RPT-COLUMN-Flight to "safety" eases China diversification

(James Saft is a Reuters columnist. The opinions expressed
are his own)

By James Saft

HUNTSVILLE, Ala, August 19 (BestGrowthStock) – 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.

(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. For
previous columns by James Saft, click on [SAFT/])

RPT-COLUMN-Flight to "safety" eases China diversification