China’s $3.2 Trillion Headache

BEIJING – While the downgrade of United States government debt by Standard & Poor’s shocked global financial markets, China has more reason to worry than most: the bulk of its $3.2 trillion in official foreign reserves – more than 60% – is denominated in dollars, including $1.1 trillion in US Treasury bonds.

So long as the US government does not default, whatever losses China may experience from the downgrade will be small. To be sure, the dollar’s value will fall, imposing a balance-sheet loss on the Peoples’ Bank of China (PBC, the central bank). But a falling dollar would make it cheaper for Chinese consumers and companies to buy American goods. If prices are stable in the US, as is the case now, the gains from buying American goods should exactly offset the PBC’s balance-sheet losses.

The downgrade could, moreover, force the US Treasury to raise the interest rate on new bonds, in which case China would stand to gain. But S&P’s downgrade was a poor decision, taken at the wrong time. If America’s debts had truly become less trustworthy, they would have been even more dubious before the agreement reached on August 2 by Congress and President Barack Obama to raise the government’s debt ceiling.

That agreement allowed the world to hope that the US economy would embark on a more predictable path to recovery. The downgrade has undermined that hope. Some people even predict a double-dip recession. If that happens, the chance of an actual US default would be much higher than it is today.