from Follow the Money

Close to $500b of debt purchased over the last 18 months, and not a cent of subprime …

September 4, 2007

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China’s reserve managers – the State Administration of Foreign Exchange – recently reported that they have exactly zero exposure to US subprime mortgages.   

“"China's official forex reserves don't include [the US subprime securities]," Wei Benhua, deputy director of the State Administration of Foreign Exchange, said on the sidelines of a financial industry meeting in Beijing”

Unlike many, SAFE apparently didn’t buy instruments with embedded risks that they did not understand, and in the process contribute to the dispersion of credit risk …

To be honest, though, I am more than a little surprised

Not by the fact that SAFE’s exposure to subprime is small – or even the now near-certainty that the recent fall in dollar interest rates increased the market value of China’s portfolio by more than enough to offset any credit related losses.  

China’s real exposure is to currency risk, not credit risk. 

But by the fact that SAFE somehow managed to invest close to $500b – I kid not – in global markets over the last 18 months without buying a cent of subprime.    An awful lot of that $500b was invested in dollar-denominated debt.  SAFE put a lot of that money to work in the US markets precisely at that point in time when mortgage-backed security insiders believed the the US market was generating some real toxic debt.   

Yet SAFE steered clear of all of it.   

Impressive.

Here is a bit of math.   Since the end of 2005, China has added $515b to its reserves.   My calculations suggest that if you net out valuation gains, the real increase – the money China actually had to invest – was more like $480b.   That is still pretty close to $500b.   And even if you net out China’s investment in Blackstone from the $480b, China still had around $475 to invest in debt markets.   At least $350b of that likely flowed into various US dollar denominated debt – though we will need to wait until next spring for confirmation in the US survey data.  

During calendar 2006 “private” Chinese investors – overwhelmingly the state banks, often playing with money borrowed through fx swaps from the central bank – bought $109b of debt, and $107b of long-term debt.   If all the Chinese state commercial banks disclosed subprime exposure (the BoC has the most foreign assets, and the most disclosed subprime exposure) was bought during this period (and there is good reason to think the banks purchases of foreign debt tailed off in the first bit of 2007), about 10% of their total debt purchases were subprime.

Apply the same ratio to the PBoC’s purchase of debt over the last 18 months and you would get $47b of subprime exposure.   That is clearly too high.  But I would have guessed that at least 1 or 2% of China’s purchases over the past 18 months  -- a period when China was showing a bit more risk appetite in the past -- might have been in various MBS and CDOS with some subprime exposure.   That would work out to between $5-10b in purchases, and between 0.5 and 1% of China’s total dollar portfolio.  

Not much, but still more than zero.

If I had to guess now, I would guess that SAFE simply wasn’t buying any CDOs – they were considered too illiquid for its reserve portfolio – and that rule, combined with a desire for high-rated paper, helped it steer entirely clear of subprime. 

Either that or there was a tacit division of labor with the state banks.   The state banks got a fair amount of fx to play with through the swaps market from the central bank, though we don’t yet know how much.   And perhaps the idea was that they would pioneer investment strategies that might later be adopted by SAFE.     

Both thoughts are pure speculation on my part though.   

But China’s “zero subprime exposure” disclosure does raises a lot of questions.

The US data shows that China has bought -- $50b or so of Treasuries, $84b of Agencies and $54b of corporate bonds over the past 18 months. 

That $187b total should be compared with the $475b in valuation-adjusted reserve growth if you think the $107b in debt purchased by the state banks and other “private” investors was purchased through Hong Kong, and compared to $580b if you think the state banks purchases are showing up in the US data along with SAFE’s purchases.

Either way, there is a huge gap between recorded Chinese purchases and any reasonable estimate of inflows into the dollar market … 

If it didn’t go into subprime, where did it go?    Are China’s purchases of Treasuries and Agencies way, way higher than the TIC data suggests?

What kind of corporate debt did China buy during this period?   I have assumed that China bought a lot of private MBS (see this post).  That is just an assumption – though one that seemed well supported by anecdotal evidence floating around the internet and the markets.   

But perhaps all Chinese MBS purchases were done by the banks?

Or perhaps market chit-chat – including the talk that the New York Time’s Keith Bradsher picked up when he reported large Chinese MBS purchases – doesn’t clearly distinguish between MBS with an Agency guarantee (Agencies in the US data) and MBS that lack an agency guarantee, which count as corporate debt in the US data.   

The last US survey leaves no doubt that China was been a huge buyer of “Agency” MBS from mid 2005 to mid-2006, and there is no reason to think that has changed over the past year. 

If talk about Chinese purchases of MBS effectively referred to MBS with an Agency guarantee, that  would help to reconcile the anecdotes suggesting China has been a big player in the MBS market with the exposure China has disclosed – though I guess it is possible that SAFE bought a lot of “private” MBS without buying any subprime debt.

Maybe now that SAFE is showing a bit more openness it might be willing to disclose how many private MBS – that is MBS that are NOT guaranteed by the Agencies – it has in its portfolio.    That would clear up a lot of mysteries.   The US data is too out of date to be much help. 

That would clear up a lot of mysteries.

Trying to figure out China’s holdings of US housing debt has turned into something of an obsession of mine.

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