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China’s love affair with US bonds is not over...yet

China and the US | China’s love affair with US bonds is not over... yet Ian Fraser

I wrote a blog post six months ago saying that Americans should not be paranoid about the possibility that China, the country’s biggest lender, will cause economic mayhem by dumping the $1 trillion plus of US Treasury Bills and dollar-denominated assets it currently holds.

I argued that the chances of such a scenario – which would send US interest rates sky-rocketing and dramatically increase America's debt-servicing costs – were remote. This was largely because of a lack of alternatives. Where else could Chinese officials find a safe haven for their vast surpluses?

Today I admit to being partially wrong. Over the past few months, Beijing has been seeking to diversify its foreign-exchange reserves. A recent article in The Daily Reckoning (The Truth Behind China's US Treasury Sale) revealed that China has been selling down its US holdings. Richard Lee wrote:

For the first six months of the year, China invested $3.4bn in Korean securities and another $20.1bn in Japanese government bonds. At the same time, it has slowly and steadily reduced its exposure to US Treasuries.

There is no question the Chinese are selling US bonds. On August 16, the US Treasury announced that China had sold US bonds for the second consecutive month – dumping approximately $24bn worth. This was on top of $34.2bn in US fixed-income securities the Chinese officially unloaded in February. Combined, both sales represent a 2.3% drop in holdings from January to June – with total US bond holdings declining by 5% since the beginning of the year.

However, endorsing my earlier post, Lee said talk of the “bond apocalypse” that is so eagerly awaited by some economists is premature. He said the value of the US bonds offloaded by Beijing in the first half of the year represents just 2.3% of China’s total overseas bond holdings. He also said it's wrong to assume China is selling because it fears for America's economic future.

There are a plethora of possible reasons the country is selling now – a shift in short-term strategy, hedging or portfolio reallocation, etc…

Lee attributes China's decision to pare back exposure to its T-bills to something more benign. Basically, he believes Chinese officials are becoming more like other investors. They want meaningful rates of return and a more diversified portfolio.

Other things preventing China from dramatically reducing its US sovereign exposure include the fact Beijing continues to peg the Yuan/renminbi to the dollar. To keep its currency within the prescribed band, China must own large quantities of US bonds.

As Lee explains: "The Chinese government sells the yuan (or renminbi) when buying US Treasuries (or US dollars) to keep the exchange rate stable. This necessity not only ensures China’s interest in retaining current dollar holdings, but also temporarily guarantees no decisions towards any massive shift in current positioning."

In an earlier blog post, Fortune’s Colin Barr claimed China’s decision to sell down its holdings of US sovereign debt has been driving down yields on T-bills.

Over two months in which China reduced its Treasury holdings by $56bn, the yield on the 10-year Treasury bond tumbled to around 3% from 3.7%. Since the end of June, the yield on the 10-year Treasury note has dropped even further, approaching 2.6%, its lowest level since the financial crisis was bottoming out in March 2009. Yields are falling as investors around the globe shift their focus to generating income at a time when optimism about an economic recovery is diminishing.

However I would question Barr's thesis. Normally in fixed-income markets, weaker demand causes bond yields to rise, not fall. Yields on US bonds are more likely to be falling because of surging demand from domestic investors, who are piling into the asset class as they become disenchanted with the stockmarket. US investors withdrew a staggering $33.12 billion from domestic equity mutual funds in the first seven months of 2010.  How very un-Chinese of them!

Further reading on China and the US and China's long-term relationship with the dollar

Tags: central banks , China , global imbalances , sovereign debt , US
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