What would happen if the Chinese pull up stakes?
China and Japan are the two largest foreign holders of U.S. Treasuries. However, the Chinese recently suggested they may diversify their foreign exchange reserves away from the U.S. dollar/Treasuries and allocate more reserves towards other assets, perhaps including U.S. corporate debt, energy and commodities, and non-U.S. dollar-denominated assets. Given the importance of Treasury sales to the U.S. economy, securities markets, the dollar and interest rates, what would be the impact of China’s decision?
Most observers believe that China’s possible move to diversify their foreign exchange reserves away from U.S. Treasuries would probably occur in such gradual increments as to soften any potential near-term repercussions. However, as China’s prominence in global economic affairs surges, any modifications in its foreign exchange policy cannot be ignored.
According to the U.S. Treasury Department, as of the end of November 2005, Japan and China together owned about $933 billion of the $2.17 trillion of Treasury securities held by foreign nations. Japan accounted for about $683 billion, while China had $250 billion. The U.K. was third at $223 billion. Though Japan’s ownership currently dwarfs China’s stake, Beijing’s rate of accumulation has been much faster. China’s total foreign exchange reserves, which amounted to nearly $800 billion at the end of 2005, are expected to reach $1 trillion this year, likely surpassing Japan’s total.
Generally speaking, says David Wyss, Standard & Poor’s chief economist, these Treasury purchases have kept the U.S. dollar high and U.S. bond yields low. “This has been good for U.S. interest rates, productivity and investment. But it’s been bad for our trade deficit, he explains. “In the long run, it has put the U.S. in an unsustainable position of having a deficit that is much too high.” For the first 11 months of 2005 the U.S. trade deficit totaled $661.8 billion, ahead of the $617.7 billion annual record set in 2004. Economists expect the U.S. trade deficit to well exceed $700-million for all of 2005. Meanwhile, China’s trade surplus with the U.S in 2005 is expected to exceed $200 billion, 25% above the record surplus posted in 2004.
Wyss noted that Treasury purchases by Japan’s central bank have decreased substantially over the past year, although private Japanese investors have more than offset that by acquiring substantial amounts of U.S. corporate bonds. “In Japan’s case, back in 2003-2004, they feared the yen would drop too much in value and they intervened heavily in the currency markets,” Wyss said. “Then, Japan ceased intervening over the last year or so — but this didn’t have much of a negative impact on U.S. markets.” In fact, the dollar rose about 14% against the yen in 2005.
The Chinese, meanwhile, have been buying Treasuries at roughly the same pace the past two years. “They have to accumulate dollars to keep the yuan down relative to the dollar,” Wyss explained. “But since China has moved to peg the yuan to a market basket of currencies, instead of just the dollar, it’s logical for them move their foreign exchange holdings to the same basket.” Indeed, last July China enacted a 2.1% revaluation of its currency by shifting from a dollar peg to a basket of currencies, potentially permitting the yuan to rise against the dollar. The yuan, in fact, rose a modest 2.6% against the dollar in 2005.
“The Chinese probably concluded they have far too much exposure to the dollar, and that the dollar has peaked for this cycle, given the Fed may be moving to a neutral position,” says Paresh Upadhyaya, portfolio manager and currency strategist at Putnam Investments in Boston. “Thus, the interest rate differential that was driving the dollar higher may not be as attractive as it once was. The risk is now the dollar may begin to depreciate. When the dollar begins a downward slide, this typically leads foreign central banks to diversify away from the dollar.”
In essence, both Japan and China are between a rock and a hard place — by holding vast amounts of dollars/Treasuries, they depress the value of their local currencies, thereby boosting their export business. But, since they own so much U.S. dollar assets, by dumping them they could hike the value of their own currencies and undermine their economic growth.
Wyss concedes that any change in China’s foreign exchange strategy would represent a reduction in demand for U.S. assets. “Other things being equal, this step by China would tend to push the dollar down and drive bond yields up. So far, this hasn’t happened since overall inflows from private bond buyers now exceeds Treasury debt purchases by foreign central banks. However, the Chinese have a lot of money invested in U.S. Treasuries and they’re probably tired of only earning only 4% on it. If they move into other dollar assets, such as corporate bonds, there would be little impact on markets. If they move into euros or other international assets, there will be.”
Higher bond yields would likely raise borrowing costs for U.S. corporations — an unpleasant scenario amidst the record budget deficit if the U.S. economy were to start to slow.
It is estimated that more than 70% of China’s foreign exchange reserves are invested in U.S. dollar assets, including Treasuries. Axel Merk, manager of the Merk Hard Currency Fund (MERKX), said if China were to stop acquiring such large amounts of dollars with its reserves — accumulating at about $15 billion every month — it could impose downward pressure on the dollar. The key to understanding the risk posed to the dollar, Merk explains, is that the U.S. current account needs to be financed daily. “Every day, foreigners need to acquire more than $2 billion in U.S. dollar denominated assets — soon $3 billion — just to keep the dollar from falling. This can be done through the purchases of U.S. bonds, or by buying assets outright.”
In the event that foreign nations, including Japan and China, lose their appetite for U.S. dollars, Merk’s Hard Currency Fund will likely “focus on currencies of countries that are less likely to manipulate their currencies.”
