China has stepped up its purchases of U.S. Treasuries in recent years, making it the biggest foreign holder of U.S. debt. By many expert accounts, this has fueled a relationship of dependency between the United States and China, whereby China has lent to the United States to help fuel its export industry, while U.S. consumers in turn have demanded more exports and further access to cheap credit. This relationship attracted increasing scrutiny in the aftermath of the global financial crisis as the United States' massive stimulus outlays and loose monetary and fiscal policies fueled doubts about the U.S. economy and the value of U.S. debt. China's $586 billion in stimulus spending bolstered its weakening export industry and raised concerns about whether China will continue to buy U.S. debt. Meanwhile, Chinese officials have made calls to replace the dollar's role as an international reserve currency with the International Monetary Fund's Special Drawing Right, and trade tensions between the United States and China have grown over products such as tires and poultry. Some experts warn economic and political pressures could lead both countries to adopt more protectionist policies at a time when the global economic recovery remains fragile.

China holds roughly $1.5 trillion in U.S. assets, at least 65 percent of China's total foreign assets, according to a May 2009 paper by economist Brad Setser, a former CFR fellow and now senior director for the White House's National Economic Council. This represents enormous growth in its U.S. dollar holdings over the past decade, which, in January 2001 amounted to less than $100 billion. Experts debate the causes of this buildup, though it is clear that a flood of foreign capital into China has been a major contributing factor. Many economists attribute the buildup to China's apparent export-led growth strategy and exchange rate policies over the past decade. China began pegging its currency to the dollar in the wake of the Asian financial crisis in 1998. That peg continued until July 2005, as China bought or sold as many dollar-denominated assets as were needed to stabilize its exchange rate against the dollar.  By mid-2004, China had developed a large trade surplus with the United States. After facing the prospect of an economic slump during the SARS pandemic in 2005, when China pumped money into the economy to stimulate growth, it announced in July that year that it would allow a 2.1 percent revaluation of the yuan to ease the inflationary pressures caused by excess liquidity.

The exchange rate appreciated gradually until August 2008 in what experts describe as a "managed float," after which many economists believe China moved back to a fixed exchange rate to prevent its export markets from collapsing during the global financial crisis. Chinese authorities have not announced an official change in policy during this period. Instead, experts "infer it from the fact that the rate hasn't moved," says CFR's Adjunct Senior Fellow for International Economics Steven Dunaway.

U.S. policymakers, businesses, and labor groups have argued that the Chinese currency is undervalued by as much as 40 percent against the dollar, making Chinese exports--such as steel pipes and tires--to the United States cheaper and putting massive dollar flows in the hands of the Chinese. Undervaluation of the yuan, these voices contend, has expanded the U.S. trade deficit with China, hurting U.S. manufacturers and depressing U.S. employment, which, in November 2009 slightly exceeded 10 percent. As evidence that the yuan is "significantly undervalued," the U.S.-funded nonpartisan Congressional Research Service cites the sharp increase in China's foreign exchange reserves--which rose from $403 billion at the end of 2003 to $1.5 trillion at the end of October 2007--along with China's large trade surplus, which reached $268 billion in 2007. During May 2007 U.S. Senate hearings, Fred Bergsten, who heads the Peterson Institute for International Economics, testified that China had been buying $15 billion to $20 billion of U.S. assets per month for several years to try to hold down the value of its currency. "The world's most competitive economy has become even more competitive through a deliberate policy of currency undervaluation," said Bergsten. Chinese leaders have stressed the need for gradual currency policies that maintain global growth. In November 2009, China's Assistant Finance Minister Zhu Guangyao said that China's policy of maintaining "currency stability" has been a "component" of the country's response to the financial crisis and that early withdrawal from those measures would incur a "big cost."

Others disagree with the notion that an undervalued yuan is the root cause of China's trade surplus and buildup of U.S. dollar reserves. The Atlantic Council's  Albert Keidel argues China's buildup of U.S. dollar reserves is not a result of its exchange rate policy but derives instead from the lax U.S. financial regulations that fueled highly leveraged over-borrowing and overconsumption of Chinese exports. "U.S. financial regulatory failures ultimately forced trade surpluses on China," says Keidel. Governments build foreign exchange reserves to fend off speculation against their currencies as they liberalize their financial markets, he says.

Some economists question whether China's exchange rate policies vis-à-vis the United States and its use of U.S. dollar reserves can be considered "predatory," or designed to depress the value of the yuan and push cheap Chinese goods into U.S. markets. Under the 1988 Omnibus Trade and Competitiveness Act, the Treasury department is required to report annually on the exchange rate policies of countries with large trade surpluses with the United States to determine if they "manipulate" their currencies against the dollar to "prevent effective balance of payments adjustments or to achieve an unfair competitive advantage in international trade."

The Treasury department has not labeled China or any country a currency manipulator. Treasury reports since China's July 2005 policy change have been increasingly critical of China but have avoided using the term "manipulation," which would trigger negotiations between the two countries and could lead to economic sanctions if the United States brought the case before the World Trade Organization. In Senate hearings on his nomination as U.S. Treasury Secretary in January 2009, Timothy Geithner responded to allegations of China's "manipulation" of its currency by saying it was a "significant issue" and that China should have "a more flexible exchange rate system."

