China unloads $34-billion of U.S. government debt
Barrie McKenna

China appears to be making good on a long-standing threat to dump U.S. Treasuries.

Foreign demand for U.S. government bonds and Treasury bills tumbled by the largest amount on record in December, according to monthly data from the U.S. Treasury Department. And China led the way, cutting its holdings by $34.2-billion (U.S.) and relinquishing its title as the world's largest holder of U.S. government debt to Japan.

In recent months, top Chinese officials have expressed growing unease about the ability of the United States to finance its swelling debt, without triggering a major devaluation of the dollar.

China has now cut its holdings of Treasuries by $45-billion over the past five months, or “a long enough period to hint strongly at a trend,” Alan Ruskin, chief international strategist at RBS Securities Inc., said in a research note.

The United States faces a record 2010 budget deficit of $1.6-trillion as it suffers plunging tax revenue and higher spending as a result of the recession.

The investment report coincides with growing tensions between China and the United States on several fronts. China has complained bitterly about U.S. trade policies, arms sales to Taiwan, and this week's planned White House meeting between U.S. President Barack Obama and Tibetan spiritual leader the Dalai Lama.

Economists have long fretted that a pullout by China and other foreign investors would force the United States to pay higher interest rates on its debt, jeopardizing the fragile economic recovery.

But most analysts don't expect China to liquidate its holdings of U.S. government securities any time soon. In December it still owned $755-billion worth of U.S. government debt, which remains one of the world's safest and most liquid investments. And in many ways, China's economic fortunes are tied to the United States – the largest customer for its manufactured goods and a safe place to park some of its swollen foreign reserves.

“While China may reduce its holdings of U.S. debt in order to send a signal to Washington, it has no intention of selling debt to the point that it wrecks the U.S. economic recovery, since doing so would destroy China's own economic and socio-political stability,” pointed out analysts at Stratfor, a think tank based in Austin, Tex.

Prospects for United States are likewise highly dependent on the continued willingness of foreign investors, including governments and central banks, to continue financing its debt at relatively low rates.

A quick exit by China would send the value of the dollar plunging, depleting the value of China's remaining holdings.

So far that hasn't happened. Interest rates on 10-year U.S. bonds have actually drifted lower in the past month as foreign investors have fled European government bonds amid concerns about Greece and other countries.

Economist Jennifer Lee at BMO Nesbitt Burns said that's why it's a good sign that Japan was a net buyer of Treasuries in December. “It is reassuring that Japan has stepped into the fray,” she said.

And yet it is significant that China is recalibrating its portfolio after more than a year of piling reserves into U.S. debt as it sought a safe haven during the financial crisis.

The shift away from U.S. government securities may also be a sign that investors everywhere are feeling less insecure and are willing to tolerate a little more risk.

And while China was pulling out of U.S. Treasuries, many other Asian countries were adding to their holdings. Japan boosted its Treasury investments to nearly $769-billion, up $11.6-billion. Hong Kong, a special administrative region of China, boosted its holdings by $6.7-billion to nearly $153-billion. Canada, Britain, Singapore, Thailand, and Australia also added to their holdings.

And overall foreign demand for U.S. long-term securities remains strong, with net purchases of $63.3-billion in December.