776.4 billion of U.S. government debt at the end of June.

U.S. commentators fret that gives Beijing an effective tool to fend off U.S. demands for yuan reform by threatening to stop buying more debt and possibly selling what it holds. China has never actually uttered such threats, though it has for years said it is working to diversify its foreign currency holdings. Beijing, for its part, has expressed worries about Washington's massive and growing fiscal debt, as any resulting dollar weakness erodes the value of its American investments.

Apart from an extreme trade war scenario, it is unlikely that Beijing would ever dump its U.S. holdings as this would send shockwaves through the market and only serve to undercut the value of its remaining U.S. investments. Washington's ballooning deficit means that it needs investors to buy government debt more than ever, but, paradoxically, the scale of issuance means that China's share of new purchases has been getting smaller. As recovery from the financial crisis effectively forces the U.S. savings rate higher, domestic buyers have become the most important source of incremental demand for Treasuries, making the United States relatively less vulnerable to changes in foreign demand.

What Would Be The Consequences Of A Sell-off Of U.S. Government Debt?

If the single largest buyer of U.S. government debt — China — sold it off or vowed to buy no more, the immediate impact would be downward pressure on the dollar. One of the United States' strongest claims for the dollar's status as a key reserve currency is that it runs “the deepest, most liquid capital markets in the world,” so if its top buyer dropped out, that claim would ring hollow and the dollar's status would be called into more serious question than it is already.

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