R.MPCIR.T TO CSiVGRESS

Assessment of the National seeurity Risl<sFosed fo ttrre united States as a Result of the

U.S. Fedenal llebt Owed to China as aCreditor of the [J.S" Governmemt

Office of the Secretary of DefenseIuIy 2012

Preparation of this reporUstudy costthe Department of Defense a total ofapproximately $4,500 for the 2012

Fiscal Year-Generated on 2012Jun06 1725 ReflD: 5-

B3A274F

The Conference Report accompanying the National Defense Authorization Act for Fiscal year2012 (House Report lI2-329,pages 742-3) requests that the Secretary of Defense "provide anassessment of the national security risks posed to the United States as a result of the UnitedStates federal debt owed to China as a creditor of the United States Government and theimplications of that debt for the United States military. The assessment shall include adescription of the United States federal debt liabilities owed to China as a cred.itor of the UnitedStates and a discussion of any options available to China for detening United States militaryfreedom of action in the westem Pacific as a result of this debt.,'

U.S. FEDERAL DEBT LIABILITIES OWED TO CHINA AS A CREDITOR OF THEUNITED STATES

The Treasury International Capital System repofis data on foreign holdings of U.S. Treasurysecurities. At the end of March2012, total foreign holdings of U.S. Treasury securities Uy bninawere $1.170 trillion, or 7.5 percent of total pubiic debt. All but $3.9 billion tf Chiou', holdingswere long-term (maturing in more than a year),

WHY DOES CHINA HOLD U.S. TREASURY SECURITIES?

"fifiiiois *o""d t6fi;rdt-oftid;iU. s tfi sfi. $a*iires a uffiU?;' da fi o;id'inG,im;;i,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-scalesovereign 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 exchangeholdings.

Over the past decade, China has consistently run substantial net trade and cunent incomesutpluses with the rest of the world, and also has typically been the recipient of large net capitalinflows, such as from foreign direct investment. At the same time, China has closely managedthe value of its exchange rate against the U.S. dol1ar, including pegging the value of its cunincyagainst 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, forChinese cuffency (the "renminbi," or RMB), this demand for RMB creates market pressure forthe value of the RMB to rise. As a result, the net inflows of foreign currency into China'seconomy from its trade and capital surpluses with the rest of the world put market pressure onChina'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 currencymarket in China and be willing to purchase U.S. dollars in whatever amounts necessary to keepthe 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, dollarsand 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 officialforeign 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 forRIVIB would exceed the available supply. Thus, China cannot reduce its holdings of foreignexchange reseryes without giving up its objective of limiting RMB appreciation, a policy iheUnited States has long urged China to abandon.

Like other central banks, the PBOC, in order to eam at least a modest retum as well aspreserving 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 includealtematives such as converling its dollars into other currencies and purchasing securities in thatcurrency, investing in asset-backed securities or equity markets, or purchasing physical assetssuch as gold. These other investments may attimes offer higher retums, but also carry gteaterrisk than U,S. Treasuries, so China, like other large reserve managers, likely has chosen toinclude a heavy weight on safe, liquid and stable assets such as U.S. Treasuries as the core of adiversified mix of assets.

OPTIONS AVAILABLE TO CHINA

Occasional commentary reported in China's media advocates selling U.S. Treasury securities inresponse 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'newsagency, People's Liberation Army academic advisors Major General Luo Yuan, Major GeneralZhu Chenghu and Senior Colonel Ke Chun.riao called on China to "dump" U.S. Treasuries aspunishment for the Obama Administration's notification to Congress that it would provide apackage of arms to Taiwan. Mr. Ding Gang, a senior editor with China's People's Daily, wrotein an editorial in August 2011 that China should directly link the amount of U.S. Treasuryhcldings 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 thecontrary, China has continued purchasing large quantities of U.S. Treasury securities. Officials atChina's State Administration of Foreign Exchange (SAFE), which manages China's ofhcialforeign exchange reserves, have repeatedly stated that they base the operation and managementof 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 ofinternational 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 diversepool 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 federaldebt held by the public, 7.5 percent of total public debt, and only slightly more than2 percent oftotal U.S. credit market debt estimated by the Federal Reserve's Flou' of Funds data. As thesefigures indicate, the ability of China to affect the market for Il.S. Treasuries, and U.S. financialmarkets 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, thiscould cause short-term disruptions in the secondary market, and lead to an inciease in the interestrate 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 onthe secondary market, and the value of U.S. Treasuries on the secondary market could fallsharply. If this occutred, China's own holdings of U.S. Treasuries would fall in value, causingdirect financial losses for China. In addition, if it determined it necessary to achieve its inflationand employment mandates, the Federal Reserve is fully capable of purchasing U.S. Treaswiesdumped on the market by China, reducing the economic impact to the United States, Finally, aswell as undermining the value of its own holdings, a policy decision by China to reduce suddenlyand significantly its holdings of U,S, Treasuries would fundamentally change the internationalfinance and business community's perception of China as a reliable and respected economic andfinanciai partner.

Aside from the aggressive option of a large-scale sell-off China has other options that are lessprovocative and would have even less effect on the United States, but are equally problematic forChina 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 reputationalccst to China for pursuing this type of antagonistic economic approach to one of its major tradingpartners 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 toput the doliars accumulated from its currency intervention in the context of significant trade andcapital surpluses. China could attempt to diversi$i holdings significantly into a basket ofdeveloped aountry debt, but no other market offers the same levels of depth, liquidity, and safetyas the market for U.S. Treasuries. Investing in developing country debt offers the potential ofhigher teturns, but al much higher risk with very limited liquidity and volume. Ultimately, Chinahas few attractive options for investing the bulk of its large foreign exchange holdings outside ofU. 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 havelimited effect and likely would do more harm to China than to the United States. As the threat isnot credible and the effect would be limited even if carried out, it does not offer China deterrenceoptions, whether in the diplomatic, military, or economic realms, and this would remain true bothin peacetime and in scenarios of crisis or war. Moreover, in times of military crisis or war, thethreshold for what might deter the United States also rises.

During his confirmation hearing in May 2011 before the Senate Foreign Relations Committee tobecome 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 "in any way influence U.S, foreignpolicy."