'China faces a dilemma' in US Treasuries

Beijing shouldn't stop buying bonds yet despite risk, analyst says

NEW YORK / BEIJING - China has "little choice" but to continue buying US Treasury bonds in the short term despite the potential risk of Washington defaulting on its obligations to foreign bondholders, analysts said on Tuesday.

China, the largest foreign holder of US Treasuries, increased its holdings by $7.3 billion to $1.16 trillion for the second straight month in May, according to the US Treasury Department.

The total foreign holdings of Treasury securities rose 0.6 percent to $4.5 trillion in May, the same month the US reached its $14.3 trillion debt ceiling the US government can legally borrow to finance its operations.

Since reaching the limit on May 16, the US Treasury has relied on accounting maneuvers to prevent a federal default. US Treasury Secretary Timothy Geithner said that if the debt ceiling was not raised by the Aug 2 deadline, the government would default on its obligations to its foreign bondholders.

"China faces a dilemma in its holding of the US T-bonds," said Dong Yuping, an economist with the Institute of Finance and Banking at the Chinese Academy of Social Sciences (CASS).

"Beijing has little choice but to continue to buy the US debt because Beijing wants a stable dollar. And the US Treasury bonds remain the most liquid investment product in the market, given China's huge foreign exchange reserves.

"But China has to come up with a backup plan of investing its foreign reserves as a long-term strategy because the trend of a weakening US dollar has become almost a certainty," he said.

China's foreign exchange reserves rose by a faster-than-expected 30.3 percent year-on-year by the end of June to reach $3.2 trillion. Analysts said that this indicated an increasing inflow of "hot money" after the latest interest rate hike by the People's Bank of China, the central bank, to contain inflation and asset bubbles.

Yao Wei, an economist for China at the French bank Societe Generale SA, said that China needs to speed up the pace of structural reforms to rebalance its economy to reduce external surpluses, internationalize the yuan, and diversify foreign exchange reserves.

"The key issue here is not what China should buy, but how China can slow down the pace of foreign exchange reserve accumulation to reduce the need to buy," Yao said. "China should seriously rethink the assumption of US Treasuries as a safe haven."

Last week, global ratings agencies, including Moody's Investors Service and Standard & Poor's, put the US triple-A credit rating on review for a possible downgrade.

The Chinese rating agency Dagong Global Ratings Co Ltd said it would consider knocking the US credit rating down another notch. Dagong downgraded it from AA to A+ in November after the US government announced a second round of quantitative easing.

However, some economists still believe that buying US government debt is "a low-risk option".

"The Treasury market is the largest and most liquid market in the world. There is no other market where large investment-grade risk positions can be transferred on such a narrow offer. It will remain so for the foreseeable future," said Chris Ahrens, an interest-rate strategist at UBS AG.

The May data of the Treasury International Capital report shows that foreign investors will still keep investing in US government debt, with Japan and the United Kingdom, the second- and third-largest holders of US Treasuries, also increasing their holdings.