I should first point out that it's not in the interest of China or Japan to dump treasuries on the market. They, themselves, would suffer capital losses from doing that.

I do think if there were -- and I should be very clear, I have not information or expectation this is going to happen. But if there were significant sales by foreign central banks, for example, that there would be some short-run effect on the market, in terms of the currency and interest rates probably.

I think the longer-term effect would be somewhat less because the market would adjust. It is a liquid market. And the holdings of, say, China of U.S. debt securities, including both public and nonpublic, is only about 5 percent of the total credit market outstanding.

[F]irst, China is a very large country and it should, at some point, have an independent monetary policy of its own, rather than being tied to the United States. In order to do that, they have to have a flexible currency.

Secondly, the flexibility in the yuan is needed to accomplish to accomplish this rebalancing from export orientation to domestic demand that I was referring to earlier.

And thirdly, yuan appreciation and flexibility would make some contribution to helping us to rebalance the current account deficit we currently have, although I think the larger force, quantitatively, would be the rebalancing of demand from exports toward domestic demand in China.

In House Q&A session.

Today, despite China’s recent successes, it still shares some of the vulnerabilities faced by the Asia crisis countries in the 1990s. For example, although it has made significant progress in reforming its banking sector through reducing nonperforming loans, the government still has a degree of influence in Chinese bank lending decisions, and some have expressed continuing concern over the health of the banking sector.

How can China direct a greater share of its output to domestic consumption? Again, increased flexibility in the exchange rate could help. As the Chinese trade surplus has continued to widen, many analysts have concluded that the RMB is undervalued. Indeed, the situation has likely worsened recently; because of the RMB's link to the dollar, its trade-weighted effective real exchange rate has fallen about 10 percent over the past five years. Allowing the RMB to strengthen would make imports of consumer goods (as well as capital goods) into China less expensive. Greater scope for market forces to determine the value of the RMB would also reduce an important distortion in the Chinese economy, namely, the effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market.

I think that the financial markets are really very deep and liquid for U.S. dollar assets. If you include not only U.S. government debt, GSE debt, but also highly rated corporate debt, for example, the size of the market for high-rated U.S. dollar credit instruments is perhaps $40 trillion or something along those lines - would mean that China is only holding a few percentage points of that debt...I think that realistic changes in China's portfolio are not going to have major impacts on U.S. asset prices or interest rates. 

The issue is not so much the change in China's portfolio; the issue really is the fact that we are consuming more than we are producing domestically. That means that foreign debt is increasing. And there may come a period or a time when foreigners are not willing to continue to add to their holdings of U.S. dollar assets. And that will, in turn, lead to perhaps an uncomfortable adjustment in the current account.

China and the global economy will both benefit from greater currency flexibility. We will continue to press China to continue to make progress on reforming their foreign exchange regime.