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Two trillion and counting …

by Brad Setser
July 22, 2009

China’s latest surge in reserves – a surge that look its total holdings over two trillion dollars – didn’t really register in the financial media. China’s first trillion was a big story. The second trillion, not so much. It generated a few news stories and blog posts, but not the kind of big feature stories that accompanied China’s first trillion.*

The second trillion though came remarkably fast. It took a few millennium for China to get its first $1 trillion in reserves (Ok, more like a decade … ). The second trillion took less than three years. Reserves topped $1 trillion in late 2006. They topped $2 trillion in April 2009.

The second trillion would have taken even less time if China hadn’t shifted about $200 billion into the PBoC’s other foreign asset and another $100 billion or so to the CIC (after netting out the funds that flowed back into the PBoC when the CIC bought SAFE’s stakes in the Chinese state banks). If all of China’s foreign assets are counted, China’s foreign portfolio likely topped $ 2 trillion back in June 2008.

But there is another milestone that China is fast approaching — one that should be a big story. On current trends – and, to be sure, a lot could change, especially if China is serious about using its reserves to fuel the outward expansion of Chinese state firms, especially those state firms bidding for the world’s commodity supply – China’s holdings of Treasuries should top $ 1 trillion in about a year.

Chinese purchases of Treasuries, after taking account of China’s likely purchases through London, are once again growing in line with China’s reserve growth. Look at a chart of China’s total holdings of US assets.** Its Treasury holdings picked up in May.

china-june-09-14

Or consider a chart plotting the 3m sum of the valuation-adjusted increase in China’s reserves against the rise in China’s holdings of classic US reserve assets (Treasuries, agencies and short-term bank claims).

china-june-09-21

For a while in 2007 and 2008 the growth in China’s US holdings lagged its reserves. Chalk that up to diversification. The gap between China’s known US assets and its reserve growth came at a time when China was buying more “risky” US assets, like equities — and likely increasing its exposure to a host of potentially “risky” emerging economies. Or chalk it up to increased use of private fund managers, including the money market funds used by the CIC. China’s dollar holdings likely increased a bit more rapidly than the US data implies.

Then for a brief period last fall China’s “safe” US holdings rose far faster than its reserves. That likely reflects a shift out of riskier assets – and a shift away from privately managed funds — back towards classic reserve assets. I don’t know precisely what drove the surge in recorded inflows to the US. But something changed. After a period when inflows to the US lagged, they suddenly surged — with almost all the inflow going toward short-term bills

And now China’s US holdings – particularly its Treasury holdings – seem to be rising in line with China’s reserves.

China is still buying other assets. Chinese state firms have been actively bidding for mineral rights – and companies that have mineral rights. And China has been stockpiling commodities. But over the last few months SAFE has essentially been buying Treasuries at – best I can tell – more or less the rate implied by China’s reserve growth.

This shows up pretty clearly on a chart plotting China’s purchases of “safe” US assets (all Treasuries, now that China has reduced its Agency purchases) and China’s estimated purchase of “risk” US assets (corporate bonds, equities) relative to the growth in the PBoC’s reserves and other foreign assets over the last 12 months.

china-june-09-4

It is hard to get headlines though with a story indicating that China’s Treasury purchases have been more or less in line with its reserve growth. There actually was more evidence that China was diversifying away from the dollar — in the sense of trying to reduce the dollar’s share of its rapidly growing reserves — from mid-2007 to mi-2008 than there is now.

In some sense the biggest story right now is that China’s reserve growth resumed before China’s export growth. That’s a major change.

Exports – on a rolling 12m basis – are trending down. While the stock of China’s reserves and other foreign assets – which used to track the growth in China’s exports – are heading up.

china-june-09-3

Add in the data on imports and it is clear that the reacceleration of China’s reserve growth in the second quarter was driven by renewed capital inflows, not by a rise in China’s trade surplus. That shouldn’t be a surprise. Private investors generally prefer growing economies to shrinking economies – especially growing economies with surging equity markets. China’s stimulus has worked. But its success has meant that money now wants to move into China, not out of China.

Chinese policy makers haven’t found a way to have it all. They want a growing, thriving China that doesn’t attract private inflows. Inflows are hard to sterilize, and China — with a still large current account surplus — doesn’t need the money. Good luck. Especially if policy makers want a growing, thriving China that remains pegged to a (once again depreciating) dollar …

See Eswar Prasad and Isaac Sorkin, among others.

