Flight to “safety” eases China diversification
China appears to be taking steps to diversify its holdings away from the U.S. dollar and may just have chosen a pretty good time to do it.
Longer term a meaningful diversification by China, which holds about a third of its $2.45 trillion currency reserves in U.S. Treasuries, is probably both inevitable and highly risky.
Inevitable, because China probably realises that, given the U.S.’s difficult fiscal and economic challenges it is not sensible to have its own fortunes tied so closely to its major client.
Risky, because wholesale sales of U.S. Treasuries by China would drive up U.S. interest rates and could spark panic selling in the dollar. That would undermine the U.S. economy, hitting demand for Chinese goods, fouling U.S./China relations and, not least, torpedoing China’s own accumulated wealth.
However, it seems, people have more important things to be scared of than Chinese portfolio sales, and are running headlong into Treasuries seeking safety from deflation and the threat of a recession. That is overwhelming any impact that China diversification is having on U.S. instruments, at least so far.
China reduced its holdings of Treasuries for the second month running in June, according to data released on Monday by the Treasury Department, sending its exposure down $24 billion to $843.7 billion. Significantly, sales included longer-dated issues, negating the argument that China is simply re-balancing away from the billions in short term U.S. debt it added during the depths of the crisis.
Overall, foreign demand for U.S. securities was about $44 billion in June, or some $5 billion less than the trade deficit, which expanded rapidly in the month. Like so many things in life, that seems to be both ultimately unsustainable but currently sustained.
And of course there is always the Federal Reserve, which is now buying Treasuries with money from maturing mortgage-related debt it holds. It hardly breeds confidence when the new big buyer of a countries’ debt is its own central bank, but yet yields on Treasuries fall as investors bet on lousy growth and no inflation.
CHINA’S YEN FOR ASIA
So far, the big winner, if you can call it that, in China’s diversification is Japan, which has seen increased demand for its bonds, sending the yen higher and complicating its effort to fight its way out of its own deflationary and recessionary trap.
“Even though the difference in yields is big, China has been abandoning U.S. debt and picking up Japanese debt. This definitely shows that it believes the risks of U.S. debt far exceed those of Japanese debt,” Zhang Ming, an economist with the state-backed Chinese Academy of Social Sciences wrote in a report.
Zhang noted that Japanese bonds are more stable because they are heavily owned domestically, an observation rich in irony. China then is going to cut back on owning Treasuries because too many of them are held abroad?
China bought a net 1.7 trillion yen of short and longer-term Japanese debt in the first half of the year, a major increase from recent years. This may well have contributed to the resurgence of the yen, which has strengthened by nearly ten percent against the dollar this year despite minuscule interest rates and very little growth.
And it is not just Japan – Chinese investors’ holdings of Korean government debt rose by 111 percent in the first six months of the year to $3.4 billion, according to Korean government data.
Interestingly, China announced what amounts to a partial opening of its capital account this week, moving to allow yuan accumulated overseas as a result of trade settlement or central bank swaps to be funnelled back into the mainland’s interbank bond market.
This is important not because it will be a lot of money, but because it paints a picture of a China that wants the yuan to have an important regional or even global role. That is necessary if China wants to position itself as a regional or global capital markets player.
It also points towards a future, perhaps a distant one, in which the U.S. dollar has a diminished role as a global reserve currency.
Getting from here to there won’t be easy or smooth. China may be able to get away with a gentle diversification so long as fear and momentum investing drives more investment into Treasuries, but at a certain point the market is liable to look at China’s actions, look at the U.S. trade deficit and decide it has something new to worry about.
Perhaps that will never happen, but at the very least it poses a risk to the U.S. dollar, a risk that will not go away any time soon.