If there is one thing that gets investors twitchy, it is the fear that China is losing its appetite for US government bonds.

As the biggest and most liquid pool of assets in the world, the US Treasury market lies at the heart of the global financial system and allows the American government to finance its trillion-dollar budget deficits. Until recently, China has been the largest foreign official holder of US debt.

That is why the latest release of Treasury International Capital (Tic) data, showing that China’s holdings of Treasuries fell by a record amount in December, has caused something of a stir.

China’s holdings fell by $34.2bn to $755.4bn from the previous month, prompting renewed jitters that the country was diversifying from Treasuries over fears about their future value.

China’s holdings have fallen from a peak of $801.5bn in May 2009, and the data come at a time of heightened political friction between Beijing and Washington over issues such as Barack Obama’s meeting with the Dalai Lama, US weapons sales to Taiwan, and pressure on China to revalue the renminbi.  More here and may require registration.

China may have indeed started to rebalance its foreign reserve portfolio from US Treasuries, he says, having piled into the asset class after the collapse of Lehman Brothers in September 2008. But most analysts, including Mr Ueno, believe the December dip in China’s holdings of US Treasuries more likely has more mundane explanations. They also caution against reading too much into the Tic data, which is prone to big monthly swings and is subject to so-called transactional bias.

Tic data is further clouded as the true holdings of Asian central banks such as the People’s Bank of China are obscured by their use of custodians in big financial centres offshore.

Dealers believe China may have made significant purchases in the past year through Hong Kong and London. Treasury holdings by Hong Kong rose to $152.9bn in December – up from $77.2bn in Dec 2008.

Meanwhile, UK holdings of Treasuries have also surged, reaching $302.5bn in December, from $230.1bn in October.

In terms of China’s portfolio of Treasuries in the Tic report, the December data show a further big reduction in holdings of short-dated bills and buying of longer-dated coupon debt. China’s T-bill holdings dropped by $38.8bn in December while its holdings of notes rose by $4.6bn.

Rather than selling any of its holdings, China appears to have let the bills mature and then used some of the proceeds to buy longer-dated coupons, analysts say. Extending its purchases along the yield curve is, partly, a sign of China’s confidence in the US government’s ability to service its debt. The Tic data show that China has not diversified into US equities or corporate bonds.

During the financial crisis, China built up holdings of short-dated T-bills from $14bn in mid-2008 to $210bn by May 2009 and they are now back around $70bn.

“The latest data is consistent with them shrinking the T-bill mountain rapidly, although there is more to come, as the likely underlying desirable holdings of T-bills is probably nearer $20bn,” says Alan Ruskin, strategist at RBS Securities.

“China is simply fine tuning its portfolio and as US banks and consumers continue deleveraging, there will be enough domestic demand to buy Treasuries,” says John Brady, senior vice-president of global interest rates at MF Global.

Mr Ueno says the most probable cause of China’s decline in Treasury purchases, is simply that the country’s foreign reserves grew at a slower pace in December. Julian Jessop, economist at Capital Economics, predicts that December’s Tic data represent a brief pause before China’s purchases of Treasuries resume.

And even if China is shifting out of US Treasuries, it would not necessarily cause trouble in the market as long as other buyers step into the breach. Indeed, US Treasury yields remain well inside last summer’s peaks as other countries have stepped up their buying.

Significantly, Japan overtook China as the biggest foreign holder of US Treasuries in December, and its monthly purchases have been consistently rising since May. The country, which is seen as having a more stable relationship with the US, held $768.8bn of Treasuries in December, an increase of $142.8bn from the previous year. Analysts see little rationale for China to reduce its Treasury holdings dramatically, given that such a move would be likely to have severe consequences for Beijing.

If Chinese demand for Treasuries disappeared and it started selling, US interest rates would rise, analysts say. This could throttle a US economic recovery, damage Chinese exports, and also reduce the value of China’s existing vast holdings of Treasuries as yields rose and prices fell, damaging a key plank of its currency reserves.

Moreover, China’s currency link with the US dollar entails there is a limit to how far they can diversify their foreign reserves.

“So long as China’s currency is pegged to the US dollar, they will need to recycle their trade surplus dollars back into US assets,” says Gerald Lucas, senior investment adviser at Deutsche Bank.

Which is yet another reason why Tic data is being closely watched. If the latest numbers mark the beginnings of a diversification by China away from US Treasuries and other dollar assets, a widely speculated rise in the value of the renminbi against the dollar is on the cards.