WHILE the downgrade of United States government debt by Standard & Poor's shocked global financial markets, China has more reason to worry than most: the bulk of its $US3.2 trillion ($A3 trillion) in official foreign reserves - more than 60 per cent - is in dollars, including $US1.1 trillion in US Treasury bonds.

So long as the US government does not default, whatever losses China may experience from the downgrade will be small. To be sure, the US dollar's value will fall, imposing a balance-sheet loss on the People's Bank of China (the central bank). But a falling dollar would make it cheaper for Chinese consumers and companies to buy American goods. If prices are stable in the US, as is the case now, the gains from buying American goods should exactly offset the PBC's balance-sheet losses.

The downgrade could, moreover, force the US Treasury to raise the interest rate on new bonds, in which case China would stand to gain. But S&P's downgrade was a poor decision, taken at the wrong time. If America's debts had truly become less trustworthy, they would have been even more dubious before the agreement reached on August 2 by Congress and President Barack Obama to raise the government's debt ceiling.

That agreement allowed the world to hope that the US economy would embark on a more predictable path to recovery. The downgrade has undermined that hope. Some people even predict a double-dip recession. If that happens, the chance of an actual US default would be much higher than it is today.

These new worries are raising alarm bells in China. Diversification away from dollar assets is the advice of the day. But this is no easy task, particularly in the short term. If the PBC started to buy non-dollar assets in large quantities, it would need to convert some current dollar assets into another currency, which would inevitably drive up that currency's value and increase the PBC's costs.

Another idea being discussed in Chinese policy circles is to allow the yuan to appreciate against the dollar. Much of China's official foreign reserves have accumulated because the PBC seeks to control the yuan's exchange rate, keeping its upward movement within a reasonable range and at a measured pace. If it allowed the yuan to appreciate faster, the PBC would not need to buy large quantities of foreign currencies.

But whether yuan appreciation will work depends on reducing China's net capital inflows and current-account surplus. International experience suggests that, in the short run, more capital flows into a country when its currency appreciates.

If appreciation does not reduce the current-account surplus and capital inflows, then the yuan's exchange rate is bound to face further upward pressure. That is why some people are advocating that China undertake a one-shot, big-bang appreciation - large enough to defuse expectations of further strengthening and deter inflows of speculative ''hot'' money.

Such a revaluation would also discourage exports and encourage imports. But such a move would be almost suicidal for China's economy. Between 2001 and 2008, export growth accounted for more than 40 per cent of China's overall economic growth. In addition, a study by the China Centre for Economic Research has found that a 20 per cent appreciation against the dollar would entail a 3 per cent drop in employment - more than 20 million jobs.

There is no short-term cure for China's $US3.2 trillion problem. The government must rely on longer-term measures, including internationalisation of the yuan. Using the yuan to settle China's international trade accounts would help it escape America's beggar-thy-neighbour policy of allowing the dollar's value to fall dramatically against trade rivals.

But China's $US3.2 trillion problem will become a 20-trillion-yuan problem if China cannot reduce its current-account surplus and fence off capital inflows. There is no escape from the need for domestic structural adjustment. To achieve this, China must increase domestic consumption's share of GDP. This has already been written into

the government's 12th five-year plan. Unfortunately, given high inflation, structural adjustment has been postponed, with efforts to control credit expansion becoming the government's first priority.

This enforced investment slowdown is itself increasing China's net savings.

Real appreciation of the yuan is inevitable so long as Chinese living standards are catching up with US levels. Indeed, the Chinese government cannot hold down inflation while maintaining a stable value for the yuan. The PBC should target the yuan's rate of real appreciation, rather than the inflation rate under a stable yuan. And then the government needs to focus more attention on structural adjustment - the only effective cure for China's $US3.2 trillion headache.