Dragon in serious trouble ?

Morgan Stanley’s Stephen Roach—chairman of Morgan Stanley Asia—stated that Chinese officials were “appalled” by the debt ceiling delay.and why not after all there spending is highest.According to Bloomberg, Roach stated, “coming so shortly on the heels of the subprime crisis, the debate over the debt ceiling and the budget deficit is the last straw [for China].”

Why are the Chinese so disturbed by the possible default of the U.S. government?

Well, for one, China is the largest foreign holder of U.S. treasuries. The U.S.’s debt makes up a significant percentage of China’s reserves. Effectively, China’s investment portfolio is severely overweight U.S. debt.A U.S. default could lead to a strong devaluation of those assets, in effect, robbing China of billions of dollars.
Reuters reported that Chinese rating agency Dagong Global plans to downgrade its ratings of U.S. debt as early as next week, even if an agreement is reached before the deadline. The company’s chairman has stated that enough damage has already been done so as to warrant a downgrade.

Would a default affect the Chinese economy?

As the U.S. remains the financial capital of the world, it may have quite a severe affect on the Chinese economy, especially if the U.S. economy itself suffers from the default.Federal Reserve Chairman Ben Bernanke has warned that a failure to raise the debt ceiling would have “catastrophic” consequences for the broader U.S. economy. As the U.S. consumer remains a major customer for China, deteriorating economic conditions in the U.S. could harm China’s export-based economy.

Further, the ability of the People’s Bank of China (PBC) to control the value of the yuan depends on the banks reserves.

Although China has resisted the yuan’s appreciation, inflation has been trending higher. The PBC may eventually be forced to revalue the yuan to fight off inflation in the country. In order to do that, the PBC may have to sell its assets and buy yuan.Of course if its assets (U.S. debt) are devalued, the PBC may be hamstrung in its ability to strengthen the yuan.

Still, China’s statements are simply another reminder that the ongoing debt ceiling negotiation affects the entire world. Should the U.S. government default, the entire globe may feel the consequences.