Yes, Beijing will stick to US government bonds, no matter what happens on the trade front
China is unlikely to sell off its huge US debt holdings because they are the most liquid and secure place for its foreign exchange reserves
The investment is one of the most liquid and secure places for Beijing to park its massive pile of foreign exchange, so much so that China is now the US’ biggest foreign creditor with about 8 per cent of the outstanding debt. The real figure could be much higher when Beijing’s proxy investors are factored in.
As China and the United States edge towards a trade war, some commentators have suggested that Beijing’s stockpile is so big that it gives it a “nuclear option” – the power to retaliate by using a sell-off of the debt to send shock waves through the US financial system.
But analysts said China was still unlikely to dump its vast holdings of US bonds and its appetite for the debt would increase in years to come as two big shifts take place: as China’s foreign reserves shrink and its foreign debt repayment obligations grow.
China has been using its foreign exchange reserves to buy US Treasuries for decades, attracted by the liquidity and security offered by the world’s biggest economy.
Those purchases are the responsibility of the State Administration of Foreign Exchange (SAFE), an arm of China’s central bank that manages the country’s US$3.1 trillion of foreign reserves.
SAFE has never disclosed details about its portfolio of reserves, treating the information as a top state secret. It has, however, openly declared its faith in US bonds.
The preference for the bonds went largely unchallenged until 2007-2008, when the fall of the Lehman Brothers investment firm set off the worst economic crisis in America since the 1930s, hurting confidence in the US dollar as an anchor currency and Treasuries as a safe haven.
China sought to fend off the crisis by launching a massive fiscal stimulus, unleashing cash for a wave of infrastructure programmes.
As the action increased demand for energy and commodities and China’s capital inflows seemed unstoppable, Chinese commentators suggested China should invest in anything but “low-yield” US government bonds. Some even suggested that Beijing should give away its reserves to its people – a suggestion SAFE dismissed as impossible.
In an effort to obtain higher returns on investment than US government bonds could deliver, China Investment Corporation, a sovereign wealth fund, was created to take over the administration of US$200 billion in assets from SAFE.
SAFE also reorganised its management of foreign reserves, known as the Investment Centre, to diversify its investments. By 2011, it had created a “co-financing” unit to delegate money to state banks such as China Development Bank in financing overseas deals, according to a SAFE annual report.
The era also saw SAFE set up overseas corporate units, including SAFE Investment in Hong Kong, and Gingko Tree Investment in London. Gingko Tree Investment, for example, operates like a real estate fund targeting London and European trophy properties. It made headlines in 2013 by buying a 40 per cent stake in UPP Group Holdings, a major provider of university accommodation in Britain, for £550 million (US$731.8 million). It also teamed up with AXA and South Korea’s Hanwha Group for a £472 million buyout of London office building Ropemaker Place.
China’s disdain for US government bonds also grew with its confidence that it had enough foreign reserves to weather a financial storm, with Premier Li Keqiang saying the stockpile was great that it had become a “burden” for the country.
REVERSAL OF FORTUNE
That perception, however, soon reversed. After reserves peaked at US$3.99 trillion in June 2014, China’s financial and economic climate suddenly grew chillier and Beijing had struggled to “defend” its reserves.
Beijing’s attempts to stem a massive stock market rout – stepping in with curbs on new share issues and enlisting brokerages and fund managers to buy massive amounts of shares – and a yuan devaluation that sparked accusations of currency manipulation – sent capital flowing out of the country.
The leadership under President Xi Jinping responded quickly with an iron fist to keep the exchange rate stable and capital in the country. China’s biggest deal makers, including Dalian Wanda Group and HNA Group, were told to sell overseas assets quickly to repatriate funds, and SAFE adopted draconian capital account measures to discourage outbound payments.
In the aftermath, US Treasuries started regaining some of their shine in China.
Alan Wheatley, an associate fellow of international economics at the British think tank Chatham House, said the financial upheaval showed Beijing “the importance of holding safe, liquid assets that can be sold in an instant … especially US Treasuries”.
