Editor's Note: Minxin Pei is a professor of government at Claremont McKenna College. The following post was originally published in The Diplomat, a stellar international current-affairs magazine for the Asia-Pacific region.

By Minxin Pei, The Diplomat

The political drama in Washington over raising the United States’ federal debt ceiling has grabbed the world’s attention. While the main protagonists in the play are the Republicans and Democrats, one spectator anxiously awaiting the outcome of the bitter partisan struggle is undoubtedly China, the largest single holder of U.S. Treasury debt (roughly $1.1 trillion).

In a nightmarish scenario of an American debt default, the prices of the Treasury bonds China has accumulated are bound to decline significantly. Even if the U.S. government decides to pay the interest on outstanding bonds before honouring its other obligations, the financial markets will likely demand higher interest rates (especially if the U.S. credit rating is downgraded), thus causing the prices of U.S. bonds to fall.

Because about 60 percent of China’s $3.2 trillion in foreign exchange reserves consists of dollar-denominated assets (in addition to $1.1 trillion Treasury bonds, China has bought hundreds of billions of dollars in mortgage-backed securities), the paper losses from the price declines of dollar-denominated bonds, and the depreciation of the dollar itself, will likely be in at least the tens of billions of dollars.

To Beijing’s credit, the Chinese government has kept relative silence so far. Except for vague calls for the United States to protect its investors, no Chinese officials have said anything that could be construed as a threat of dumping U.S. Treasury debt if Congress fails to raise the debt ceiling. The official press, including tabloids known for nationalist rhetoric (such as the Global Times), has been restrained in its coverage on the issue. To be sure, China has maintained an ultra-low profile out of self-interest. It will only hurt itself more if it raises alarm about a possible U.S. default and spooks the financial markets.

Read: Al Qaeda goes local in India.

China’s $2 trillion dilemma is well-known. Since 1994, China has kept its currency, the renminbi, effectively pegged to the dollar. While initially this policy worked well in stimulating Chinese exports and stabilizing domestic prices, Beijing allowed the peg to continue for too long, mainly to maintain an undervalued currency in gaining a competitive advantage in foreign trade. By the middle of the last decade, the undervaluation of the renminbi became a hot bilateral issue between the United States and China as America’s bilateral trade deficits with China soared.

Under pressure from Washington, Beijing reluctantly began to raise the value of its currency in mid-2006 (when its total foreign exchange reserves totalled just under $1 trillion). China’s revaluation process was disrupted by the global economic crisis in 2008. Fearful that its growth could falter if revaluation made Chinese exports less competitive, the Chinese government suspended raising the value of the renminbi in late 2008. As a result, Chinese current account surpluses continued to balloon. The numbers are astounding. In July 2009, China reported $2.2 trillion in forex reserves, more than double the amount in 2006. Today, two years later, China’s forex reserves have reached $3.2 trillion.

To be sure, smart Chinese technocrats, particularly those in the People’s Bank of China (the Central Bank) have long been aware of the pitfalls of a rigid currency regime and excess forex reserves. They advocated a more flexible forex system and a gradual revaluation of the renminbi. But as we know, economic decisions of such magnitude are made by politicians, not technocrats. Beholden to powerful local interests (mainly coastal export-oriented businesses and their allies in the government), Chinese leaders have dithered on currency reform – and dug themselves deeper and deeper in the dollar hole.

Read: China encircles India.

One obvious question to ask here is whether Chinese leaders know the phenomenal risks of holding trillions of dollars in U.S. debt, given the low interest rate and the depreciating value of the dollar. Should Beijing have diversified its forex investments? Why not invest in assets not denominated in the U.S. dollar?

The answer is, sadly, China has tried practically every trick known to get into non-dollar assets. It has set up a $300 billion sovereign wealth fund to invest excess foreign reserves in foreign companies. It has encouraged state-owned companies to acquire assets abroad, such as natural resources and firms. It has launched an experimental scheme to settle foreign trade in the renminbi, instead of the dollar. It has dabbled in purchasing distressed European sovereign debt. The list goes on.

Unfortunately, these efforts to diversify forex holdings have yielded disappointing results. Chinese attempts to acquire natural resources have met with strong resistance in most parts of the world (except in Africa). China’s sovereign wealth fund’s investments overseas haven’t been successful either, mostly due to political opposition. Chinese state-owned firms seem to have done better. But the tens of billions of dollars they have spent on projects may not generate economic benefits. Expanding the use of the renminbi to settle trade reduces currency risks, but does little to restrain the growth of China’s dollar holdings – in the two years since China began this experiment, Chinese forex holdings grew more than 50 percent.

So for the moment, China finds itself in a $2 trillion hole it has dug for itself over the last decade. It watches the political paralysis in Washington and the resulting economic uncertainty in complete helplessness. Contrary to the fears harboured by many Americans that China would use its mammoth Treasury holdings as a financial weapon of mass destruction against the United States, China is being taken to the equivalent of the financial cleaners in the unfolding U.S. debt ceiling drama.

Read: Korea's multicultural future?

It’s tempting to accuse the Americans, the Republicans in particular, of behaving recklessly. But for Beijing, the more meaningful thing to do is to figure out how to get out of its $2 trillion hole. Allowing a more rapid pace of revaluation of the renminbi is clearly one. But there’s another – possibly better – alternative.

Why not give each Chinese citizen $1,000 in U.S. Treasury bonds and let them decide what to do? Call it a special social harmony dividend. This could transfer the financial risks from the Chinese state to the Chinese people, while boosting the wealth and consumption of the average Chinese – in other words, killing two birds with one stone.