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Why China won't sway the debt ceiling debate

October 8, 2013: 10:49 AM ET

China may be the biggest foreign holder of U.S. debt, but it won't meddle in Washington politics.

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FORTUNE -- As Congress drags its feet against a looming deadline to increase the nation's borrowing limit or risk default, China urged Washington this week to act quickly and ensure the safety of its U.S. investments.

The message from the world's second-largest economy isn't surprising. As Chinese Vice Finance Minister Zhu Guangyao noted on Monday, China is the largest foreign creditor to the U.S.

The country has the world's largest stockpile of foreign-exchange reserves, partly due to its efforts to encourage exports by holding down the value of its currency, the yuan. China doesn't disclose its holdings, but a chunk of its foreign reserves is invested in U.S. government debt; as of July, the country held $1.27 trillion in U.S. Treasuries. That's more than any country, followed by Japan, which holds $1.135 trillion.

If anyone should worry about a possible default, it's the Chinese, according to Deutsche Bank. It ranked China third as having the largest holdings of U.S. debt next to recipients of U.S. social security and the U.S. Federal Reserve.

MORE: Why the 14th Amendment matters in the debt-ceiling crisis

"On the question of the debt ceiling, the Chinese side feels the U.S. needs to take realistic and resolute steps to ensure against default on the national debt," Zhu said.

Given China's stake, it's reasonable to think the country is positioned to break the debt-ceiling impasse. Theoretically, China could threaten a large sell-off that could potentially send bond prices into free fall. But that's a crazy idea that nobody is actually supporting -- at least not seriously nor publicly, especially not China.

Of all the apocalyptic debt ceiling warnings, China's has been relatively muted. It's similar to the tone officials set in July 2011, the last time a stalled Congress pushed the U.S. to the edge of default. The fight eventually led Standard & Poor's to downgrade the U.S. government's AAA credit rating for the first time in 70 years.

On Monday, Zhu recalled the 2011 downgrade, saying he hoped the U.S. would take a lesson from history and realize its responsibilities as both the world's largest economy and holder of the global reserve currency, according to Xinhua.

MORE: 4 debt ceiling scenarios freaking out traders

Even if some expect China to intervene, officials likely have more to lose than gain. It's a tricky situation, and China will stay away from meddling too deeply in Washington's problems for a few reasons:

For one, just as China hates when America criticizes its domestic policies, it makes China more reluctant to intervene in U.S. policies. More than that, choosing which party to side with could put China in a tough spot with negotiations down the road, says Yun Sun, a visiting fellow at the Brookings Institution. If anything, the Chinese likely view the political wrangling in Washington as symptomatic of a Democratic government, as then U.S. Secretary of State Hillary Clinton rationalized it to China in 2011.

And while China may hold incredible amounts of U.S. government debt, it doesn't have much leverage. China could sell off Treasury debt, but then that risks sending bond prices into free fall, lowering the value of whatever Treasuries China may have left. And whatever Treasuries China sells, it will be hard for officials to replace its investments, says Nicholas Lardy, senior fellow at a Washington, D.C.-based think tank, the Peterson Institute for International Economics. China has been reluctant to buy European debt amid its own ongoing debt crisis, and there aren't many other markets to turn to that are as deep and liquid as the U.S. Treasury market.

Lardy, an expert on the Chinese economy, adds that in the worst-case scenario if the U.S. does indeed default the country may re-evaluate its investments in U.S. Treasuries for the long-term. But that may already be happening separate from the Washington debt fight. In recent years, China has been trying to diversify away from U.S. government debt to seek higher returns and reduce risk. As of June, about 35% of the foreign-exchange funds held by China's State Administration of Foreign Exchange were in U.S. government debt, according to a Wall Street Journal analysis, compared with 45% in June 2010.

If this continues, many years from now if the debt fights in Washington continues, China may have less at stake than today.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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