China has quietly unloaded 10 percent, or US$100 billion, of its US Treasury holdings in the first half of the year. During the past 40 years of rapid economic growth after recovering from a quasi-ruined state that officially ended in 1976, China has amassed a huge pile of foreign reserves partially through its trade surplus. The US Treasuries have always been the prime choice for China to park its foreign reserves. What made it run away from the traditional safe haven for its hard-earned foreign reserves?
One explanation is that Beijing is leveraging its financial power as the second-largest US Treasury holder to retaliate against Washington for its increasingly open support of Taipei and hawkish actions against China. This view has been popular among Chinese nationalistic thinkers and public thought leaders. By dumping US Treasuries, as the theory goes, China can induce waves of sell-offs of the bonds and tumble their value.
The problem with this thinking is that it does not account for the size of US Treasuries held internationally, which is US$7.4 trillion. China holds merely 1.3 percent of them. Even if China manages to unload its entire holding all at once, which is unfeasible, it would still not be enough to cause a market tsunami as destructive as intended. Thus, retaliation is not behind China’s action.
Another explanation is that China’s latest move is part of its precautionary efforts of reducing its dependence on the US dollar-dominated international monetary system. Since the outbreak of Russia’s war in Ukraine in February, Beijing has strongly objected to any international sanctions levied on Moscow, and has been keeping a watchful eye on how Russia manages to withstand the sanction-inflicted financial crunches.
So far, China has received mixed signals from Russia. The seizure of nearly two-thirds of Russia’s foreign reserves by the West has crippled Russia’s purchasing power and transaction ability in international trade. On the other hand, Russia has since switched to and relied on two alternatives — its ruble-based SPFS system for transferring financial messages and China’s yuan-based Cross-Border Interbank Payment System — for its international payment needs.
That Russia came out of the sanctions only half-scratched, commodity trade-wise, gives China some degree of comfort that a withdrawal from the dollar dominance is a way to mitigate the severity of international sanctions it would have to face should it decide to attack Taiwan.
However, Russia’s success in finding China as a shield to deflect sanction pain does not imply that China would have the same luck, since Russia’s economy is only about one-10th of China’s.
The notion that China’s downsizing of its US Treasury holdings is a safety precaution can be further debunked by two observations: First, China’s US Treasury unloading, although large by absolute size, is slow for urgent risk management, given that China is preparing military action against Taiwan if its “peaceful reunification” with the nation fails to materialize.
Second, China converted less than half of the unloaded US Treasury holdings to non-dollar positions in holdings in the Cayman Islands and Bermuda, suggesting that risk diversification was not the primary motivation behind China’s moves.
This view is consistent with a less noticed change — ie, China’s foreign exchange reserves had been steadily dropping from US$3.25 trillion to US$3.07 trillion in the first six months of the year.
Therefore, it is not only China’s US Treasury holdings that have shriveled, but the coffer of its foreign reserves as a whole.
What is going on with the world’s second largest-economy’s foreign-exchange reserves, which by far are the largest in the world?
To tackle this question, it is essential to understand the composition of China’s foreign-exchange reserves. China’s gigantic US$3 trillion foreign reserves are mainly from three sources: international trade surplus, inbound foreign direct investments (FDI) and external debts denominated in foreign currency.
The latter two, although counted as disposable reserves to some extent in practice, must be paid out when foreign investments withdraw or when foreign debts are due.
Since the 1980s when Beijing opened up to Western capitals, it has received US$1.6 trillion in foreign direct investment.
Foreign debts-wise, as of the end of the year, China has registered US$1.5 trillion in outstanding external debts denominated in foreign currency, of which 53 percent, or US$800 billion, were short-term debts, Chinese State Administration of Foreign Exchange data showed.
Total FDI and short-term external debts alone accounted for US$2.3 trillion of China’s US$3 trillion in foreign reserves, leaving China with only US$700 billion of truly owned reserves assets, just on par with what Russia had before its invasion of Ukraine.
Furthermore, taking into account the size of China’s US$17 trillion economy, China’s net foreign-exchange reserves volume is far below the IMF-recommended optimal level — 10 percent of GDP — for a fast-growing economy such as China’s.
In its economic heyday, China could bring in US$200 billion to US$400 billion annually through its trade surplus. So far, this steady supply of foreign currency has afforded Beijing the ability to fund its Belt and Road Initiative, foreign aid and other outbound FDIs.
With tensions growing between Beijing and its major trade partners in the West, China has sensed the beginning of the end of its profitable international trade model.
How far can China’s US$700 billion net foreign reserves go? Its need for crucial imports (oil, computer chips and data processors, iron ore, animal feed, etc) to maintain a minimum level of economic activities would cost the country between US$600 billion and US$700 billion annually.
Without a steady supply of a sizeable trade surplus to fill up the foreign reserves coffer, China would have to curb other foreign spending.
Meanwhile, the world has witnessed a drastic reduction in Belt and Road Initiative funding since 2020 as China’s first major spending adjustment to its deteriorating foreign reserves.
China’s gigantic foreign-exchange reserves were built largely on borrowed money and profits from an exploitative trade practice. The ongoing decoupling between China and the West will have two consequences for China: the loss of its customary trade surplus, and net outflow of FDI along with the trend of supply chain repositioning.
With FDI leaving the country and the maturation dates of external debts approaching, it will be more difficult for China to meet its essential imports needs and foreign debts obligations without tapping into its foreign reserves’ safe haven — its US Treasury holdings.
Although these changes will not bring down the house of China’s foreign reserves instantly, the first card has already been removed from the bottom. China will likely continue to cash in on its US Treasury holdings to make ends meet, only to be outpaced by the shrinking of its foreign reserves pool.
Daniel Jia is founder of consulting firm DJ LLC Integral Services in Spain.
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