By Wang Xu (China Daily)
Updated: 2009-06-29 08:19

When China's holdings of US Treasuries dipped in April, it was seen as a clear indicator of the nation's uneasy relationship with the world's reserve currency - to sell in the face of a sliding greenback or hold to protect the value of its assets from eroding further.

Indeed, there have been enough pointers about China's concerns over the safety of its $2-trillion foreign exchange reserves, 60 percent of which is thought to be held in dollar-denominated assets.

Top officials, including Premier Wen Jiabao, have openly expressed concern about Chinese investment in the US. The country has also actively mooted the idea of a super sovereign reserve currency to replace the dollar.

Besides, it has also sought to promote the use of the yuan for foreign trade and investment; a first step, some think, toward challenging the dollar's status as the preferred currency of international trade and capital flow.

The April data, however, are insufficient to conclude that China is on the way to dumping its US Treasury notes. In the short run, a rapid disposal of T-bonds is likely to result in price drops, which Chinese foreign exchange reserve managers would do anything to avoid. But, in the long run, a diversification of the nation's reserves now looks unavoidable, and may well be on the cards.Premature sign

China was not alone in doing so. Foreign investors overall sold a combined $44.6 billion of US Treasuries in April, compared to a net increase of $47.3 billion in the previous month.

"This matched a shift in the global trend away from US debt purchases," Stephen Green and Jinny Yan, economists at the Standard Chartered Bank, wrote in a research note.

Over the past months, there have been increasing concerns that the rising rate of inflation and a depreciation of the US dollar would hurt the value of US Treasury bonds. The US Federal Reserve's decision to buy Treasuries and corporate debt, called 'quantitative easing', was nothing but printing more money. But, as the money supply soars, the rate of inflation spirals as well.

"One month's data is not enough for us to change our view that China continues to buy," Green and Yan wrote. They believe the April data was under-estimated partly because purchases by China through London and other financial centers were not represented. "If we see a second month of net sales, then we will have to reconsider this story."

"In the short term, it would be difficult for China to move away from holding US dollar assets, especially US Treasuries, given all the constraints that it faces," Wang Tao, an economist with UBS Securities, said.

China is the largest official holder of US Treasury and agency debts. Economists say any significant move away from these holdings may drive down the value of the debt, which, in turn, would result in losses to the nation's remaining debt holdings.

"This is a process that should be incremental; if any move is made too quickly, countries making that move will bring forth the outcome they try to avoid," Ardo Hansson, World Bank's Lead Economist for China, said at a press conference recently.

"Moreover, there are few alternatives to USD assets in the short term," said Wang. "The main alternative for China's foreign exchange reserves would be other government bonds, which are usually too small and too illiquid."

Besides investing in other government bonds, there were also discussions regarding using China's reserves to buy gold and other commodities, which are expected to provide a cushion against inflation.

The nation said in May that its gold reserves had risen to 1,054 tons by the end of 2008, up from 600 tons in 2003. That makes China the fifth largest holder of gold reserves in the world, with only six countries holding more than 1,000 tons.Diversifying dollar-heavy currency reserves

"We do expect China to increase its purchase of gold and other commodities over time, but these markets are just not big enough to make a meaningful dent in the structure of overall foreign exchange holdings," said Wang.

"For example, if China decided to hold 5 percent of its current $2 trillion reserves in gold, it would need to buy more than 3,000 tons of gold, or about one year of world production."

Yet, China does not plan to get mired in a "dollar trap", although a complete departure from the dollar could take years, if it happens at all.

The nation is now considering investing no more than $50 billion in bonds issued by the IMF, the Xinhua News Agency quoted an official at the State Administration of Foreign Exchange as saying. The foreign assets administrator, an arm of China's central bank, manages nearly $2 trillion in official reserves.

The move echoed Russia's, Brazil's and India's decision to invest $10 billion each in International Monetary Fund bonds, a move to diversify from their dollar-heavy currency reserves.

IMF bonds are denominated in Special Drawing Rights, or SDRs, a synthetic currency used by the IMF. China and Russia have pushed to increase the use of the SDR, which analysts say could help diversify their reserves away from the US dollar

Over the past months, China has signed currency swap deals worth 650 billion yuan with six nations to increase the use of the yuan. Besides, it also signed a deal with Brazil last month, which permitted bilateral trade transactions to be conducted in Brazilian reals and the Chinese yuan.

"We think a more sustainable way to reduce the risk of China's foreign assets would be to reduce the accumulation of the current account surplus," said Wang of UBS Securities, adding that it would require far-reaching structural reforms such as allowing for the appreciation of the yuan.

Wu Xiaoling, former deputy governor of the People's Bank of China, wrote in an article published by John Wiley & Sons (Asia) Pte Ltd that China's monetary policies will necessarily have greater global influence as China's economic and financial systems merge with those of the rest of the world. The influence of international factors on Chinese monetary policies will also increase.

"China's renminbi will one day be a major global currency, quoted on markets around the world. It will be the currency in which much of Asian trade is denominated and a reserve asset of central banks around the world," said Green in an article published by John Wiley & Sons.Related readings: