In a week which has seen those long quiescent bond vigilantes wielding their cudgel in the US bond market, it is notable that there has been a distinct change in official Chinese foreign exchange investment policy since last Summer, with a shift out of US agency debt and long dated bonds to short duration Treasuries and commodities such as copper. Additionally, there has been an acceleration of bilateral trade deals with countries like Brazil and Argentina that bypass the dollar. While strategy remains opaque, it seems reasonable to infer that the country is now scrambling to reduce its huge exposure to dollar assets as the implicit policy over the last 20 years of subsidizing exports to US consumers and recycling the resultant trade surplus back into US financial assets has run out of road. Moreover, as I have been warning repeatedly in relation to the downside risks on bonds, not only is a tidal wave of liquidity likely to fuel inflation but supply is soaring while key official demand is declining as Asian and OPEC trade surpluses slump. Total Treasury issuance over the last 12 mths was $1.6trn (equivalent to China's entire holding of US financial assets). In Q1 of 2009 alone, long dated issuance reached $278bn; China only bought $15 billion while foreign central banks bought $85 billion in short-term Treasury bills, including $32 billion from China. It shouldn't be surprising in this context that the 2/10 year bond spread hit a record yesterday at 275 bps as China and others boycott long duration US bond exposure. In fact, total central bank demand for longer-term Treasuries has been trending down since August 2008, making every bond auction this year a nerve biting affair as private sector buyers are sought to fill the funding gap.
That China has had serious misgivings about recent Fed actions is no secret, but their massive accumulated reserves have left them captive to US policy. The last thing they want right now is to precipitate a crisis of confidence in the dollar by official statements or action, but Beijing is acutely aware that it will be the biggest loser from manufactured CPI inflation to erode the crushing US debt burden. On 27 March I wrote: 'Near term, a combination of growing private sector savings and Fed manufactured inflation will erode the consumer debt mountain, but probably not fast enough to avert a public debt funding crisis sooner or later in the long period of broad economic stagnation that seems the most likely outlook.' As markets accept the reality that trend US GDP growth is now at best 2% medium-term, sooner is a good bet. China's portfolio strategy of focusing new investment on the most liquid short-duration paper and exiting its Agency exposure seems to reflect those risks.
The country is also loaning its dollars to private Chinese companies and trade partners (note recent large dollar loans to Russia and Kazakhstan for energy deals), using them to acculuate commodity stockpiles and equity stakes in commodity-based companies around the globe, and increasing holdings of other currencies (naturally via your boosted trade with these partners), all of which works to decrease the percentage of dollars being held in your reserves, thus decreasing your dollar exposure over time. It's hard to see U.S.-China trade increasing much beyond an inventory restocking bounce, as consumer deleveraging in the U.S. has barely begun and credit availability will remain constrained. China hopes its trade with other emerging market partners will take up some of the slack so that its reserve growth should naturally mean an increase in non-dollar assets, particularly the Brazil-China model of using regional currencies in trade becomes a trend. Ultimately, if China wants a bigger international role for its currency as the flip-side of dollar diversification, it will have to make the RMB fully convertible and lift the huge restrictions on bringing funds in and out of the country. Brazilian and other exporters to China choose will only be happy to be paid in RMB, when it becomes as easy to trade and hedge against as the dollar. Of course, that opening of China's capital account implies a loss of economic control that sits uneasily with an ultra-centralized Communist political system, and therein lies the country's dilemma. A failure by the US to find buyers at anything like these yield levels for the $1trn of debt left to auction by September (or the $5trn plus over the following 4 years) may just force their hand and accelerate the inevitably traumatic move to a post dollar reserve currency world in which an internationally traded RMB will play a key role, but by no means a dominant one.
