US bonds still comprise a major share of Chinese foreign reserves. Currently, China's foreign reserves have surpassed US$1.2 trillion, the largest number in the world. About 70 percent of these reserves are dollar assets, including high liquidity US bonds, securities and corporate bonds.

 

People are becoming increasingly uneasy about reports saying China is reducing its holdings of US bonds. Currently, China is the second largest holder of US bonds, retaining 10 percent of all tradable bonds of the United States. Some analysts fear that China's new moves to reduce this number will drag the US bond market down and further weaken the dollar.

 

Worry first came from the US Department of Treasury in June. Statistics showed by the end of April this year, China held US$414 billion in US bonds, US$5.8 billion less than they held by the end of March. Total tradable US bonds are worth around US$4.4 trillion.

 

Analysts argue that China has continuously been increasing its holdings of US bonds before this downtrend. Yet the rare move may possibly indicate a new trend towards shedding some of the excessive holdings.

 

The case is reminiscent of another event coming on November 25, 2004. On that day, Yu Yongding, then member of the Monetary Policy Committee under the People's Bank of China, mentioned that of all Chinese foreign reserves, dollar assets had decreased. Two days after his speech, the US bond market suffered a major decrease.

 

Therefore, recent reports of shrinkage in holdings have caught the attention of the US Department of Treasury. US Treasury Secretary Henry Paulson, Chairman of the US Federal Reserve Ben Bernanke, and his predecessor Alan Greenspan all recently publicly stated that the reduction of the US bond holdings by foreign countries should not pose a threat to US economic security. They argued that China only holds the one-day trading amount of all the US government bonds combined.

 

As a matter of fact, China isn't currently intent on cutting its holdings of US bonds.

 

Market forces hand

 

Liu Fuxiang, Professor with the University of International Business and Economics, noted that China's move is normal and is in line with market operation principles.

 

Liu said that the dollar has been weakening and depreciating, thus dollar assets no longer enjoy the same attraction as they used to. In order to save the country from losing money, China is smart to sell off some of the US bonds.

 

Liu's view is echoed by Zhong Wei, financial professor with Beijing Normal University. Zhong said that Chinese foreign exchange rate reform has led to mild appreciation of the yuan against the dollar, thus reducing the necessity of dollar assets. The reason for cutting US bonds is that interest rate trends in the middle- and long-term for US bonds are unpredictable and uncertain. Currently, most Chinese foreign reserves are dollar assets. If the dollar depreciates greatly, China will suffer huge losses.

 

In fact, China is not alone. British and Russian central banks have shown similar concern.

 

Statistics from the US Department of Treasury show that Britain reduced its holdings of US bonds by US$12.4 billion in April, the biggest cut of all countries.

 

In general, world investors were selling US bonds in April. By the end of April, countries outside the United States held US$2.17 trillion, down US$28.2 billion from the end of March.

 

Xie Guozhong, former chief economist with Morgan Stanley China, contended that China's April move was caused by the change in expectations over yields of the US bonds and because of the US inflation rate.

 

Since 2002 the dollar has depreciated 15 percent. In April, the US bond market depreciated US$555 billion, forcing US bond holders to sell.

 

Moreover, the Chinese central bank also has to trade foreign reserves to maintain the renminbi exchange rate in order to keep it floating within a reasonable range, and shedding US bonds, which take the biggest share in China's foreign reserves, becomes the first choice for maintaining this level.

 

Optimizing foreign reserve structure

 

The US$5.8 billion in US bonds China shed are just a small sum, but it reflects a fact that the Chinese central bank is consciously optimizing its foreign reserve structure.

 

Currently, China's foreign reserves have surpassed US$1.2 trillion, the largest number in the world. About 70 percent of these reserves are dollar assets, including high liquidity US bonds, securities and corporate bonds. About 20 percent of the reserves are euro assets and the final 10 percent are made up of currency assets such as the Japanese yen and the South Korean won.

 

Judging by the foreign reserve structure, dollar assets make up the largest proportion. China's bulk purchase of US dollar bonds provides financial support for the US treasury deficit and helps maintain US interest rates at relatively low levels.

 

Current trends show that in the next few years, Chinese foreign reserves will increase steadily. With renminbi appreciation the US dollar will depreciate. This means the value of China's dollar reserves will decrease significantly. Therefore, China must change its foreign reserve structure before losing out.

 

"Dollar assets should make up about 60 percent of all Chinese foreign reserves," said Liu.

 

Two years ago, China planned to diversify its foreign reserve structure.

 

On May 31 this year, the vice governor of the Chinese central bank Wu Xiaoling stated clearly that China didn't mean to reduce the dollar assets in its foreign reserves, but that the importance of the euro as a reserve currency is certainly on the rise.

 

The Chinese central bank is also considering whether or not it would like to increase the proportion of its holdings of Japanese yen and gold. Meanwhile, China is investing its US assets to reduce losses caused by the dollar depreciation.

 

China is planning to set up a national foreign reserve investment company that will manage US$200 billion of the Chinese foreign reserves. While not yet officially established, the company has already taken some action. In May it invested US$3 billion in the biggest US private equity firm-the Blackstone Group.

 

In 2006, the State Administration of Foreign Exchange canceled restrictions on Chinese investment abroad and said it intends to support domestic companies as they begin to invest overseas. Before, domestic companies could only invest at most US$5 billion abroad each year and they had to get approval from the supervisory department if their purchase of foreign reserves surmounted US$10 million.

 

"Those measures didn't reduce the dollar assets, but will reduce its proportion in the Chinese foreign reserves," said Liu.

 

No abrupt reduction

 

Professor Liu said that in order to optimize foreign reserves, China will proceed in a stable, safe and floating manner. That means diversification of the foreign reserve structure will be a gradual process and China won't cut its US bonds substantially.

 

Tan Yaling, senior researcher with the Bank of China, agreed with Liu's opinion. She said that US bonds are still one of the most stable investment objectives, as "the US economy is far better than that of other countries."

 

Tan contended that compared with the United States, the economic structures of the European Union and Japan are relatively weak and are less mature and steady. As a result, currency stability of those countries is not as strong.

 

He Fan, a research fellow with the Chinese Academy of Social Sciences, said China's stance in regard to holding US bonds is a great concern of the global financial market, thus China is faced with a conundrum: US dollars are undergoing a depreciating trend, and if China sells the US bonds in large amounts, the dollar will further depreciate substantially, leading to a plunge in the value of Chinese foreign reserves. However, if the US economy is in trouble, the Chinese economy will also suffer because the United States is the biggest export destination of China.

 

He said it seems necessary to reduce the proportion of dollar assets as other currencies appreciate. But in effect, China doesn't want to see the chain reaction caused by a large-scale sale of US bonds. For instance, selling bonds will help increase the US interest rate and the cost of loans, which will result in a slump in consumption. The consumption slump will reduce US imports from other countries, thus exporting companies of other countries-especially China-will be hurt enormously. In the end, China's economy will suffer.

 

The United States is the most powerful country in the world and its status as such will continue over a long period of time. Whatever currency-euro or yen-cannot challenge the dollar's dominant status. No other economies are as attractive as the economy of the United States. When China-US trade relations deepen and political cooperation grows stronger, China will never and should not ignore the long-term value of dollar assets.

 

Tao Dong, chief economist of Asia-Pacific region with Credit Swiss First Boston, stated confidently that "China won't sell dollars as people fear and it will continue to buy dollar assets this year."

 

(Beijing Review July 12, 2007)