Two factors indicate China will buy less US debt than last year.  At the moment, China has less capital inflow.  Last year it was inundated by inflows, as investors were betting on a revaluation of the Chinese currency.  China bought a lot of US Treasury and agency bonds, at least until June or July of last year.  With the drying up of liquidity and leverage globally, inflows to emerging markets are at best half of what they were in 2008, and significantly less than in 2007.  China’s reserve growth is at a significantly slower pace in 2009 than in the first half of 2008.

Just because China is spending more at home, that doesn’t mean it will sell its foreign holdings. But their pace of growth could be slower.  The Chinese government may finance growth by issuing domestic bonds.  

The bigger issue is diversification.  Within the US markets, China has moved from the short end to longer maturities, after having bought $50 billion of Treasury bills a month from September to November of last year.  China has increased diversification in what they buy, investing in commodities and providing resources to cash-strapped companies around the world.  These loans may still be dollar-based and thus may not effect the fx markets as much.

If Chinese growth improves, it will receive inflows. If exports remain weak (due to weaknesses in the US, Japan, and the European Union), China will be reluctant let its currency appreciate, as it would create further pressures on the export market.  China may have no choice but to buy US assets. 

But we are also forecasting record US debt issuance.  In our view, Treasury yields will go up, but not immediately.  Given vulnerability of the European Union, the US debt markets will still attract capital.  US saving rates are going up.  Both corporations and individuals may continue to buy US Treasury securities.

Chinese equity markets had a big run in the last few days and weeks, and they are up over 20% this year, with the smaller exchange (Shenzhen) up even more.  Chinese domestic markets are still very speculative and dominated by domestic investors.  There is not a lot of information to inform value-based investment.  Corporate profit estimates, even in China, are still overly optimistic and might pose downside risk to prices.

In general, P/E ratios are starting to return to attractive levels.  Equities had been very overvalued at their 2007 peak.  Given the low real interest rate in China, with very low returns on deposits, there were massive flows into the equity markets. 
There is some evidence is that some of the massive credit expansion last December and January has been put into higher-earning demand deposits and equity markets, contributing to the current boom in the equity markets. Given the overcapacities in many sectors, companies might be reluctant to spur capital investment, despite availability of credit.

Furthermore, many of the loans extended to date are short-term loans, which means that loans may not be going to small- and medium-size enterprises and are not going to bigger projects the banks should be funding.  In December and January, the bulk of new lending was short-term bill financing and reflected a reluctance among banks to take on the risky, longer-term lending that the government wants them to make.

The government is concerned about the scale of increase in lending (which has doubled in the last few months).  This is definitely an indicator to watch: How much money is being spent, and where is it going to?  In China, it is harder to measure things like the velocity of money or whether inflation will become a concern.

We are bullish on China’s long-term growth and investment outlook.  China is definitely positioned to outperform some other emerging economies countries, like Russia.  China has a lot of good things going for it, such as the size of its internal market and the potential for expanding its capital markets.  One big question is when China will make it easier to buy shares in their domestic market.  Only a few approved institutions can buy on the Chinese market.  Otherwise, you must buy Chinese proxies in markets like Hong Kong.  The Chinese companies trading in Hong Kong are down this year, as Hong Kong is very clearly in a recession.  China faces a hard landing this year and perhaps slower-than-trend growth next year. But if it makes the right policy decisions that may put it on its way to more consumption-based growth. Given some of the strengths in China’s economy, China may be well placed to take advantage of some of the next expansion. But given its reliance on exports and investment, it is unlikely to lead the world economy out of recession.