The managers of China's enormous US$2.45 trillion pot of foreign-exchange reserves have been buying Japanese government bonds recently - lots of them.
According to data from Japan's Ministry of Finance, China bought almost 1.3 trillion yen (HK$116.7 billion) worth of Japanese government bonds over the first five months of the year. To put that amount into perspective, it's five times as much as Chinese buyers bought in the whole of 2005, the previous record year for Chinese purchases of Japanese public debt.
Now, it's no secret that China's reserve managers desperately want to diversify their holdings away from US dollar assets. With around two-thirds of their reserves denominated in dollars, and most of that amount invested in US Treasury bonds, they are understandably nervous at how the US budget deficit has exploded since the beginning of the financial crisis. With US public debt rapidly approaching 100 per cent of gross domestic product, Chinese officials fret that US authorities may be tempted simply to print money to repay their debts, undermining the real value of Beijing's holdings.
Although their worries are understandable, buying Japanese government bonds is hardly the obvious thing to do if you are scared by high levels of government debt. After two decades in which successive Japanese governments have tried to kick-start economic growth with giant public spending packages, Japan's sovereign debt now stands at almost 220 per cent of gross domestic product, dwarfing even the US government's ratio.
It's possible that Beijing's reserve managers believe the government of Japanese Prime Minister Naoto Kan might triumph where its predecessors have failed and succeed in revitalising the country's ailing economy.
If so, they are optimistic. Last month, Kan's cabinet published its 69-page Blueprint for Revitalising Japan. In it, Kan's government pledged to defeat the country's persistent demand-killing deflation by March 2012, and set out its plans for balancing the budget and achieving a 2 per cent real annual growth rate over the next 10 years.
Eschewing both the inefficient infrastructure investments of the past and painful structural reforms, Kan's government is counting on 'a third approach', which relies heavily on boosting the environmental, health care and tourism sectors as well liberalising intra-Asian trade.
For example, the government hopes to create a 50 trillion yen environmental market by reducing Japan's greenhouse gas emissions to 25 per cent below 1990 levels by 2020. Similarly, it is hoping to generate 50 trillion yen a year and nearly three million jobs by throwing Japan's health care sector open to private companies.
On top of that, the government aims to increase the number of tourists visiting Japan to 25 million a year from six million in 2004, and to generate 12 trillion yen of demand with the creation of an Asia-Pacific free-trade area.
At the heart of Kan's plan, however, is a proposal to boost Japan's competitiveness by slashing the corporate tax rate from 40 per cent now to between 25 and 30 per cent, while attacking the government's deficit by doubling Japan's consumption tax from 5 to 10 per cent.
The strategy's chance of success looks slim. Cutting corporate taxes will exacerbate the deficit in the short term. Meanwhile, increasing the consumption tax is risky. A smaller increase in 1997 was widely blamed for pushing the economy into recession, and observers fear that raising the rate now will crush consumer demand. That will not only worsen the deficit, weak demand will make it even more difficult for the Bank of Japan to overcome deflation, which has plagued the country's economy for much of the past decade, and continues to run at an annual rate of around 1 per cent, despite more than 10 years of ultra-loose monetary policies.
And if the economic obstacles were not daunting enough, there are political problems to consider, too. The government's defeat in last weekend's upper-house elections threatens to jeopardise Kan's legislative agenda and could still lead his own party to oust him from office. As a result, it is hard to believe that Kan's plans to defeat deflation, balance the budget and revitalise growth are likely to work.
That doesn't necessarily mean Japanese government bonds are an uglier investment for China's reserve managers than US or euro-zone government debt. But neither are they much more attractive.