US debt default may compel China to diversify its foreign exchange holdings

AFP, SHANGHAI

Thu, Oct 17, 2013 - Page 15

A US debt default could spur China to diversify its multitrillion US dollar foreign exchange reserves — the world’s largest — as Beijing seeks to boost its voice in the global economy, analysts say.

A historic default would inevitably lower the value of China’s US dollar assets and have a broader impact on its economy, the second largest in the world.

Chinese officials and state media have already sounded the alarm as the deadline approaches for the divided US Congress to raise the debt ceiling and avoid a financial catastrophe.

Analysts said the heightened possibility of default is likely to cause China to further diversify its reserves — which it is already doing — and even trim holdings of US Treasuries, but they ruled out Beijing dumping its holdings.

The bulk of China’s foreign exchange reserves, which reached a towering US$3.66 trillion at the end of last month, are held in the greenback.

“If there really is a default, the Chinese government will definitely speed up foreign exchange reserve diversification, seeking safer bonds of other countries,” said Liao Qun (廖群), a Hong Kong-based economist with CITIC Bank International (中信銀行國際).

“If there is an acceleration in diversifying, there might also be a reduction in holdings [of US Treasuries],” he said. “China has a reason to do so, but of course it would be extremely difficult.”

China is the largest foreign holder of US Treasury bonds with US$1.28 trillion, closely followed by Japan with US$1.14 trillion.

Any large-scale selling of US debt by China would erode the value of its remaining holdings, analysts said, while few other asset classes anywhere in the world are large enough to park such vast amounts of cash, leaving Beijing with few practical alternatives.

In the longer term, Japan may also rebalance its portfolio a tad to diversify away from holding US government debt, said Yoshikiyo Shimamine, executive chief economist with the Dai-ichi Research Institute in Tokyo.

However, Tokyo’s political dependence on the US — for example, in its defense pact — mitigates against a sudden switch, he added.

“There is no financial instrument that is as highly liquid as US Treasuries,” he said, implying that it is difficult to see any major economy abandoning them.

Another worry for Beijing is the impact a Washington debt default would have on the US and global economies. China is heavily dependent on exports and foreign investment to maintain momentum in its own economy, which expanded 7.7 percent last year, the slowest growth since 1999.

A default “would definitely have a noticeable impact on the US economy,” said Sun Junwei (孫君瑋), a Beijing-based economist for British bank HSBC Holdings PLC.

“In this way, it would also have a negative impact on China’s economy,” she said.

Meanwhile, South Korea warned of risks of volatility in the won and stresses within its bond market as the US grapples with the threat of a default.

Prolonged tension over US fiscal policy adds to the danger of increased volatility in financial markets, the South Korean Ministry of Finance said in a report prepared for a parliamentary audit yesterday.

Bond issuance by companies with low credit ratings may wither, the report said, amid a criminal probe and financial crisis at the Tong Yang Group. South Korea will strengthen monitoring of financial markets and act quickly if necessary to curb volatility in its currency, the ministry said.

Speaking in the city of Sejong, South Korean Minister of Finance Hyun Oh-seok highlighted concern over the effect of the US Federal Reserve’s plans to reduce monetary stimulus when the US economy strengthens sufficiently.

Additional reporting by Bloomberg