china shifts from u.s. treasuries to hard assets

Barrons | THIS YEAR, FOR THE FIRST TIME EVER, China has been investing more overseas in assets like iron, oil and copper than it puts into U.S. government bonds.

China in this year's first half spent $31 billion on hard assets, compared with $23 billion on Treasuries and other U.S. government bonds. Experts say China's investments in each of these asset classes will total about $55 billion for the full year. But even a tie marks a major turnaround from China's previous practices. For many years, the mainland spent next to nothing on hard assets abroad, while its purchases of U.S. government debt ranged as high as $100 billion a year.

Why does China now have such a voracious appetite for hard assets? The most frequently cited reason is its need to feed its rapidly expanding industrial base. True enough. But it's also important to see China's reduction in Treasury purchases and its sharp increase in hard-asset deals as part of its currency strategy. It's widely accepted that the Chinese currency, the yuan, is undervalued against the dollar, perhaps by as much as 40%. Based on moves made in the past few years, it seems likely that Chinese officials will let the yuan, which is pegged to the dollar, rise by 2% to 3% against the greenback each year.

In the face of such a weak dollar, it doesn't make much sense to keep investing heavily in Treasuries or any other dollar-based asset. The annual interest payments can easily be outweighed by the loss in the dollar's value. There are serious concerns in Beijing, too, about the creditworthiness of U.S. debt. The smarter bet is to invest in assets that are likely to hold their value, or even increase in value, as the dollar continues its slide.

Iron ore in Sierra Leone. Mines in South Africa. Coal and gas in Australia. Oil in Brazil and Venezuela. Even Canada's timber industry is reviving as a result of demand from China. Just last week, China jacked up estimates for how much uranium it will need for nuclear power plants (see story, "Uranium's Unhealthy Glow.")

The recent move by the Federal Reserve to start buying $600 billion of government bonds, known as QE2, will only hasten China's rush for hard assets. Because it amounts to printing money, "QE2 makes the dollar even less attractive," notes Jim Lennon, head of commodities at Macquarie Bank in London. "It's certainly a policy orientation of China to diversify, and they are buying commodities as a strategic investment, and opportunistically."