In first steps to skirt ‘dollar trap’, China takes to Asian bonds

There is “compelling evidence” that China is taking “significant steps” towards diversification of its foreign exchange assets away from the US dollar and into Asian asset markets, which offer relative value, say economists.

Although it’s difficult to track China’s investments in the absence of country-specific breakdown of its $2.4 trillion (and rising) sovereign portfolio investment, there is “compelling evidence” that China’s foreign exchange managers are active in the Japanese, Korean, Canadian and Australian bond markets, according to Standard Chartered economist Jinny Yan.

The volume of China’s investments in these bond markets is still small relative to its flows into US and European debt markets, but nevertheless this may mark a defining moment in China’s attempts to move out of the ‘dollar trap’ it found itself in.

China’s foreign exchange reserves are projected to rise to $3 trillion by end-2011, and needs alternatives to US dollar assets to park them in.

Beijing is also simultaneously advancing its agenda to internationalise the Chinese yuan (also called the renminbi) gradually, adds Nomura analyst Tomo Kinoshita. On Tuesday, China’s central bank announced pilot measures to allow foreign banks to invest renminbi funds they receive (as a result of renminbi trade settlements) in China’s renminbi bond market.

The liberalisation is “rather limited” in scale at this stage, but it nevertheless represents an “extremely important intermediate step” towards the internationalisation of the renminbi, note Standard Chartered analysts.

But even after China’s reserve managers’ record two-month sale of a cumulative of $56 billion in US Treasuries in May and June, nearly 70% of China’s reserves are still held in US dollar assets, points out Yan. “As of end-June we believe China held around $1.8 trillion worth of US dollar assets, of which $1.2 trillion was in Treasury notes and bills.”

China, adds Yan, is more likely to take a “gradual approach” to diversifying its reserves. “With GDP growth still largely dependent on exports, and on US consumption in particular, China would be negatively affected by a sharp rise in US market rates.”

Fast-growing, stable Asian economies are becoming “much more attractive investments than their flagging US and European counterparts,” and China seems to have given them a vote of confidence, notes Yan.

No less significant, says Kinoshita, is Tuesday’s move on the renminbi. “This is a logical extension of the previous measures announced in June and provides foreign banks with a way to invest in renminbi assets.”

By facilitating such investments, the new measure should encourage approved overseas banks to accept renminbi deposits and offer good interest rates to depositors, which in turn would encourage international trade settled in renminbi. 

“As the amount of investment in China’s bond market is limited to the real demand that has arisen from the trade settlement, we think this measure should not undermine China’s capital controls,” reasons Kinoshita.