Is China dumping treasuries?

This is the million dollar (literally!) question.

Yes China had said that it wouldn’t use the nuclear option and probably meant it, ’cause there’s no need for it to actively sell down UST. As today’s TIC data indicates, China trimmed its UST holdings by not rolling over its maturing T-bills. This way, China can reduce its UST holdings w/o alarming the market. Plus, China also has large amount of foreign currency inflows each month from its trade surplus. It can simply buy less of the UST.

The question should be where does China put its cash instead? In addition to resources shopping spree across the globe, another option is to diversify into other currencies. JGB and euro bonds have both seen strong Chinese demand lately. The FT reports that Chinese Premier Wen Jiabao voiced strong support for the euro during a state visit from Angela Merkel. What it fails to pick up is the connection between that and China’s recent change in its currency regime to a reference making up of a basket of currencies. Reuters is doing a better job of reporting the meeting.

China is a responsible, long-term investor that has always pursued the principle of diversifying its investments, Wen said.
“The European market has been in the past, is now and will be in the future one of the main investment markets for China’s foreign exchange reserves,” he said.

Given the massive appreciation of RMB against the euro so far this year, diversifying into euro assets has the added benefits of supporting Chinese exports to Europe, China’s largest market, bar none. Given time, it will also result in slight appreciation of the RMB against the USD, deflecting some political heat. But make no mistake, there’s no free lunch in this world. Diversification away from treasuries will surely have an impact on US interest rates. Spain “successful” bond issue last Tuesday came at almost 15% higher yield than in April.

Impact of the European crisis on China

While the endless rounds of flip-flops are entertaining in a wicked way, it will be stupid to treat the European crisis as just a reality show. For one thing, the EU, rather than the US, is China’s largest export market, and exporters are already howling from the pain of an effective 14.5% currency appreciation in 4 months against the euro.

What else? Most have given up on any prospect of immediate revaluation of the RMB. The US is already harping a different tone regarding currency ahead of the Sino-American Strategic and Economic Dialogue next week. There are also stories of hot money outflow. Michael Pettis rambles on the prospect of more trade conflicts, perhaps even in the form of tariffs. Shocking! Economic basket case resorts to beggar-thy-neighbor policies and trade conflicts (or any sort of conflicts) intensify during hard times. What’s more interesting is actually at the end of the post, almost as an afterthought, he suggests that China might be able to mitigate the risk by buying euros.

By the way is there anything that China can do to head off conflict?  Yes.  It can buy euros, the more the better –just lift every offer out there.  By strengthening the euro, or at least limiting its weakness, this strategy will force the brunt of the adjustment back onto European surplus countries rather than onto the US and, via the US, back onto China.  Sarkozy and other European leaders might not be very happy, of course, but they will be at least partially mollified by the net capital inflows and the reduced humiliation of a collapsing euro.

I know, I know, China had just sold its euro bonds and parked the money in dollar, as per the most recent TIC data. But I still think this scenario is more than feasible. When the crescendo calling for RMB revaluation was at its loudest, western media were full of quotes from “Chinese experts” that seem to readily acquiesce to RMB appreciation. However, when you actually look at their speech, preferably in the original, what those people are advocating is a reform of the currency management mechanism rather than straight appreciation per se. One term that pops up very often is “basket of currencies”, i.e. replacing the USD reference with a secretive brew of multiple currencies, a la Singapore. Li Daokui, member of the monetary policy committee of the PBoC is flogging the basket of currencies idea these days. A central government think tank is also calling for breaking the “predictable path of currency movement”.

In this sense, the current dollar strength actually gives China good cover to carry out with the proposed reform. Instead of maintaining a hard peg with the dollar, China can intervene by buying up some euros, and selling from its dollar reserves to pay for it of course. This diversification will help to halt the RMB’s appreciation against the euro and will appease to US cries for stronger RMB. Parking your wealth in the bunds is way safer than the treasuries, if you ask me.

The natural implication of this change in regime is an inevitable rise in US interest rate. When you have a buyer boycott, it is possible to have higher interest rate despite hollowing deflation. China has not withdrawn her money from the Bank of the US so far, only because it has nowhere else to go. After a substantial fall in the euro, and most of Europe’s problems priced in, things might look quite different.

The irony of it, should it materializes, is that the RMB might appreciate against the dollar just when about everyone has written it off, and those that pushed for it might live to regret it.

Failed bills auction in China

All eyes on the dramatic beginning of the end of the euro these days, that few seem to take note of the second failed bills auction in China in a month. The Finance Ministry sold only 97% of its planned RMB20bn sale of 273-days bills, at an average yield of 1.72%, compared to 1.54% at the previous auction.

It’s interesting that the Bloomberg story pinned the cause of the failure at liquidity shortage, as the PBoC raised reserve ratio for the banks earlier this month. I guess this is another way of framing the issue. A more direct explanation is that the market is expecting some sort of rate hike and 0.18% increase in yield is not deemed adequate to cover the risk.

Shanghai to impose property tax

Rumors abound that Shanghai will be among the first batch of localities to impose a 0.8% property tax (per annum, on appraisal value) on second homes, as these are classified as “for profit”.

After a series of tough measures, turnover at most cities have fallen dramatically while prices have not budged, as fat profits from last year help buttress most developers from cash flow pressure. This new tax is largely seen as a follow up to earlier measures, to make sure that policy control does work its way and cools China’s property market.

Many commentators are doubting the ability of the central government in achieving its policy objective. I think this is taking too sanguine a view, or perhaps too pessimistic, depending on your stance. Make no mistake, if the Chinese government truely wants to clamp down on housing prices, it will succeed. The runaway housing market has already turned into a political issue, and nothing political is taken lightly in China.

The real question should be what are the consequences? Will everything be just swell after property prices come down from outer space? There already are signs that liquidity squeezed out from the property market is wrecking havoc in other sectors of the economy, like the all important farm produce. Today there’s an interesting story in the Chinese media about Wenzhou speculators (oh, these folks are famed, and not just for making lighters) turning towards gold. One also need to bear in mind that China aims to reform its domestic utilities and resources pricing this year, by taking away the huge subsidies. All these factors just make the 3% CPI target increasingly untenable. The risk of a Q2 rate hike is very real, perhaps even at this coming weekend for the real paranoid.

Inflation data out

And they don’t look good.

April CPI was up 2.8% YOY (consensus at 2.7%), dangerously close to the 3% threshold set by the government. PPI up 6.8% YOY (vs. 6.7% forecast). The banks made RMB774bn new loans in April, a hefty 52% increase over March.

The plan was to tranquilize Chinese economy with policy measures and wait for the global liquidity tide to ebb. Well, this ain’t gonna happen. If anything, there’s more free money  now than ever.

Maybe it’s time to bite the bullet and hike interest rate. Either that, or people will soon start demonstrating ’cause they can’t afford vegetables.  The Tiananmen protest in 1989 started out as demonstration against raging inflation after all.