Is Beijing Bailing on Treasuries?

While China was a net seller of U.S. government debt in April, it's not likely to make any big moves out of U.S. dollar assets anytime soon

by David Cohen

Chinese investors sold a net $5.8 billion in U.S. Treasury securities in April, leaving them net sellers of U.S. government debt for the first time since October, 2005. The data were somewhat ominous amid the recent sharp sell-off in Treasuries that has pushed the 10-year yield above 5.10% for the first time in a year, briefly hitting a 5-year peak.

But while the move might be viewed as an effort toward diversifying the world's largest foreign-exchange reserves, it hardly represents an abandonment of the U.S. government market. China held $414 billion of the $4.4 trillion of marketable Treasuries in April, making its investors the second-largest foreign holders of Treasuries, after Japanese investors.

The figures were part of the Treasury Dept.'s monthly international capital (TIC) report, the most authoritative source covering U.S. dollar-denominated asset transactions between U.S. residents and foreign investors. The net selling by the Chinese in April was concentrated in a net sale of $4.8 billion in short-term Treasury bills, far from unprecedented, together with the net disposal of $900 million in notes and bonds, the first monthly net sale since November, 2006, and only the second such occurrence in two years.

Higher Rates Weighing on Demand

Note, however, that net purchases of $15 billion in U.S. Treasuries in February had trailed only the $16.5 billion in April, 2005. Furthermore, the April net sale was accompanied by a net purchase of $8.9 billion in long-term U.S. agency debt, trailing only the January, 2007, monthly figure.

Foreign investors own about half of all marketable Treasuries, as China and other Asian economies, along with oil-exporting nations including Russia, have assembled massive foreign-exchange reserves from swelling balance-of-payments surpluses. Perhaps by coincidence, the April swing in Chinese net purchases of Treasury notes and bonds mirrored a slowing in foreign net buying in Britain. International investors operating through London sold a net $12.4 billion, as the prospect of higher rates and stronger growth weighed on demand.

Treasury Secretary Hank Paulson and Fed Reserve Chairman Ben Bernanke have repeatedly played down concern of a sell-off in Treasury holdings by foreign investors, Paulson noting last week that China's holdings amount to about one day's worth of trading in the Treasury market. Still, they cannot help thinking about the subject, as a loss in appetite for U.S. Treasuries and U.S. dollar assets generally could boost bond yields, as well as pressure the dollar's exchange rate vs. other major currencies, with potential implications for economic growth and inflation.

Incentives to Diversify

Indeed, Treasury Deputy Secretary Robert Kimmitt plans to lobby China and Russia to keep investing in the U.S. on trips to Moscow and Beijing this week, and told reporters last week he plans a similar message on upcoming visits to Japan, South Korea, and the Middle East.

China has every incentive to pursue the diversification of its foreign-exchange reserves gradually, but it would want to avoid the losses to its own portfolio that might be triggered by a large-scale liquidation of U.S. Treasuries. Thus, diversification should largely be pursued through allocation of new inflows of reserves. Similarly, rapidly switching reserves out of U.S. dollar assets could feed expectations for a stronger yuan, spurring unwelcome capital inflows and pressure on the Chinese currency. In that vein, keep in mind that China continues to accumulate sizable additional reserves through its regular intervention in foreign-exchange markets aimed at restraining the rate of appreciation in the yuan, adding another $135.7 billion during the 2007 first quarter.

In the face of rising Chinese reserve accumulation, the Treasury's TIC data show the magnitude of net accumulation of U.S. dollar assets (long- and short-term) has continued to increase, from an annual $76.2 billion in 2005 to $106.6 billion in 2006, with a further year-over-year increase in the 2007 first quarter.

Waiting for the May Data

That trend would appear to bear out assurances from Premier Wen Jiabao, who in March downplayed concerns that Chinese moves toward diversification would cause a slump in U.S. securities, describing Chinese purchases of U.S. dollar assets as "mutually beneficial."

It would seem inappropriate to blame some sudden reallocation by China for the recent surge in Treasury yields. More likely, the sell-off in Treasuries and rise in yields is traceable to prospects for stronger U.S. growth and its implications for Federal Reserve policy. Of course, the sharp sell-off in Treasuries did not begin until May, and we have yet to see the TIC data for Chinese net transactions for that month. Stay tuned.

Cohen is director of Asian economic forecasting for Action Economics.