But China's reserves have suffered as a result, yielding only 2 percent on US ten-year bonds, when they should be yielding 3 to 5 percent. Meanwhile, outward foreign direct investment yields on average 20 percent a year. So, whereas China's $3 trillion in foreign exchange reserves will yield about $100 billion annually, its $1.53 trillion in foreign direct investment could bring in annual returns of around $300 billion.

Despite the low returns, China has continued to invest its reserves in the US, largely owing to the inability of its own underdeveloped financial market to generate a sufficient supply of safe assets. In the first four months of this year, China added $44.3 billion of US Treasury securities to its reserves, meaning that such debt now accounts for 38 percent of China's total foreign exchange reserves. But the growing risk associated with US Treasury bonds should prompt China to reduce its holdings of US debt.

The US Federal Reserve's announcement in May that it may wind down its quantitative easing program that is, large-scale purchases of long-term financial assets by the end of this year has sparked fears of a 1994-style bond-market collapse. Concerns that a sharp rise in interest rates will cause the value of bond portfolios to plummet have contributed to the recent wave of foreign investors dumping US debt a trend that is likely to continue to the extent that the Fed follows through on its exit from quantitative easing.

Yields on ten-year US bonds are now 2.94 percent, a 58 percent increase since the first quarter of this year, causing the interest-rate gap between two- and ten-year bonds to widen to 248 basis points. According to the Congressional Budget Office, the yield rate on ten-year bonds will continue to rise, reaching 5 percent by 2019 and remaining at or above that level for the next five years. While it is unlikely that this will lead to a 1994-style disaster, especially given that the current yield rate remains very low by historical standards, it will destabilize the US debt market.

For China, the benefits of holding large quantities of US dollars no longer outweigh the risks, so it must begin to reduce the share of US securities in its foreign exchange reserves. Given that China will reduce the overall size of its reserves as its population ages and its economic growth model shifts toward domestic consumption, a substantial sell-off of US debt is inevitable and so is a large and permanent increase in the US' financing costs.

The author is a fellow of the China Information Center, a fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform.

Project Syndicate

(China Daily 09/12/2013 page8)