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Despite default risk, Beijing is stuck with US Treasury debt

None of the diversification options – commodities, foreign equities and property and debt of other big sovereign borrowers – look attractive

PUBLISHED : Wednesday, 16 October, 2013, 12:00am
UPDATED : Wednesday, 16 October, 2013, 2:39am

The international flap over US debt ceiling negotiations is causing disquiet in Beijing.

The chances that Washington will actually default on US Treasury bills and notes are tiny. Even if talks continue beyond tomorrow's self-imposed deadline, when the government's gross debt is expected to reach its US$16.7 trillion limit, the Treasury will still be able to roll over maturing bills and will have more than enough cash flow to cover its interest payments.

Yet Chinese officials are worried. Yesterday, Vice-Finance Minister Zhu Guangyao called on Washington to take "concrete steps" to resolve the deadlock and prevent a default.

Meanwhile, the tone of China's media coverage has become increasingly shrill, with Xinhua proclaiming that "such alarming days when the destinies of others are in the hands of a hypocritical nation have to be terminated, and a new world order should be put in place".

This nervousness is understandable. At the end of last month, China held a record US$3.66 trillion in official foreign exchange reserves. Much of that money is invested in US government debt. According to US data, at the end of July, China owned US$1.28 trillion of US Treasury securities - more than a third of its official reserves (see the first chart).

When you are sitting on US$3.66 trillion, there is only so much you can buy

That probably understates the true picture of China's exposure. If past patterns of holdings are anything to go by, then it is likely that Beijing owns an additional US$200 billion or so in Treasury debt held by custodians in European and Caribbean financial centres.

Meanwhile, China continues to accumulate new reserves at a blinding pace. The total value of Beijing's holdings shot up by US$163 billion between June and September.

Much of that increase can be attributed to valuation gains as the euro portion of China's reserves rose in value against the US dollar. Beijing also earned about US$35 billion in interest on its existing debt holdings.

But according to estimates by Mark Williams and Wang Qinwei at independent research house Capital Economics, the People's Bank of China also bought as much as US$90 billion in foreign exchange during the third quarter to prevent the yuan from appreciating. About US$70 billion of those purchases were made in September alone (see the second chart).

Officials would dearly like to curtail their intervention, but yesterday's jump in the value of the yuan to a near 20-year high against the US dollar illustrates the upward pressure exerted on the yuan's exchange rate by both trade and hot money flows.

Officials worry that if they were to stop intervening, runaway yuan appreciation would quickly erode the competitiveness of Chinese-made goods at a time when export volumes are already soft.

As Williams and Wang explain: "China's policymakers remain deeply uncomfortable with allowing market forces a say in determining the exchange rate at times of uncertainty."

China's reserve managers would also like further to diversify their existing holdings away from US Treasury debt.

But when you are sitting on US$3.66 trillion, there is only so much you can buy. In recent years, Beijing has built up strategic reserves of key commodities, including oil. But with the capacity of commodity markets relatively small, the diversification effect is meagre.

China has also branched out into international equities and property. But again, the amounts Beijing can buy without triggering local resistance are limited.

That leaves the debt of the world's other big sovereign borrowers: the euro zone, Japan and Britain.

But although China has diversified into all three, none looks exactly attractive, even compared to bonds issued by a US Treasury bumping against its debt ceiling.

In short, Beijing is stuck with holding US government debt. No wonder officials are seething.

tom.holland@scmp.com