from Follow the Money

Just what is in China’s portfolio? And do foreign central banks think Agencies are Treasuries?

March 12, 2007

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China's decision to set up a new investment authority with a mandate to invest in a range of assets -- not just traditional reserve assets -- has attracted a lot of attention.  But as the Bank of New York notes, China hasn't yet revealed a lot of the key details about the new authority, including how it will raise the money to finance the purchase of its foreign assets and how quickly it will build-up its assets. 

The announcement of the new investment authority though has had one useful byproduct: it has produced a flurry of information about the content of China's existing portfolio.

Keith Bradsher of the New York Times – reporting out of China – notes that China has roughly $100b in U.S. mortgage backed securities.   That seems right to me.     

People close to the State Administration of Foreign Exchange, which is controlled by the People's Bank of China and manages the country's reserves, estimated that the agency already held about $100 billion worth of American mortgage- backed securities. That may seem to be an unusual place to invest foreign-exchange reserves, but it was selected in the hope of achieving better yields than those on U.S. Treasury securities.  None of these mortgage-backed securities is said to be tainted by the subprime loan portfolios that have recently fallen sharply in value.

Bradsher also notes that China holds $600b in Treasuries.    

Experts estimate that it holds another $600 billion or so worth of U.S. Treasury securities that it lends actively to generate extra profit, as well as at least $200 billion worth of euro-denominated bonds. The remainder is thought to be held in bonds denominated in yen and other currencies.

That seems off to me – at least the $600b Treasury estimate.  The US Treasury’s own data puts China’s actual holdings of Treasuries at around $350b.   

The TIC data -- which is the source for the most recent Treasury estimate -- tends to understate China’s actual holdings.   The survey data is better -- but it is now dated. 

 June 2005 is roughly $360b of Chinese reserves ago (more like $330b of reserves ago if you adjust for valuation gains). When the next survey comes out, China's current holdings may be revised up.  The last survey led the US to increase its estimate of Chinese Treasury holdings by over $50b (see the series break in June 2005).    But it won’t be revised from $350b to $600b.

So where did the $600b number come from? Here is one theory: a lot of central banks seem to consider high rated Agencies to be a very close subsistute for “Treasuries.”   Or they at least don’t always differentiate between the two when talking to the press and public.

One example. Russia’s investment guidelines for its oil stabilization fund allow for investment in a wide range of highly rated fixed income securities (with relatively short maturities).  It is often reported that Russia correspondingly holds a lot of Treasuries.  However, the US data suggests Russia overwhelmingly holds short-term Agencies.  Agencies accounted for $61.956 of $61.966b in recorded Russian short-term holdings in the June 2005 survey (see p..66).   Ergo -- be careful.  Sometimes the distinction between Agencies and Treasuries seems to get a bit blurred.

The last (June 2005) survey put Chinese holdings of treasuries at around $300b -- $277b of long-term treasuries and $21b of short-term Treasuries.  At the time, Chinese holdings of Agencies totaled around $192b.   Since then the US data shows Chinese holdings of Treasuries have risen by $50b, to around $350b.   Purchases of long-term debt have actually been a bit higher, but China has reduced its short-term holdings a bit. The flow data indicates another $57b (roughly) in agency purchases – enough to bring the total up to $250b.

$350b of Treasuries and $250b of agencies is, well, $600b.  Exactly the number Bradsher reported.   

That could be a coincidence.   But it might not be.  In the past, the PBoC sometimes seems to have drawn on the US data to describe the composition of its portfolio.   That way, it avoids giving out any state secrets.

$600b in Treasuries and Agencies plus $100b in private mortgage backed securities  puts SAFE's dollar portfolio in the $700 range – which would be a bit lower than I would estimate.  Remember, China’s central bank holds $1070b or so.  $700b works out to a bit above 65% of China's portfolio.     

China's actual dollar holders would be a bit higher -- as the $700b total doesn’t include China’s onshore or offshore dollar bank deposits, its holdings of bonds issued by the World Bank and its holdings of dollar-denominated emerging market debt.   Even so, I suspect $700b is on the low side for China's actual claims on the US.

Richard McGregor of the FT -- who usually is well informed -- reports that around 75% of China's reserves are in dollars.  Think $800b.  That seems about right to me.

