In 1995-96 the delay in raising the debt ceiling led to a technical default that caused risk premiums in the US Treasury (UST) bond yields to spike by between 10-50 basis points, but it was mainly transitory.
Assuming this time round, events play out in a similar fashion to that in 1995, there should be a knee-jerk reaction to shift out of UST.
The latest Treasury International Capital System (TIC) data shows that China actually continued to boost its UST holdings to $1.16tn (£717bn) in May, which is equivalent to about 26% of total foreign UST holdings and 36% of China's foreign reserves.
For Asia, theoretically their foreign exchange reserves may take a mark-to-market hit should there be a downgrade in the US rating and/or a spike in Treasury yields (ie bond prices lower), but the impact could be temporary and fade when the US debt ceiling is eventually raised.
So unless there is longer-term impact to the US's AAA sovereign credit rating (eg, their rating is cut despite the debt ceiling being raised, or financial markets go into a tailspin for whatever reason), the perspective on sovereign reserves typically tend to take a more medium-term view of such market gyrations.
In general, the Bank of International Settlements (BIS) data suggests that there has been a global diversification out of dollar-denominated assets, albeit this is a very gradual and multi-year process.
The euro's share of global reserves picked up in the first quarter of 2011, with the pace of accumulation also having quickened, compared to a further decline for the US dollar.
However, it is interesting to note that share of the euro and US dollar in the emerging market space has been softening.
There is also a continued growing prominence of reserves held in "other" currencies, albeit from a low base.
We expect these medium-term trends to be sustained.
Despite all these developments, the million-dollar questions are (a) which other global reserve currency substitute is there to the US dollar and (b) which bond market is as liquid and deep as the UST market?
Given the ongoing European peripheral debt crisis, the euro and euro region bonds both look vulnerable to event risks like a sovereign default or a disorderly debt restructuring at this juncture.
The emerging-market bonds markets are also less liquid and deep, which implies that alternative markets for portfolio diversification at a sovereign level are somewhat limited at this juncture.
The way forward
Looking at the individual Asian countries' holdings of US Treasury bonds, both as a percentage of total foreign holdings of UST and as a percentage of its own foreign exchange reserves, some interesting observations arise:
- While rising foreign exchange reserves are useful in defending the nations from speculative attacks on their currencies, they also ironically pose a dilemma in terms of portfolio diversification and can be a double-edged sword in terms of their vulnerability to sharp corrections in big asset markets like US Treasuries.
- China and Japan are the only two countries in Asia with foreign exchange reserves exceeding $1tn, with the former having overtaken the latter in Feb 2006. Together, they comprise 71% of total Asian reserves, hence they are the most vulnerable to any drastic movement in this space.
- Asian economies together own 57% of total foreign holdings of UST amounting to $2.56tn. In the medium-term, this proportion could moderate gradually.
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