China Dumps the Dollar as Yields Sink

China cut its holdings of Treasury notes and bonds by the most ever in June, instead favoring the debt of Europe, Japan and Korea. The move has fueled speculation that plummeting U.S. yields are driving away the Asian giant, which has ambitions for its currency, the yuan, to replace the dollar as the world's main reserve currency.

China's holdings of long-term Treasuries fell by $21.2 billion in June to $839.7 billion, a U.S. government report showed recently. Total Chinese investment in U.S. debt declined 2.8% to $843.7 billion, the smallest in a year, following a 3.6% slide in May.

The shift comes as President Barack Obama increases U.S. debt to record levels, making it harder to finance sales to sustain the U.S. economic expansion.

[mm-toolbar] The People's Bank of China on June 19 ended its currency's two-year peg to the dollar, saying it would allow greater "flexibility" in the exchange rate. The yuan has since appreciated by 0.5%.

Prior to letting it float, the central bank had been limiting the yuan's appreciation by selling the currency and buying dollars, a policy that led to the accumulation of the world's largest foreign-exchange reserves and the build-up of its Treasury holdings.

But the Treasury sales and the rapidly appreciating yuan may be signaling China has bigger things in mind for its currency.

The People's Bank of China said on Monday that it would allow foreign central banks and overseas lenders to increase investment in its domestic interbank bond market.

Analysts interpreted the move as a way of promoting the renminbi, while reducing China's exposure to the U.S. dollar.

"This is an integral part of pushing the internationalization of the renminbi," Wang Tao, chief China economist at UBS AG (NYSE: UBS) told the Financial Times. "In order to encourage foreign institutions to get involved in renminbi settlement, you need to give them somewhere to invest."

Money Map Press Chief Investment Strategist Keith Fitz-Gerald believes the Chinese have a long-term plan to replace the dollar as the international reserve currency.

"The Chinese yuan is already well on its way to becoming that globally accepted standard unit of exchange and the proverbial genie, as they say, is out of the bottle," Fitz-Gerald wrote in a column last year for Money Morning. "At the very least, China's currency is likely to be granted a global status on par with the current major currency trading pairs for purposes of settling international transactions, whether the West wants that to happen or not."

China also is turning more bullish on European and Asian economies.

China said earlier this week it had been buying "quite a lot" of European bonds, and Japan's Ministry of Finance said on Aug. 9 that China bought $20.3 billion more Japanese debt than it sold in the first half of 2010, the fastest pace of purchases in at least five years.

Additionally, China has more than doubled South Korean debt holdings this year.

China [will] allocate some reserves to "financial assets in major Asian economies," Ding Zhijie, a former adviser to China's sovereign wealth fund, told Bloomberg in an Aug. 16 interview.

"The significance of both the dollar and euro has declined because of the global financial crisis and the European debt crisis, while the role of some emerging-market currencies rose," said Ding, dean of finance at Beijing's University of International Business and Economics.

While China may have long-term ambitions for its currency, some analysts think the Treasury sales are a simple reaction to shorter term developments - cashing in on an investment that has appreciated significantly since the U.S. began buying its own debt to keep interest rates low.

"This may have been opportunistic," James Caron, head of U.S. interest-rate strategy in New York at Morgan Stanley (NYSE: MS), one of 18 primary dealers that trade with the Federal Reserve, told Bloomberg News. "Look at the level of yields. If you've held a lot of Treasuries, you've done well."

Also, with rates at record lows, buying more treasuries now could be a losing proposition for China. Two-year rates will climb to 0.85% by year-end, according to a Bloomberg survey of financial companies. The two-year note yielded a record low 0.48% earlier this week.

Investors who purchased the securities today would lose 0.4% if that projection proves correct.

"Buying now is a big risk," Hiroki Shimazu, an economist in Tokyo at Nikko Cordial Securities Inc., a unit of Japan's third-largest publicly traded bank told Bloomberg. "I don't recommend it."

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