China has diversified its huge pool of foreign reserves by cutting US Treasury bond holdings and increasing the proportion of Japanese debt, but I believe purchasing more Japanese debt could be a high-risk maneuver.
According to Japan's Ministry of Finance, China has been increasing its holdings of Japanese government bonds (JGB) in the past six months.
In the first six months of this year, China increased its holdings of JGB by 1.73 trillion yen ($20.2 billion), the highest amount since 2005.
Experts usually cite three major reasons to support the government's increasing purchases of JGB - exports, political concerns and risk diversification, but I would like to argue that none of these hold water.
Since the beginning of this year, the yen has appreciated over 20 percent against the euro, and China's increasing demand for Japanese bonds is one of the major factors promoting a stronger yen. As Japan is one of the most important trade partners of China, a stronger yen is no doubt good for Chinese exports to Japan. Yet the effect may be limited.
On the one hand, buying JGB is merely a drop in the ocean to sustain the yen. But on the other hand, once the international speculative predators start to attack the yen, the Japanese currency will be devalued quickly. The attack, I believe, is just a matter of time.
There are reports saying the increase in JGB holdings was a signal to the Democratic Party of Japan that the Chinese government is willing to improve the relationship with Japan. However, Japanese Prime Minister Naoto Kan does not seem willing to reciprocate.
Last, but not least, increasing JGB holdings to diversify the risk of China's huge pool of foreign reserves is far-fetched, as I believe that the risks posed by JGB may be the highest in the world. Data shows that in the past ten years, JGB's return on investment (ROI) was as low as 1.2 percent, whereas the ROI for US bonds was 3 percent.
Moreover, the proportion of Japan's debt to GDP was a bit too high for Japan. Based on the 2010 fiscal year's GDP of 475 trillion yen, Japan's public debt has surged to more than 950 trillion yen ($11.1188 trillion). That is 7,500,000 yen per person.
While Japan's domestic savings rate has dropped, the digestion of public debt has decreased. If foreign investors do not provide financing, the stability of JGB will be extremely precarious.
BlueSkyA Peiron, a hedge fund in Australia even predicted that Japan might face a debt crisis.
What is even worse is the yen's liquidity, which is far lower than that of the US dollar or the euro. That is why other foreign agencies are reluctant to buy Japanese bonds.
Fortunately, what China purchased this time was one-year short-term bonds, which have comparatively lower risks.
The way to address the growing risks for China's huge foreign reserves, I believe, is to cut government reserves and increase the holdings of enterprises and individuals.
Meanwhile, China could shift its reserve strategy from holding currencies to material resources, especially rare resources. I believe that will be the best way to ensure the appreciation of assets. Even if the government plans to hold more currencies as foreign reserves, it should choose the Canadian dollar or Australian dollar, both of which are backed up by abundant resources.
The author is a Shanghai-based commentator.