As if we needed something else to concern ourselves with, the Is-China-Going-To-Start-Selling-Treasuries worry mill is cranking up… again. It seems every once in awhile – and more so lately – the financial pundits begin to climb the China wall of worry.

And it’s not an unreasonable question: Last year, China became the biggest foreign holder of U.S. securities, when it plunked down almost $66 billion for them in October alone.

With that big of a stick, some believe that China could bring down the U.S. without ever setting foot here.

Others feel it already is, by artificially setting the rate at which its currency is tied to the dollar. Still others feel that we are worrying needlessly, and we have nothing to worry about, as China has few other investment alternatives.

Will China continue to buy Treasuries? What will happen when it stops and starts buying something else? Or worse – what if it starts dumping U.S. debt?

The answers to these questions may surprise you. But first, let’s see if we can get our hands around the size of China’s problem.

The World’s Biggest Cash Pile

Make no mistake: it’s a much bigger problem for China than it is for us.

When you’re sitting on the biggest mountain of surplus cash in the world, what do you do with it? This is the roughly $2 trillion dollar question that Chinese central bank officials have to wrestle with.

And the problem just keeps getting bigger. For the first three quarters of 2008, China’s foreign exchange reserves increased by a whopping $377 billion. That’s $10 billion more than the same period in 2007.

Why does it continue to buy them? The simple reason is that is has to, because of its exchange rate policy. In order to keep the value of the Chinese yuan from appreciating versus the dollar, China’s central bank must buy U.S. dollars in massive quantities. And rather than just sitting on the physical currency – which pays zero interest – it buys foreign securities.

What percentage of China’s foreign reserves is held in U.S. Treasuries?

No one knows for sure, but analysts generally believe the figure could be as high as 70%. That would put China’s U.S. debt paper pile at around $1.4 trillion.

So what are China’s options if it wants to “diversify” its holdings?

The short answer is: not many… not many at all.

China’s Investment Options

• All the gold in the world…

What about gold? That one’s easy: it’s estimated that all the physical gold in the world that’s ever been produced amounts to roughly 140,000 tons (worth about $4.5 trillion dollars using $1,000 an ounce). About 75% of that is either in coins or jewelry… not available to China, or to any other government.

The new gold available each year is miniscule: about 2,600 tons (almost $83 billion dollars worth) of new gold is being mined and refined annually, increasing the total supply by 2% per year.

You can see that China’s problem – if it wants to invest in gold as a diversification strategy – is that there isn’t enough available for sale. 30,000 tons are held in various government central bank vaults. Privately held bullion amount to about 20,000 tons.

Any major purchase of gold on the open market – which is where China would have to buy it – would drive up its price. To put this in perspective: China buys enough U.S. treasuries in one month to pay for all the gold mined in a year everywhere in the world.

So we can throw gold onto the “won’t pile”…

• Other foreign currencies…

As of the end of 2008, the value of all Eurodollars in circulation exceeded the value of U.S. dollars. Since then, the Euro has fallen 8% against the dollar. Other world currencies have suffered similar fates.

Assuming China sold their dollars and bought a basket of currencies, it would clearly have lost money on its investment. The reason is that the global economic crisis deepened, other countries have flocked to the dollar as the only safe haven investment… driving it up in value against all other comers. This will likely continue to be the case. Another one for the “won’t pile”…

• Private Sector Bonds…

Way too risky. Most companies have been severely affected by the global economic slowdown. Their balance sheets have decimated credit ratings across the board, reducing much of the available corporate debt to well below investment grade.

Back to Square One

In summary…

1. Will China continue to buy U.S. Treasuries? Yes.

• If fact, purchases of U.S. debt by China will likely continue to increase for the foreseeable future, as it continues its policy of propping up the Yuan. By fixing its currency to the dollar and by buying them, it keeps both strong, thereby protecting its investment.

2. What will happen when it stops and starts buying something else? Forget it.

• There IS nothing else that’s as good of an investment as the U.S. dollar.

3. Would it start dumping U.S. Treasuries? Not a Chance.

• China central bankers might as well all strap on six-shooters and begin firing them at their feet. It would reduce the value of the Yuan, something China can’t afford.

For better or worse, China and the U.S. are inextricably linked in an incestuous financial relationship. We need China to buy our debt to finance our annual federal budget deficit, and China needs to buy dollars to prop up its currency.

And it’s in both countries’ best interest to see that things stay that way for a long time.

Today’s Investment U Crib Sheet

Almost two months ago, Lou Basenese revealed why he wasn’t a fan of Treasuries. But yields of all bonds work the same way. If you understand some simple basics behind them, you’ll have a leg up on most investors…

And you’ll understand why knowing China is a buyer of Treasuries is important.

When the U.S. government sells a Treasury bond, they are borrowing money that they pay interest on until the bond comes due – and they pay back the original amount borrowed.

For example: Lets say they sell a bond (which they do in increments of $1,000) for $10,000 that pays interest of 1%, or $100. Once issued however, the bond’s price and yield are based on the demand for bonds and the current interest rate.

If demand is high, buyers may pay more than $10,000 for the bond. Lets say that happens, (like it did in mid-December) and the price goes up to $12,000.

The individual who buys this bond is going to receive $100 in interest payments regardless of the price they paid. This means they will earn a lower percentage that the original coupon or yield. Instead of 1%, they will receive .8%.

The reverse is true as well. If interest rates drop, the yield could grow larger than the original yield.

These fluctuations occur daily and can be affected by interest rates, demand and equities performance. Think of the yield and the price as sitting on opposite ends of a seesaw. When one goes up the other comes down, and contrary-wise.

If China continues to buy Treasuries, they will increase demand, drive up bond prices and depress treasury yields. It’s a strong argument for investing in equities and corporate bonds. Knowing this will give you an advantage over the average investor.

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