Though many concentrate on the exchange-rate dimension of trade and currency imbalances, some experts say links between these issues are overwrought. The Congressional Research Service cites data showing that increasing productivity in Chinese export firms--a factor unrelated to exchange rates--has contributed to Chinese export growth.

There is also evidence to suggest that much of the U.S. trade deficit (which widened in September 2009 by 18 percent to $36.5 billion, the largest increase in a decade) from China comes from the many export-oriented U.S. multinational companies that have moved production to China to take advantage of its low labor costs. In 1986, only 1.9 percent of China's exports came from foreign-investment enterprises in China; in 2006, the share rose to 58.2 percent, a CRS report notes. Some analysts argue that the use of foreign inputs in Chinese exports also dilutes the relationship between exchange rates and U.S.-China imbalances. According to 2003 congressional testimony by Stanford University economist Lawrence Lau, an appreciation of China's currency would not significantly alter China's exports to the United States, since, by his estimates, only 20 percent of the value of Chinese exports comes from China's assembly of imported parts, while 80 percent comes from the value of parts before they are imported.

Critics of China's exchange rate policies and its trade surplus say the resulting buildup of China's dollar reserves threatens growth and stability in the U.S. economy. The Petersen Institute's Bergsten has said that China's policy of keeping the yuan undervalued leads to a "sizeable dollar overvaluation" and rising trade deficits. These deficits in turn provoke industry leaders to ramp up pressure for protectionist U.S. trade policies, he argues, which in the past policymakers have responded to by drastically devaluing the dollar. Bergsten cites the dollar's drop by more than 30 percent under the Reagan-era Plaza Accord (1985-1987) and the Nixon administration's import surcharge and removal of the dollar's gold peg, which effected more than a 20 percent devaluation of the dollar during the early 1970s.

Another concern is whether the United States can continue to rely on China to buy U.S. debt as the U.S. deficits grow. Some analysts contend that the U.S. economy would suffer a significant blow if it lost the favorable interest rates offered by China to finance its debt. CFR's Center for Geoeconomic Studies notes that China's purchases of U.S. Treasuries have actually accelerated over the past year but that China has been trading its long-term Treasuries for short-term notes, an indication of the country's growing concern about inflation and U.S. debt eating at the dollar's value.

Even if China abandoned its dollar peg and allowed the yuan to appreciate in line with U.S. demands, the likely resulting slowdown in China's economic growth could lead to political unrest, some experts say. "China has an 8 percent growth target because it needs that growth level to maintain enough jobs to absorb surplus labor in China's rural areas. Without the labor, you breed conditions for instability," says CFR's Dunaway.

In the United States, a continued buildup of U.S. debt has heightened global concerns about the safety of holding U.S. assets and could, some experts argue, cause central banks and private investors to dump their dollars in favor of safer investments. In an October 2009 interview, CFR's Benn Steil said that "the world is very conscious of the incentives the U.S. has to inflate away its burgeoning debt, meaning that U.S. insouciance in the face of a further dollar decline could provoke a run on the dollar in the currency markets." A devalued dollar, said Steil, might lead to higher inflation and interest rates in the United States, as well as slower U.S. growth and increased unemployment.

Many U.S. policymakers have called for China to wean itself off export dependence and build up domestic consumption to correct the "global imbalances" that drew so many U.S. dollars to China to begin with.  The Obama administration and G-20 leaders, including the Chinese President Hu Jintao, pledged at the Pittsburgh summit in September to develop a program to address these imbalances and undertake "monetary policies consistent with price stability in the context of market oriented exchange rates." Yet, as long as China remains the biggest creditor of the United States, it will be difficult for the United States to directly influence Chinese leaders on currency matters, some experts say.  So far, repeated U.S. calls for China to revalue its currency have had little effect. In a July 2008 Financial Times op-ed, Morris Goldstein and Nicholas Lardy of the Petersen Institute argue that Chinese efforts to appreciate its currency are only a third to a half of what is needed in "rebalancing the sources of its economic growth."

Bergsten has noted Europe's incentive to join the United States in pressuring China to revalue its currency, since its economy will suffer from a rise in the value of the euro if the dollar declines sharply. U.S. congressional leaders have also proposed ways to act against China through international bodies, including referring the matter to the International Monetary Fund and bringing a formal complaint to the WTO that would treat the alleged currency manipulation as an unfair trade subsidy.  "The IMF has never labeled a country a currency manipulator, but it's something they need to think about, because if there's no pressure, there's no change," says Dunaway, a former IMF official on Asia. He says China returned to a fixed exchange rate last year in part because "the issue dropped off the agenda" globally. Other experts question the efficacy of appeals to international institutions on the matter. In a December 2008 paper (PDF), Stanford University's Robert Staiger and Alan Sykes write that proving China's violation of WTO commitments vis-à-vis its currency policies would be difficult, and they dispute the notion that currency devaluation alters trade balances in the long run.

Some say focusing on China's currency is merely a distraction from other drivers of U.S. debt. In an October 2009 interview, Morgan Stanley's Stephen Roach said the currency issue is a "red herring" for U.S. policymakers and that the United States should instead focus its efforts on boosting U.S. savings. "If we want to redirect our economy away from excess consumption towards more of a savings-based economy, then and only then, can we wean ourselves off of Chinese products," said Roach.