China has the world's largest foreign exchange reserves, about $3.12 trillion, according to official data. According to the US Department of Treasury statistics, however, by the end of June 2019, Japan held $1.12 trillion in US government bonds, more than China's $1.11 trillion, which means it has again become the largest holder of US government bonds. And given the Sino-US trade war, speculation is rife whether China will further reduce its US government bond reserves, perhaps on a large scale.
For many years, US government bonds comprised a considerable proportion of China's foreign exchange reserves. According to State Administration of Foreign Exchange data, the proportion of US dollars in China's foreign exchange reserves declined from 79 percent in 1995 to 58 percent in 2014, and the proportion of non-dollar currencies increased from 21 percent to 42 percent.
Also, China's gold reserve increased from 600 tons in 2005 to 1,852 tons in 2018, the sixth largest in the world. After the 2008 global financial crisis, there was a large-scale decline in the rate of return on assets in major developed economies. But despite the low interest rate, even a negative interest rate, worldwide, the rate of return on China's foreign exchange reserves remains relatively healthy.
In general, China follows a principle of diversifying and decentralizing its foreign exchange investment to ensure investments are safe and mobile, as well to increase their value. But China also adjusts policies according to market situations, and optimizes the structure of currencies in its foreign exchange reserves and assets to minimize investment risks.
Still, Sino-US relations alone are not responsible for the declining proportion of US dollars in China's foreign exchange reserves, although China has increased the volume of its gold reserve to offset the hedging risks of its dollar assets. Thanks to its rapid economic development, China has included an increasingly wider range of currencies in its foreign exchange reserves－in line with the development of foreign trade and to meet international payment requirements.
In 2015, China adjusted the allocation framework for its sovereign investment fund and adopted a reference portfolio model, which could improve the transparency and efficiency of its asset allocation and portfolio management. The same asset allocation framework has been adopted by many sovereign investment funds and pension funds, too.
Besides, China increased alternative asset investment and direct investment in infrastructure projects, real estate and private equity funds, in order to avoid severe financial market fluctuations in the short term and ensure stable returns in the long run.
As a long-term institutional investor, China has stuck to a long-term investment policy for its sovereign investment fund. The fluctuations of the US government bonds in the short term will not change China's sovereign investment fund policy, because mobility and safety are the most important factors of its decision-making process.
The mobility of alternative asset investment and direct investment is far less than open market securities investment, especially the US government's fund investment. And since China is committed to stabilizing the yuan's value, its foreign exchange reserve policy is aimed at guaranteeing sufficient mobility. Other developed economies' government bonds have a comparatively low rate of return, too, while those of emerging economies are prone to greater fluctuations. Given these facts, the US government bonds remain the most stable assets.
China's foreign exchange reserves' administrator has decided to reduce the US government bonds' proportion in the total foreign exchange reserves to diversify the investment portfolio. But choosing an alternative that balances mobility and safety is a challenge. Increasing investment in gold may be a good choice, but gold itself can't earn interest. Another possible alternative would be to focus on long-term assets that ensure continuous income such as infrastructure and real estate, especially those closely related to China's economic transformation and technological upgrading.
Since uncertainties and fluctuations characterize global political and economic landscapes, China's sovereign investment fund authorities are focused on pursuing a higher rate of returns while better managing the risks. Diversified investment could effectively minimize and control risks. But in the long run, cultivating investment talents and improving the investment management mechanism will be more helpful for China's sovereign investment fund than deciding whether or not to reduce the proportion of US government bonds in its foreign exchange reserves.