Is China Diversifying its Foreign Reserves?

Sources
FT.com: Beijing's rebalancing raises fears for Treasuries
USTreasury.gov: Treasury International Capital Data for December 2009

China's holdings of U.S. government bonds declined by a record amount ($34.2 billion) to $755.4 billion in December 2009 from the previous month, according to the Treasury International Capital (Tic) data, released on February 16th. Such data combined with the recent political frictions between the U.S. and China made investors wonder whether China began to diversify from Treasuries. According to Yasunari Ueno, a chief economist at Mizuho Securities in Tokyo, the conflicts between two countries over the issues such as President Obama's meeting with the Dalai Lama and weapons sales to Taiwan by U.S. need to be monitored because they "could cause China to become even less enthusiastic buyers of U.S. Treasuries."

However, most analysts including Mr. Ueno say that the December Tic Data is likely to indicate "a brief pause" before resuming the purchase of Treasuries. While China has reduced its holdings in Treasuries from May 2009, China may have purchased through Hong Kong last year. Hong Kong's holdings in Treasuries increased up to $152.9 billion in December 2009 from $77.2 billion in December 2008. Also, the fact that China increased its holdings of longer-dated coupon debt rather than short-dated bills shows that China is confident in the U.S. government's ability to pay its debt.

Even if China diversifies from Treasuries, the market will not be necessarily in trouble as long as there are other buyers such as U.S. banks or other foreign governments to fill the gap. In December 2009, Japan overtook the China's position as the largest foreign official holder of U.S. Treasuries, holding $768.8 billion. Furthermore, it would not be economically sound for China to reduce its holdings. If China sells U.S. government bonds, U.S. interest rates will rise, which would impede economic recovery in the U.S. This would have negative impacts on Chinese exports, and reduce the value of China's pre-existing holdings of the U.S. government bonds. In addition, as long as Yuan is pegged to the U.S. dollar, China will be limited in diversifying its foreign reserves because it needs to "recycle" its trade surplus dollars back into U.S. assets.

Discussion Questions:
Do you think a deteriorating political relationship between the U.S. and China could have an impact on China's decision to manage its foreign reserves?