Opinion: China’s love-hate affair with US Treasuries will only grow

The mainland’s reserves rose above US$2 trillion and are set to keep mounting this year. It has little choice but to keep putting most of this into US Treasuries.

  • 15 Jul 2009
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Having so much money you don’t know what to do with it might not seem like much of a problem. But when you’re talking about US$2 trillion it can take on new dimensions.

China reported that its foreign exchange reserves topped US$2.13 trillion at the end of June. In the past three months alone the amount grew US$177.9 billion, probably the largest single quarterly gain on record.

The rise was partly due to an appreciation of the US dollar, and some is down to local banks buying renminbi with foreign currency amounts to take advantage of higher interest rates in China. But a large amount was down to foreign capital, which continues to pour into the mainland.

“You can add up the factors – high economic growth, appealing interest rates, almost no risk against the US dollar – and add one more theme: asset prices in China have enjoyed some of the best performance in the world over the past six months, especially property,” says Tin Lu, China economist at Bank of America – Merrill Lynch. “It’s very natural and understandable that money is flowing into China.”

Given that this situation does not look likely to change, China’s US$2 trillion in reserves will only keep rising. Having to cope with an ever-expanding piggy bank sounds is far from the worst of problems, but Beijing still has the headache of where to put it all.

In the short-term at least the country has little choice. It will have to invest most of it into US Treasuries. “There is no other market that is as liquid as US Treasuries,” said Lu. “They have little choice but to continue buying them.”

It is a frustrating situation for China’s policymakers. Diversification is key, even if you are the world’s largest investor, and Beijing is already believed to have put the bulk of its reserves into Treasuries. Policymakers must be reluctant to further increase the country’s exposure to a weak US economy.

But its alternatives are limited. One option would be to place a chunk of the money coming in into state investment funds like the China Investment Corp. (CIC). The trouble is that the CIC lost a lot of money on some investments it has made. The PBOC would be very reluctant to do the same, given the wrath it would incur.

Other possibilities are for the central bank to raise its holdings in European government bonds or even long-term Japanese Government Bonds. Physically buying several tonnes of gold could be another option.

While these are all possibilities, the US Treasury market looks likely to be the biggest recipient of the mainland’s burgeoning FX reserves.

China may be slowly weaning itself off the waning demand of US consumers, but its reluctant addiction to US government debt is becoming stronger than ever.

Seeking a bigger seat
China’s mounting exposure to US dollar debt raises another question: why have officials from the People’s Bank of China and Beijing politicians been so vocal about dropping the dominance of the US dollar in FX reserves in favour of special drawing rights?

Casting doubt on US dollars as the global currency of choice could diminish the currency’s value. That seems counterproductive, given China’s vast US dollar-denominated FX reserves.

The likelihood is that China is playing bait and switch. Beijing knows that the US dollar will remain the international currency of choice for a long time to come, but it is making the statements to pressure the US into giving it what it really wants: increased international influence.

In the last few years China has increasingly flexed its international financial muscles through state-owned enterprise acquisitions and bi-lateral lending across the world. Observers believe that the country also wants to increase its influence in multilateral agencies, especially the International Monetary Fund (IMF).

Country voting rights at the IMF are meant to reflect the economic power of each nation, and China rightly feels it hasn’t got enough sway. While its economy accounts for roughly 7% of global GDP, its IMF voting rights are currently less than 4%.

Observers believe China would like to gain its full weighting, possibly before the next timetabled period of adjustment in 2011. Placing public pressure on the US over the dominance of the US dollar could be one tactic to meet this goal.

Additionally Beijing’s statements on the US dollar could be part of a long-term strategy to introduce the renminbi into the IMF’s special drawing rights (SDRs).

SDRs are a form of reserve asset for central banks. Currently they are comprised of four currencies – US dollars, euros, Japanese yen and British sterling.

China may well want to the renminbi to be included. That would explain why its officials have been so keen on advocating SDRs as an increased component of foreign exchange reserves.

The next time the IMF reviews the currency composition of SDRs is November 2010. Given that a key requirement for a currency to be included in the SDRs is for the backing economy to have a free capital account, there is almost no chance that China could meet that deadline.

But it is possible that the renminbi could meet it by 2015, the following date for a review of the SDRs.

China’s communist regime is well known for drawing up five-year plans. Could its recently-announced pilot scheme to settle renminbi offshore and the loud statements about the merits of SDRs be the opening moves in its next one?

  • 15 Jul 2009

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