China has been increasingly concerned about its exposure to U.S. debt.It owns $3.2 trillion in foreign exchange reserves, of which $1.1 trillion are in U.S. treasuries. And after the S&P downgrade of U.S. credit rating, all the talk has been about China, diversifying its foreign exchange holdings.
In fact, just today, Gary Locke, the new U.S. ambassador to China assured China that its dollar investments were safe. The downgrade had little immediate impact on the Asian giant, but if the U.S. resorts to printing money, China stands to lose from dollar depreciation or inflation.
For now, it seems like China may have to buy more U.S. treasuries to secure its own investment value and stabilise the market, but the only real solution to China’s dilemma according to Societe Generale analyst, Wei Yao, is a flexible yuan:
“What China can do and needs to do is to start letting the yuan go. A more flexible yuan means less intervention from the central bank and a slower pace of FX reserve accumulation, which was running at USD 60 bn per month in H1.
…There is no doubt that concerns over growth and employment would continue to be a counter argument to any drastic moves, but the balance of political thinking is probably tilting. We may see China to move faster towards a stronger and more flexible yuan.”
Last week China’s central bank raised the yuan fix, making the currency stronger. Here is a SocGen chart that looks at China’s yuan fixing price, against the dollar index, which measures the value of the USD against a basket of foreign currencies. The chart shows the yuan appreciating:
[credit provider=”Societe Generale “]