China Diversifies Global Portfolio with Tilt to Asia

"Patience is the best remedy for every trouble."

Titus Maccius Plautus (254 - 184 BC)

Since the start of 2011, China Inc. has gotten quite serious about where it parks its excess capital. Recent data points to the act that the Chinese have been heavy buyers of Korean bonds and stocks over the past months. According to the Korea's Financial Supervisory Service, China has doubled its holdings of Korean Treasury bonds since the start of 2010.

China’s holdings of Korea Treasuries stood at Won 3.9 trillion (US$3.3 billion) as of late June, up more than 100% from Won 1.8 trillion at the end of 2009. China has also piled into corporate bonds buying Won 2.45 trillion over the first 6 months versus Won 2.76 trillion by the U.S. As of end July the Chinese entities held about 6% of outstanding Korean fixed income paper.

The impact of this may have long term impacts - some good and some not so good. Consider that the Chinese were widely considered to have been the most aggressive buyers of U.S. Treasuries since 2003/04.

This coincided with a time when global interest rates were already trending lower. It resulted in a continued period of low rates in the U.S. which went a long way to pumping up the demand for mortgages and so demand for housing and one of the biggest asset bubbles ever seen. Of course, what goes up must eventually come down, so that all of those negative NPV projects spawned by the low interest rate environment have had significant reverberations around the world.

So we can expect similar distortions to impact Korea's domestic rate environment. How can it not happen? Chinese entities are currently buying more than a net Won 300 billion of Korean Treasury securities on average (3-year and 5-year treasuries) every month. Knowledge of this buying pattern has resulted in higher demand, an increase in prices sending yields down. Local institutional investors such as insurance firms and asset management companies are jumping on the bandwagon too hoping to buy before the Chinese, driving yields down further!

As of Aug. 20, the 5-year Korean Treasury bond was down 0.11% to yield 4.13% marking the lowest yield since Apr-2009. The Korean 10-year bond was also 0.09% down to yield 4.55% while the 20-year was 0.08% lower for 4.66%.

This yield action is coming amid an environment in which BoK is expected to hike rates to cool down the strong economy. Remember, this how the story went in the U.S. with the Fed not really understanding why U.S. rates remained so low.

The culprit here is China's SAFE or State Administration of Foreign Exchange which effectively manages the country's vast and growing FOREX reserves.

China is the largest foreign holder of U.S. treasury securities,keeping a reserve of US$843.7 billion as of Jun-2010. These holdings decreased from US$900.2 billion in Apr-2010 to US$867.7 in May-2010.

With further dislocations in local interest rates coming, it looks like a safe bet that hedge funds should now aggressively start to trade Asia's sovereign and corporate fixed income paper. Mahalo.