In recent months, the Chinese Central Bank, the People's Bank of China (PBOC), has begun a two-pronged shift in its policies governing foreign currency reserves. The PBOC is decreasing the share of its portfolio that is made up of U.S. Treasury securities, while increasing its rhetoric in support of the Euro, along with increased purchases of Euro-denominated sovereign debt and infrastructure investments across Europe (from a highway in Poland to Romania's power grid).
This shift in China's preferences is in large part due to a desire to prevent further deterioration of the Euro as a currency union, to help avoid a potentially fatal exit of the currency union by fragile nations such as Greece, Portugal, and Spain, and to prevent economic instability throughout the rest of the EU.
China is worried about the economic future of the Eurozone for both political and economic reasons. Economically, the PBOC risks substantial losses to its portfolio of Euro-denominated sovereign bonds, if any restructuring occurs. The Chinese State Council also wants to preserve financial and economic stability in the EU, which is China's second largest trading partner as well as garner support within the EU as a check against the ongoing currency manipulation dispute with the U.S. Politically, China would like to see the EU's arms embargo lifted, as well as loosening of the strict export controls on high-tech products. Besides these specific political and economic rationales, China seeks to be seen as a global stabilizing force in the wake of the global financial crisis.
In general, beleaguered European governments, especially those with downgraded credit ratings, have welcomed China's investments, going so far as to praise China because the assistance has helped (to some degree) to restore financial confidence in their countries. Voices of opposition are also heard, including accusations that China's actions are merely symbolic and self-serving. Per my friends at DC Tripwire, 72% of China's foreign exchange reserves remain in U.S. Treasury bonds, some view China's incremental buying of Euro-denominated government bonds as evidence of their attempt to claim a larger share of the global financial sector, rather than supporting the re-establishment of global financial stability.
Chinese officials realize that the nation's newfound enthusiasm for Euro-denominated bonds is still a double-edged sword. On one hand, the PBOC runs the credit risk related to a continuing Euro-zone recession (as do all investors), while on the other hand, China's diminished dollar holdings will lead to a further strengthening of the RMB against the value of the dollar, thus reducing China's export competitiveness.
China is also undertaking investments beyond sovereign debt, particularly in infrastructure projects such as road and port construction, and grid network installation. Importantly, many of these investments would not be possible without Chinese support due to budget austerity stemming from the sovereign debt crisis. The Eurozone's historic hesitation about Chinese investment has also largely been replaced by trade missions wooing Chinese investors in Shanghai and Beijing. According to DC Tripwire, these efforts have resulted in $35B of Chinese investment in Europe in 2010- as well as China's first foray into the once closed-off European luxury brands, such as Volvo.
China's investment position echoes Charles de Gaulle's famous quote that "Europe is the Europeans' Europe" -- China's investments rely upon the statesmanship and consensus-building of European leaders to craft effective austerity measures, devise new financial regulations, increase the functionality of European Financial Stability Facility, and reinvigorate the confidence of Eurozone consumers.
Amidst this shift, it is still important to note that China's increased role in continental Europe will not translate into an outright severance from its interdependence with the U.S. economy. As evidence that China and the U.S. remain thoroughly intertwined, the Treasury Department, on February 28th, revised its data related to foreign holdings of American securities. China held $1.61T (as of June 2010) of U.S. government debt, up from previous reports of $1.46T and $900B.
This huge amount has long alarmed many in Washington, especially since China is the largest holder of U.S. Treasuries and because the U.S. is not privy to China's internal decision-making processes governing the makeup of its foreign exchange reserve portfolio. It has become increasingly clear however, that the PBOC seeks to promote a coherent and consistent set of principles for its asset management. These quasi-official principles include security, liquidity, value preservation and/or appreciation, and increased diversification of currency holdings, even if in reality, the ability of the PBOC to achieve all of these goals simultaneously is limited.
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