A Forex View From Afar

The Chinese Conundrum

Before the G20 conference this past weekend, top Chinese officials had complained about the safety of the U.S. Treasuries.

Being by far the largest U.S. bondholder, China has a lot of influence over the debt market. It is said that, the People’s Bank of China holds up to $1 trillion in Treasury notes and government-backed debt, issued by public/private entities like Freddie and Fannie.

It is easy to see why the Chinese government is concerned about the fate of U.S. debt, since such a huge amount of debt holds two major risks: interest rate risk and currency risk. Bonds have a unique relationship between its price and yield, as one rises the other drops. As such, if the yield rises on a bond, its price would fall. Here is where the Fed comes in play.

Eventually, the Fed would have to raise the interest rate, even though this might not happen in the near (or medium) future. A higher interest rate would drag the price of U.S. Treasuries lower, while increasing its yield. From such a move, the Chinese foreign reserves would take a hard hit, because U.S. bonds will lose their value.

Another hit that China might take comes from currency risk. U.S. Treasuries are denominated in dollars, and a steep depreciation of the greenback would pose a huge risk, even though many say the Usd/Cny rate is manipulated.

Neither of these two outcomes are likely to happen in the short term, but as the credit crisis comes to an end and things start to return to normal, money will start pouring out of the U.S. economy in search of higher yields. As such, the dollar and Treasuries will be certain victims, something that should worry the Chinese officials.

Currently, Chinese officials cannot do too much about it, but in time, they will have to begin to diversify from U.S. debt. One of the golden rules of building a successful portfolio is to diversify, something that they have not done, and now the State Administration is paying the price for this. Most analysts say that, President Obama will have a huge problem funding the federal deficit if China was not buying Treasuries.

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