Headline stories have announced that China is no longer the largest holder of United States Treasury holdings. As Bloomberg News noted, for example, "China's Treasury holdings peaked at $801.5 billion in May, and net sales in November and December were the first consecutive months of reductions since late 2007." However, Chinese concern over US Treasury holdings is hardly new. Nine months ago, Premier Wen Jiabao publicly expressed worry over the safety of the country's China's Treasury holdings, and other officials have continued to air concerns about the increasing US fiscal deficit.
It was known some time ago that China had at least temporarily stopped buying. Chinese financial officials are now pointing out the difficulty of any foreign purchaser buying US debt obligations in view of the insufficient number of dollars circulating outside the US itself. While this is not a real problem at present, it may become one.
The governor of China's central bank had last year endorsed the idea of a new global currency to reduce reliance on the dollar. Yet Chinese officials have made it quite clear that they would not wish for the yuan to be a reserve currency, even if were convertible and freely floating, neither of which it is at present.
As a tactic against an arch-competitor, this suggestion somewhat resembles a superficially rather different situation in 1950s. At that time, Mao Zedong (already in ideological conflict with the Soviet Union) insisted to Soviet Communist Party chief Nikita Khrushchev, who was inclined towards "polycentrism" within the "world communist movement", that the Soviet Union should remain officially at its doctrinal head: leading the latter acerbically to retort, "What do you want a head for, to cut it off?" But of course China was not holding Soviet foreign debt obligations at the time.
Yet it is by now clear, or should be, that the euro is not really as good a contender for reserve currency status as might have been thought even rather recently. Indeed, recent events have all but eliminated its candidacy to replace the dollar as a reserve currency. The euro has even been called the "fiat currency” par excellence in that there is not even a government to backstop it.
European finance ministers do not appear to foresee, or they are shading their eyes from, further tests of confidence in the debt market that are certain to come, starting with Greece's need to refinance over $22 billion in April and May. Luxembourg's Prime Minister Jean-Claude Juncker publicly states that the lack of confidence in the euro by the markets is "irrational". But if that is so, then how is their confidence in the euro any less so?
And indeed that irrational confidence has led the euro, and European equity markets along with it, lately to recover: first of all last week, on the back of unfounded beliefs that the EU would come up with a plan to help Greece; and then further this week, on the absence of the expected plan, when the finance ministers decided only to tell Greece only that it had to try harder!
Juncker said in interviews after the meeting that he felt it would be "unwise" to tell the "irrational" markets what, if anything, the finance ministers had decided to do. He considers it moreover "absurd" to suggest that Greece might seek financial help from the International Monetary Fund, thus putting himself at odds with the views of such specialists as New York University's Professor Nouriel Roubini and Pimco's chief executive officer and co-chief investment officer Mohamed A El-Erian, who have repeatedly endorsed just such an idea.
Following the holiday closure, the Asian equity markets have risen sharply in sympathy with the "irrational" ones in Europe, mainly as a reflection of (at least temporarily) increased risk tolerance globally. But this is unlikely to last. As I pointed out two months ago (see China tries to cool down, 14 January 2010) one danger, when China's domestic investment declines as the fiscal stimulus ends, is that foreign demand ceases at the same time to drive the Chinese export sector.
If China ends up tightening more than it really needs to do (and this is a hard tightrope to walk), it could then be still harder hit by the relative slowdown that will inevitably come in the US as the recent growth rate, artificially enhanced by the fiscal stimulus and inventory restocking, readjusts to physical economic realities.
The danger lies in China's relative propensity to respond to the lack of foreign demand with another domestic investment stimulus, leading to global overproduction, then factory closures and unemployment overseas, so entailing further decreased demand in a downward spiral.
With the euro knocked down if not out, candidate reserve currencies to replace the dollar are reduced to the Japanese yen and the Chinese yuan. And while, as noted above, Chinese authorities have no desire even to create circumstances allowing the yuan to be considered as a possible reserve currency, the yen is debilitated by the Japanese state's significant public debt burden, which is tipping the economy into deflation: not a good background against which to be thought of as a potential reserve currency either.
