Getting a hold on China’s U.S. dollar holdings

| May 17, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Escalating tensions in the U.S.-China trade dispute have reignited concerns that China could weaponize its holdings of U.S. dollar assets, ostensibly engaging in large scale liquidations from its stockpile of foreign exchange reserves. Most analysts and U.S. government officials consider this unlikely, as it would almost certainly result in depreciation of the U.S. dollar versus the yuan and perhaps other Asian currencies, hurting China’s export-based economy and being a drag on growth in the Pacific Rim. However, if China were tempted to test the market’s and the White House’s reaction to such a sale, they could do so without it showing up in their official holdings data. The government could potentially liquidate some of the $400 billion or so of U.S. Treasuries and corporate debt in custody accounts in Belgium or Luxembourg, long thought to be held on behalf of Chinese government or state controlled accounts.

Trade and currency intervention build China’s foreign exchange reserves

In March 2000, China held less than $60 billion of U.S. Treasury securities. Stable political  and trade relationships between China and the U.S. were still evolving, and the yuan was pegged to the dollar. Trade between China and the U.S. expanded rapidly after October 2000. From the Council on Foreign Relations timeline of U.S. Relations with China,

U.S. President Bill Clinton signs the U.S.-China Relations Act of 2000 in October, granting Beijing permanent normal trade relations with the United States and paving the way for China to join the World Trade Organization in 2001. Between 1980 and 2004, U.S.-China trade rises from $5 billion to $231 billion. In 2006, China surpasses Mexico as the United States’ second-biggest trade partner, after Canada.

As trade with China increased, China’s foreign exchange reserves began to build along with their holdings of U.S. Treasury securities (Exhibit 1). In 2005, China officially quit pegging the yuan to the dollar, but continued to managed the exchange rate in order to control its’ rate of appreciation.

Exhibit 1: China builds FX reserves as it manages currency exchange rate

Source: TIC data, Bloomberg, Amherst Pierpont Securities

During the financial crisis, China reverted to managing the exchange rate within a very narrow band, then controlled the appreciation for years afterwards. The currency intervention required to stabilize the exchange rate resulted in a tremendous build up in foreign reserves, heavily tilted towards U.S. dollar assets. The yuan appreciated to a low of 6.04 versus the dollar in January 2014, as the foreign exchange reserves reported by the People’s Bank of China (PBOC) hit $3.4 trillion, towards an eventual reported high of $3.99 trillion by June of 2014.

China’s holdings of U.S. dollar assets

The Treasury International Capital (TIC) reporting system estimates $1.5 trillion of U.S. Treasury, agency, corporate debt and equities are held in custody in China, virtually all of which is presumed to belong to official government or state-controlled banks and investment funds (Exhibit 2).

Exhibit 2: U.S. dollar assets in China and U.S. Treasuries in custody in Belgium

Source: TIC data, Amherst Pierpont Securities

It is also widely presumed that China’s official holdings are larger than those held in China, and likely include a significant share of U.S. dollar assets held in custody in Belgium and Luxembourg. From an excellent Council on Foreign Relations blog post by Brad Setser, from January 17, 2018:

China’s Treasury holdings are also a bit higher than formally reported.

The U.S. major foreign holders table (which is the data everyone uses) shows Treasuries that Chinese institutions hold in U.S. custodians. But starting in 2011, China seems to have started using a Belgian custodian for a portion of its holdings—Belgium’s holdings surged then, and again in 2013-2014.

The case that these should be attributed to China is very strong. They certainly aren’t really “Belgian.” And, well, the sum of Belgium’s (long-term) holdings and Chinese holdings fits better with China’s reserves than the China line alone. China’s holdings were flat when China’s reserves were rising from 2011 to the end of 2014. And, well, China’s holdings likely fell by more then reported in 2015 and 2016 when China’s reserves were falling (back in 2015 and early 2016 the counterpart to the fall in China’s reserves was a reduction in China’s holdings of U.S. stocks and a fall in Belgium’s treasury holdings… hmmm).

To illustrate the point Brad Setser is making above, Exhibit 3 shows the dramatic rise in Belgium custody holdings of U.S. Treasury securities during the same period of 2011 through 2016 when the PBOC was conducting large scale currency interventions.

Exhibit 3: Yuan exchange rate and Belgium U.S. Treasury holdings

Source: TIC data, Bloomberg, Amherst Pierpont Securities

For similar reasons, another $200 billion of holdings of U.S. corporate debt in custody in Luxembourg and Belgium are also presumed by many analysts to be held on behalf of China’s government. Also from Setser’s blog post, referenced above:

China likely holds some U.S. corporate debt. But, well, those holdings have—for some reason—never appeared in the U.S. custodial surveys. China’s holdings here blend in with the large custodial holdings of corporate debt of “Luxembourg” and “Belgium”—in other words, the custodial data for corporate bonds just tells us that a lot of these bonds are held in global custodial centers. So there are reasons to think China’s total U.S. bond portfolio exceeds the $1.45 trillion implied by summing up China’s custodial holdings of Treasuries and Agencies, and then adding in the Belgian portfolio.

Exhibit 4: U.S. corporate debt held in Belgium and Luxembourg

Source: TIC data, Amherst Pierpont Securities

It’s less clear how much of the corporate debt held in custody in Luxembourg and Belgium might ultimately be for Chinese official accounts. Conservatively, perhaps $200 to $300 billion of the $1.2 trillion might be held on behalf of the PBOC’s investment arm, the State Administration of Foreign Exchange (SAFE), or other Chinese state banks or investment companies.

The problem with selling U.S. dollar assets

The PBOC is not transparent regarding its intervention in the FX markets, but in the current environment it probably does not require much to maintain a reasonable level of the yuan versus the U.S. dollar and other currencies in the basket. However, if China were to suddenly begin selling U.S. Treasuries or other U.S. dollar assets, the market might panic, and would understandably attempt to get in front of that trade, given the sheer size of their holdings. Arguably that might be a tool of last resort that China could deploy if trade negotiations were to completely break down. The downside of doing so is that China would ultimately need to repatriate those U.S. dollars back into yuan, causing a significant appreciation of their currency. As an economy still built around exports, that would likely become a significant and long-term drag on China’s growth.


john.killian@santander.us 1 (646) 776-7714

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