China ranks number two (behind Japan) as the largest holder of U.S. Treasury bonds. So when China threatens to sell off its holdings, it should be big news. Instead, we get the esteemed Senator Graham stating:
"would advise our Chinese trading partners to work with us to achieve meaningful currency reform rather than issuing draconian threats. Congress has been incredibly patient on this issue, and the consequences of inaction without real reform are too great to many sectors of our economy." (Wa. Post)
"Draconian threats." Now there's an interesting choice of words. In common parlance, that is generally interpreted as "cruel" or "punishments that are harsher than the crime." Which crime are we talking about? There has been significant U.S. pressure on China to revalue the yuan upwards. China has chosen to take a moderate pace in any such revaluation.
In July 2005, China unpegged the yuan from the dollar" and moved to a "basket" of currencies to determine the yuan's value each day.
The value of the yuan is a many-edged sword. On one hand, increasing the value of China's currency, increases the the competitive rate of U.S. exports. However, such a move also decreases its competitiveness against other exporters - say India, Malaysia, and Singapore. On the other hand, increasing the Yuan's value also means that U.S. imports from China cost more, and perhaps even more importantly, that the value of U.S. debt to China increases.
One interesting aspect of the move in 2005 was that it immediately gave China a discount on oil. Since oil trades in U.S. dollars, a higher valued yuan means fewer dollars necessary for oil acquisition. However, the weakness of the dollar gives all those with a stronger currency such a discount (for example, having recently visited England, the exchange rate was $2.03 for £1).
The not so subtle threat by China to sell off dollars (Wa. Post) is quite a significant threat. As of May 2007, China held $407.4 billion in U.S. bonds. Japan held $615.2 billion; the UK $167.6 billion; OPEC $121 billion (U.S. Treasury Dept). The threat is referred to as "the nuclear option," which captures the potential impact on the U.S. economy. A major sell off of dollars would further devalue the dollar against other currencies and could trigger a major inflationary spiral in the U.S.
So back to "draconian threats." "Draconian" comes from the legal code that Draco laid down for Athens in roughly 620 BC (Wikipedia). The punishments for crimes were exceptionally harsh with even minor offenses requiring the death penalty. Harsh indeed, but Wikipedia offers a pertinent example of Draco's code:
... "any debtor whose status was lower than that of his creditor was forced into slavery."
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