Bernanke said "there is no indication (the Chinese) are thinking of radically changing their composition of assets" and to back away quickly from their U.S. holdings would "not be in their interest." He added the threat of China moving away from U.S. assets is not "a significant risk."

As reported by Dow Jones News

Beginning in July 2005, the Chinese government officially unpegged the RMB from the dollar, and, since then, the currency has appreciated by about 6%.  Chinese policymakers seem likely to allow this process of gradual RMB appreciation to continue, so long as it is slow and orderly.  Few people, however, believe that even a more substantial RMB appreciation would have much effect on China's overall trade balance. F or one thing, to the extent that China imports many components used in producing its export goods, an appreciation lowers the cost of those imports, offsetting somewhat the effect on export prices.  For another, demand for many Chinese exports tends to be fairly strong, regardless of price, which implies a limited trade response to an appreciation.  Most observers do not see China's trade surplus coming down until it ramps up government spending and domestic consumption, increasing its own demand for foreign imports.

To exert some control on slow and orderly movements in the RMB, the PBOC intervenes in the foreign exchange market, buying dollars with RMB that it issues. This intervention has resulted in the PBOC's accumulation of over $1 trillion in foreign reserve assets. Moreover, such intervention also swells the domestic supply of bank reserves. Therefore, to avoid inflation, the PBOC must offset the associated liquidity increase by sterilizing reserve inflows. It has accomplished this by issuing low-yield PBOC bills in open market operations and by progressively raising the reserve requirements of domestic banks. However, the policy of forcing low-yield PBOC bills on the banking sector works at cross-purposes with banking sector reforms, which are ultimately aimed at creating a banking sector that operates on a sound commercial basis.

[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.

While China has increased the flexibility of the renminbi, permitting it to appreciate by 6.5 percent against the dollar since it was officially unpegged in July 2005, it is still much less flexible than the currencies of the Asia crisis countries. The central bank has resisted pressures for more rapid appreciation of the renminbi by intervening in the foreign exchange market and building up its holdings of foreign reserves. Limiting appreciation of the currency in this manner complicates the use of monetary policy to produce an orderly slowdown in China’s currently booming economy.

As an emerging leader within the region, China could also play a major role in promoting regional exchange rate flexibility. For example, Thailand’s Finance Minister recently argued that his nation’s economic conditions would be helped by a faster pace of renminbi revaluation. If China were to move more quickly, it could well encourage even greater exchange rate flexibility among the East Asian fledgling inflation-targeters, as they would be able to pursue their goal of reaching price stability without losing export competitiveness.

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.

Further appreciation of the RMB, combined with a wider trading band and with the ultimate goal of a market-determined exchange rate, would allow an effective and independent monetary policy and thereby help to enhance China's future growth and stability.

... [T]he dramatic rise in the level of official reserves in much of the emerging world is not simply the consequence of a desire for a greater financial cushion against external vulnerability. It also results from the lingering aversion to letting exchange rates adjust upwards in response to market forces.

As capital markets become more open, this middle ground is harder to sustain. The broadening recognition of this is leading to a gradual increase in exchange rate flexibility, and this process is likely to continue. The pace of progress, progress in the direction of more openness to capital flows and greater exchange rate flexibility, will depend in part on the pace at which these governments are able to strengthen the resilience of the domestic financial system and set in place the broader institutional framework and supervisory regime that are vital for an open economy.

A second possible explanation of the evident decline in the term premium is linked to the increased intervention in currency markets by a number of governments, particularly in Asia. According to this explanation, foreign official institutions, primarily central banks, have invested the bulk of their greatly expanded dollar holdings in U.S. Treasuries and closely substitutable securities, and these demands by the official sector have put downward pressure on yields. This interpretation has some support, including research that I did with two coauthors that found that longer-term yields came under significant downward pressure during episodes of heavy official purchases of dollars in 2004...

However, these observations speak more to the existence of a short-term impact of large purchases and sales--the result of limits to liquidity in the very short run--than to the perhaps more important question of whether those transactions have a lasting effect on yields.

A reasonable conclusion is that the accumulation of dollar reserves abroad has influenced U.S. yields, but reserve accumulation abroad is not the only, or even the dominant, explanation for their recent behavior.

For global growth to be sustained at a reasonably strong pace during this period of adjustment, the desirable increase in U.S. savings, and the necessary slowing in U.S. domestic demand growth relative to growth of U.S. output, would have to be complemented by stronger domestic demand growth outside the United States, absorbing a larger share of national savings. Exchange rate regimes, where they are currently closely tied to the dollar, will have to become more flexible, allowing exchange rates to adjust in response to changing fundamentals. Reforms to financial systems and to social safety nets over time would help reduce the need for exceptionally high levels of domestic saving we see in many countries. The global nature of these requirements does not imply that the United States can put the principal burden for adjustment on others

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.

It is in China's interest to allow its currency to move up, largely because its procedures that it uses to support its currency requires that their central bank accumulate very large quantities of US Treasury securities.  Unless they sterilize that very substantial inflow, they create significant distortions in their financial system and ultimately could be very serious for the Chinese economy.

The sooner the Chinese, in their own self-interest, move to a more flexible currency regime, perhaps leading other Asian currencies to become more flexible as well, the better for all participants in the global trading system.

[A] substantial part of the world economy...has an interest in shadowing the dollar closely, as they absorb excess capacity, and...these governments are likely to continue to want to acquire dollars to make that exchange rate objective possible.