* Jim Fallows’ big feature story didn’t appear until 2008, so it didn’t really accompany China’s first trillion. But it was probably the most widely read of all stories on China’s reserves.
** As usual, the survey revisions have been smoothed out using the Setser/ Pandey methodology; I also estimate that around 50% of the UK’s recent purchases of Treasuries will be reattributed to China in the 2009 survey. . My estimate for China’s corporate bond portfolio is based on cumulative flows over the last four years rather than the survey data, as China seems to use a non-US custodian for its corporate bonds.

23 Comments

  • Posted by But What do I Know?

    So it seems to me that the Chinese are OK with buying T-bills with their dollars (to earn whatever miniscule return they can get on those) but are unwilling to buy long Treasuries (or MBS). There’s no reason why this can’t go on for some time–but then again there’s no reason why it can’t end suddenly either. It reminds me of the dams that the Army Corps of Engineers keeps building higher and higher to keep the Mississippi River from changing course–eventually something will break, but as long as it doesn’t we can go about our business.

    What do the Chinese do with the euros they have in reserve and how many are there?

  • Posted by HZ

    If US C/A deficit melts away — it takes the fiscal deficit to come down a couple points in GDP terms while private savings hold up for this to happen — then the Chinese holdings is eventually a non-issue. If they don’t want the Treasury someone else will. However the fiscal picture does not look good at all with explosive medical cost growth about to come online in a couple of years.

  • Posted by don

    Informative. Thanks.

  • Posted by locococo

    Trillions, these days
    do tend to devalue quite fast …

    Mainly due to privately managed funds.

  • Posted by Rajesh

    But what about China’s liabilities? Yuan held abroad was minuscule before 2006. I suspect that as China is slowly liberalizing its currency rules, a good portion of the growth of its assets is offset by Yuan denominated assets held by the over-seas Chinese. The apparent increase in trade denominated in Yuan will only make this trend accelerate.

  • Posted by sillythings

    Hi Brad,

    Can you share your thoughts on the economic implications of China investing a larger portion of it’s reserve on more riskier assets around the world.

    China’s last decision to invest it’s reserve on US treasury and MBS contributed to the current financial crisis. I have to imagine whatever else China decides to invest in, the consequence could be just as significant.

    For example, many view today’s recovery of oil price is because of China stock piling. Furthermore, Chinese companies traditionally have been making commodity components for American companies. However, US companies are at a 40% discount from their October 2007 peak. Why be satisfy with building only low margin commodity components. Why not buy the Apple Inc. of the world? Also, what does this mean for the under valued China currency exchange rate? Can the under valuation of the RMB be corrected by China exporting manufactured goods while the US exporting assets? Can the currency exhange imbalance be fixed without China appreciating it’s RMB?

    There is one clear bright side. China could potentially significantly lift asset value and help repair household net worth. Since 2 trillion is 4% global GDP, it may be the biggest stimulus to the global economic recovery?

    Thanks again.

  • Posted by Rien Huizer

    Brad,

    a little out of context:

    “Directors welcomed the important progress made in the past few years in increasing the market’s role in determining the exchange rate, as well as the consequent substantial real appreciation that has been achieved since the exchange rate reform in 2005. Some Directors nevertheless supported the view that the renminbi remains substantially undervalued. Looking ahead, many Directors considered that a further strengthening of the renminbi would be part of a comprehensive strategy to rebalance the economy by increasing the purchasing power of households and the labor share of income, and reorienting investment toward non-tradable sectors. Exchange rate flexibility would also allow monetary policy to focus more clearly on price stability. A number of other Directors pointed to the methodological difficulties of making exchange rate assessments. These Directors generally considered that exchange rate appreciation would only play a supplementary role in supporting reforms to reorient the Chinese economy and should be pursued in a gradual manner, as and when conditions permit.”

    Looks like the IMF and Beijing agree on the direction of domestic policy. They must have been reading your blog. As Twofish mentioned a while ago, foreign views are often used to convince a domestic audience. In this case the “losers” seem to be the SOEs and the shady types who supply services in the countryside. But reform aiming at stripping the decentral rich and powerful has never worked in China, outside war-like and revolutionary environments. Why would it work this time and , if it does not work, what will be the result of a failed attempt? Is this why Mr Hu had to return home?

