Analyzing central bank and reserve manager behavior is never simple given the lack of official discussion and strategic sensitivities. Given that, we spend a good amount of time recording all comments we see as relevant to develop our understanding. We have estimated for some time that China specifically has an interest in investing as much as 500 Bio EUR in Europe. Our analysis is based off a number of comments that have come out of China over the past 12 months.
In our piece dated August 8th, 2010, "The Dollar Has Fallen and Can't get Up," we noted that:
"On June 19th 2010, Yu Yongding, a former advisor to the People's Bank of China (PBOC) suggested in the China Securities Journal that China should reduce its holdings of the USD to diversify risks of 'sharp depreciation.' This followed on from statements made in May 2010 when he stated China should allocate its reserves in line with the weightings of Special Drawing Rights (SDRs)."
Although the State Administration of Foreign Exchange (SAFE) is cautious in releasing reserves composition, we understand that China has approximately 3 Trln USD in foreign exchange reserves, of which anywhere from 65%-75% are composed of USD assets. Also, 65% of 3 Trln USD equals 1.95 Trln USD.
If China would prefer to have its USD weighting in-line with the SDR weighting, then based off the SDR weightings published by the IMF on December 30th, 2010, it should hold around 41.9% of its reserves in USD-based assets. The difference between where it is (65%) and where it should be (41.9%) is 23.1%. Also, 23.1% of 3 Tri USD comes to 693 Bio USD, or approximately 479 Bio EUR.
In our piece dated May 26th, 2011, "Deja-Vu, China to the Rescue," we noted that:
"CIC, China's Sovereign Wealth Fund, stated they were ready to invest up to 6 Bio NZD in New Zealand assets and government bonds. This is significant in that reserve managers typically invest based on available liquidity and relative economic size. A 6 Bio NZD investment into an economy with a GDP of approximately 140 Bio USD, translates into a similar GDP-weighted appetite for European assets of approximately 700 Bio USD; around 500 Bio EUR."
Statements from the PBOC and CIC that lead to the same conclusion are significant, and explain why China has expressed so much interest in Greek developments. Indeed in comments regarding China on June 28th, 2011, German Chancellor Merkel noted that "China has a 'massive' interest in a stable EUR." Her comments were joined by those from Chinese Premier Wen Jiabao, who said "China has expressed support for Europe at various times. In other words, when Europe is in difficulty we will extend a helping hand from afar ... We will according to need definitely purchase certain amounts of sovereign debt."
Today, In an unusual move, ECB President Trichet defended Chinese investment in the eurozone during his question and answer session at the European Parliament. There, according to Market News International, he "dismissed fears that a stronger investment of Chinese public funds in eurozone sovereign debt securities could distort yields."
So where is the trade?
We believe that the consistent bid for the EUR/USD has no end in sight. This will continue to mystify macro investors who point to weakness in peripheral countries and look only to downside in the EUR/USD. Our weekly positioning poll indicates a lack of positioning and conviction across all markets. For the past 12 months peripheral news has worsened yet the EUR/USD has rallied. Being short the EUR/USD has been a painful, but not lonely, trade for those not in our camp.
The soft-restructuring of Greek debt we believe will result in a need for European banks to raise new capital, as their balance sheets face erosion from the mark-down in peripheral asset values. Much as the capital needs of U.S. banks were met with Asian reserve manager injections following Lehman's demise, we believe that we will hear of a spate of Chinese and other sovereign wealth investments in the European banking sector. While Asian investment in Europe will come through EFSF participation, we believe it will also come through the secondary route - investing in banks that own the underlying paper.
Investment in a region plagued with uncertainty will result in significant goodwill awarded to the investor. As we noted in our report dated June 16, 2011, "Will China Play the White Knight?"
For some time China has been blocked from purchasing sensitive technology companies in the United States. We believe the political capital that would be gained by China from investing in the European Periphery would open the door for China to purchase sensitive operations in Europe and gain further international votes on the global stage. We believe that a 500 Bio EUR investment in Europe, comprised of up to a 20% investment in periphery would solve a number of underlying issues.
1) China would gain reserve diversification out of the USD instantaneously.
2) China would gain the appreciation of France and Germany given they would relieve the pressure from both countries banking systems.
3) Europe would be the beneficiary of a White Knight, who would assume and indeed could consume the risk; a risk that is relatively minimal given the overall investment that we expect from China.
We believe China will be the White Knight, and is riding to Europe's rescue. Despite the "tape bombs" exploding on the news wires, we believe these pullbacks in the EUR/USD should be seen as a buying opportunity. The last comments from China regarding its thinking on U.S. debt came from Li Daokui, an adviser to the People's Bank of China on June 8th, 2011; stating, "I think there is a risk that the U.S. debt default may happen." adding, "I really hope they would stop playing with fire."
On that note, a political investment in the European Periphery may be the most prudent move.
We believe any 500 Bio EUR investment will not happen overnight, but rather over a gradual time horizon and when opportunities present themselves. However, we do expect this to play out over a five-year time horizon in line with many of China's stated goals. The argument is rather simple. If China is willing to invest up to 6 Bio NZD into New Zealand, a country with an annual GDP of around 140 Bio, then why is a 500 Bio EUR investment in Europe, a region with an annual GDP of around 13.8 Trln, so out of the question?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.