US banking woes compound China’s need for US Treasury alternatives

With so much risk flooding the global financial sector, it makes sense for China to look for alternatives to investing in US Treasuries
However, questions remain over how to diversify that risk and maximise returns at the same time, given the ubiquity of the US dollar

David Brown

Published: 3:45pm, 3 Apr 2023

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The world has entered into a new phase of global instability, making it imperative again for investors to batten down the hatches against the spectre of rising risk. The aftermath of the Covid-19 pandemic, the effects of the Ukraine war, the recent inflation spike and now the latest banking crisis are making it that much harder for investors to choose where they should ideally lie on the investment curve to mitigate their risks.

For large sovereign investors such as China, the challenge is made even harder by the fact that its traditional bolt-holes are looking less secure.

The US dollar may be regarded as the go-to safe haven in a troubled world, but with so much specific risk originating in the United States right now, Beijing might be better off looking elsewhere for better protection.

The trouble is that the scope for suitable alternatives is limited. China is already in the process of reducing its risk exposure to US sovereign risk. Its holdings of US Treasury bonds fell to US$859 billion in January, its lowest level since 2009, marking a fall of 17 per cent over the last year alone.

The impact of the US Federal Reserve’s interest rate tightening during the last year and the associated uncertainty in the US Treasury bond market has been an obvious cause for concern, but there are deeper worries now about the risk of wider systemic risk considering the problems evident in global banking sector over the last few weeks. The problems arising from the collapse of Silicon Valley Bank and fears of contagion spreading more widely through financial markets will have not helped matters.

While financial market turmoil seems to have settled down for the time being and fears about further Fed tightening will have eased following better-than-expected US inflation news, recession worries and concerns about a possible US debt default still need to be weighed.

A selection of milks and seasonal nogs are displayed for sale at a Kroger supermarket in Atlanta, Georgia, last October. The US Personal Consumption Expenditure (PCE) index, which is the Fed’s preferred inflation gauge, rose less than expected in February on a monthly basis. Photo: AFP

While Beijing has been scaling back China’s holdings of US Treasuries, investments in US agency bonds and other alternatives have risen in the last year. These moves might need to be reversed should economic and political factors take a turn for the worse in the next few months.

The risk of a full-blown US debt default might seem a very remote possibility, but that’s not to say it would never happen or that the Treasury market won’t be prone to a nasty bout of jitters should the row over the US debt ceiling continue.

The non-partisan Congressional Budget Office estimates that the deadline for when the US could no longer pay its bills could come any time between July and September this year, depending on the country’s fiscal outlook.

If the stand-off between the Biden administration and the Republican-controlled US House of Representatives intensifies, there is much at stake with the current borrowing limit set at US$31.4 trillion. The economic fallout from a default of this magnitude would be catastrophic for the world, and it’s no wonder China has concerns about its US dollar-based exposure.

China’s investment needs are vast considering the nation’s stockpile of official exchange reserves worth US$3.1 trillion, combined with the revenue generating power of a nearly US$900 billion trade surplus, a large part of it received in US dollars.

The need to diversify from US dollars into other currencies is understandable, especially if China’s confidence is starting to wane. China’s dilemma is how to diversify that risk and maximise returns at the same time.

China needs a large government bond market to invest in, one with great depth, high liquidity, easy access, good security and low transactions costs. The US Treasury market ticks all those boxes but poses a major challenge if China wants to reduce its dollar dependence in a world where the US dollar still accounts for 58 per cent of the world’s official currency reserves.

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The alternatives are limited. The euro accounts for about 21 per cent of the global official reserves market, but it remains overshadowed by geopolitical risks from eastern Europe, fallout from the global banking crisis and low returns.

The Japanese yen accounts for about 6 per cent of the global currency reserves market and offers even lower yield appeal, with yen interest rates still stuck in negative territory.

The best that Beijing can do is gradually reduce its US dollar dependence without rocking the boat too much and diversify its risk as wide as possible in the long term. China needs to insulate itself against US contagion risks, but it could be up against it if market events turn sour again in the short term.

David Brown is the chief executive of New View Economics