Combine two data points
- The August fall in Treasury holdings in the Federal Reserve Bank of New York’s custodial accounts (the data is released weekly here); and
- The very modest increase in China’s reported holdings of Treasuries this year, and an outright fall in the second quarter, in the TIC data.
You can combine them and tell a story that China is starting to sell its Treasuries.
I don’t buy it. Not really.
China – along with some of the oil exporters – is still adding to its reserves in a quite significant way. China’s reserve growth (like Saudi reserve growth, but surprising, unlike Russian reserve growth) stemmed far less from capital inflows than from its current account surplus. Financial market turmoil has reduced inflows into the emerging world – and generated outflows from places like Russia – but it hasn’t reduced China’s large surplus, or for that matter the large surplus of the major oil exporting economies.
So China still likely has about $40b or so a month to place somewhere. If China wants to transfer say $80b to its new investment fund, it doesn't need to sell anything. All it needs to do is to park two months of the central banks' dollar purchases in the international banking system.
Now it is true that China doesn’t seem to be putting a lot of its rapidly growing reserves into the Treasury market. Relatively speaking, it has been buying more Agencies and corporate bonds this year, and fewer Treasuries.
But a bit of caution is in order even here. Someone is holding a lot of Treasuries in London -- UK holdings have increased by about $135b in the past 12 months. And for the past two years, a lot of the UK’s supposed Treasuries really turned out to belong to China (look at the adjustments in the historical data). The high-frequency US data clearly doesn’t capture all Chinese Treasury purchases. China is likely buying fewer Treasuries, but not quite as few as the TIC data suggests.
It is possible – as Macro man notes – that China has been building up very liquid short-term assets (think deposits or bills) rather than buying longer-term Treasuries as it prepares to launch its investment fund. Chinese holdings of t-bills should eventually show up in the US data, but Chinese bank deposits probably wouldn’t.
It is even possible that SAFE recognizes a good trading opportunity – the only time China can sell Treasuries without disrupting the market is when the market really, really wants Treasuries. That is the case now. China could be taking some profits on its Treasury holdings (note the rise in Japan’s reserves, that all stems almost entirely from the fall in US interest rates which increased the market value of Japan’s portfolio – China has similar gains) and locking in slightly higher yields on only marginally more risky Agency bonds. If that is what it is doing, good for it – its actions are fundamentally stabilizing. It is selling what the market wants to buy what the market doesn’t want. Lucia Mutikani of Reuters quoting Tony Crescenzi:
"Central bank debt trading desks are quite heavy and recognize that yields have gone up significantly recently, creating a trading opportunity to gain a little more yield," said Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York.
All that said, though, I personally would bet that central banks other than China are responsible for the fall in the FRBNY’s Treasury holdings over August.
Here is what I suspect has been going on.
Over the course of 2007, three things have been happening.
First, some central banks with large existing holdings of Treasuries have been slowly reducing their Treasury holdings – whether by selling into the market or by not rolling over maturing bonds – and adding to their Agency holdings (and perhaps otherwise diversifying as well). Korea and Japan are the obvious examples. If nothing else was going on, that would tend to lower Treasury holdings.
Second, those central banks that are adding to their reserves rapidly have been buying more Agencies and fewer Treasuries – China is the most obvious example (Russia is, strangely enough, buying more Treasuries than in the past … but that isn’t saying much, since it previously held an “all Agency” portfolio)
And third, the overall pace of global reserve growth picked up sharply. In the first two quarters of the year, I suspect it will be about $300b a quarter – a $1.2 trillion pace – though that estimate hinges on the q2 IMF data and some expected revisions to the q1 data.
The result – central banks were buying a lot more of everything, including Treasuries. So their Treasury holdings were going up, just not as fast as their holdings of other assets. In some parts of the Treasury market, there actually aren’t many outstanding bonds left for the central banks to buy.
August though was a bit different. Global reserve growth slowed, particularly in places where global reserve growth reflected large capital inflows. International investors took profits and took money off the table. Money even flowed out of a few markets – Russia most notably.
Absent those inflows, the trend move out of Treasuries and into Agencies looked a bit more prominent. And I suspect that central banks needing liquidity sold their most liquid asset – Treasuries. That is a good thing. Right now the private market wants Treasuries.
But the fall in the Fed’s custodial holdings exceeds Russia’s need for liquidity – and even if you add in a few other countries, my guess is that the fall is a bit bigger than can easily be explained by a slowdown in global reserve growth.
So a few central banks that previously held long-term Treasuries sold – and either bought Agencies or moved into bank deposits.
That could include Japan and Korea. This would be a great time for both to accelerate their long-standing plan to diversify away from Treasuries.
And it also might include various European central banks. Remember, a lot of European banks right now have an enormous need for dollar liquidity (all their conduits) ….
I hadn’t thought of the European angle, but Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York, did. Reuters:
"half of the decrease (in Treasury holdings) relates to the purchases of agency securities. The rest of it may be that central banks are looking to hold dollars, rather than investments because there has been a shortage of dollars in the European banking system."
It makes sense to me.
This is a case where the easy conclusion (central bank Treasury holdings are falling, China must be selling) is not likely to be the right conclusion.
I have long argued that there is a risk that central banks are a potential source of financial instability should they stop adding to their dollar holdings at points in time when the market doesn’t want dollars. That still strikes me as a risk – though not a high probability one. There are a set of countries that hold far more dollars than makes economic or financial sense, and at some point they might decide that they don't want to continue to buy even more.
But all indications suggest that emerging market central bank have been a stabilizing, not a destabilizing, force in the markets over the past month.
If the US economy disappoints and the dollar continues to slide though, some will be put to the test. The key to the dollar’s broad stability has been central banks willingness to put a disproportionate share of their reserves into dollar assets of all kinds when the dollar is under stress.
Goldman's fx team and Barry Eichengreen don’t think a financial crisis that originated in the US subprime market will ultimately prove to be dollar positive. I agree.
Update: The fall in Taiwan's reserves in August suggests that it was one of the sellers -- though its sales alone cannot be the entire fall. Yves Smith of Naked Capitalism is more inclined than I am to think the recent fall in central bank Treasury holdings suggests trouble. I would note that the fall in Korea and Japan's holdings of Treasuries likely reflects a shift toward Agencies, not a shift out of the dollar -- though Korea probably is also trying to reduce the dollar share of its portfolio. And in any case, this is precisely the time when central banks can lighten up on Treasuries without disrupting the market.