I suspect that given China's repeatedly expressed concerns about the value of the dollar, the move is probably about reducing medium- and long-term dollar risk exposure. The lack of medium- and long-term fiscal consolidation in the U.S. and absence of imminent work toward that end e.g., the recent budget proposal was a status quo document, is raising concern outside the U.S. The IMF has called the effort in the U.S. slower than expected. China has repeatedly expressed concerns about the value of the dollar. By itself, this move probably won't have a huge impact on the U.S. The next logical move, capping (either a hard cap, which would be more severe, or a relative cap as a % of China's overseas currency holdings) and then slowly reducing China's dollar holdings, could collide with the still prevalent status quo fiscal approach, once the imbalances associated with the structural budget deficit begin to overwhelm cyclical factors.
At this point, it remains to be seen what will trigger a genuine push for medium- and long-term fiscal consolidation in the U.S. The economy has experienced sustained growth for nearly two years now. Two fiscal commissions offered a number of concrete recommendations, all of which were ignored in the budget proposal. That the status quo budget was introduced even as numerous states are already struggling with pension/health benefit imbalances and parts of Europe experienced debt crises is quite remarkable. The complacency is almost surreal.
IMO, aside from the first symptoms of a crisis where U.S. interest rates begin to rise appreciably due to changing risk premia (as opposed to inflation), the fiscal policy inertia in the U.S. might not be shattered unless one or more of the following occur:
1. The U.S. is given a negative outlook by the credit rating agencies (something I think will happen by the end of 2012 on the current course) and/or suffers its first downgrade in its AAA credit rating.
2. The IMF takes the U.S. to task in its next Article IV review, calling U.S. fiscal policy off course, inconsistent with the fiscal imbalances the nation changes, and warning that such an approach is increasing global credit and currency market risks.
3. The combination of foreign economy growth opportunities (competition for capital) and growing foreign worries about U.S. fiscal policy lead to the development of a persistent and appreciable trend toward reduced foreign investment in the U.S., including financing of the U.S. government.
