China is being backed into a corner on currency

When China first started stockpiling US Treasuries as it kept its currency pegged to the US dollar, never in its wildest dreams would it have imagined begging the US not to default on debt obligations.

Currently China is the largest holder of US Treasuries, clocking up $US1.277 trillion, accounting for 22 per cent of Treasuries. Japan is not far behind with a $US1.135 trillion holding.

But China is now backed into a corner, sitting uncomfortably in an undesirable position, that has seen Vice Finance Minister Zhu Guangyao direct comments to the US to prevent a debt default and ensure the safety of Chinese investment in the United States.

Buying US Treasuries is part of the business model it has pursued for years and it really has no choice but to continue to do so. To move away from this would require buying other foreign debt, causing that particular currency to rise. Altering the global allocation of capital like that would most likely be disastrous for China and wreak havoc on the renminbi as the global flow of funds adjusts.

Assuming a worst-case scenario in which the US do default on debt obligations, China would be forced to continue buying Treasuries to avoid the renminbi soaring to levels that would threaten the competitiveness of its business model. 

If this is the case, China might not be the enthusiastic buyer of US Treasuries it once was.

Since Roosevelt’s era the US dollar has been the world’s reserve currency and there has been no reason this would not be the case. But political disorder in the US and the threat of default on its debt obligations could put the currency in jeopardy, requiring China to act in a way it would prefer not to.

While China holds fewer Treasuries than it did in mid 2011, the decline is a mere 2.8 per cent -- not enough to conclude it is actively selling Treasury holdings as some commentators have speculated. A more plausible justification would be that maturing Treasuries were not replaced with fresh debt.

As much as possible, China will endeavour to continue to manipulate the US dollar to its advantage.