BEIJING (Reuters) - China will soon be dethroned by Japan as the top holder of U.S. government debt as the Chinese central bank has been dipping into its foreign exchange reserves to support the yuan, while its Japanese counterpart has been content to allow the yen to weaken, economists said.
Investors are paying close attention to declines in China’s holding of U.S. Treasuries as any sharp sell-off could add further upward pressure to U.S. interest rates, which in turn can undermine the Chinese currency. The figures for foreign ownership of U.S. Treasuries in October are due out on Thursday afternoon in Washington.
On Wednesday, the U.S. Federal Reserve raised interest rates and signaled a faster pace of rate increases in 2017, sending yields on shorter-dated Treasuries to their highest levels in more than five years.
U.S. President-elect Donald Trump's attacks on Beijing over its trade and currency policies, as well as his questioning of the stance of current and past U.S. administrations concerning Taiwan, has triggered fears that China could decide to sell U.S. Treasuries in response.
However, Chinese government policy advisers, who declined to be identified because of the sensitivity of the subject, say they believe that’s highly unlikely.
An official at the news department of the People's Bank of China, the nation's central bank, declined to comment.
China’s holdings of U.S. Treasuries fell by $28.1 billion to $1.157 trillion in September from August -- the lowest in four years, according to data from the U.S. Treasury Department. The October figures are expected to show another decline, and Japan could potentially take over the No.1 spot from China.
The more important figures will be for November and December, which won’t be released until some weeks into next year. They will show what happened after Trump won the U.S. presidential election on Nov. 8,, and investors sold off Treasuries in anticipation of rising U.S. economic growth and larger U.S. government budget deficits as Trump plans to cut taxes and borrow to fund new infrastructure spending.
If China did reduce its holdings of Treasuries in the autumn it may well have avoided some losses. Treasuries have been shredded since the election, and investors have faced a negative total return of 3.3 percent in that span, according to the Bank of America/Merrill Lynch U.S. Treasury Index. Losses have been particularly steep in longer-dated paper, with the 10-year note falling 5.7 percent and 30-year bond losing 10.3 percent, both on a total return basis.
Japan kept its position as the second-biggest owner of U.S. Treasuries with $1.136 trillion in September. Its holdings fell by $7.6 billion from August but were still $14 billion higher than in December 2015.
Japan’s holdings eclipsed China’s for just one month in February 2015, the first time since the 2008-2009 global financial crisis.
"China has been selling dollars to keep the yuan steady while Japan is very happy to let the yen depreciate,” said Chester Liaw, an economist at Forecast Pte Ltd, Singapore.
Economists say they expect China to continue to reduce its holdings of U.S. government debt, considered as the most liquid dollar assets, to help defend the yuan, but a big sell-off looks unlikely. The yuan <CNY=CF XS> fell to its weakest level against the U.S. dollar in more than eight years on Thursday, after the Fed's rate rise and outlook.
“China has been consciously cutting its holdings of U.S. Treasuries, to defend the yuan, and it’s hard to stop this trend,” said Zhou Hao, Singapore-based economist with Commerzbank.
China’s foreign exchange reserves, still the world’s largest, have fallen by $942 billion from a peak hit in June 2014, to a six-year low of $3.052 trillion in November, a drop of 24 percent. Meanwhile, China has reduced its U.S. Treasury holdings by $111 billion between June 2014 and September this year, a drop of 9 percent.
The PBOC is likely to spend more of its reserves to support the yuan, although it’s walking on a tightrope, seeking to slow the yuan’s descent while trying to preserve the reserves by reducing capital outflows through tighter controls.
Some traders believe the $3 trillion mark is a key psychological level for the PBOC, but it risks rapidly churning through its remaining stockpile of reserves if the U.S. dollar keeps climbing and Beijing has to fight to steady the yuan.
Some Chinese government economists have put the minimum prudent level of reserves at somewhere between $1.62 trillion to $2 trillion.
One central bank adviser said earlier this month that China should use its foreign reserves to help maintain market confidence in the yuan, as expectations of further depreciation have led the exchange rate to weaken too far against the U.S dollar.
But government policy advisers don’t believe that dumping U.S. Treasuries is among policy options to be considered by top leaders, even if China wants to retaliate against the United States. That will, of course, also depend on whether Trump carries through on his threats to declare China a currency manipulator, impose punitive tariffs on Chinese imports into the U.S., and whether he abandons the 'One China' policy.
Liquidating a big chunk of U.S. debt holdings could roil financial markets and force the United States to scramble for funds, but analysts believe such a move by Beijing would risk starting a fire sale in which the value of its own portfolio would burn.
There are few alternatives to U.S. government bonds, with their negligible risk of default and positive yields.
“This (dumping U.S. debt) is a bad idea. It will not be among retaliatory measures to be considered by the government,” said one Chinese government policy adviser.
Reporting by Kevin Yao; Editing by Martin Howell