Is China Dumping or Accumulating U.S. Treasuries?

The latest Treasury International Capital (TIC) report shows that, at the end of 2009, China was no longer the largest foreign owner of Treasury securities, having relinquished back to Japan the No. 1 spot it had claimed in September 2008. Between November and December, mainland China's holdings fell 4% to $755.4 billion. Is this a bad omen for the U.S. government and Treasury bond holders alike?

China must keep its appetite
If Chinese appetite for U.S. debt wanes and there is no one to make up the shortfall in demand, government bond yields could rise, creating losses in bond portfolios (those of investment banks, for example -- see table below) and putting increasing strain on the U.S., which needs to finance ballooning deficits.

Source: Capital IQ, a division of Standard & Poor's.
Note: Available-for-sale and trading assets must be marked to market. For the former, gains and losses are reflected on the balance sheet, affecting the value of bank capital. For the latter, gains and losses show up directly on the income statement.

Beyond the headline numbers
Not so fast. According to The Wall Street Journal's "Heard on the Street" column, the doubling in U.K. and Hong Kong holdings of U.S. government securities over the past year suggest that China could be the ultimate owner of some of the bonds in these financial centers. Besides, China's "direct" holdings are still larger than they were a year ago.

The truth of the matter is that although China would like to reduce its dollar exposure, there is a distinct lack of alternatives (for China, not for individual investors). Furthermore, China is locked in a risky tango with the U.S. -- U.S. consumers buy Chinese goods, China recycles the dollars it accumulates into dollar assets, which enables it to maintain the yuan at a depressed level ... which ensures its exports goods remain competitive. So the cycle continues, exacerbating global imbalances.

Watch this duo
Similar to the extraordinary liquidity central banks injected into the banking system in the crisis, U.S. and Chinese policymakers will eventually need to curb this cycle (gracefully, if possible). Investors need to add this to their mental checklist of macro-level risks for this decade. The path the U.S. and China select will have an enormous impact on the global economic and investing environment.

China is concerned about the value of the dollar, and U.S. investors should be as well. Tim Hanson explains why it's time to get out now!