Is China's European Rescue Just A Big "Bait And Switch"?
Something interesting happened on the way to China's bailout of Europe. After recently China stepped up its Eurosupport rhetoric, and even put a token amount of money where it mouth is, €1.1 billion in directly placed Portuguese bonds specifically, and who knows how much in secondary market purchases, many of the clouds over Europe, and specifically the Euro, have been lifted temporarily, resulting in a modest jump in the EURUSD from just under 1.29 last week to nearly 1.32 today. Which makes sense: after all the EU is China's second biggest trade partner, and as a habitual importer, China needs the EU's currency as strong as possible to preserve its imports. Yet what is odd, is that over the past 24 hours we have received numerous notifications that it is none other than Chinese banks that have been selling the EURUSD! Which makes one wonder: is China's European "rescue" just one big bait and switch distraction?
Keep in mind that it was just announced that Chinese FX reserves swelled to an unprecedented $2.85 trillion, jumping by a massive $199 billion in Q4, the biggest amount on record. And of course, this is not all USD denominated. In fact, according to estimates, the euro accounts for 25% of the total amount, or about $710 billion. Seen this way, it suddenly becomes far more clear why China is much more focused on the EURUSD, and why every marginal change in the pair actually has a far greater impact on the country's asset allocation decisions.And China is the best when it comes to strategically allocating FX reserves.
Here's the math: assuming roughly €510 billion in EUR-denominated holdings, just the last 5 day jump in the EURUSD from 1.29 to 1.31 means that the USD value in a static pool of €-holdings has increased by about $11 billion (on paper). But here's the kicker: it is not on paper, and if the rumors are true, China is actively converting EUR holdings to USD. It appears that the mid-1.31 range is one appropriate exit point. So from an IRR standpoint, China invests €1.1 billion in Euro peripheral bonds knowing full well that the biggest backstopper is the ECB, in essence letting the country frontrun Europe's taxpayers. And in return it gets a marginal improvement in its FX holdings to the tune of $10 billion. In other words, every 100 pips improvement in the EURUSD results in a ~$5 billion boost to the USD valuation of EUR-denominated holdings. And if the latest €1 billion investment allowing the country to "buy" $10 billion in FX gains is any indication, China sure knows what it is doing.
Furthermore, with it allegedly actively selling EURs as a result, it appears that the country is in effect betting against Europe, and is continuing to reduce its 25% EUR allocation, with the USD as a beneficiary.
This is certainly not Euro-positive, but it means that every time the EURUSD drops below 1.30 China will ramp up the rhetoric of its European support, and do an occasional €1-2 billion direct investment, which allows the country to offload another several billion in EUR at a higher fixing.
To those who see this as a great bait and switch, you are not alone. Yet this is nothing more or less than perfectly permitted FX-warfare, in a world in which countries like China with a pegged currency will do all everything in its favor to preserve exposure in whatever currency it finds strongest.
The only question then remaining is at what new low threshold level in EUR-denominated FX reserves will China say enough and pull back the rhetoric... and its wallet?