Analyzing China's Cloaked Currency Reserves

China has amassed one of the biggest pools of capital.  It was in the form of central bank reserves.  At its peak, it had been around $4 trillion.  The make up of these reserves is a closely guarded secret. However, when the yuan is going to be including the IMF's SDR, it’s anticipated that China statement will have to report the currency allocation of its reserves.  China would not necessarily publish these though IMF would include them in its aggregations process that it publishes every quarter.

China's reserves dropped $300 bln more than four consecutive quarters through the middle of the year.  In Q2 2015, reserves fall $40 bln.  Stemming from its trade surplus and investment income, direct investment flows, economists expect reserves to have increased rather than fall.

The gap in between what the economists’ models say that reserves should be, and what the PBOC reviews them has become the proxy for capital flight.  As the models differ, the estimate of the capital flight differs.  One large investment bank estimates it at $800 bln.  Another one claims $520 bln.

Many observers take it another step.  On the assumption that the bulk of China's reserves are invested in Treasuries, a decline in reserves is a decline in Treasury holdings.  The most authoritative source comes from the US Treasury.  This is depicted in this Great Graphic from Bloomberg.  This shows that as of the end of May, China held $1.27 billion of US Treasuries.  It is unchanged ($2 bln more) than it held when its reserves peaked last 06.

The PBOC may hold Agency bonds as part of their reserve holdings, not only Treasuries.  In the first five several weeks of this year, China's Agency holdings rose by $14.5 bln.  By the US reckoning, China's Treasury holdings rose by $26 bln in the Jan-May period.

Some claim that China is disguising its flows.  They reason that this was done on Euroclear in Belgium.  There had been a six-month period in late 2013 and into early 2014 that US data showed a large accumulation associated with Treasuries in Belgium.  They rose from $173 bln in September The year 2013 to $381 bln in March 2014.  At first, some thought this was Spain shifting its reserves, however it relates to Euroclear's exchange function, likely collateral.

Since Belgium's holdings of US Treasuries has fallen, particularly over in the Feb-May period. This is shown here in this 2nd Great Graphic. The US Treasury data shows Belgium's Treasury holdings fell from $354.5 bln in The month of january to $203bln as of May.  There isn’t any compelling reason to think it was China.   What is its motive?  A big run up and then a big run down in short order does not fit China's modus operandi. 

Perhaps the data is flawed.  The US Treasury data only aggregates information of activity through US institutions.  Maybe China has been selling its Treasury holdings around the sly.  If there were such a large seller of US Treasuries because the capital flight story implies surely the markets might show it.  Where is this?  Assuming that China's reserves tend to be kept invested in the belly of the curve, let us look at what has happened to 5-year and 7-year US produces. The former has risen by 5 bp since China's reserves peaked.  The latter has fallen 7 bp.  The actual dollar-yuan rate is unchanged from the finish of last June.

It isn’t clear why the The far east would sell Treasuries now.  The actual Fed is preparing the market for a rate hike.  While this may weigh on Treasury prices, being an investor that may hold till maturity, not a trader, the change in prices is of little significance.  The yield is locked.  The key towards the total return is the buck, and Chinese officials are well aware of the divergence of monetary coverage. 

Maybe the US market is so heavy and liquid that it offers easily absorbed the Treasury and dollar sales. Could additional markets have absorbed the hundreds of billions of dollars that economists' models suggest have left China?  The European stock and bond markets are obvious places to look.  A surge of Chinese cash does not appear to be evident. 

Chinese economic data is not often thought to be of high quality.  The methodology it utilizes does not appear to be very transparent.  It is not clear the independence of its statistical collection and reporting.  This, incidentally, is one of the creditors' needs that Greece has recognized.  

It does appear that there happen to be capital outflows from China.   Many are likely exaggerating it. It may stem from incomplete data.  It may also be a function of not understanding current data.  For example, China's industry surplus is often treated like a source of capital inflows.  However, what is reported is merchandise industry.  China records a service deficit that offsets part of the merchandise excess.  China's reserves are not just about all sitting idle.  Some have been loaned out to other parts of the government, like the Export-Import Bank, for example.  What is the accounting practice China uses for this? 

Since its foreign currency reserves are so large, value, that is changes in asset prices and currencies (since the reserves are reported in $ $ $ $) are an important part of a rigorous evaluation. What is the accounting practice with this?  Economists who estimate the actual composition of China's reserves then estimate the valuation changes.  For example, using round figures to illustrate the point, assume China has $4 trillion in supplies, of which 25% or $1 trillion have been in euro investments.  Since the finish of H1 14, the dinar has lost 20% against the buck.  Holding all equal, that of course it is not, that on your own would account for a $200 bln decrease in the dollar value of China's reserves.

Great Graphic: China's Keeping of Treasuries is republished with permission from Marc to Market