China won't risk its assets with a rebalancing act
Relax. Fears that China will scale back its purchases of US treasuries after last week's yuan revaluation, or even begin to dump American bonds, are wildly misplaced.
No one knows quite how much US debt China owns, but the sum is huge. Over the past few years, Beijing has intervened massively in the foreign exchange market, selling yuan and buying US dollars to maintain the exchange rate peg it relinquished last Thursday.
By the end of last month, the People's Bank of China had built up a stock of foreign reserves worth US$711 billion. Economists debate exactly how much of that is held in dollar-denominated assets, but it is certainly most.
With the yuan formerly pegged to the US dollar, most of China's trade and investment inflows denominated in the American currency, and market liquidity concentrated in dollars, it would have made no sense to intervene against any other currency.
Today, according to the best estimates of foreign exchange and fixed-income asset dealers, China probably holds 75 per cent or more of its reserves in US dollars. Much of that is in the form of US government or agency debt.
After last Thursday, the fear is that the central bank will begin rebalancing its reserves to reflect the composition of the currency basket it has adopted as a reference for the yuan's value. No one yet knows the basket's exact make-up but the universal assumption is that the dollar will carry a far lower weight than 75 per cent, possibly about half as much.
'By moving to a currency basket, China will need to diversify its enormous portfolio of foreign exchange reserves,' wrote Morgan Stanley chief economist Stephen Roach in a research note sent to clients after the revaluation. That could lead to a wholesale flight from dollar assets, warned Mr Roach, 'a precipitous decline in the dollar, a spike in US interest rates, a collapse in the US property market, a severe adjustment by the American consumer, and a sharp global recession'.
The bond market appears to share Mr Roach's concerns. On Thursday, investors reacted to news of the Chinese policy shift by selling off US government debt, pushing the yield on 10-year treasury notes - the benchmark long-term interest rate - sharply higher.
Thankfully, these fears are wide of the mark. It is simply not true that, as China has switched to managing the yuan against a basket of currencies, it must also switch its reserves into those currencies. The central bank could happily hold its reserves in dollars without undermining the basket's validity as a reference tool.
What is more, just because the central bank is now managing the yuan against a basket of currencies, which doubtless includes the euro, the yen and the dollar, it does not mean it must suddenly begin buying and selling euros and yen. The bank can steer the value of the yuan against its basket most easily by intervening only in the dollar-yuan market, by far the most liquid currency pair traded on the Shanghai foreign exchange market.
It is true that, as a long-term goal, China would like to diversify its foreign exchange holdings. Beijing plans to spend about US$10 billion building up a strategic oil reserve, for example. But the central bank is certainly not going to rush into a rebalancing, especially if that is likely to precipitate a sell-off in US currency and debt, undermining the value of the assets it holds, and trigger a global recession that would inflict severe damage on the Chinese economy.