If US defaults, will China bail on Treasurys?
With the deadline for the U.S. to raise the debt ceiling just over a week away, China and Japan – the largest foreign holders of U.S. Treasurys – have stepped up calls for quick action to avoid a default.
While market watchers currently assign a low probability to a U.S. debt default, if this scenario were to play out, what is the risk of the nation's top creditors bailing on its government debt?
"We do not think that China or Japan would sell significant amounts of the U.S. Treasury holdings. These holdings were built up as part of their FX reserve diversification programs and these flows are unlikely to be unwound," said David Forrester, senior vice president, G10 FX Strategy at Macquarie.
"Such [action] would lead to panic selling by other investors and generate larger losses for China and Japan," he added.
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China and Japan held $1.28 trillion and $1.14 trillion in U.S. Treasurys, respectively, as of July 2013, according to U.S. Treasury data. Thus, a fall in U.S. government bond prices would deplete the value of their reserves.
"While enacting a selling program would be a suitable means for Japan and China to express displeasure, it's counterproductive for them," said Timothy Riddell, head of global markets research, Asia at ANZ.
In the event of a default, Japanese and Chinese reserve managers are likely to allocate less reserves to U.S. government debt going forward, say experts.
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"You would see harsh warnings by Japan and China, and it would impact their future investment plans," said Mitul Kotecha, head of global foreign-exchange strategy, at Credit Agricole. "But for now, they're in a difficult position," he added.
This week, both Chinese and Japanese policymakers voiced their concerns over the debt ceiling standoff.
"The U.S. must avoid a situation where it cannot pay [for its debt] and its triple-A ranking plunges all of a sudden... if that happens, the U.S. would fall into fiscal crisis," Japanese finance minister Taro Aso told reporters on Tuesday.
(Read more: Japan should fear US shutdown, says IMF)
Meanwhile, in its first official reaction to the U.S. political stalemate over the budget and looming debt ceiling deadline, Beijing said "the clock is ticking" and urged politicians in Washington to "ensure the safety of the Chinese investments," the Financial Times reported on Monday.
Assuming there's no resolution to the debt limit impasse, Riddell says European and Japanese bond markets could be beneficiaries.
"The stability of Europe now that the [European Central Bank] has provided a backstop to prevent a breakup of the euro means that it's got more appeal," he said.
—By CNBC's Ansuya Harjani; Follow her on Twitter @Ansuya_H