China's new investment sweethearts

With the share of US assets in its foreign reserves at a decade low, China is boosting its investment elsewhere, with geopolitical implications for the US and the world.

China is boosting its investments in its major trading partners, such as Europe and Australia, as it increasingly turns away from the United States as a favoured destination for its $US3.2 trillion in foreign exchange reserves.

US Treasury data released last week showed that China’s purchases of US securities increased by 7 per cent to $1.73 trillion as at June 30, 2011, an increase of $115 billion from 12 months earlier. The same period saw China’s foreign exchange reserves climb by $736 billion to $3.2 billion. As a result, the share of US assets in China’s foreign reserves dropped to a decade low of 54 per cent in mid 2011, down from around 65 per cent a year earlier and a high of 74 per cent in 2006.

According to Andrew Batson from the respected investment research group, GaveKal, the Chinese appear to have continued to reduce their appetite for US dollars in the second half of 2011. He notes that recent monthly data from the US Treasury monthly data points to a decline in China’s US Treasury holdings from $1.3 trillion in June to $1.15 trillion by December.

In part, he says, this trend could reflect the fact that growth in China’s foreign exchange reserves slowed sharply in the second half of 2011, and actually reversed in November and December, as China’s trade surplus narrowed and capital outflows picked up. China, he says, may have had to sell some of its more liquid US assets as a result.

But Batson points to a more interesting question. Combining Chinese and US data, it appears that China invested about $460 billion in non-US assets in the year ending June 2011, a big jump from the estimated $176 billion in the previous 12 months.

So where did the money go? According to Batson, the most obvious answer is Europe, which is now a more important export market for China than the US, and also has a large and deep debt market.

China has an interest in buying up more euro-denominated assets because it helps protect Chinese exporters from euro devaluation, while protecting the value of China’s existing euro investments. It also helps boost the euro as an alternative reserve currency to the dollar.

Another possibility is that China might be investing more in Japan. Japan’s Ministry of Finance reported a jump in Chinese purchases of Japanese bonds in 2010, at a time when the Bank of Japan was trying to stop the yen from rising too strongly. At this point, China’s purchases of Japanese securities appears muted, but Batson points out that China could be placing bets through the UK, as it does with its US holdings.

Last year around ¥65 trillion ($US800 billion) flowed into Japanese money markets from the UK.

Batson argues that China may also be investing heavily in its other major trading partners, such as Australia, even though we have less liquid markets. He notes that there’s been strong demand for both Australian dollar and Australian bonds since China began diversifying its foreign exchange reserves away from US dollar assets.

He also notes that some emerging Asian countries have been including more Chinese yuan in their reserves mix, and it’s possible that China may be reciprocating, by adding currencies such as the Malaysian ringgit, the Singapore dollar, and the Thai baht.

In the US, there are fears that China’s diversification away from US bonds will eventually push bond prices lower and drive US interest rates higher. But so far there are few signs of this happening, with US 10-year bond yields still trading below 2 per cent.

But, as Batson points out, there could be interesting geopolitical implications of China’s decision to invest its reserves more broadly – both in terms of helping the euro to survive and also in deepening China’s financial linkages within Asia.

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