China's Currency Flows Still Aid the U.S. Dollar

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Includes: CYB, FXI, PGJ, UDN
by: Mitul Kotecha

Data earlier this week revealed that China’s foreign exchange reserves topped $2 trillion at the end of Q2 2009; reserves increased by a massive $178 billion over the second quarter. Other Asian central banks also increased their FX reserves over Q2, marking a resumption of reserves growth following several months of flat reserves holdings. The increase in reserves in Asia also reflects FX intervention by Asian central banks to prevent their currencies from strengthening against a generally weaker US dollar.

Much of the gain in China’s reserves may have come from a sharp reversal in hot money flows back to China rather than trade and investment inflows, which is likely to be somewhat worrying news for the authorities in China despite the impressive rise in overall reserves. The jump in reserves is not exactly good news given that it could make it more difficult for China’s reserves management policy and will likely lead to greater calls to allow the Chinese currency, the yuan to strengthen further.

It appears that despite calls for a new reserve currency, the Chinese authorities have been buying huge amounts of dollar assets to maintain a stable exchange rate. As the recent US Treasury TIC flows data reveals, some of this wound its way back into US Treasuries, with China’s US Treasury holdings rising by $38 billion in May (the latest month of data) though this was insufficient to outweigh the selling of Treasury bonds by other countries.

Indeed, foreign official investors moved to the front of the curve and were massive buyers of US Treasury bills rather than Treasury bonds, purchasing $55.6 billion of bills in May whilst selling a total of $21.8 billion in Treasury bonds despite China’s strong purchases over the month. It at least looks like Russia followed up on its threats of reducing its exposure to the dollar and sold $12.5 billion in Treasury bonds in May, however.

China is the largest holder of US government bonds and now holds over $800 billion followed by Japan with $677 billion. China’s buying of US Treasury bonds is good news for the US administration as sell huge amounts of Treasuries to fund the burgeoning fiscal deficit. Nonetheless, it also shows that little has changed in the symbiotic relationship between China and the US. Until the Chinese yuan is allowed to strengthen this relationship is likely to continue to remain in place.

Although the US current account deficit has narrowed sharply over recent months, falling by over a third in Q1 2009, the US reliance on Asian money remains strong. On the other side of the coin, China will likely continue to be a major purchaser of US Treasuries as it pays the price for a stable exchange rate policy and until it adjusts from an export orientated to domestic led growth.

This is good news for the dollar or at least less bad news and supports the view that diversification away from the dollar is a long term process with a rapid selling of dollar assets remaining a threat rather than a reality but only as long as China maintains its policy. Indeed, according to recent IMF data the dollar proportion of global foreign exchange reserves rose to 65% in Q1 2009. An orderly decline in the dollar remains the most likely bet.