Decoding China’s US Treasuries strategy

SHANGHAI: China is the world’s biggest foreign holder of US Treasuries, which it uses to manage the value of its currency and park its massive foreign-exchange reserves. But a Bloomberg report last Wednesday suggested that Beijing may be reviewing its vast holdings, sending Treasury yields to 10-month highs.

Still, many factors limit China’s room to manoeuvre on Treasuries. Let’s look at the key questions:

Why does China own $1.2 trillion of Treasuries in the first place?

In part because Treasuries are the only instruments seen as liquid enough to park part of China’s massive foreign-exchange reserves, which have surged thanks to years of export surpluses.

China also fixes its exchange rate against the dollar, so buying and selling dollar assets is largely aimed at managing the value of the yuan. US Treasury data shows that, over time, Chinese holdings of Treasuries have been relatively stable.

Could China really dump, or at least pare, those holdings?

The People’s Bank of China would trigger a sell-off if market participants believed it has truly soured on Treasuries, which would cause the value of its own reserves to fall. That is not an outcome that would be palatable politically or economically.

Even if the central bank were to dial back its Treasuries holdings, there appear to be few options to replace them. Ten-year US Treasury yields are more than 200 basis higher than those on comparable German Bunds. Japanese 10-year government bonds yield about zero.

China could move investments to other dollar-denominated debt such as mortgages or deposits, reallocate investments to euro, yen or other currency-based assets or buy debt from emerging countries.

Is China just sending a signal to the United States?

China has been discomfited by President Donald Trump’s tough talk on trade and may have been sending a warning shot to Washington.

The US trade deficit with China is still rising, thanks to a steadily growing US economy and buoyant jobs growth. The deficit reached $344.4 billion in January-November last year, from $319.3 billion in the same period in 2016.

What does this all mean for Treasury yields?

Declining participation by China could reduce overall demand for US government debt, and the Treasury would need to pay higher yields. The US will be raising debt issuance to make up for declining purchases by the Fed and ongoing strains on the budget.

If China retreats, would other buyers step in?

Other sovereigns, banks, large asset managers and insurance companies might fill any gap left by China. Treasuries benefit from their relative safety and liquidity. They are also in demand by banks to meet regulatory requirements relating to liquid asset holdings.