  • Posted by Rien Huizer

    Oops, old age no excuse for clumsiness: copied to little of the the PIN. Again:

    “To lessen the reliance on investment and increase employment, Directors supported an increase in the cost of capital through a cautious liberalization of domestic deposit and loan rates, when conditions permit, to be accompanied by appropriate adjustments to financial supervision. They generally agreed that measures to promote capital market development would play a useful complementary role in raising household income, lowering the savings rate, boosting consumption, and improving the allocation of capital in the economy. They welcomed the authorities’ intention to participate in an FSAP (Financial Sector Assessment Program) to help identify priorities for further financial sector reform. Directors also recommended allowing the costs of other factors of production, such as energy, water and land, to increase further in order to support the government’s intentions to improve energy efficiency and protect the environment.
    Directors welcomed the important progress made in the past few years in increasing the market’s role in determining the exchange rate, as well as the consequent substantial real appreciation that has been achieved since the exchange rate reform in 2005. Some Directors nevertheless supported the view that the renminbi remains substantially undervalued. Looking ahead, many Directors considered that a further strengthening of the renminbi would be part of a comprehensive strategy to rebalance the economy by increasing the purchasing power of households and the labor share of income, and reorienting investment toward non-tradable sectors. Exchange rate flexibility would also allow monetary policy to focus more clearly on price stability. A number of other Directors pointed to the methodological difficulties of making exchange rate assessments. These Directors generally considered that exchange rate appreciation would only play a supplementary role in supporting reforms to reorient the Chinese economy and should be pursued in a gradual manner, as and when conditions permit.
    Directors recognized that, over the near term, rebalancing the economy could raise unemployment as jobs are shed in export-oriented sectors. At the same time, they considered that the authorities could employ policies to provide income support, retraining, and social programs for laid-off workers. Some Directors indicated that any moves towards trade protectionism should be avoided. Directors believed that, over a longer horizon, the employment gains from rebalancing towards domestic consumption and an increase in service sector employment should outweigh short-term losses. Over time, there would also be important and wide-ranging spillovers from rebalancing, with Chinese consumption becoming a key factor in driving global growth.”

  • Posted by Jason

    Hi Brad,

    Great work. Last year, if I recall correctly, China had net outflows. If we had a repeat situation, with the weaker trade surplus, how would the dynamics change. With a time lag, would China have to use their reserves? Would it even matter considering there will be a bid for treasuries (assuming China outflow would be related to a flight to quality)?

  • Posted by bsetser

    Jason – last year china had net outflows in q4. for the year I think they had net inflows if you adjust for the pboc’s other reserve assets (though i need to check). if net outflows came back, it would offset the trade surplus — and if the outflows were large, china would have to dip into its reserves. and i think you are right that in that context, the money flowing out of china would be looking for safety, assuring a treasury bid even though SAFE will be buying less.

    what do I know. there is no European data set comparable to the TIC data that allows a direct estimate of China’s euro holdings. most estimates would put it at between 15 and 20% of China’s total reserves (e.g. $300-400b). China certainly holds a fair number of French OATs and German bunds. Beyond that, your guess is as good as mine.

    maybe some readers of this board could help us out; i would be interested in colour on China’s euro portfolio …

  • Posted by Glen M

    Any more reserves and they will fall under the non proliferation treaty.

    Seriously, at what point is it too much and counter productive?

  • Posted by Cedric Regula

    And boy can we count.

    Just saw this on the Across the Curve blog. The treasury announced next weeks funding. The total is more than twice as much as they have done in a week so far. But as the author notes, much of it is short term…but even so…

    +++++++++++++++++++++++++++++++++=
    Supply Tsunami
    July 23rd, 2009 11:46 am The Treasury will auction something in the neighborhood of $ 236 billion in securities next week.

    Let me breakdown the component parts.

    I will begin with the one piece of the puzzle which is not yet set in stone. prognosticators expect that on Monday the Treasury will announce an auction of $ 31 billion 4 week bills.

    Everything else I note here has been announced already publicly.

    There will be $ 6billion in a reopening of a 20 year TIPS bond.

    There will be $ 42 billion 2 year notes.

    There will be $ 39 billion 5 year notes.

    There will be $ 28 billion 7 yearnotes.

    There will be $ 27 billion one year bills.

    There will be $ 63 billion on three month bills and six month bills.

    If Sister Mary Consolata taught me well,that is $ 236 billion.

