China and US Treasuries - BBH

"China introduced capital controls and the dollar depreciation last year saw the value of its reserves rise. They rose by $129 bln in 2017. The US TIC data suggests Chinese buyers may have bought a little more than $130 bln of US Treasuries through October (most recent data)," BBH analysts explain.

Key quotes

China is a large and powerful country, but there are limits on what it can achieve.  It cannot rebuild its reserves and not buy foreign assets.  Remember the sovereign bond purchases by the ECB and BOJ absorb the net new issuance of their governments.  The US is the only major net new supply of core sovereign bonds.     

There is scope for some mild adjustments in allocation of China's reserves.  However, to do so comes at a cost.  First, the US yield is 200+ basis points than Germany on 10-year borrowings.  Of to say the same thing, the US 10-year yield is roughly five-times higher than Germany.  Japan's 10-year yield is 7.5 bp and is presently in a 10 bp +/- on either side of zero, enforced by the BOJ.     

There may be another consideration: Politics.  The most pressing issue here is trade.  US President Trump talked aggressively about China during 2016 campaign, but in this here was very much part of what seems like what has become a tradition for the last couple decades or so.  However, also consistent with that tradition, upon assuming office, Trump did not back up the words with fresh action against China. China was not cited as a currency manipulator, for example, and the 25% tariff on Chinese goods that was suggested has not materialized.

Arguably Year 2 of the Trump Administration could be different.  Trump did not get the kind of cooperation he sought from China in dealing with North Korea.  China's trade surplus with the US is growing.  Over the next week or two, the US Commerce Department must recommend whether or not to impose a tariff on steel and aluminum imports to protect US national security.  The threat is aimed at China, but other countries and producers could get snarled in such action.

Later in the month, the Trump Administration is due to decide whether it wants to protect the US solar panel industry.  Also, possibly ahead of the Trump's State of the Union address (January 30), a decision may be made on retaliation for intellectual property rights violations, but the investigation that was launched last year may not be completed until later in the year. 

The Bloomberg account cited two considerations for the less supportive assessment of US Treasuries.  The first was that they may be less attractive than other assets.  Fair enough, but not just any asset will do.  It must be large, transparent and safe.  We recognize that on the margins, the PBOC could shift the allocation of its reserves.  This would likely be a gradual process, and if history is any guide, probably wouldn't have much market impact.

The second consideration is trade.  The news wire story did not elaborate on this point.  We suspect, if that account is truly representative of important opinion in China, that it is a proverbial shot across the bow to warn the American First administration.   It cannot simply ride roughshod over others.  Still, in the recent past, China has shown an ability to decouple political considerations from its reserve management.

Yesterday, China announced a change in the way its sets the daily reference rate.  We do not see a connection between that decision and the Bloomberg report today, suggesting that some officials are concerned about China's Treasury holdings.   The dropping of the "counter-cyclical factor" would seem to give market forces greater sway in setting in the yuan's reference rate, but China's embrace of market forces seems more opportunistic (when it agrees with the direction the market is moving) than an ideological commitment.