Weekly Geopolitical Report – China’s Foreign Reserves: Part III (June 18, 2018)

by Bill O’Grady

This week, we will conclude our study on China’s foreign reserves.  In Part I, we discussed the evolution of foreign reserves from gold to the dollar, with a historical focus.  In Part II, we used the macroeconomic saving identity to analyze the economic relationship between China and the U.S.  This week, using this analysis, we will discuss the likelihood that China will “dump” its Treasuries and the potential repercussions if it were to do so.  From there, we will examine the impact of such a decision by China to reallocate its reserves.  Finally, we will conclude with market ramifications.

What if China decides to dump its reserves?
So, finally, we come to the issue at hand.  Are China’s foreign reserves a real threat to the U.S. economy?  Are the reserves a viable financial weapon?  China occasionally suggests they are.[1]  However, a weapon is only credible if the blowback isn’t significant.  It appears that the costs to China of dumping its U.S. Treasury bond positions would be considerable.

What would happen to the value of China’s reserves?  A common problem with holding concentrated positions is retaining value while exiting the position.  If China began aggressively selling its position, the value of its reserves would decline as well.  If yields rose by 100 bps, to 4%, we estimate the yearly return would drop by approximately 7.9%.[2]  China’s total foreign reserves are around $3.2 trillion; as mentioned in Part II, it’s a state secret as to the allocation but if we assume Treasuries represent 70% then a 7.9% decline would cause a capital loss of $152 bn.  Obviously, a 10-year T-note rate of 4% would likely trigger a U.S. recession but the costs to China would be significant as well.  It is also important to note that this calculation doesn’t take into account the impact on the dollar’s exchange rate.  But, mostly certainly, the dollar would depreciate, causing even greater losses to China’s dollar foreign reserve holdings.

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[1] https://www.telegraph.co.uk/finance/markets/2813630/China-threatens-nuclear-option-of-dollar-sales.html

[2] This is calculated with a regression of total return on the 10-year T-note against the (a) yearly change in 10-year yields, and (b) the level of interest rates on the 10-year T-note.