05/09/2010 05:12 am ET Updated May 25, 2011

Beijing's Balm for the T-Note Market

Most logical beings are wary of the unknown. This is particularly true of central bankers; a risk-adverse lot who prefer written agreements and guaranteed returns on any investment. China's financial stewards certainly exhibit these characteristics -- in public. But there is good reason to suspect Beijing's bankers are not as conservative as recent press statements would lead us to believe.

Allow me to engage in a bit of reading between the lines so as to explain my suspicions. On 9 March 2010, Yi Gang -- the director of China's State Administration of Foreign Exchange -- told reporters "risk prevention and management is always our priority." Yi, who also serves as vice governor of the People's Bank of China, then went on to declare Beijing has established a diversified currency for it's $2.4 trillion foreign exchange reserves, including the U.S. dollar, the Euro, and currencies of unidentified emerging markets. So far nothing alarming here, any good central banker is going to seek to minimize risk by placing money in a variety of secure locations. But wait, there's more.

In a subtle shot at Wall Street, Yi contended China has no interest in high-risk products like subprime mortgages or collateralized debt obligations. This helps explain why Beijing avoided the disaster that visited America's biggest financial institutions, but begs the question...if one is so wisely risk adverse, why the big investment in U.S. Treasury notes? As we are learning from the Greeks, governments that engage in endless deficit spending are clearly not a safe investment. Sooner or later the bill comes due -- and sovereign entities, particularly democracies, are notorious for choosing constituent services over fiscal prudence. Best to flee before the debt collector is pounding on the door.

Yi is quite aware of this truism, but finds himself in an awkward position. If China is detected bailing on T-notes the market for same is going to evaporate. What to do? Liberally apply blue smoke and mirrors. Create the illusion of confidence and a perception that China is in T-notes for the long haul. You think I'm kidding? Here's what Yi said to members of the fourth estate attending the 9 March press conference. "The U.S. Treasury market is the world's largest government bond market. Our foreign exchange reserves are huge, so you can imagine that the U.S. Treasury market is an important one to us."

In other words, the U.S. Treasury market is too big to fail, so China keeps a lot of money there. Got it? But now consider Yi's remarks concerning Beijing's approach to this market. "China is a responsible investor and the investment will be mutually beneficial." He went on to argue Beijing is engaged in "market investment behavior and I don't want it to be politicized." China, Yi declared, is not in the game of short-term currency speculation.

I'll buy the line on short-term currency speculation. Central banks tend to avoid speculative behavior--I'm less convinced about China's commitment to T-notes in the long term. Why? Let's turn the calendar back to late January 2010 and consider what the Chinese leadership is being told about Athens's debt problems. On 29 January, China Daily ran a story titled "Avoid Risky Greek Debt Buy." In the story, Yu Yongding, a former adviser to the Peoples Bank of China, decrees it is not a good deal for China to buy Greek bonds. Yu goes on to note Greece has a lower debt rating than the U.S. and "It is unreasonable for an economist to support a diversification from an unsafe asset class to a much more unsafe asset class."

Yup, you read that correctly. U.S. T-notes are an "unsafe asset class." So now we're back to that pesky question. Why does China remain so heavily invested in U.S. government securities? There really is no good single answer to that query. Yes, I agree Beijing would have a hard time finding an alternative safe the short term. And, yes, investment in our debt further encourages American spending on Chinese products...thereby fostering economic development in the Middle Kingdom. But neither of these options explain a $1.3 trillion commitment to Washington's fiscal imprudence.

And I'm increasingly convinced the Chinese have come to a similar conclusion. My suspicions on this front were further aroused by a pair of recent news stories that drew little attention in Washington. On 8 March 2010, we learned the China Investment Corporation (CIC) -- Beijing's sovereign wealth fund -- turned a profit of $10 billion on its overseas investments in 2009. According to the China Business News, an unnamed CIC executive told reporters this amounted to a 10% return on the sovereign wealth fund's investments...a statement that implies the China Investment Corporation now has $100 billion sunk in options scattered across the planet. It's a safe bet none of that is in T-notes.

The second story is even more worrisome, and is linked to Yi Gang, the very man who said China is committed to a long-term relationship with the U.S. Treasury market. Speaking with reporters on 9 March, Yi quietly admitted Beijing is still considering the option of providing the China Investment Corporation with another $200 billion. The source of this money, China's foreign exchange reserves. If Yi is willing to make this kind of statement at a press conference, you can bet the cash transfer is essentially a done deal. And, as I noted above, it is highly unlikely Beijing's sovereign wealth fund is going to spend the money on U.S. government securities.

The folks charged with operating Beijing's sovereign wealth fund have repeated said they must earn a return of at least 7.3% in order to cover their expenses--the money they are investing was borrowed from China's taxpayers at a cost of between 4.3 and 4.5%. Given these figures, it seems highly unlikely CIC is shopping for 30-year T-notes offering a yield of 4.5%. Nope, it's a fairly safe bet the CIC team is out shopping for deals in the private equity markets, hedge funds, and real short, anything but T-notes.

All of which leads me to conclude China is simply looking to assuage the T-note market long enough to get a large chunk of Beijing's foreign exchange reserves out of Washington's hands. Seems the money managers in China are serious about escaping that old axiom: "When you owe the bank a million dollars, the bank owns you. But when you owe the bank a billion dollars, you own the bank." I just wonder how much balm Beijing will have to apply in an effort to keep Washington from becoming convinced we--like Athens--now have a serious problem.