There is a lot of confusion surrounding China and its role as a holder of U.S. government debt.
An exchange at the beginning of episode 6 of the second season of House of Cards provides a perfect illustration of this. In the show, members of the presidential administration are discussing which tack to take with China, and the president suggests playing hardball.
"If China doesn't show at the refunding auction, long-term interest rates will spike!" warns someone at the table—ostensibly the treasury secretary.
"And in a week, yields on our 10-year notes will pierce the 7 percent threshold," chimes in Frank Underwood (the show's main character, portrayed by Kevin Spacey). "That could happen."
You've probably heard this before in American political discourse. There's this idea that if China decides to stop buying U.S. government bonds, the U.S. Treasury will have a failed auction and bond yields will surge. There are two big problems with this: First, there is a system of primary dealers in place to make sure that failed auctions won't happen, and second, China's holdings of U.S. Treasuries are not some sort of "leverage" that the Chinese government holds over the U.S. government.
On the contrary, China's Treasury holdings are a function of its foreign exchange reserve accumulation.
As other countries buy Chinese goods with dollars—the primary currency of international trade—it puts upward pressure on the Chinese renminbi. China's central bank accumulates dollar reserves to counter this upward pressure, and it holds those dollar reserves in U.S. Treasuries in order to garner interest.
China's foreign reserves continue to rise, so it is in no position to "dump U.S. debt," as politicians sometime like to claim it will. It is true that its central bank has begun to allocate away from Treasuries as a percentage of its reserve portfolio, but this is the sort of thing that must be done over time.
So when you hear politicians engaging in fear-mongering over China's holdings of U.S. government bonds, remember that it's complete nonsense.
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