Wang Yongzhong, a senior researcher with the Chinese Academy of Social Sciences’ Institute of World Economics and Politics, agreed, saying: “US Treasuries are the favourite asset class [for countries] during financial market turbulence.”
That turbulence has abated but new turmoil looms on the horizon in the form of trade tensions between China and the US. Amid the threats of tariffs and counter-tariffs, speculation has grown in China that the central government is weighing whether to retaliate by halting or slowing its US Treasuries purchases.
SAFE has been swift to dismiss such suggestions as “fake news”, saying it would continue to buy US Treasuries according to global market principles.
A source familiar with the matter told the South China Morning Post that the idea of dumping any of China’s US$1.19 trillion of US Treasuries had never been on the table for the administration.
The source said it was in SAFE’s DNA to park most of its money in bonds.
“The command chain is quite long … And it often takes weeks to change a trading strategy,” she said. That investment approach was “suitable for bonds [but] not for stocks or derivatives”, pointing to continued US Treasury purchases, the source said.
In addition, US Treasuries offer the kind of security China needs to protect itself against a range of financial and political uncertainties abroad.
Li Jie, head of the Foreign Reserves Research Centre at the Central University of Finance and Economics in Beijing, said that with a hawkish administration presiding over the US Federal Reserve, China needed liquid assets to prepare for a rainy day; and no asset was more liquid than US government bonds.
“Every cycle of US interest rate increases is a crisis for emerging markets … Argentina and Turkey are already wobbling,” Li said. “China needs enough liquid assets to keep the yuan exchange rate stable.”
The desire for liquidity can be seen at Gingko Tree, which eased up on acquisitions or even started to sell. Ropemaker Place in London, for instance, is being put up for sale, according to CoStar, a London commercial property agent and information provider.
TROUBLE AT HOME
On top of that, the liquidity of US Treasuries can help China counter weaknesses in its own fundamentals, providing a stable asset with global value as the country’s foreign debt keeps rising and its international payment fundamentals worsen.
China’s foreign exchange reserves – its holdings of cash, bank deposits, bonds, and other financial assets denominated in currencies other than the yuan – have on the surface remained steady over the past year and half, hovering at around US$3.1 trillion. But the amount of China’s foreign debt – the loans it owes other countries or institutions of other countries – reached US$1.7 trillion as the end of 2017, up US$300 billion from a year earlier, according to SAFE data.
China’s central bank has been borrowing from other countries through currency swaps with foreign central banks, although it’s unknown whether the borrowed money was billed into the country’s reserves. According to the first quarter monetary policy report, the People’s Bank of China borrowed US$222 billion worth of foreign currencies from other central banks but only lent 411 billion yuan (US$65 billion) in return.
All that means China has to put a bigger share of its reserves in liquid assets, not shiny buildings in London, to cope with repayment needs.
In a sign that China’s international payment fundamentals are worsening, the first quarter gave China its first quarterly current account deficit since joining the World Trade Organisation in 2001, which means it now buys more goods and services than it sells to the rest of the world.
China’s bilateral trade surplus with the US is bigger than the country’s overall surplus. Thus China would have a trade deficit if US President Donald Trump’s demand for balanced US-China trade became a reality.
Offloading US Treasuries would strip China of its major buffer against capital outflows, putting
the world’s second-largest economy into a dangerously unstable financial position.
In spite of policy and political uncertainty under the Trump administration, the liquidity and security that US Treasuries offer continues to be unrivalled by any other form of asset.
Arthur Kroeber, co-founder and research head of Gavekal Dragonomics, said a Beijing sell-off of US Treasuries, which was utterly unlikely, would only make Beijing look reckless and foolish – the last thing Xi would want as China seeks to play the “good guy” in contrast to the unpredictable Trump.
In addition, a big sale from China of US Treasuries in the open market would mean China would have to buy replacement assets, but none constituted a viable alternative, Kroeber said.
It is not surprising then, that during the three rounds of trade talks between Beijing and Washington, neither Beijing nor Washington publicly made China’s holding of Treasuries as an issue for negotiation.