China’s management of its $1,000bn foreign exchange reserves is coming under pressure from a combination of rising domestic interest rates and the fall of the US dollar on currency markets.
The US dollar fell on Friday to a 19-month low against the euro, in part because of comments by Wu Xiaoling, a deputy governor of the People’s Bank of China, about the dangers of holding excessive US-dollar reserves.
China announced earlier this year that it would try to diversify the composition of its reserves and to invest some of the money in higher-yielding instruments, such as US corporate bonds, ahead of US Treasuries.
Ms Wu’s comments did not amount to any change of policy, according to economists, but their impact did underline the sensitivity of the markets to the issue of China’s reserve management.
“I don’t see a shift in the underlying policy – the market tends to overreact,” said Qing Wang, an economist with the Bank of America in Hong Kong.
Andy Rothman, China strategist for CLSA, the brokerage, said Beijing had changed the composition of its reserves in recent years, not by selling US dollars but by buying less when making fresh investments.
“While a few years ago, maybe $75-$80 of every new $100 in reserves would go into dollar assets, now possibly only $65-$70 do,” he said.
China’s huge holdings of US dollars make it sensitive to any weakening of the greenback, because the PBoC would be forced to record the losses on its balance sheet holding the reserves.
But Beijing’s policy of keeping the renminbi more or less stable against the dollar means it will inevitably accumulate even higher reserves.
To keep its currency stable, the PBoC uses renminbi to buy the dollars coming into the country generated by a growing trade surplus, which then accumulate as foreign reserves.
The PBoC attempts to keep the money supply from growing too quickly by taking most of the renminbi used to buy dollars out of the system by issuing central bank bills to local financial institutions – a process known as “sterilisation”.
Sterilisation has been profitable in recent years for the PBoC because of the spread between low Chinese rates and the returns offered by US Treasuries.
The one-year central bank bill has an interest rate of about 2.8 per cent, more than two percentage points lower than US Treasuries with a similar maturity.
But the PBoC has been caught over the last month by a rise in short-term rates in the inter-bank market, which reached 3.9 per cent last Friday, up from 2.4 per cent in November.
The seven-day rate in the inter-bank market is the closest thing China has to a genuine market rate.
Hong Liang, an economist with Goldman Sachs in Hong Kong, said the rise had been caused by large banks asking for higher rates from borrowers they believed were using the funds to invest in newly buoyant local stocks.
With the PBoC committed to large-scale sterilisation operations, Ms Liang said “the central bank bills will have to compete on yields with other demand for funds in the economy”.
The PBoC was forced to delay an auction of “sterilisation” bills last week.