There is mounting evidence that China's central bank is undertaking the process
of divesting itself of longer-dated US Treasuries in favor of shorter-dated
There is also mounting evidence that China's increasingly energetic new
campaign of capitalizing on the global crisis by making resource buys across
the globe may be (1) helping its
central bank to decrease exposure to the dollar, while (2) simultaneously
positioning China to make much greater profit on its investment of its reserves
into hard assets whose prices are now greatly beaten down, while (3) also
affording it greatly increased control of strategic resources and the
geopolitical clout that goes with it. This is turning out to be a win-win-win
situation for China as it capitalizes upon the important opportunities afforded
it by the present global crisis.
The exact size and the precise composition of China's huge forex reserves, the
exact degree of China's exposure to the dollar and its viable options, if any,
in decreasing that exposure are matters of intense interest, because China's
policies in this regard could have gargantuan implications for the US and the
global financial systems and for the dollar.
One of the foremost experts who continues to research and track these matters
is the highly respected Brad W Setser, a Fellow for Geoeconomics at the
prestigious Council on Foreign Relations in New York. His work is providing
significantly deeper insight into the size and composition of China's reserves
and is affording the world a better view of that country's options in managing
its reserves going forward and what the implications of those options might be.
Another expert whose ongoing work is also adding very important, deeper insight
into such matters is the highly respected Rachel Ziemba, lead analyst on China
and the oil exporting economies at the prestigious RGE Monitor, founded by
Drawing on the work of these two experts, let's examine the matter of the
likely size and composition of China's forex reserves and its investment
options going forward, and the probable implications of those options for the
The first issue is to determine the actual size of China's foreign exchange
reserves. Its central bank officially confirms the current figure of about
US$1.95 trillion. However, Setser's work reveals that China's actual reserves
are significantly higher and may actually be as high as $2.4 trillion,
according to his latest figures . About $2.2 trillion of this total figure
is easily identifiable, according to Setser, with the remaining $200 billion
being his estimate of the amount currently held in China's state banks.
As for the issue of the composition of these reserves and its total exposure to
the dollar, the most recent Treasury International Capital (TIC) report by the
US Treasury has China's holdings of Treasuries at $696 billion as of the end of
2008. However, Setser's research indicates China's total holdings of US
Treasuries is likely to be more than that figure, since some of the purchases
of Treasuries by the UK and Hong Kong should actually be attributed to China's
central bank. China also holds US government-sponsored agency debt (Fannie Mae
and Freddie Mac paper) and corporate bonds, but the recent TIC reports indicate
its central bank has been steadily divesting itself of these assets in favor of
As for China's purchases of Treasuries over the most recent three months
(October - December of 2008), note this statement from Setser:
the past three months, almost all the growth in China's Treasury portfolio has
come from its rapidly growing holdings of short-term bills not from purchases
of longer-term notes.
Setser goes on to make the point that
China's central bank is unquestionably divesting itself of the comparatively
less-safe assets such as agency debt in favor of very short-dated Treasuries.
The best estimates of the total exposure of China's central bank to
dollar-denominated assets of all kinds is about 70%, or somewhere between $1.5
trillion and $1.7 trillion depending upon whether you use the $2.2 trillion
figure or the $2.4 trillion figure for the total sum of China's reserves.
That uncomfortably high level of exposure to the dollar is what has been
causing concern to flare in China most recently. A much more desirable figure,
from China's standpoint, of its total exposure to the dollar would be 50% or
less of its total reserves. A reserve composition of 50% dollars to 50%
everything else is much safer because an excessive decline in the value of the
dollar would tend to be offset by corresponding increases against the dollar in
the value of the non-dollar assets comprising the rest of the reserves.
In order to get to that more desirable composition fairly quickly over the next
several months, China would have to somehow divest itself of as much as $450
billion of its existing dollar-denominated assets, not purchase a significant
amount of new dollar-denominated assets, and accomplish all this without
triggering a global dollar panic. That's a very tall order indeed - but it is
not by any means impossible. How so?
If we stand back to look at Setser's work from a distance, we see what appears
to be a clear strategy on China's part that is potentially very compelling. The
country has its official reserves, which it acknowledges now total about $1.95
trillion, and it also has its unofficial or secret reserves, which Setser
estimates at about $450 billion at present.
Coincidentally (or perhaps not merely coincidentally) the secret reserves total
about the same sum that China needs to divest itself of in order to reach the
desired composition of its reserves noted in the previous paragraph - about
$450 billion. At this point, recall the intriguing and potentially very
important statement quoted earlier (see
DOLLAR CRISIS IN THE MAKING, Part 2), a statement made by Fang Shangpu,
deputy director of the State Administration of Foreign Exchange and reported by
the Xinhua News Agency on February 18, 2009:
Fang Shangpu, deputy
director of the State Administration of Foreign Exchange, noted Wednesday that
the report released by the US Treasury of the amount of government bonds held
by China included not only the investment from the reserves, but also from other
financial institutions. It might be a hint that Chinese government is not
holding as much US government bonds. [Italics added]
China is managing its foreign exchange reserves with a long-term and strategic
view, Fang told a press briefing. "Whether China is to purchase, and to buy how
much of the US government bonds will be decided according to China's need,"
Fang said. "We will make judgment based on the principle of ensuring safety and
the value of the reserves," Fang said.
Is Fang Shangpu hinting
that China has intentionally, as a deliberate strategy, divided its reserves
into two general holdings, official and secret, and that SAFE (the State
Administration of Foreign Exchange) has ensured that the composition of the
official (government) holdings of the $1.95 trillion is such that its exposure
to the dollar is not the roughly 70% assumed in the West, but rather something
much closer to the desired target of 50%, while the secret reserves hold
predominantly dollar-denominated assets?
If this is the case, then China could employ a number of schemes to
clandestinely further reduce its total exposure to the dollar, using its secret
reserves, all the while maintaining safety for the official reserves. Note Fang
Shangpu's recent statement to the Wall Street Journal regarding how carefully,
and with what foresight, China manages its reserve holdings:
subprime crisis evolved into the international financial crisis in September
last year, we have executed the central authorities' plans to cope with the
international financial crisis and launched the emergency response mechanism.
We have closely followed developments, made timely adjustments to risk
management, taken decisive and forward-looking measures to evaluate and remove
risks ... "
Chinese officials have been painfully aware, for
several years now, of the increasing risks of too great an exposure to the
dollar. It simply isn't believable that their level of prudence and foresight
in this regard was so low as to allow them to fail to formulate and execute
strategies designed to limit that exposure to safer levels