China Turns Bearish on US, Buys Yen, Euros

In what could foreshadow the future composition of world currency reserves, domestic US investors now hold the majority of America’s debt. According to the latest information from the US Treasury department, for the first time in three years, American financial institutions and private citizens owned more of America’s debt, than did foreign investors. The advantage may only be slight at 50.2 percent, but this could mark the beginning of a fundamental change in how America finances its growing operational deficit.

Prior to this recent shift, Asian countries, led by China, were the principle holders of US debt, with the greenback making up roughly 35 percent of China’s two and a half trillion in foreign currency reserves. While domestic demand for US debt has increased somewhat, it is China’s recent sell-off of US Treasuries that is mostly responsible for tipping the scales towards domestic investors.

During the first half of the year, China held nearly $940 billion in US dollars as part of its total foreign currency reserves. Since May, the Asian giant has sold $72.7 billion according to recent figures from the US Treasury Department. Most of the newly-available capital has found its way into euros and the yen.

In his previous role as an advisor to the People’s Bank of China, Yu Yongding stressed the need for greater diversification and urged officials to reduce the Central Bank’s exposure to the greenback. Yu argued that falling yields have made the US dollar less attractive as an investment, and even though several Euro-member nations face difficult credit problems of their own, European investments still represent higher returns than US-backed securities.

“We didn’t sell any European bonds or assets,” Yu said in a recent interview. “Instead, we bought quite a lot.”

The news that China is moving away from the US dollar coincides with comments made by Federal Reserve Chair Ben Bernanke on August 10th. As the recovery in the US continues to stumble along at a much slower pace than anticipated, the Fed has signaled that it will return to a more active role based on further quantitative easing to stimulate the economy. This will include the Fed reinvesting principle payments on the Central Bank’s mortgage holdings into Treasury notes in an attempt to keep capital flowing into the financial system.

“The pace of economic recovery is likely to be more modest in the near term than had been anticipated,” read a statement released by the Federal Open Market Committee. “The Committee will keep constant the Federal Reserve’s holdings of securities at their current level.”

Earlier this year, Chinese Premier Wen Jiabao chided the US government for failing to do more to support the dollar; this stands in stark contrast with Yu’s comments affirming China’s “confidence in Europe’s economy, in the euro, and the euro area”. It remains to be seen if the Federal Reserve’s commitment to additional support will entice China to top up its US holdings.

Regardless of the politics that may be involved, the reality is that China needs someplace to invest its reserves, and despite recent actions and some pointed comments regarding US policy, China still holds in excess of $850 billion. Also, if you recall, it was just over a year ago that China upped its gold holdings at the expense of the dollar, claiming that US policies were intentionally devaluing the dollar. It was not long after that however, that China reversed course and actually boosted its US holdings to an all-time high.

Given the history, there will be many watching to see how this plays out. Will the selling of dollars for yen and euros turn out to be nothing more than a warning shot across the bow, or is China serious about reducing its US exposure?

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