In Troubling Sign For The US, Reserve Managers Plow Into Chinese Yuan, Dump Dollars

The IMF released the Currency Composition of Official Foreign Exchange Reserves (COFER) data for Q2 2018 on Friday. The total of reserves that are broken down by currency went up by $123BN, and unallocated reserves fell by $243BN. The most notably observation in the COFER report is that reserve managers actively decreased their allocation to USD – more than offsetting the effect of dollar appreciation – while at the same time adding significantly to non-USD allocations and especially to Chinese Yuan reserves.

Commenting on the report, Steven Englander from Standard Chartered notes that there are two possible big pieces of news in the Q2 COFER data, but only one that is likely to be meaningful.

The meaningful news is the continued run-up in CNY in reserves portfolios, even in a quarter when CNY depreciated sharply. This suggests increasing demand among reserves managers for CNY in their portfolios. Most likely this reflects the importance of CNY in trade and initiatives taken by the Chinese government to internationalize CNY. This buying is probably long-term in nature, as CNY is not yet sufficiently liquid in all time zone and EM selling of CNY when EM is under pressure could backfire.

At the same time, the drop in the USD share of allocated reserves is likely to be the less meaningful development. It could be interpreted as diversification away from USD but this conclusion is premature. The currency allocation of the China reserves portfolio is still being added piece by piece, and the USD share is uncertain. In addition, some EM countries were very likely intervening to stabilize their currencies to prevent a sharp drop. This intervention was likely USD selling and buying of local currencies as the USD is the most liquid part of their portfolios.

Putting the data together, Englander finds some unambiguous inferences. The major one is that Q2 non-China reserve manager holdings of CNY went up from USD 146bn to USD 193bn, despite a 5.2% depreciation that would normally have reduced the value of CNY reserves in USD terms.

This suggests that:

  1. global reserve managers have a strong appetite for CNY;
  2. market participants excluding non-China reserve managers were big sellers, offsetting reserve manager buying and forcing the CNY down by 5.2%;
  3. CNY in reserves is now roughly at the levels of AUD and CAD, and about 40% of GBP and JPY holdings, so there is room for a lot more buying.

Meanwhile, of the USD 123bn increase in allocated reserves, the USD went up by USD 53bn, well below its 62.5% share in allocated reserves in Q1. Most likely there was some intervention by EM reserve managers whose currencies were under pressure, with USD sold as the most liquid holding. On the other hand, reserve managers appear to have actively purchased EUR to lean against the effects of EUR depreciation.

However, as noted above, what was most notable was the rapid allocation to China by reserve managers.

The chunk of China’s reserve portfolio that was integrated may have had a small USD share, but it would have had to be unusually small to generate the small USD increment. The selling of USD in intervention was more important; the reverse of the USD buying that occurred when the USD was under pressure. It is also possible that reserve managers were diversifying out of the USD, either for portfolio reasons or because of political differences with the US. That said,  at just 1.8%, the CNY weight remains relatively limited, but we think this can slowly rise over the next few years.

While there are various nuances to the data, the accelerating rotation out of USD reserves and into Chinese reserves is a trend that is worth watching, especially if it indeed represents a "diversification away from USD" as a result of political disagreements with the US, a sign that de-dollarization is starting to affect capital allocation decisions at the institutional level among global central banks.