November 19,2008

China Buys More US Debt, Supports the Dollar as the Biggest Creditor

By CSC staff


China has finally succeeded in becoming America’s No. 1 creditor. Figures released yesterday by the US Treasury show China holding $585 billion US national debt by the end of September, and overtaking Japan, which had been the largest US creditor for eight years.

China achieved the distinction through two moves. In September, it increased its holding of US national debt, in the form of Treasury securities, by $43.6 billion, the largest monthly increase of the year, while in the same month Japan sold off $12.8 billion of US securities, leaving it holding $573.2 billion worth. The UK, America’s third largest creditor, also largely increased its holding, by $30.3 billion to $338.4 billion.

Since the outbreak of the financial crisis, the US economy has declined steadily, and analysts here dispute over whether China should increase or cut its holding of US debt. Some believe a weak dollar will damage China’s foreign exchange assets, so many suggest the government sell US national debts.

The market for US national debt can not be regarded as fully competitive. Instead, it is essentially a market dominated by oligarchs. As most national debt is held by a few official organizations, any slight move can trigger exchange rate fluctuation. As an important dollar supporter and large holder of US debt, if China started to sell its US securities, the RMB/USD rate would be seriously affected. A weaker dollar would lower China’s wealth accumulated through trading surplus. "In this situation, China will be steadfast in maintaining the stability of USD," said Liu Yuhui, head of the economic evaluation center at the Research Institute of Finance under the Chinese Academy of Social Sciences.

China needs to keep a certain amount of cash on hand to guarantee it has enough currency to cover three months of the country’s imports, to intervene in the exchange market, and to cope with capital outflow triggered by RMB depreciation. It is estimated that the China should keep about $300 billion to $400 billion in cash.

Meanwhile Liu Yuhui believes that while China cannot change the structure of its large existing foreign exchange reserve, it can make some strategic adjustment to diversify its portfolio. Mr. Liu said such large dollar position was very likely to suffer losses, while a USD depreciation and commodity price hike would greatly lower China’s purchasing power.

But an industry insider also said that due to the current global financial turmoil, buying US debt might be the best way to reduce the risk for China’s foreign exchange reserve. He said although the US has been seriously hurt by the financial crisis, European losses have been more serious, and commodity assets such as gold and petroleum are not safe enough since their prices can fluctuate drastically. Also, buying US debt securities has a strengthening effect on the dollar.

In 2009 the US may issue about $1.8 trillion of debts, a staggering sum, due to President-elect Obama’s promise on tax cuts and medical insurance reform, and there is no way it can sell all that to domestic investors. Since foreign investors now already hold $1.5 trillion of US debt, few are likely to step up to a large part of the new stuff, so the US will have to issue more dollars. "Whether issuing national debt or more dollars, USD is very likely to depreciate in a long term."

While China chooses to increase its holding of US debts, Japan seems to be doing the opposite. Liu Yuhui thinks the situation in the two countries is different. The whole Japanese economy is very sensitive to exchange rate. Too rapid yen appreciation will seriously hurt its trade, and the situation will worsen during economic recession. "Japan intervenes in the currency markets frequently to prevent the yen from appreciating too quickly. The Japanese central bank spends a great amount of its foreign exchange reserve on intervention, so its holding of US national debt may change from month to month.


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