China Worries about Value Shrinkage in U.S. Bond Holdings

August 8, 2011 Posted by China Briefing Reading Time: 3 minutes

Aug. 8 – China, the largest U.S. foreign debt holder, has just breathed a sigh of relief after the United States avoided a massive default by agreeing to raise the nation’s borrowing ceiling on August 2, but the ensuing downgrade of U.S. credit by Standard & Poor’s (S&P) has again underlined the risk that China may see a value decline in its over US$1 trillion holdings of U.S. bonds in the future. The Chinese stock market reacted strongly to the downgrading news today and voices urging China to make more requirements on U.S. bond issuance in order to better secure its own interest are becoming louder.

The Chinese government’s official news agency Xinhua published a commentary on Saturday, harshly condemning the United States for its “debt addiction,” calling for international supervision over the dollar issue, and emphasizing that the world may need a new stable global reserve currency. It also pointed out that as the largest U.S. foreign creditor, China “has every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets.”

The roundly-worded commentary followed S&P’s recent decision to lower the United States’ AAA credit by one level to AA+ and keep the outlook at “negative,” regardless of the fact that the country’s lawmakers have already agreed to raise the US$14.3 trillion debt ceiling by another US$2.4 trillion and enforce a plan that targets US$2.4 trillion in spending reductions over the next 10 years. The rating agency said the main reason for the downgrade is that the U.S. government’s fiscal consolidation plan has fallen short of US$4 trillion – the amount of spending cuts S&P had said it preferred. What is more, S&P also expressed its concern that “predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges” more than it had envisioned back in April. The U.S. credit could even be lowered again if the country fails to meet the spending reduction goal it agreed to within the next two years, the company indicated.

China has accumulated US$1.16 trillion of U.S. debt so far – more than 40 percent of its US$2.8 trillion in total foreign currency reserves last year – in a bet to increase its dollar asset value and minimize gains in its local currency for better export performance. However, the recent string of events – including reports on the U.S. government’s high level of deficit, political wrangling over the borrowing limit, and S&P’s subsequent downgrade – have increased concerns over a future value loss in China’s foreign reserve assets. Zuo Xiaolei, chief economist of China Galaxy Securities, predicted that China’s foreign reserve’s buying power will decrease significantly as a result of the downgrade.

Zuo believes China should have a say in the U.S. bond issuance and its future development model. The yields of U.S. bonds should increase with the gaining inflation rate to offset the risk brought by the U.S. dollar’s depreciation. The United States should also focus on developing its real economy by introducing foreign direct investments, rather than borrowing new debts. In addition, Zuo stressed that China’s foreign reserves should reduce their reliance on U.S. dollars, as confidence in the dollar is declining.

China’s capital market, together with the global stock market, reacted strongly to S&P’s announcement. The Shanghai Index of the A-share market plummeted by 3.68 percent this morning, reaching the lowest level since July 20, 2010 by lunch time. Hong Kong’s Hang Seng Index also declined to its lowest value in the past 11 months, decreasing by 2.56 percent in the morning.

The current situation has led China to question what it can do to prevent future losses and whether the massive pool of foreign reserves can find other investment avenues. Sean Callow, a senior currency strategist at the Australia-based Westpac Banking Corp., believes that although Asian states that are currently holding nearly half of U.S. debts will not be happy about the downgrade, they “will just have to hold on and stick it out.”

“There is pressure on them to hold on to liquid assets and there is nothing more liquid than the Treasury market. At least Treasuries have been doing well and they aren’t holding on to distressed assets,” Callow added.

U.S. Treasury Secretary Timothy Geithner also said during an NBC television interview that he is not worried about China stopping its purchases of Treasuries despite the reduced rating by S&P, and he believes China will continue to be a strong investor in the United States going forward.

The U.S. Department of the Treasury also questioned S&P’s credibility after the agency downgraded the United States, criticizing the fact that S&P made its judgment based on a US$2 trillion “mistake” and then changed the rationale for its decision after its mistake was made apparent.

China Considers Opening up Debt Capital Market

China Trims U.S. Treasury Holdings in January