Simon Derrick expects the Europeans will tell the Chinese not to diversify, since they don't want an even higher euro.  I rather suspect the Europeans quietly have been delivering that message to China for some time now.

What explains the gap between the $700b in Chinese holdings that emerge from the TIC data and the $800b estimate that emerges from a more top down estimate? 

Simple: The TIC data probably understates China's purchases of US debt since June 2005.

Since the last survey, the TIC data indicates China has bought around $165b in treasuries, agencies and mortgage backed securities (labeled corporate debt in the US data).  Its short-term claims also fell by $15b over that period – for an overall increase in recorded US holdings of US debt of $150b.  China’s reserves increased from $710b to $1070b over that period – and increase of $360b ($330b after adjusting for valuation changes).   My personal view is that over $150b of that $330b increase went into US debt.

There is another wrinkle: The entral bank isn’t the only source of Chinese dollar holdings.   Central huijin (the holding pen for the PBoC’s stake in Chinese banks) holds another $60b in total assets, presumably mostly in dollars.  The state banks have been forced to hold the funds they have raised offshore offshore – and they presumably are primarily in US or Hong Kong dollars.  And through various swaps the PBoC placed $14b with private banks in 2005 and probably another $30-$40b in 2006 … 

Central Huijin got its dollars before June 2005, so its assets should have been counted in the survey -- my calculations compare China's roughly $530b in reported assets in the survey to $710b in reserves and $60b with Central Huijin, for a total of $770b.  But the dollars from the bank IPOs and various swaps generally came after June 2005, so they in some sense shoudl be added to the increase in reserves.

If all of China's additional “reserve like” foreign assets are added to the SAFE's holdings, official China has north of $1200b in foreign assets -- or an increase of around $400b since June 2005.   

If 75% of those are in dollars, that works out to around $900b. 

Ergo -- I would say that $700b is the lower bound of China's "official" dollar holdings, and $900b is probably close to the upper bound.

All this is just an attempt to square Bradsher’s reporting with my own numbers – both to test Bradsher and to test my own understanding.    Bradsher clearly got a bit more access to the SAFE than most.  

But I think there is a broader point here too – one that Richard Duncan has made in the past.   

Fannie and Freddie do a lot of things.  But one of the things that they do particularly well is transform US mortgage lending into assets that central banks can comfortably call reserves.     Their credit guarantees make long-term US mortgages more attractive.   An agency guarantee gets rid of default risk – and reduces the central bank’s need to worry about all sorts of pesky details about the US mortgage market.   Interest rate risk remains … but that is something central banks think they understand.

And for those central banks that don't want interest rate risk (and pre-payment risk) , the Agencies also finance a portion of the portfolio with short-term debt.  Here the agencies also intermediate between foreign central banks demand for short-term reserve assets and the US household sector’s desire for long-term financing …

I am not sure the US really has a comparable advantage in financial intermediation.  London – and for that matter several other European financial centers – are doing rather well at borrowing funds from the world at low rates to invest at higher rates.   The US by contrast is struggling to attract as much as it needs to cover its current account deficit.   But I am pretty confident the US has a comparative advantage at turning home loans into securities that fit nicely into a traditional central bank portfolio.     

The latest flow of funds data shows that central bank purchases of Agencies have matched their purchases of Treasuries in both 2005 and 2006. 

Then again, lots of central banks now seem interested in holding a rather less traditional portfolio.  In 2006, that meant more agencies and for the adventurous, more “private” mortgage backed securities.   In 2007, it likely means dipping their toes in the equity markets …

A last administrative point: as I noted at the end of last week, RGE now requires that all those who want to comment register.   I do not want this to hinder the discussion at this blog, which I value very highly.  

Those registering have two options -- one is to just register to participate in the comments section of the blog  (there is a box in the registration process that says "blog comments only"), the other is to register for a trial subscription to RGE and to sign up for RGE's biweekly email as well as to register for the blog.   The blog registration will remain in effect after the trial subscription expires.   Registered users can still post comments anonymously on the blog.    RGE also generally doesn't accept yahoo or gmail emails for registration purposes.  If you have questions/ difficulties, please email me at brad dot setser at rgemonitor dot com.

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