Americans could be excused for feeling some discomfort at the “ominous” image of the US Treasury Department headquarters in Washington bedecked with the flags of the People’s Republic of China in honour of visiting Chinese President Hu Jintao.

As the Wall Street Journal noted in a tongue-in-cheek blog captioned “People’s Republic of US Treasury”, the flags are a common courtesy for high-level visiting dignitaries. But, the writer noted that given that China held $US896 billion of US Treasury debt as of November — the picture had “some unsettling overtones”.

But it’s not clear that the Chinese leader would find the picture any more reassuring.

Figures released on the eve of the Chinese presidential visit showed that China was a net seller of US government debt in November, although it still retained its position as the largest foreign creditor to the US.

China sold off $US21.1 billion of short-term Treasury debt, but boosted its holdings of longer-term debt by almost $10 billion. As a result, China’s total holdings of US government debt fell by $11.2 billion to $895.6 billion.

Some see China’s surprise decision to reduce its portfolio of US government debt as a signal of Chinese discontent over the US Federal Reserve’s $US600 billion bond-buying program, which kicked off in early November.

Others believe that China wanted to draw attention to America’s dependence on ongoing Chinese financial support in order to blunt US criticisms of its undervalued yuan.

Whatever the reason, China’s decision to pare back its holdings of US bonds in November caused some jitters that China might indeed have decided to diversify the investment strategy for its massive foreign currency reserve which stood at $US2.85 trillion at the end of last year.

If China were to step back from buying US government bonds, US interest rates would rise, putting fresh interest rate strains on US households and corporates.

These fears were slightly relieved after figures showed that China sold a net ¥81.3 billion of Japan financial assets in November, mostly Japanese government bonds, after buying up ¥262.5 billion the previous month.

And although Chinese politicians have scored headlines in the European press by promising to invest in the debt of peripheral countries such as Portugal and Spain, the actual amounts invested to date are relatively small.

What’s more, it’s clear that some senior Chinese officials have misgivings about increasing Chinese exposure to the bonds of debt-laden eurozone countries.

In a strongly worded opinion piece published in today’s Financial Times, Yu Yongding, a former member of the monetary policy committee of the Chinese central bank, argues that China “must urgently seek clarification as to whether its holdings of euro periphery debt will be part of any restructuring”.

He adds: “Until such clarification is provided, or the eurozone comes up with a permanent resolution mechanism, China should give no commitment to support the eurozone through direct government bond purchases — this risks simply throwing good money after bad.”

But Yu also points to the risks that China is running as a result of its position as a major creditor to the United States.

At present, he says, the US is debasing its currency as a result of the Federal Reserve’s bond buying program, while President Barack Obama’s recent tax deal with Congress has not alleviated concerns about US budget deficits.

As a result, he warns, ominously, “2011 could be the year where China sends a clear message to the US: do not expect any more munificence.”

*This article was originally published on Business Spectator.

Peter Fray

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