China is America's biggest foreign creditor. Could it turn off the tap?

Beijing reacts to Trump's national security speech
Beijing reacts to Trump's national security speech

Investors are getting worried about what America's biggest foreign creditor might do next.

A report that China is reconsidering how much U.S. debt it buys rattled markets on Wednesday and raised questions about the relationship between the world's two largest economies.

Here's what you need to know:

What happened?

Bloomberg reported Wednesday that the Chinese government is looking to cut back on the amount of U.S. government debt it buys, citing unidentified people familiar with the matter.

The article quickly caused a sell-off in U.S. Treasury bonds. But on Thursday, the Chinese agency that manages the country's foreign currency holdings cast doubt on the report.

"We believe the story may have quoted the wrong source, or a piece of false information," the State Administration of Foreign Exchange said in a statement.

The response fell short of a full-throated denial, and didn't push U.S. Treasury prices higher.

What's the bigger picture?

China already holds a huge amount of U.S. government debt. The latest data from the Treasury Department puts it at $1.2 trillion -- and some independent estimates suggest it could be even higher. But Beijing's rate of purchases has been slowing down for a while.

China's vast stock of U.S. debt is a byproduct of the huge amount of goods it sells to Americans.

Related: Trump and China: 2018 could get nasty

Some of the dollars spent on these goods eventually find their way to China's central bank, which uses them to buy U.S. government debt.

Buying Treasuries keeps the dollar stronger relative to the yuan, which has helped Chinese exports in the past.

What's at stake?

Investors worry that if China purchases fewer Treasuries, the U.S. government will have to find alternative buyers. It may also have to increase the rate of interest it pays.

That would raise the cost of servicing U.S. government debt, which is currently estimated at more than $20 trillion.

Higher debt costs could have a number of damaging effects, including leaving less cash for spending elsewhere.

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Businesses and consumers may also be faced with higher borrowing costs. All of this would filter down through the U.S. economy, and cause a slowdown in activity.

Why would China dump U.S. debt?

Some market experts speculate that China might want to send a message to President Trump over trade.

Analysts expect Trump will take tougher measures against China in the coming months, potentially setting off a trade war. His administration could impose tariffs on imports of steel, aluminum and solar panels, which would hurt Chinese manufacturers.

Related: GOP tax bill could make the trade deficit worse

Easing up on buying Treasuries would be "a proverbial shot across the bow to warn the 'America First' administration," said Marc Chandler, a currency strategist at investment firm Brown Brothers Harriman.

What would it cost China?

Other experts dismiss the idea that China would use bonds to play politics.

"It is very unlikely that China would slow its purchases of U.S. Treasuries to warn the Trump administration against aggressive trade measures," said Michael Hirson, a director at political risk consultant Eurasia Group.

He added that a "politically induced" sell-off of Treasuries would threaten global economic growth, which would be bad news for China and its big export industry.

Related: China accuses Trump of 'sabotaging' world trade

A fire sale would also hit the value of China's vast Treasury holdings and may even end up weakening the yuan against the dollar, experts say.

China has favored a weaker yuan in the past, but its focus recently has been on keeping its currency stable.

"It's hard to see how China would emerge from this scenario better off," said Mark Williams chief Asia economist at research firm Capital Economics.

- Serenitie Wang contributed to this report.

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