Hedge fund quiz question #1: Is the yield curve flat because traders think the fed is likely to overtighten (leading to a recession in a year or two), or because of all those foreign central bank dollars looking for a parking spot?
By my count China already has over a trillion dollars in reserves and reserve-like assets. But I am counting the funds the PBoC shifted to the state banks. In a couple of months, though, China will formally announce that its reserves now top a trillion dollars. So it isn’t exactly a surprise that Chinese policy makers would be spending a bit of time thinking about how to use those funds.
The key fact for the global economy is not that China holds a trillion dollars in reserves. It is that those reserves are growing at a pace of around $20b a month/ $250b a year. This reserve increase has continued even as interest rate differentials have moved steadily in the dollar’s favor. China constantly struggles not just to invest its existing reserves productively, but to find new places to park its ever growing reserves.
Right now, there is no reason to think that China won’t have $1,500b in reserves in about two years time. Not unless Chinese policy makers show an ability to act far more decisively than they have so far.
$250b is a lot of money to invest every year. I suspect there are some constraints on how China can invest it. There aren’t many – strike that, there aren’t any – emerging markets that could absorb inflows on that scale. Modest sized industrial economies like Australia and the UK are also too small to absorb more than a small fraction of the total. Look at their respective current account deficits in dollar billions.
Japan’s government debt market is very, very big. But JGBs don’t pay much interest, and the PBoC likes a bit of carry. So China really is left looking at the US and the European market. I don’t really buy the notion that European debt markets are too small and illiquid for China. China likely has been placing funds in some smaller and less liquid debt markets in the US, not just the most liquid of instruments. But I do think that it would be hard for China to continue to peg to the dollar and dramatically increase its euro allocation.
Suppose China now invests 25% of its reserve growth in euros. That is $60b a year or so. Real money. Suppose it decided it wanted to invest 50% in euros. That is $125b a year. I suspect that a $60b increase in net flows to Europe would have an impact on the euro/ dollar exchange rate. And if it did, China’s peg implies that the RMB would depreciate along with the dollar. That would force China to buy more reserves.