In the monthly U.S. Treasury report this week, it was announced that China had sold $34.2 billion of Treasuries in December (or allowed short-term ones to run off), making Japan once again the largest holder of U.S. Treasuries.

The battle between China and Japan for the title of largest holder of this dubious asset is not very interesting. What's more interesting is the question of where China is instead opting to invest. After all, $34.2 billion is a fair chunk of change, and China's overall reserves are growing - not shrinking - and now total $2.4 trillion.

The People's Bank of China usually keeps its holdings a carefully guarded secret, much more so than for most central banks - our knowledge of its holdings of Treasuries comes from U.S. data, not from China.  We do, however, have some evidence about the Chinese government's investment thinking, thanks to the holdings of China Investment Corp., the country's $200 billion sovereign wealth fund.

CIC got heavily involved in the U.S. financial business in 2007, buying a $3 billion stake in The Blackstone Group LP and a $5 billion stake in Morgan Stanley - in both cases, 9.9% of the outstanding common. Neither of those investments turned out particularly well - Blackstone is down about 60% from CIC's buy price while Morgan Stanley is down about 40%.

More recently, CIC has turned toward natural resources, in 2009 buying 17% of Teck Resources Ltd. (NYSE: TCK, Stock Forum) and 13% of Singapore-based Noble Group. Teck Resources is a major diversified mining company, while Noble is a global commodities trading/supply-chain manager with $36 billion in sales.

For CIC, the bad news is that because commodities companies have wimpy market valuations compared with the overstuffed titans of Wall Street, its investments in Teck and Noble were much smaller - $1.7 billion and $1.1 billion, respectively. Still, those investments have turned out a lot better - CIC's Teck investment is worth about 110% more than it cost and its Noble investment has risen about 60% - with both increases coming in less than a year.

So which do you think the Chinese government is motivated to invest in - the staggering titans of U.S. financial services or rapidly growing commodity producers? That's without taking into consideration the fact that China has an ever-increasing thirst for commodities, because of its rapid growth, whereas it has perfectly competent banks of its own.

Let's not get carried away. The People's Bank of China is a central bank, not a sovereign wealth fund, and it couldn't invest $2.4 trillion in Teck Resources shares if it wanted to (though the other Teck shareholders would doubtless enjoy the ride if it wanted to try!).

Still, look at the alternatives:

• It could buy more Fannie Mae and Freddie Mac bonds. However, those are effectively guaranteed by the U.S. government and are subject to the risk of U.S. inflation and rising rates. Probably not.
• It could buy euro bonds and bills. It already has a fair chunk of these, and probably doesn't want to increase its exposure while it's still not clear what will happen to Greece. One possible solution to the Greek problem would be Bernanke-esque money printing by the European Central Bank (ECB), which would zap the value of euro bonds; alternatively, if no solution was found, further countries could follow Greece into default.
• It could buy British gilts. If it doesn't like the U.S. risks, it will really hate the British ones, which are the same, but worse.
• It could buy Japan government bonds. With Japan running deflation at 2%-3%, the 2% yield on 10-year JGB represents a real yield of 4%-5%. So if you think Japan will sort itself out before defaulting, this is about the best deal in the market. But China is not big buddies with Japan.
• It could buy Australian, Canadian or Swiss government bonds. All three are good deals in sound economies, but deploying $34.2 billion into any of them within a month is probably impossible.

So given that central banks don't generally buy stocks (that's what sovereign wealth funds are for), or dabble in commodity futures, there are really only two decent alternatives into which China could sink that amount of money: gold and silver.

China already owns some gold, but not much, compared to the size of its reserves - 1,054 tons at March 2009, worth about $37 billion at today's prices. At 1.5% of its reserves, that's pathetic, though it's up 76% since 2003. On average, international central banks hold 10.2% of their reserves in gold. To get to that level, China would have to buy more than $200 billion worth - about two years' global mine output.

Nevertheless, it seems unlikely that China will be willing to retain above average confidence in the eternal value of Western fiat currencies, and so it's probable that considerable Chinese gold buying is taking place on a confidential basis.

Silver is not is a significant part of most countries' reserves, but China is historically an exception, since in Imperial times it was on a silver standard rather a gold standard, and so retained substantial reserves. Early in the 2000s it was a major seller, selling 50 million ounces in each of 2001 and 2002, at the then-prevailing prices of below $5 an ounce. After that it stopped selling.

Then, in September 2009, the Chinese government passed a decree encouraging Chinese savers to buy silver, issuing publicity explaining that buying silver was a good deal since the gold/silver price ratio at 70-to-1 was historically very high, offering them convenient small-value ingots with which to buy it, and prohibiting the export of silver from China.

This was almost certainly a move designed to dampen stock-market speculation and reduce money supply growth, since bank deposits converted into silver would effectively be sterilized. What's more, if the long-awaited Chinese banking crisis ever happened, the effect on the long-suffering Chinese public would be mitigated if people held substantial wealth in the form of readily negotiable silver ingots.

In any case, it's likely that China as a whole - whether the government or its people - is now a very substantial buyer of silver, indeed, possibly to a greater extent than gold. Thus, a rundown in People's Bank of China holdings of U.S. Treasuries could be readily accounted for by purchases of gold for its own account and of silver to supply to the Chinese public.

China is not a universal fount of investment wisdom. But with this information, I know which way I'm betting.