    To be fair it oversates the case somewhat. Much of it is in short dated T bills where there is not much risk. And much of it rolls over maturing paper.

    However,in terms of sheer size and magnitude it places the financing needs of the US government in stark relief.
    ++++++++++++++++++++++++++++++++++

  • Posted by yoda

    only fool buy gov bond now? bond supply tsunami will the bond value. Dow above 9000 and going up. that will further crash gov bond value. by the way, FED is determined to decimate dollar with 0% rate policy.

  • Posted by Cedric Regula

    I knew the Bond Jedi would be back.

    10 yearling hit 3.7% today. 4.55% on the 30 yearling.

    Dollar index at 79.

  • Posted by Jason

    Thanks Brad. It will be interesting if this situation arises – I am assuming (with large outflows), they will be in a tough situation – attempting 8-9% growth while keeping the exchange rate the same (maybe govt. bond sales). I am probably simplifying the situation.

    Cedric – Perhaps the treasury wants to get it out of the way (Considering almost all the deficit governments wants to sell a large amount of bonds this year). A case of the early bird gets the worm?

  • Posted by Cedric Regula

    Jason

    I think it’s kind of a snowball effect. Much of this is re-funding, or reshuffling of old debt, and the average maturity of treasury debt has been shortening up to about 4 years now. So they have to sell shorter term notes and bills more often. Add this years $1.8 Trillion in new deficit financing and that explains the ever bigger numbers. All this is just masking the fact that long term rates are too low, but I think the Treasury wants to keep it that way because they don’t want to drive up mortgage rates by putting a lot of longer term treasuries up for auction.

    Also the 10 year budget already calls for another 8 trillion in borrowing after this year. So we aren’t getting anything out of the way.

  • Posted by yoda

    you do know Bernanke (Sith Emperor) and Treasury (Sith Apprentice) will manipulate/push down long date yield and beat Bond Jedi silly right?

  • Posted by yoda

    with tsunami supply of gov bond, you will thought bond jedi demand higher yield, but 10yrs still below 4% when DOW already broke up 9000. and you have central banks (china, japan) all crowd into t-bill with 0% interest rate. and this phenomenon can continue to long long long time like FED is targeting 0% and decimating dollar for long long long time. and bond jedi will be missing in action for long long long time.

  • Posted by Cedric Regula

    Patience Yoda.

    Do not let the Darkside upset you. Remember your teachings.

    Helicopter Wen may become an ally of the Bond Jedi. This may give the carry traders and other sympathizers of the Empire cause for concern. This is a powerful Force that can defeat the Darkside! But if deflation concerns and risk aversion return, the Darkside strengthens. So beware, there may be future threats to the Bond Jedi ahead.

    Use the TBT Force, Yoda…average down on pullbacks, you should!

  • Posted by yoda

    anyway, wont touch the bond unless 10yrs yield is above 5% or Bernanke change targetting 0% rate policy and start the exit strategy.

  • Posted by mark johnson

    Since the Wetherd ratio of short term yields matches the internal deficit ratio, there should be a precession of prices.

  • Posted by Judy Yeo

    diversification away from US dollar assets can only take place at a snail’s pace particularly when much of the world is watching you not unless you want to start a fire sale like situation in which case you can also expect collateral damage to your existing holdings. Which brings us to the more politically correct solution – start a fund or sub concern focussed on what might be best described as venture capital with a nationalistic view – fund anything from startups to promising strategic industries and even private companies looking for some funding- China has the opportunity to kill many birds with that one stone – after all, what makes the public happier than seeing some nationalist pride played out commercially – it’ll be the commercial equivalent of the oylmpics – of course, without the gaffes or scandals preferably. The only worrying elements they need to watch out for are transparency and keeping corruption at bay . Of course that’ll raise hackles – if the unease over SWFs is bad, wait till you see what happens if China puts its money where its intentions purportedly are.

  • Posted by RodgerRafter

    I suspect that China is quite happy to have high levels of inflows now because this takes some pressure off of the government to keep providing a high level of stimulus. They’d rather have private industry pursuing profitable opportunities in the domestic and export markets.

    A big part of the outflow problem late last year was likely due to hedge fund delveraging. As you state, “China’s stimulus has worked.” Now a more stable group of investors is moving in at better prices and for better reasons. China is the best growth market both for investors and for companies wanting to sell their goods. They can ease off the stimulus as long as this continues.

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