Merk also believes a reduction in Treasury purchases by China would lead to higher U.S. interest rates as bond prices fall. “There is disagreement on how big an impact it would have,” he said. “Fed chairman Alan Greenspan has argued that foreigners mostly purchase on the short end of the yield curve, where they have little influence on the yield.” He also noted that China buying fewer Treasuries will have negative implications for the U.S. housing market. “Lower Treasury purchases means less demand, which means bond prices fall and yields rise,” he said. “The government needs to offer a higher yield to sell its debt. Higher yield means higher mortgage rates for home buyers, and that is a weight on the housing market.”
There would also be an impact beyond the dollar itself, Merk adds. “If a foreign central bank purchases U.S. Treasuries, it is not so different from the Fed purchasing Treasury notes from regional banks,” he noted. “When that happens, banks receive cash and have increased lending power. Foreign purchases of U.S. Treasuries are directly stimulative to the U.S. economy, even before any impact on the yield curve.”
Upadhyaya contends that any diversification in China’s foreign exchange will be gradual and likely result in somewhat lower purchases of U.S. Treasuries, “but it will not have much impact on U.S. markets or economy.” He believes, however, that the Chinese are clearly seeking more attractive assets, perhaps energy holdings. “The Chinese have been trying to build a strategic petroleum reserve like the U.S. has, Upadhyaya said. “They may feel that energy prices will stay high for a much longer period because of the supply/demand scenario. They may also buy metals and other commodities, or maybe even European bonds.”
Merk cited that China’s highest profile move into energy assets was state-controlled CNOOC Ltd.’s $18.5-billion attempt to purchase the American energy company Unocal. Although that takeover bid failed, it illustrated China’s desperate and ongoing quest for foreign commodities and natural resources — they have also sought energy investments in Canada, Latin America and Australia.
Kenneth Buntrock, portfolio manager of the Loomis Sayles Global Bond/Instl (LSGBX), notes that China could shift some of their reserves to pay for the country’s enormous local infrastructure projects needs, or even pour money into their nascent relationship with commodity-rich, but undeveloped, African nations.
“The Chinese have subsidized their currency to sell cheap goods to the U.S.,” Merk said. “In return, they have accumulated billions of dollars. Now they will find out whether these dollars are worth anything at all as they try to use them to secure their future natural resource needs. If disappointed, China and other Asian countries may accelerate their diversification out of the U.S. dollar and into a basket of hard currencies as well as gold.”
Wyss points out, however, that U.S. fixed-income assets “still offer more yield than, say, European bonds. But as the Federal Reserve stops tightening and the European Central Bank continues to tighten for the rest of the year, U.S. bonds assets may seem less attractive.” Buntrock indicates that among the five regions that offer 30-year bonds (U.S., UK, Euroland, Canada and Japan), U.S. bonds still provide the highest yields, as well as the most robust bond market in the world.
China’s neighbor Japan presents a different kind of challenge to the U.S. economy. “Japan is a much larger holder of Treasures, so if they made any change in their foreign exchange policy, that could have a significant and immediate impact on U.S. markets,” Upadhyaya says. But this scenario is unlikely. The Japanese, he points out, have not diversified their foreign exchange assets outside of U.S. Treasuries.
Buntrock concurs that Japan is unlikely to enact any changes in its foreign exchange reserves. “The Japanese tend to be very conservative in fiscal matters,” he said. “Given that the yen is undervalued and 10-year Japanese bonds provide only a 1.5% yield, they’ll focus on foreign fixed income assets, particularly U.S. Treasuries, searching for yield. The Japanese have no reason to diversify their foreign reserves.”
The bottom line, Wyss concludes, is that the U.S. “cannot continue running this high deficit and offset it by borrowing from overseas. To reduce the trade deficit, other countries have to be willing to reduce their trade surpluses, and so far they’ve shown no willingness to do that.”
Though it’s too early to determine the long-term impact of China’s foreign reserve diversification, the U.S. dollar could be affected if the Chinese move from holding their reserves in dollar assets. In general, currency calls are difficult to make for even experienced investors and traders, but there are some instruments at their disposal to take advantage of the direction of the dollar.
ProFunds Rising U.S. Dollar Fund (RDPIX) seeks to match the performance, before fees and expenses, of the U.S. dollar index. Dollar bears might prefer ProFunds Falling U.S. Dollar Fund (FDPIX), which rises when the dollar index falls. Rydex Investments recently launched two similar funds: The Rydex Srs Tr:Strengthening Dollar/H (RYSBX) rises twice as much as the performance of the U.S. dollar index, while its inverse, the Rydex Srs Tr:Weakening Dollar/H (RYWBX) falls twice as much when the dollar index rises.
For direct exposure to foreign currencies, Franklin Templeton:Hard Currency/A (ICPHX) primarily buys short-term money market instruments, and forward currency contracts, denominated in foreign currencies. Merk Hard Currency Fund, invests in a basket of hard currencies from countries with strong monetary policies. Both are designed to protect against depreciation of the U.S. dollar.
The U.S. Current Account Deficit*
Current Account ($bil.)
Year-Over-Year Percent Change
*Current account deficit is the trade deficit plus the net balance in services, net income on overseas investments and net transfers.
SOURCE: Standard & Poor’s
InvestmentAdvisor.com has more mutual fund news from Standard & Poor’s available here.