As the largest foreign buyer of US government securities, China can only fret as the value of its holdings is held hostage to a fractured political process in Washington. But while the longer-term implications of these developments are likely to hurt the United States’ democracy and human rights agenda as far as China is concerned, ironically, they will help its international financial situation.

On the political front, China’s leadership will quietly welcome comparisons with the relative ease with which its system is able to move on collective action within a tightly-controlled political process. This will reinforce self-serving messages as the Communist Party celebrates its 90th anniversary, especially as the party has been under considerable pressure lately to redefine itself, as its society is no longer isolated, rural, and poor, but is now globally integrated, urban, and fixated on wealth accumulation.

And, while China struggles to achieve a ‘soft landing’ from its economic stimulus programme, the fiscal problems in the United States will be used as a reminder to its restless constituents that democracy doesn’t guarantee that the right compromises will evolve to support the common good. Nor will the problems in Europe in forging a collective sharing of looming default burdens, or the continued decline of the Japanese economy, strengthen the case for liberalizing China’s political system. Indeed, all this will make it even harder to bridge the cultural divide that separates China from the West over the way they view global issues.

But on the economic front, recent developments are likely to push China’s leadership to move more aggressively to reshape the policies relating to the country’s exchange rate and trade regime that have exacerbated tensions with the United States over the past decade. The United States’ fiscal woes will reinforce the view that it makes little sense for China to continue generating trade surpluses that must then be used to buy US securities, which may only diminish in value over time. Any lingering notion that mercantilist tendencies still drive Chinese policymakers should now be discarded.

Some estimates suggest that with unchanged external policies, China’s foreign exchange holdings could increase from the current $3.2 trillion to $5 trillion by 2015. But with the prospects of all three major reserve currencies under a cloud, parking such amounts in foreign securities is unappealing, making it unlikely that these levels will materialize.

China’s overseas direct investments—which amounted to less than $5 billion seven to eight years ago, but now run around $60 billion annually—are another option for channelling these surpluses. But sensitivities among OECD countries make it unlikely that China can find enough attractive opportunities in the resource- and technology-based industries to make this a serious alternative. While growth in overseas investments will be brisk in the coming years, this won’t satisfy China’s desire to diversify its holdings, and returns would still be vulnerable to exchange rate fluctuations.

As a result, China’s leadership no longer sees much to be gained from accumulating foreign reserves. Its former preoccupation with job creation from export production makes less sense as its population ages and the labour force begins to shrink within the next few years. Increasingly, the challenge is to meet the job expectations of unemployed college graduates as their numbers have doubled over the past decade, instead of just trying to create largely menial positions. The pressure is now on to develop more high-valued services and knowledge-intensive product lines—with quality rather than quantity being the primary concern.

For these objectives to be achieved, though, more rapid appreciation of the renminbi rate will help rather than hurt. But exchange rate changes alone won’t be enough. Much more important is reversing the tax, subsidy, and interest rate policies that discourage the requisite high-value service activities from emerging.

The shift away from mercantilist objectives will be reinforced by the desire to move more rapidly to internationalize use of the renminbi. The authorities see greater use of the renminbi abroad as a means of insulating themselves from the instability and declining value of the dollar, euro, and yen. They also welcome the prestige factor and advantages in having the renminbi as an international reserve currency. But they face the predicament that the preconditions for being an international currency are that it must be freely traded in global markets, with its value and availability subject to market forces rather than government controls.

For the moment, China will push much harder for the renminbi to be used for settling trade and services transactions, but continue to be cautious about freeing up capital flows. As such, the world will probably see the emergence of a hybrid-type global currency that will be used relatively freely to settle current account transactions, but remain controlled in terms of the volume and purpose of renminbi-denominated capital flows. This would, in principle, still allow China to retain tight control over its monetary policies and exchange rate adjustments.

However, these artificial separations can’t be sustained. China is moving down a slippery slope and, over time, the pressures to liberalize capital flows and allow the value of the renminbi to be shaped by market forces will prove to be overwhelming. This will force the country to accelerate the process of creating the necessary institutions and regulatory safeguards for the renminbi to be a true international currency. In doing so, it will complement other policies that will help reduce China’s trade imbalances.

And the current US fiscal woes will have at least one beneficial side-effect—they will help to lower the tensions that have arisen during the recent ‘currency and trade wars’ between the two countries.