China foreign reserves took record hit last month
China’s decision to lets its currency float, and fall, last month proved to be a very expensive choice.
The People’s Bank of China on Monday said that the country’s foreign-exchange reserves plummeted a record amount in August as it tried to stabilize the yuan.
After the central bank devalued the currency on Aug. 11, stock markets around the world tumbled on fears the world’s second-largest economy was slowing at a much faster rate than expected. The move sent the yuan lower than expected and the PBOC spent $93.9 billion, the largest-ever monthly drop in dollar terms, to prop up the yuan and prevent it from falling further.
At the end of August, the PBOC still held foreign reserves of $3.56 trillion. Although down from a peak of nearly $4 trillion in June 2014, it still holds nearly one-third of all holdings by central banks world-wide.
The implications for the US government-bond market remains uncertain. As of June, China was the world’s largest holder of Treasury bonds, holding $1.27 trillion, according to US Treasury Department. About 40% of China’s foreign-exchange reserves are held as Treasurys, according to Bank of America Merrill Lynch.
Despite the selling pressure from China, which should send prices lower and yields higher, Treasury yields still remain low.
A fall in China’s reserves shouldn’t necessarily affect US interest rates as money leaving China “doesn’t disappear,” Nikolaos Panigirtzoglou, global market strategist at J.P. Morgan in London told the Wall Street Journal. Panigirtzoglou said as companies sell their yuan, they typically put their dollars in a bank, and the banks often buy US government bonds with the money.
In fact, even as China has been selling, other factors have sent other investors scurrying to buy the safe haven of US bonds. As the dollar strengthens, it has made bonds more attractive. Also, when the US stock markets tumbled in August, investors rushed into bonds. This surge in demand would have sent the yield plunging, but the yield on the benchmark 10-year Treasury fell just 0.13 percentage point, reported the WSJ.
The big problem here is that if the yuan continues to fall, the central bank cannot indefinitely keep using foreign reserves to stabilize the exchange rate.
The big worry is large capital outflows. Peter Thal Larsen of Reuters said, “Each time the People’s Bank of China sells dollars in return for yuan, China’s money supply shrinks. The central bank can offset this by allowing Chinese banks to reduce their large reserves of domestic currency. But the risk is that the PBOC struggles to keep up with capital outflows. A liquidity drought is the last thing China’s slowing economy needs.”