The press has been full of stories about the dangers to US credit ratings and growing concerns by foreign official investors about the value of their holdings of US Treasury bonds. A combination of concerns about the rising US fiscal deficit, Fed quantitative easing and potential monetization of US debt, have accumulated to fuel such fears. Given the symbiotic relationship between China and the US it is perhaps unsurprising that China has been one of the most vocal critics. I have highlighted this in past posts, especially related to the risks to the US dollar. Please refer to US dolllar beaten by the bears and US dolllar under pressure. However, my concerns that foreign investors have been shunning US Treasuries recently may have proved somewhat premature.
Should China or other large reserves holders pull out of US asset markets, it would imply a sharp rise in US bond yields and a much weaker dollar. However, it is not easy for China or any other central bank to act on such concerns. China is faced with a “dollar trap” in that any decline in their buying of US Treasuries would undoubtedly reduce the value of their existing Treasury holdings as well as drive up the value of the Chinese yuan as the dollar weakens. Such a self defeating policy would clearly be unwelcome.
One solution that China has proposed to reduce the global reliance on the dollar and in turn US assets was to make greater use of Special Drawing Rights (SDRs) which I discussed in a previous post, but in reality this would be fraught with technical difficulties and would in any case take years to achieve. Nor will it be quick or easy for China to persuade other countries to make more use of the yuan in the place of the dollar. The first problem in doing so is that fact that the yuan is not a convertible currency and therefore foreign holders would have difficulties in doing much with the currency.
Foreign official concerns are understandable but whether this translates into a major drop in buying of US Treasuries is another issue all together. Foreign countries have been gradually reducing their share of dollars in foreign exchange reserves over a period of years. This is supported by IMF data which shows that dollar holdings in the composition of foreign exchange reserves have fallen from over 70% in 1999 to around 64% at the end of last year.
In contrast the share of euro in global foreign exchange reserves has increased to 27% from 18% over the same period. This process of diversification likely reflects the growing importance of other major currencies in terms of trade and capital flows, especially the euro, but the pace of diversification can hardly be labeled as rapid.
Importantly, there is no sign that there has been an acceleration of diversification over recent weeks or months. Fed custody holdings for foreign official investors have held up well. In fact, these holdings have actually increased over recent weeks. Moreover, the share of indirect bids (foreign official participation) in US Treasury auctions have been strong over recent weeks. Taken together it provides yet more evidence that foreign official investors haven’t shifted away from US bonds despite all the rhetoric.