from Follow the Money

Rising private Chinese purchases of US debt …

November 15, 2006

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Yes, that is a new topic.

But private Chinese demand for US debt seem to be rising.   The World Bank Quarterly Update reported – drawing on Chinese data -- that “Chinese individuals and institutions bought $45 billion in foreign notes and bonds in the first half of 2006.”  

Chinese foreign direct investment – particularly in oil and gas – has gotten a lot of attention.   But the total outward flow of foreign direct investment in the first half of 2006 ($6 billion) pales relative to private Chinese purchases ($45b) of the world’s debt, let alone official purchases of debt ($122b, assuming all reserves were invested in debt).

And, judging from the q3 balance of payments data – which shows a huge surge in private capital outflows from China, enough to hold China’s reserve growth below its current account surplus for the first time in a long-time – those private outflows have continued.   See Richard McGregor in the Financial Times.

So what is going on?  

Stephen Green of Standard Chartered (quoted here) has done great work on the topic, but it is behind their firewall.  Sorry. 

He thinks most of the outflow comes from the banking system.    

Some of it clearly reflects the investment of the funds Chinese banks raised through their IPOs in international markets.   The Bank of China raised $11b in the first half of this year (ICBC raised more, but not until the third quarter).   But even if all of the IPO proceeds were invested in bonds, that wouldn’t explain a $45b outflow. 

Green thinks that the Chinese data in the first half of 2006 may have captured the investment of past bank recapitalization out of the PBoC’s reserves (recapitalizations that were done in 2003 and 2005) in international markets.     That’s possible.

It is also possible that Chinese bank’s purchase of foreign assets was financed in other ways.   The PBoC has been known to swap its dollars with the banking system for the banks’ RMB.   That gives the banks dollars to play with – in a way that limits their exposure to the risk of RMB appreciation (the central bank promises to buy the dollars back at the rate in the contract no matter what happens to the $/ RMB) 

It is even possible that the banks simply took some of their excess RMB – they have way more RMB on deposit than they are able to lend out domestically – and bought dollars.   That though would be risky.   It is the kind of bet that is very exposed to a sharp move in the $/ RMB.

Or perhaps Chinese firms – perhaps encouraged by the state – kept some of their export profits offshore and invested their funds in US and European debt. 

Both Green and the World Bank think that most of the outflows came from the banks … not from individuals.    Individuals in China continue to find RMB deposits more attractive than dollar bonds.   The World Bank:

“[Overseas fixed income products] at the moment are not very attractive because the yield differential with domestic instruments may not compensate for expected appreciation of the RMB.   By the end of September, the approved QDII quota for individuals’ investment totaled $11b, but only a few billion was used.” 

The puzzle:  Why are Chinese banks and perhaps state firms so much more interested in holding dollars – given the exchange rate risk – than Chinese individuals?

No one really knows the answer to that question – though some very smart folks are looking into it.    

It does seem that these outflows have gotten bigger in q3 not smaller.   That is the only way China’s q3 reserve growth makes sense – given the surge in China’s trade surplus, rising interest income on China’s reserves and ongoing FDI inflows, China’s q3 reserve growth should be more like $75-80b than $50b.

From the United States point of view, it doesn’t really matter if the PBoC or Chinese banks buy US debt.  Total Chinese purchases of US debt matter more than who in China is doing the buying. 

And this data suggests that total Chinese purchases of US and European – debt were quite large in h1.   Maybe $167b ($45b private; $122b official) in the first half, or over $300b for the year.   

The PBoC, in some sense, took China’s current account surplus and used it to buy US and European debt.   And private banks and firms took the equity inflows into China – both from FDI and portfolio equity inflows associated with the IPOs – and used them to buy … drumroll … US and European debt.    The net result was lots of Chinese demand for US and European debt. 

While it doesn’t matter to the US who in China is doing the buying, the PBoC, though, would rather obviously prefer to have others in China hold more dollars.  It has more dollars than it really wants.   And so long as Chinese banks and firms hold dollars offshore, the PBoC’s reserves don’t rise – and the PBoC doesn’t need to sterilize.  It is comparable to state oil companies depositing their oil windfall offshore.   Export proceeds (or IPO proceeds) are never exchanged for local currency at the central bank, so the local currency doesn’t need to be withdrawn from circulation by the central bank (sterilization).

But this shift does make it a bit harder for me to use Chinese reserves data to help estimate the scale of Chinese flows into US markets.    A rising fraction of Chinese flows are coming from sources other than the PBoC.   For reasons that are rather mysterious.

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