China is turning US dollar liquidity into Renminbi liquidity?

I’ve been puzzled by one thing recently: almost everywhere in the world is pumping liquidity into the market, from the US to China. But where does the money go other than refilling depleted capital base at major financial institutions?

I think I found the answer, or at least one of the possible answers, after I read the most recent 13D report.

 

China owns between $1.27 trillion and $1.43 trillion of US dollar-denominated assets, including treasury securities and debt issued by other government agencies, such as FNM and FRE. The conventional wisdom is foreign holdings of US treasuries are just too big to sell. However, China and other large holders do not have to sell, merely refuse to roll over existing positions, i.e. not to refinance US debt upon maturity. The average maturity of US government debt, as of June 2008, was 4.5 years. Some 37.6% of US government debt is due in less than a year. While the exact maturity of China’s holdings is unknown, most of it is believed to be short-term, according to 13D.  

What does China do with the recouped principal from matured US treasuries, assuming they’re actually not rolling over?

 

1)      Encouraging the hot money in China to leave – not as RMB, but as dollars. This is happening when most foreign banks face liquidity crisis back home. Chinese banks have limited interbank lending to foreign banks;

2)      Using dollars to purchase crude oil (just read somewhere China is accelerating the build-up of its strategic reserves, which is why Dalian Ports (2880hk) moves up again);

3)      Issuing domestic CNY bonds/notes to absorb the Renminbi converted from dollar cash proceeds collected from matured US securities and invest such massive amount of money into infrastructure projects

 

Essentially, what China does is cashing out of US treasuries and US agency debt upon their maturity and reinvesting into either commodity stock (particularly cheap ones, like crude oil which is down to US$55 from over $100) or domestic debt, which is further invested into the domestic fiscal expansion projects. As a result, the total liquidity pool in the world might not have changed much, but simply switching from US debt to Chinese debt as China is currently determined to change its fiscal policy from surplus to deficit.

 

Implications:

1)      Not rolling over existing US treasuries and agency debt enables China to gradually exit US securities without disrupting the market. At some point of time, China’s US treasuries and agency debt portfolio could become small enough for China to dump US securities more quickly if necessary

2)      China has enough capital at its disposal to stimulate the economy (the two-year stimulus package is worth $586bn or Rmb 4tn), thanks to its massive FOREX reserves, a lot of which is likely being withdrawn from short-duration US securities upon their maturities and converted to Renminbi currency spent on domestic inventory and fixed asset investment;

3)      The current dollar strength could be just another sign of capital dislocation and will not be sustainable given China’s seemingly gradual exit from its gigantic US treasury and agency debt holdings

4)      The near term dollar strength has caused the short term oil price significantly lower than long term contract prices, which help China to build up its strategic oil reserve at today’s much cheap prices

5)      While it will not completely resolve China’s many near term problems, such as manufacturing overcapacity in a slower global demand environment, relatively small consumer contribution to overall economy, etc., the increased supply of Renminbi is reflationary. In the near term, it might be outweighed by the deflation elsewhere because of liquidity tightening outside China, particularly for commodities related to global economy, such as copper, steel, etc. Eventually, however, as the US/Europe economy stablizes, China could be well likely be a leading inflation source.

 

Based on such hypothesis, I’d be bullish on Chinese equities in 2H09 and 2010, in anticipation of a potential swing from deflation to inflation, led by China first and followed by the rest of the world later. On the other hand, I’m not quite sure US equities can recover significantly if China continues to cash out of US treasuries. Dollar could get weakened again some time in the future and yield curve could be flattened with lack of buyers for short term/medium term treasuries.

 

P.S. there is a similar article on Montley Fool website. Here is the link http://www.fool.com/investing/international/2008/11/12/why-chinas-stimulus-plan-will-change-the-world.aspx

 

 

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