Why is China Dumping U.S. Treasuries?

Figures released by the U.S. Treasury Department on Tuesday showed that China reduced its holdings of U.S. Treasury securities by $34 billion in December. This marked the second straight month that China has been a seller, making Japan now the largest owner of U.S. Treasuries. According to U.S. government data, Japan’s stockpile of Treasury securities stood at $769 billion in December, while China’s came to $755 billion, down from $790 billion held in November.

Needless to say, these capital market actions have sparked numerous stories purporting to explain why China is dumping U.S. Treasuries.

One report blamed the securities sales on the recent announcement by the United States that it would sell $6.4 billion of arms to Taiwan. This argument was given some credence when Majors General Zhu Chenghu and Luo Yuan and Colonel Ke Chungqio of China’s People’s Liberation Army were quoted in an official Chinese publication calling for the Chinese government to retaliate against the United States economically, beyond the sanctions already announced, for this decision.

General Luo, a researcher at the Chinese Academy of Military Sciences, told China’s Outlook Weekly:

We should go in for a strategic mix of retaliation across politics, military matters, diplomacy and economics… For example, we could sanction them using economic means, such as by dumping some U.S. government bonds.

The Wall Street Journal had a somewhat different take, arguing in Heard on the Street that it wasn’t at all clear that China had, in fact, reduced its holdings.

How so? The key is to look at U.S. Treasury holdings in the U.K. and Hong Kong. Both have at least doubled in the past year. At the end of December, the U.K.’s holdings totaled $302.5 billion, and Hong Kong’s were $152.9 billion. In the Treasury International Capital data, analysts suspect a large portion of the holdings from those places—perhaps as much as half—in fact originate in China. The problem arises because Treasuries are often held on behalf of clients in financial centers like Hong Kong or London. For the data compilers, it’s hard to unearth the ultimate owners of the debt.?

The Wall Street Journal goes on to argue that indirect Treasury purchases suit China politically.

Headline data showing mainland China’s purchases of Treasuries leveling off help allay domestic criticism that China, a “developing” country, is keeping the profligate U.S. government afloat. ?It also injects a grain of doubt into the minds of free-spending U.S. policy makers when it comes to assuming that China will always be there to snap up the country’s debt.

There is no question that the relationship between the United States and China is deteriorating by the day. It began in 2009 with the U.S. tariff on tires; manifested itself in the complete lack of dialogue between the Obama Administration and China over the issue of climate change in Copenhagen; and has been exacerbated this year by the Google Internet war, arms sales to Taiwan and President Obama’s meeting with the Dalai Lama.

However, China always acts in its own best interests, and I don’t believe that China would shoot itself in the foot to protest any of these measures, its PLA generals notwithstanding. As many economic analysts point out, China’s stockpile of foreign currency reserves is so large that it has to own dollar-denominated assets, and any wholesale dumping of these assets would only drive down the value of the remaining securities in its portfolio. That is why I believe the explanation by the Wall Street Journal may be more accurate. International money flows are always difficult to decipher, and China has both political and economic reasons to obfuscate its capital market actions.

Sometimes, though, the simplest explanation is always the best. Perhaps China is just playing the currency markets, seeking to maximize its overall investment return? After all, $34 billion of sales is still less than a 5 percent move on a $755 billion portfolio.

I’m not a foreign exchange specialist, but in implementing its currency policy, it seems to me that China pays particular attention to the relationship between the U.S. dollar and the Euro, the two major currencies in the world. Over the past five years, there have been two notable events in China’s currency history—July, 2005 when China released the yuan’s peg to the U.S. dollar, allowing the Chinese currency to appreciate by 21 percent within two years; and July, 2008 when China once again pegged the yuan to the greenback, this time at approximately 6.8 to 1. It may be mere coincidence, but both events occurred when the dollar and the Euro were at high and low points relative to each other.

In the latter half of 2005, the U.S. dollar was at a high point against the Euro, which I would argue gave China room to release its dollar peg. By July, 2008, when China reinstituted the peg, the dollar’s value in relation to the Euro had fallen by 38 percent from its 2005 high. (At its high point in 2005, one U.S. dollar purchased 0.85 euro. By July, 2008, one dollar purchased only 0.62 euro, much to the chagrin of American travelers to the continent.)

It’s natural then for China’s currency traders to look at the relative values of the dollar and the Euro in determining their trading strategies. What have the dollar and the Euro been up to over the past year? After peaking at about 1 USD to 0.80 Euro in early 2009, the dollar fell throughout the year to a low of 1 USD to 0.66 Euro in early December. Throughout December and into this year, however, the dollar has regained strength, appreciating by approximately 12 percent against the Euro. Currently, one dollar buys 0.74 Euro.

My guess is that China’s currency traders have been selling into this rally, taking advantage of recent dollar strength. If the dollar continues to gain ground, look for China to continue to sell U.S. Treasuries. If dollar strength appears sustainable, look for China to once again reconsider the peg and allow the yuan to appreciate against the dollar. In this way, China’s currency traders may be tipping us off to future changes in the country’s currency policy.

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