China's Risk with Dollar

China buying U.S. debt dollars Treasurys

Over the short term China will continue to buy up U.S. dollars in order to keep their export business thriving, but over the long term they're definitely taking steps to ensure they're not forced to be put into this position again.

China’s foreign-exchange reserves are growing again, aiding the Obama administration to sell extraordinary amounts of debt as it seeks to pull the world’s largest economy out of a recession.

Stockpiles of currency rose by a record $178 billion in the second quarter to top $2 trillion for the first time, the People’s Bank of China said recently. The numbers are close to two-thirds the size of China’s economy.

The cash holdings are increasing as the central bank sells its currency, the yuan, to try to stop an appreciation that would make the country’s exports more expensive. The yuan sales mean for all the calls by China and other emerging markets for an alternative to the dollar as the world’s reserve currency, it has little choice but to keep buying U.S. government assets.

“People are talking about whether the Chinese may actually one day dump the dollar and Treasuries because of the problem in the U.S., but they are missing the point,” said Stephen Jen, head of macroeconomics and currencies in London at BlueGold Capital LLP. “The reserves are so big because China needs to keep the exchange rate stable for its exports. Therefore, they have to keep buying dollar assets.”

To me, Jen misses the point. Just because over the short term the Chinese are buying U.S. dollar debt doesn't in any way deter the idea that they will have a policy of getting rid of the dollar over the long haul. As the dollar continues to plunge in value and inflation really takes hold, then we'll see what the Chinese will really do.

The need to balance gains in its currency led China, the largest global holder of U.S. Treasuries, to more than double its holdings of U.S. government notes and bonds in three years to $763.5 billion in April, according to U.S. Treasury data. The amount was equal to 38 percent of its reserves at the time.

Stimulus Spending

Barack Obama’s administration is trying to sell a record amount of debt to pay for measures to revive the U.S. economy. New York-based Goldman Sachs Group Inc. projects that government borrowing go as high as $3.25 trillion in the year ending Sept. 30, almost four times the $892 billion in 2008, to finance the budget deficit.

The reluctance to let the yuan appreciate when the world is mired in the deepest recession in six decades means that China will keep accumulating U.S. debt, even if the amount of its purchases declines, according to economists at RGE Monitor, a New York-based research firm headed by economist Nouriel Roubini.

“Despite China’s concerns about the value of its large stock of U.S. assets, reserve diversification will continue to be difficult."

Cash Surge

China’s reserves have grown by almost 14 times over the last 10 years as exports generated a trade surplus that pumped in cash. Capital Economics Ltd. estimates that exports will generate 30 percent of China’s growth this year.

Investors have also recently pushed cash into emerging markets such as China, amid signs that their economies will recover more quickly than those of developed nations.

Such investment inflows mean that “policy makers bought dollars and sold local currency in order to prevent currency appreciation. China will continue intervening to keep the yuan trading at about 6.83 per dollar through the end of this year.

Yuan’s Stability

The yuan’s value has barely changed in the past year, following a 21 percent appreciation in the three years after China scrapped its dollar peg in July 2005. The demand for dollars conflicts with China’s recent calls for the world to consider drawing away from the greenback as its sole reserve currency.

“As the Chinese were becoming more vocal in regard to the need to move away from the U.S. dollar, they were in actual fact buying more dollars than ever,” said Derek Halpenny, European head of global currency research at Bank of Tokyo-Mitsubishi UFJ Ltd.

People’s Bank of China Governor Zhou Xiaochuan urged the International Monetary Fund in March to move toward creating a “super-sovereign reserve currency” to eventually replace the dollar. Premier Wen Jiabao said the same month that he was “worried” the dollar would weaken.

Speaking to Al-Arabiya television yesterday, U.S. Treasury Secretary Timothy Geithner expressed confidence that the dollar “will remain the principal reserve currency.”

Dollar Dominance

The dollar’s share of global foreign-exchange reserves increased to 65 percent in the first three months of this year, the most since 2007, according to the International Monetary Fund.

China is trying to reduce its reliance on the U.S. currency in other ways. It signed 650 billion yuan ($95 billion) of currency swaps this year with nations from Argentina to Belarus and is encouraging trading partners to use the yuan to settle cross-border trade.

The country’s top currency regulator this week relaxed curbs on overseas investment by local businesses, allowing more funds to flow abroad starting Aug. 1.

The 21.4 percent drop in net exports in June from a year earlier means “the yuan is stuck in cement until the middle of next year at least."

“The reserves will continue to pile up,” said Zhu Baoliang, chief economist of China’s State Information Center, an affiliate of the National Development and Reform Commission, the nation’s top economic planning agency. “Over the short term, there is not much that China can do but continue to buy U.S. Treasuries while hoping that the U.S. economy can recover as soon as possible so that China’s investment won’t suffer too much loss.”

However you want to communicate this, China over the long term will continue to diversify and not allow its currency and postion to be so dependent on the U.S. dollar. For now they'll continue to buy, but already they're taking steps to eliminate the inherent risks and very real threat of owning U.S. dollars.

China buying U.S. debt dollars Treasury's