China has a foreign reserve dilemma

The agreement reached by US lawmakers to raise the debt ceiling may have eased investor concern, but China, the largest foreign holder of US debt, is faced with the challenge of diversifying a massive foreign exchange portfolio endangered by a weakening USD, economists said Monday.

Although China has not officially responded to Washington's latest plan to address its debt problem, analysts said that Beijing is likely to view the plan as a positive step in restoring investor confidence in the USD and US bond market.

"The agreement is likely to avert default by Washington and it certainly is a relief for China," said Chen Daofu, director of the policy research center at the financial research institute of the State Council's Development Research Center.

Japan, the 2nd-largest holder of US debt, also welcomed the deal and said that it hoped that the US could take further steps to stabilize financial markets.

While the last-minute deal eased the immediate debt crisis in the US, some economists said that whether it will help prevent a possible downgrade of the credit rating is still in doubt.

International rating agency Standard & Poor's has warned that it could downgrade the credit rating of the US even if the debt ceiling was raised by Tuesday's deadline if politicians in Washington failed to achieve a "credible solution" to the rising US debt burden and the risk of further "policy stalemate".

The U.S. economy grew by 1.3% in Q-2, far lower than the expected 1.8%. Economists said that underlying growth has probably been effected by the massive Quantitative Easing program launched by the US Federal Reserve.

"A failure for the US to return to strong growth would be bad for the Global economy even if the major emerging-market countries have attained self-sustaining growth," Joseph E. Stiglitz, a Nobel laureate in economics and professor at Columbia University, warned in a recent article.

"We still cannot rule out the possibility of a downgrade of the US credit rating if Washington fails to come up with a long-term and balanced solution to address its debt problem," Chen said. "For policymakers in Beijing seeking alternative ways to invest the massive foreign exchange reserves and to reduce its rapid accumulation remain the crucial challenges," he said.

China's foreign exchange reserves rose by a faster-than-expected 30.3% Y-Y by the end of June to reach US$3.2T.

The country increased its holdings of US Treasury bonds by US$7.3B to US$1.16T in May, the 2nd straight month it increased its US debt holdings, according to the US Treasury Department.

Yu Yongding, a former adviser to the People's Bank of China, has repeatedly called on the government to reduce the holdings of US Treasury bonds and to halt future purchases as the dollar will probably continue to weaken. But some analysts said that a massive sell-off of US bonds would be financial suicide for China as it would drive down the value of its own holdings.

They added that Beijing is faced with a dilemma as it has little option but to keep buying US bonds to calm jittery markets.

Derek Scissors, research fellow in Asia Economic Policy at The Heritage Foundation, said that Beijing will probably just store money in simple bank deposits both at home and overseas until the US budget situation is resolved. "The debt standoff is 1st and foremost about irresponsible government-not just right now but for a decade by both parties, both houses of Congress, and two presidents," he said. "Beijing is probably not buying Treasuries as intensely as it did last year."

Investment bank China International Capital Corp (CICC) Monday warned in a report that the US economy remains a cause for concern. "The debt crisis may have a negative impact on the fiscal spending of the US government, which may drag down the US economy for the rest of the year," Hou Zhenhai, an analyst at CICC, wrote in a report.

Paul A. Ebeling, Jnr.

Paul A. Ebeling, Jnr. writes and publishes The Red Roadmaster's Technical Report on the US Major Market Indices, a weekly, highly-regarded financial market letter, read by opinion makers, business leaders and organizations around the world.

Paul A. Ebeling, Jnr has studied the global financial and stock markets since 1984, following a successful business career that included investment banking, and market and business analysis. He is a specialist in equities/commodities, and an accomplished chart reader who advises technicians with regard to Major Indices Resistance/Support Levels.