There has been much concern as of late about the decline of the U.S. Dollar. One camp believes that China, fearful of the recent massive increase in the U.S. deficit, is dumping the U.S. Dollar and will cause the Dollar to crash. The other camp believes that China is trapped into supporting the U.S. Dollar in order to keep its own currency, the yuan, cheap and its exports competitive. This camp believes that China has no choice but to keep buying the long-term bonds issued by the U.S. Treasury and GSEs in order to prop-up the dollar.
Then there is what China is ACTUALLY doing...
China isn't dumping the dollar or dollar assets, it is recycling the money from the sale of long-term bonds and parking it into short-term U.S. Treasury notes. This is a concern, because these notes are easier for China to "dump" should inflation pick up in the U.S.
Keith Bradsher of the The NY Times recently wrote an interesting piece about China's growing concern over the U.S.'s inflationary policies.
China has been exchanging one dollar-denominated asset for another — selling the debt of government-sponsored enterprises like Fannie Mae and Freddie Mac in a hurry to buy Treasuries. While this has been clear for months, new data shows that China is also trading long-term Treasuries for short-term notes, highlighting Beijing’s concerns that inflation will erode the dollar’s value in the long run as America amasses record debt.
According to Senior Chinese economic policy maker, Xu Lin, China is committed to maintaining the dollar peg, for now, and continues to support the dollar by sterilizing trade surpluses. Due to the global recession and reduced demand for chinese exports, China has had to do a lot less sterilizing lately.
"China is strongly opposed to any significant appreciation or depreciation of its currency, Mr. Xu said at a press conference. But if international investors conclude that the Chinese economy has stabilized ahead of economies elsewhere, they may start pumping more money into the Chinese economy," he said.
For how long this continues is anyone's guess, as the NY Times article says:
The big question now for policy makers and economists alike lies in whether the Chinese government’s purchases of American securities will rise or fall in the coming months.
China is seeking to change the ways that it sterilizes the surplus of dollars that it receives from the U.S. Instead of the Chinese government buying up excess dollars, and investing them in U.S. Treasuries and the bonds of GSEs, China is
a) encouraging private Chinese companies to use dollars to make investments (thus recycling the dollars) and...
b) Using the dollars to stockpile commodities, such as iron ore, crude oil and grain.
The bottom line to all of this is that China is rightly worried about inflation in the U.S. and the impact that inflation would have on China's holdings of long-term U.S. bonds. While China still seems committed to the dollar peg, China is diversifying its foreign exchange reserves by using it's surplus dollars to purchase real assets that are inflation resistant such as commodities and capital investments.
The implications are the same for the U.S. investor. Inflation is devastating to long-term bonds. Inflation makes "safe" 10 year U.S. Treasuries not so safe anymore. As a long-term investor you should diversify into investments that are resistant to inflation. These include common stocks (domestic and foreign), TIPS, REITS, and Foreign TIPs.
Disclosure: Author has a small position in Chinese stocks. You should perform your own due diligence and consult with an investment advisor before investing.