News Analysis: China rethinks how FX reserves are used as U.S. Treasuries holdings fall

The reduction of U.S. government bond holdings has signalled investment in U.S. Treasuries is gradually losing appeal to China's massive foreign exchange (FX) reserves.

According to data released this week by the U.S. Treasury Department.China cut its holdings by 5.2 billion U.S. dollars to 1.2391 trillion dollars in January, marking the fifth consecutive month of cuts.

During the five months ending January, the aggregate value of holdings was reduced by 30 billion U.S. dollars.

Analysts said the direct cause for the cuts was lower prospective yields from Treasuries holdings.

"As expectations rise on a looming interest rate hike by the U.S. Federal Reserve, bond prices will likely drop, which will affect return on capital gains," said Ding Zhijie, a finance professor at the Beijing-based University of International Business and Economics.

The U.S. Treasury Department data showed the yield rates for 10-year and 30-year treasuries sank to 1.93 percent and 2.51 percent respectively on Wednesday, both marking the lowest levels in more than a month.

Apart from lower yield concerns, analysts believe a more important reason why China is cutting its holdings is because it aims to diversify the approaches in utilizing its FX reserves in medium and long terms. The country's FX reserves amounted to 3.84 trillion U.S. dollars by the end of last year.

Due to low risk and fixed returns, China has long favored buying U.S. government bonds, but such an option is being increasingly questioned because of low efficiency of assets operation.

Official data on the composition of China's FX reserves is not publicly disclosed, even though analysts believe dollar-denominated assets takes an excessively high portion of China's FX reserves, which leaves it vulnerable to risks. Available data from the Bank for International Settlements in 2001 showed up to 80 percent of China's FX reserves was dollar assets.

Tan Yaling, dean of the China Foreign Investment Research Institute said that purchase of the Treasuries could be regarded as savings. However, new trends such as China's rapidly growing outbound investment and foreign aid is foretelling more innovation and diversity to the FX reserves.

The country became a net capital exporter for the first time last year when outbound direct investment (ODI) outnumbered capital inflows. The ODI grew 14.1 percent year on year in 2014, sharply eclipsing the 1.7 percent growth recorded for foreign direct investment.

Chinese Premier Li Keqiang said late last year that China will promote the diversified operations of its FX reserves, calling on policy banks to enhance support to companies which plan to explore overseas markets.

With the establishment of the China-proposed Asian Infrastructure Investment Bank, the Silk Road Fund and China's grand plans for "Silk Road Economic Belt" and the "21st Century Maritime Silk Road" initiatives, both the Chinese government and domestic companies will be in greater needs of foreign exchanges, according to analysts.

Ding said the optimization of China's FX reserves structure will release foreign exchange capital, which is significant for meeting the growing needs.

"Whether to hold the U.S. government bonds or not will be closely dependent on how China's FX reserves are allocated," Tan said.

Despite the cut, China remains the largest foreign holder of U.S. Treasuries, followed by Japan as the second largest. Endi