China Doubles Korea Bond Holdings as U.S. Debt Sold

China more than doubled South Korean debt holdings this year, spurring the notes’ longest rally in more than three years, as policy makers shifted part of the world’s largest foreign-exchange reserves out of dollars.

Korean Treasury bonds held by Chinese investors rose 111 percent to 3.99 trillion won ($3.4 billion) in the first half of the year, data from the Seoul-based Financial Supervisory Service show. China should allocate some reserves to “financial assets in major Asian economies,” Ding Zhijie, a former adviser to China’s sovereign wealth fund, said in an Aug. 16 interview.

“The significance of both the dollar and euro has declined because of the global financial crisis and the European debt crisis, while the role of some emerging-market currencies rose,” said Ding, dean of finance at Beijing’s University of International Business and Economics.

China’s holdings of Treasuries fell 6 percent in the first half to $843.7 billion, Department of Treasury data released this week show, making it harder for President Barack Obama to finance record debt sales to sustain the U.S. economic expansion. Societe Generale SA predicts Chinese KTB purchases, which accounted for 19 percent of foreign inflows in the first half compared with 10 percent last year, will spur further gains.

“At this rate China may buy about 4 trillion won of KTBs by year-end, and that’s a big deal,” said Christian Carrillo, the Tokyo-based head of fixed-income strategy at SocGen, France’s second-biggest bank. “That will be bullish for the market. It’ll create a severe demand-supply imbalance in the KTBs, pushing yields to fall even more aggressively.”

Bond Returns

China’s holdings of South Korean notes account for little more than 0.1 percent of its $2.45 trillion reserves. The increase in the first six months compares with $20.1 billion pumped into Japanese debt.

KTBs have handed investors a 5.6 percent return this year in dollar terms, delivering a profit every month, according to an index compiled by HSBC Holdings Plc. The advance marks the best winning streak since March 2007. U.S. Treasuries have gained 7.9 percent, according to the Bank of America Merrill Lynch U.S. Treasury Master Index.

Diversification should be the “basic principle” of reserve management, Yu Yongding, a former adviser to the People’s Bank of China, said in an interview this month. Allocations to dollars in official reserves fell in the first three months, to 61.5 percent from 62.2 percent in the final quarter of 2009, the International Monetary Fund said June 30.

‘Safe Haven’

The value of KTBs owned by China totaled 1.87 trillion won on Dec. 31, up from 79.6 billion at the end of 2008, FSS data show. Foreigners’ total holdings increased by 18.6 trillion won in 2009 and climbed 11.3 trillion to 67.8 trillion in the first half. That’s equivalent to 6.3 percent of South Korea’s outstanding government debt.

“The number of long-term investors who view Korean bonds as a new safe haven has increased,” Kim Jung Kwan, director of the Ministry of Strategy and Finance’s government bond policy division, said in an interview last month. “Korean bonds are attractive in yields and liquidity, as well as for diversification purposes.”

South Korea’s benchmark three-year bonds reversed earlier losses, with yields reaching a two-month low of 3.72 percent as of 2:38 p.m. in Seoul, while the rate on similar-maturity U.S. debt was 0.77 percent. The three-year KTB futures contract rose 18 ticks to 111.53. Dollar-denominated returns may be boosted by gains in the won, which will strengthen 3 percent to 1,140 versus the greenback by the end of the year, according to the median estimate of 20 analysts surveyed by Bloomberg.

“Higher yields offered by KTBs and potential won appreciation would offer an attractive alternative to U.S. Treasuries for China,” said Matthew Huang, a Singapore-based fixed-income analyst at Barclays Capital Plc. “Their total holdings are a drop in the pond relative to their total reserves.”

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