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Tom Holland

When you're in a hole, stop digging.
In a nutshell, that's the advice Yu Yongding offered to China's economic policymakers yesterday.
These days, Yu is a professor at the Chinese Academy of Social Sciences, but in the past he has sat on the monetary policy committee of the People's Bank of China, as well as a string of other high-powered advisory bodies.
So what Yu says is often worth listening to, and yesterday he was saying that China should stop buying US Treasury bonds.
Lots of people in Beijing agree with him. According to official US figures, at the end of December, China held a massive US$1.16 trillion in US Treasury debt.
The true figure is higher. Beijing makes a portion of its Treasury purchases through third parties. Without going into too much detail, we can estimate with a fair degree of confidence that at the end of last year, China's central bank owned around US$160 billion in US Treasury bills and notes held by London banks. That means China's overall holdings of US government debt were worth a thumping US$1.32 trillion. In other words, almost half of China's total foreign-exchange reserves were invested in US Treasury bonds.
And China's reserve managers continue to buy at a furious rate. By adding the purchases through London to the increase in China's official holdings, we can estimate that Beijing made net purchases of US Treasury debt worth nearly US$350 billion last year. That's US$29 billion a month.
These purchases bother Yu. With gross US government debt now US$14.2 trillion - 96 per cent of America's gross domestic product - and rising, he believes the US government is heading for an effective default.
Yu acknowledges that there is not much China can do about its current stock of US Treasuries; selling them is not a realistic option. But he does argue that China should stop buying more.
Unfortunately, Yu doesn't say what China should do instead, so let's consider some of the options.
Beijing bought those Treasuries in the first place because it had to do something with all the US dollars it accumulated by exchanging China's export earnings and inward investment flows for yuan. So the most obvious solution is diversification. Instead of buying US Treasuries with its money, China should buy something else.
Unfortunately, this is more difficult than it sounds.
Rather than buying US Treasuries, the central bank's reserve managers could invest their US dollars in US corporate debt or equities. They already buy some, but the trouble is that private-sector bonds and stocks are considered even more risky than US government debt. Buying more of them wouldn't solve the problem.
Alternatively, Beijing could buy debt issued by other governments. There are drawbacks with this option, too. The only real candidates are bonds issued by European governments, or Japanese government debt.
But Beijing already owns large quantities of both. With Europe midway though its own public debt crisis and many economists warning that defaults by several European governments are only a matter of time, China's reserve managers are understandably wary of massively ramping up their purchases of European bonds. Meanwhile, Japan, with its public debt now standing at 200 per cent of gross domestic product - the highest in the world except for Zimbabwe - is even less attractive as an issuer.
Another option could be to buy commodities. This is a popular one in Beijing. Just yesterday one senior Communist Party official suggested that instead of buying up US Treasuries, China should invest its money in building a strategic stockpile of rare earth minerals.
Alas, this wouldn't work either. According to the US Geological Survey, in 2009 the world mined 126,230 tonnes of rare earths. At current sky-high prices, that entire tonnage would be worth only US$4.6 billion. In other words, if China wanted to buy rare earths instead of Treasuries, it would need to buy the world's entire annual output of the minerals, plus the output of an additional 74 planets.
And that calculation ignores that 95 per cent of the world's rare earth production comes from China anyway. To replace its US Treasury purchases, Beijing would have to buy rare earths mined abroad, which means it would need to buy the total international mine production of 1,500 planets. That's not practical.
There is, however, another option: Beijing could stop digging.
The central bank is buying US Treasuries because it has to do something with the foreign currency it is accumulating. If it doesn't want to buy any more, it could stop soaking up all the foreign currency that flows into China.
Of course, if the central bank simply stopped buying foreign currency, then the inflows would drive the yuan's exchange rate through the roof overnight, which would play hell with China's export industries. To relieve the upward pressure on the yuan, Beijing would have to allow private capital to flow freely out of the country.
In other words, if Beijing wants to stop buying US Treasuries, it will have to float its currency and dismantle its capital controls.
That solution, however, would fatally weaken the Communist Party's grip on China's economy. It's not going to happen any time soon. China is in a hole, and it's going to go on digging.



China is deep in a hole, but Beijing won't stop digging