Tuesday, May 26, 2009

China owns the market

Beijing is caught in 'trap' over dollar

China's official foreign exchange manager is still buying record amounts of US government bonds, despite Beijing's increasingly vocal fear of a dollar collapse, according to officials and analysts.

In recent months, senior Chinese officials, including Premier Wen Jiabao, have repeatedly signalled their concern that US policies could lead to a collapse in the dollar and global inflation.

But Chinese and western officials in Beijing say China is caught in a "dollar trap" and has little choice but to keep pouring the bulk of its growing reserves into the US Treasury, which remains the only market big enough and liquid enough to support its huge purchases.

In March alone, China's direct holdings of US Treasury securities rose by $23.7bn (£14.9bn) to reach a new record high of $768bn, according to preliminary US data, allowing China to retain its title as the biggest creditor of the US government.

"Because of the sheer size of its reserves Safe [China's State Administration of Foreign Exchange] will immediately disrupt any other market it tries to shift into in a big way and could also collapse the value of its existing reserves if it sold too many dollars," said a western official, who spoke on condition of anonymity.

The composition of China's reserves is a state secret but dollar assets are estimated to comprise as much as 70 per cent of the $1,953bn total. China owns nearly a quarter of the US debt held by foreigners, according to US Treasury data.

The collapse of Fannie Mae and Freddie Mac, the US mortgage financiers, last summer prompted Safe to adjust its strategy and buy far more short-term US government securities, instead of longer-maturity bonds and notes.

When you become the "owner of a market" through manipulation, in this case by artificially lowering the value of a currency, the Renminbi, you face tough choices. There are consequences, usually bad ones when you do this for too long as so many "commodity cornering" traders have found out. China has the option of forcing its currency up to reflect its growing clout in the global economy, or it can start to sell its dollar holdings and shift into something else, most likely a more diversified basket of currencies/commodities or gold/silver.

Treasuries are in trouble as they can only be held up by foreign purchases or monetization by the Fed. Seeing as how the foreign purchasers see a lot of credit/inflation risk, we are only left with option 2. Monetization is outright inflation of the currency and leads to bad things like hyperinflation. Equity markets are reflecting this risk in higher nominal prices.

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