Earlier today, Bloomberg - citing the ubiquitous "people familiar with the matter" - confirmed what we’ve been pounding the table on for months; namely that China is liquidating [9] its UST holdings.
As we outlined in July, from the first of the year through June, China looked to have sold [10] somewhere around $107 billion worth of US paper. While that might have seemed like a breakneck pace back then, it was nothing compared to what would transpire in the last two weeks of August. Following the devaluation of the yuan, the PBoC found itself in the awkward position of having to intervene openly in the FX market, despite the fact that the new currency regime was supposed to represent a shift towards a more market-determined exchange rate. That intervention has come at a steep cost - around $106 billion according to Soc Gen. In other words, stabilizing the yuan in the wake of the devaluation has resulted in the sale of more than $100 billion in USTs from China’s FX reserves.
That dramatic drawdown has an equal and opposite effect on liquidity. That is, it serves to tighten money markets, thus working at cross purposes with policy rate cuts. The result: each FX intervention (i.e. each round of UST liquidation) must be offset with either an RRR cut, or with emergency liquidity injections via hundreds of billions in reverse repos and short- and medium-term lending ops.
It appears that all of the above is now better understood than it was a month ago, but what’s still not well understand is the impact this will have on the US economy and, by extension, on US monetary policy, and furthermore, there seems to be some confusion as to just how dramatic the Treasury liquidation might end up being.
Recall that China’s move to devalue the yuan and this week’s subsequent benchmark lending rate cut have served to blow up one of the world’s most popular carry trades. As one currency trader told Bloomberg [11] on Tuesday, "it’s a terrible time to be long carry, increased volatility -- which I think we’ll stay with -- will continue to be terrible for carry. The period is over for carry trades."
Here's a look at how a rules-based carry strategy designed to capture yield differences would have fared in the universe of G10 CCYs (note the blow ups around the SNB's franc shocker and the yuan deval):
[12]
In short, the music stopped on August 11 and to the extent that anyone was still dancing going into this week, the PBoC’s decision to cut the lending rate along with RRR buried the trade once and for all.
Estimating the size of that trade should be a good indicator for just how expensive it will be - i.e. how much in Treasurys China will have to liquidate - to keep the yuan stable. The question, as BofAML puts it, is this: "can China afford the unwinding of carry trades?"
The first step is estimating the total size of the trade. Although estimates vary, BofAML puts the figure at between $1 trillion and $1.1 trillion. Here’s more:
As analyzed above, the size of RMB carry could be quite high and thus exert downward pressure on RMB. But the PBoC should have scope to defend its currency if necessary. The PBoC’s toolbox includes its $3.65tn FX reserves (at end-July), as well as measurements to tighten FX controls on individuals, corporate and banks, if necessary, including imposing stricter requirements on NOP, among others.
That said, we doubt if the PBoC will persistently intervene as rapid decline of FX reserves undermines market confidence anyway and imposes challenges to the PBoC. Alternatively, the PBoC could impose stricter FX controls but that would be considered as a backward move of capital account opening up. Nevertheless, we believe the PBoC intervention will still have spillover effects on the market.
In other words, if this entire $1 trillion trade gets unwound, China will need to offset the pressure by either i) draining its reserves, or ii) taking a big step backwards on capital account liberalization. The latter option would be bad news for Beijing’s efforts to liberalize markets and land the yuan in the SDR basket.
Of course, as noted yesterday and as tipped by SocGen earlier this week, the liquidation of $1 trillion in FX reserves would put enormous pressure on domestic liquidity, tightening money markets meaningfully, and forcing the PBoC to cut RRR 10 times (assuming 50 bps intervals). As BofA notes, China can’t "afford another liquidity squeeze like June 2013 given very poor sentiment nowadays and China’s economic downturn."
Putting the pieces together here - and here is the critically important takeaway - we know that the size of the RMB carry trade could be as high as $1.1 trillion. If that entire trade is unwound, it would require China to liquidate a commensurate amount of its reserves in order to keep control of the yuan - or else resort to FX controls. Here's the point: if China were to liquidate $1 trillion in reserves (i.e. USTs), it would effectively offset 60% of QE3.
Furthermore, based on Citi's review of the academic literature which shows that for every $500 billion in EM reserves liquidated, the yield on the US 10Y rises 108bps, if the PBoC were to use its reserves to offset a hypothetical unwind of the entire RMB carry trade, it would put around 200 bps of upward pressure on 10Y yields.
So in effect, China's UST dumping is QE in reverse - and on a massive scale. Facing this kind of pressure the FOMC will at the very least need to exercise an exorbitant amount of caution before tightening policy and at the most, embark on another round of asset purchases lest China's devaluation and attendant FX interventions should be allowed to decimate whatever part of the US "recovery" is actually real.
