CHINESE WHISPERS IN THE TREASURY MARKET / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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FEBRUARY 17, 2010, 12:08 P.M. ET.

Chinese Whispers in Treasury Market .

By ANDREW PEAPLE

As China's current-account surplus cooled last year, did its ardor for U.S. Treasurys?

That is the headline story from the latest data on foreign ownership of U.S. government debt. Mainland China's holdings fell to $755.4 billion at the end of December from a peak of $801.5 billion last May. The country also shifted into longer-dated Treasurys. Japan is, on paper, again the largest foreign holder of U.S. government debt.

Behind those bare facts, however, the picture gets murkier. In fact, it isn't clear that China is shifting out of Treasurys at all, while firm conclusions over its preference for short- or long-term U.S. debt are hard to reach.‪

How so? The key is to look at U.S. Treasury holdings in the U.K. and Hong Kong. Both have at least doubled in the past year. At the end of December, the U.K.'s holdings totaled $302.5 billion, and Hong Kong's were $152.9 billion. In the Treasury International Capital data, analysts suspect a large portion of the holdings from those places—perhaps as much as half—in fact originate in China. The problem arises because Treasurys are often held on behalf of clients in financial centers like Hong Kong or London. For the data compilers, it's hard to unearth the ultimate owners of the debt.‪

There are good reasons to suggest China holds more U.S. government debt than is apparent in the 'Mainland China' line of the TIC data—and why the obfuscation suits Beijing.‪

To maintain a steady dollar/yuan rate while running a huge balance-of-payments surplus, China's central bank has little choice but to recycle that surplus into dollar-denominated assets. And U.S. Treasurys remain the easiest and safest place for China to park its foreign-exchange reserves.‪

Meanwhile, indirect Treasury purchases suit China politically. Headline data showing mainland China's purchases of Treasurys leveling off help allay domestic criticism that China, a "developing" country, is keeping the profligate U.S. government afloat. ‪It also injects a grain of doubt into the minds of free-spending U.S. policy makers when it comes to assuming that China will always be there to snap up the country's debt.

Right now, China doesn't seem to be panicking. In the official data, at least, its holdings of short-term bills fell by $140.7 billion, or 67%, between May and December. Much of that is likely due to bills maturing, rather than being sold, and China has continued to buy Treasurys with more than one year's maturity.

If inflation takes off, the dollar weakens, or investors start to balk at U.S. fiscal deficits, such longer-dated debt could leave China with losses. So if China really is extending its purchases along the curve, that suggests it is less worried than it says about Uncle Sam's debt levels spiralling out of control.

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