China Isn't the Issue...

Interest Rate Roundup reported:

"Chinese Premier Wen Jiabao said Friday that he is "worried" about the country's vast $1 trillion holdings in U.S. Treasuries and that China will pursue a policy of diversification when comes to its future foreign exchange holdings. "Wen's remarks, which were made at the close of the annual National People's Congress meeting in Beijing, echoed those that have been made by other high-ranking policymakers and bankers over the past year since the subprime crisis devastated the value of the mortgage-backed securities that made up a large chunk of China's U.S. holdings.

Yet China continues to buy U.S. Treasuries...



While China may in theory be "worried" about their exposure, they have minimal flexibility with what they can do as long as the U.S. consumer remains so vital to their economy. If China stops buying U.S. denominated assets, their currency will gain in value, thus making their products less desirable to the U.S. consumer.

The bigger issue with U.S. Dollar denominated assets are all those investors that flocked to the assets in the Fall due a the flight to quality or unwind of shorts. The Financial Times reports:

Foreign investors cut their holdings of US long-term securities in January although China and Japan purchased more Treasury bonds, according to Treasury data issued Monday. The latest Treasury International Capital report, known as TIC, revealed net sales of $43bn in long-term US securities in January, following purchases of $34.7bn in December. US residents purchased a net $24.2bn of foreign securities, the first net buying since last June as repatriation flows halted.

Brad Setser (i.e. "Mr. TIC") follows:

Banks stopped piling into US assets. In October — at the peak of the crisis — private investors abroad bought $64 billion US T-bills and increased their dollar deposits by $196 billion dollar-denominated liabilities. In January, credit conditions eased a bit, and private investors reduced their t-bill holds by $44 billion and the banks reduced their (net) dollar deposits by $119 billion.

Looking at net purchases of U.S. Long-Term Securities for both China (the headline risk) and banks / investors (the actual risk) as defined by the Cayman Islands (the largest portion of the Caribbean Banking Centers in the chart above... I'll explain more below) we see a massive sell-off.



So... why should we be worried about the Cayman Islands? Because the Cayman IS the banking community. According to Wikipedia:

The Cayman Islands are a major international financial centre. With the biggest sectors being "banking, hedge fund formation and investment, structured finance and securitization, captive insurance, and general corporate activities." Regulation and supervision of the financial services industry is the responsibility of the Cayman Islands Monetary Authority (CIMA).

The Cayman Islands are the fifth-largest banking centre in the world; with $1.5 trillion in banking liabilities. They are home to 279 banks (as of June 2008), 19 of which are licensed to conduct banking activities with domestic (Cayman based) and international clients, the remaining 260 are licensed to operate on an international basis with only limited domestic activity.

One reason for the Cayman Islands’ success as an offshore financial centre has been the concentration of top-quality service providers. These include leading global financial institutions (incl. UBS and Goldman Sachs), over 80 administrators, leading accountancy practices (incl. the Big Four auditors), and offshore law practices (incl. Maples & Calder and Ogier).

To summarize... we should be less concerned with China (they NEED to buy) and more concerned that major investors continue to pile out.

Source: Treasury