China’s Back-Door Yuan Strategy

It has been widely reported that China has dramatically reduced its purchases of US Treasuries over the past year.  But it would be wrong to conclude that China has stopped intervening in currency markets or even that it is dumping the dollar.

A more logical interpretation of China’s recent moves is that Beijing is pursuing what might be called a back-door yuan strategy, which is designed in part to disarm critics in the US and reduce pressure for currency appreciation.  The strategy consists of reducing official US Treasury purchases (and instead buying Treasuries through London) and substituting some purchases of US government debt with purchases of debt from Asian economies, with the knowledge that this in turn would force Japan and other economies to increase their purchase of dollar denominated debt to try to prevent the appreciation of their own currencies.

In other words, this program merely hides or shifts China’s foreign exchange intervention.  The consequences for the global economy of China maintaining competitiveness through this back-door yuan strategy are potentially more disruptive because it can set off a cycle of competitive devaluations among major trading economies. 

Purchasing Treasuries through London

It is difficult to know with certainty the amount of US Treasuries China purchases in any one month or quarter.  This is because China, like other countries, purchases US Treasuries through London and those purchases are officially considered purchases by the United Kingdom. 

From July 2009 to July 2010, the Chinese were officially net sellers of $93.2 billion of US government debt.  During the same time period, US Treasury holdings in the United Kingdom increased by $277.2 billion. 

The original purchasers of US Treasuries bought in London are not transparent, but there is strong evidence that the Chinese are responsible for a significant portion of the $277.2 billion increase of US Treasury holdings in the United Kingdom.  One, China has continued its pace of reserve accumulation and has not shifted dramatically into other assets like gold.  Two, the decline in the Chinese holdings of US Treasuries coincides with an increase in holdings in the United Kingdom (see chart 1).  If the Chinese are purchasing Treasuries through London, then this could explain in part why the U.K.’s Treasury holdings have increased.

Buying Other Asian Debt

What is clear is that China has aggressively been purchasing the debt of other Asian governments (although not so aggressively as to rule out the purchase of US Treasuries through London). 

The Chinese purchased 2,360 billion yen ($26.2 billion) of Japanese government bonds (JGBs) from January to July 2010, an increase from zero during the same period in 2009 and far surpassing any previous period of Chinese JGB purchases (see chart 2).  Japanese Finance Minister Yoshihiko Noda recently said, “I do not know what their true objectives are, but we would like to clarify their objectives.”

According to a Seoul-based Financial Supervisory Service, China also purchased 3.99 trillion won ($3.4 billion) in Korean government bonds, doubling their holdings during the first half of 2010.

The large Chinese purchases of Japanese and Korean government bonds have contributed to yen and won appreciation.  The yen appreciated 8% against the dollar this year and reached a 15-year high of 83 yen-per-dollar in mid-September.   

In response to a strengthening yen, Japanese policy makers undertook unilateral action to sell an estimated $20 billion yen into the market, the largest single-day yen intervention in history.  During the day following the intervention, the yen depreciated by 2% against the dollar.  Although the yen intervention has had limited success, Japanese policy makers remain intent on depreciation, which will eventually put upward pressure on the dollar.

The Japanese intervention could cause a chain reaction of currency devaluation in Asia.  After the Japanese intervention, the director of foreign exchange at the Korean Finance Ministry, Kim Yi Tae, alerted that they are “closely watching” the situation in the financial markets.  In a separate response to a strengthening won, Kim Yi Tae said they would consider intervention in their own currency if “exceptional” exchange rate movements occurred, setting off a potential domino effect of currency devaluations.

Chinese purchases of Asian currencies could force countries like Japan and Korea into currency intervention, weakening their domestic currencies and strengthening the US dollar.  The yuan will remain undervalued and continue to support China’s export-oriented growth.  This postpones a necessary economic transition in China and could set in motion a wave of competitive devaluations across Asia.

The back-door yuan strategy may be used to try to disarm critics in the United States that say the Chinese are currency manipulators by reducing their official purchases of US Treasuries (even though they may secretly purchase Treasuries through London).  It also allows the Chinese to argue that the Japanese are manipulating their currency, and that they are not.

Conclusion

If this is indeed a conscious Chinese strategy, then it is a dangerous game. 

Purchases of Treasuries through London hides China’s role in global currency markets and aggressive Chinese purchases of other Asian currencies will force those countries to engage in currency intervention.  This could set off a wave of competitive devaluations across the largest world economies, cause exchange rate instability, and damage global growth.

Under these circumstances, what we need is not just an American strategy on the yuan but a larger multilateral strategy aimed at currency realignment to support a world economic recovery.   We need to bring the Chinese into a conversation with Japan, South Korea, and Europe to discuss how leaders can prevent a “race to the bottom” of destructive currency intervention and devaluation.