China’s U.S. debt overhang needs Chinese cure

By Wei Gu
June 3, 2009

Wei Gu — Wei Gu is a Reuters columnist. The opinions expressed are her own. —

When U.S. Treasury Secretary Timothy Geithner told students at Peking University that China’s holdings of U.S. Treasury bonds were safe, his answer drew loud laughter from the audience.

Even economist and columnist Paul Krugman, who is often critical of U.S. economic policy, found himself defending America when he was repeatedly asked the same questions in China recently: Will you (U.S.) underwrite the value of China’s holdings of U.S. government debt? Will you be prepared to pay a much higher rate of interest against the risk of high inflation and dollar depreciation?

This is a big change from two decades ago, when many Chinese felt the best way to preserve their savings was to convert yuan into dollars on the black market.

Dollars are still affectionately called “mei jin” in Chinese, which literally translates to “American gold”, but they are now also referred to as toxic assets by many in China.

Last week’s decline in U.S. bonds and the dollar after the sale of $100 billion in new U.S. Treasuries have made the Chinese even more concerned about the country’s estimated $1.4 trillion of reserves parked in dollar-denominated assets.

The Chinese government wants to assuage rising domestic fury about the losses China faces on its $2 trillion foreign reserves, so the country’s economists have come up with various options for Washington to “guarantee” the value of China’s dollar holdings.

China craves such a guarantee because it has no choice but to keep buying U.S. debt. Were it to stop doing so, the value of its existing holdings would be imperiled.


There is, however, something Beijing can do to rid itself of the shackles of its reliance on U.S. Treasury bills: allow its companies and citizens to invest more freely abroad, and loosen its grip on the capital account.

When the private sector buys dollars from the central bank to invest abroad, the pile of foreign currency the central bank has to manage will decrease over time.

Currently, Beijing enjoys a near-monopoly on investing externally (as well as domestically) as it is virtually the only holder of dollars in the country given the stringent controls on foreign exchange holdings.

Given the huge volume of funds Beijing handles, and the requirement to keep reserves in liquid securities, much of the cash has found its way by default into the U.S. Treasuries market.

The yuan has appreciated about 20 percent against the dollar in the past four years, while returns on U.S. Treasuries at most match that, meaning the reserves have made no money in yuan terms.

Private sector investors would be more likely to be interested in stocks and commodities than in “boring” Treasuries. Buying stakes in the world’s best companies and securing natural resources are also in China’s strategic interest. China’s sovereign wealth fund has progressively been doing that on behalf of its 1.3 billion people, but the fund only accounts for 10 percent of China’s reserves.

China has talked about “cang hui yu min”, meaning dividing some foreign currency holdings among its citizens. So far, it has put some dollars on state-owned banks’ balance sheets, partly in an effort to mask the rapid pile-up of its reserve holdings, and allowed Chinese investors limited access to foreign securities through certain funds.

For ordinary Chinese, there is growing interest in investing beyond Chinese assets. People do want to diversify their yuan holdings, buy property abroad for children studying overseas and invest in foreign bluechips. But under current rules they are not even allowed to buy stocks of Chinese companies traded in Hong Kong.

Beijing has also stressed a “going abroad” strategy in recent years, but Chinese companies with global ambitions still have to go through lengthy approval process. That partly explains why China’s outbound foreign direct investment accounts for about 3 percent of the global total, far below its share of world trade and economic output.

Now is a good time to loosen some control, since China’s economy is healthier than most others, the risk of big capital outflows is relatively lower.

Admittedly, even reform of this sort is fraught with short-term risk because the markets will punish the dollar as soon as it senses the effect of what the Chinese are doing.

But what is clear is that the key to preserving the value of China’s reserves lie in the hands of Beijing, not Washington — pursuing a U.S. guarantee for China’s current investment strategy is barking up the wrong tree.

— At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

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