PBOC and Reserves

This post draws significantly from M. Pettis

First - TIC data only shows direct foreign ownership, so the data does not account for UST held by PBoC indirectly or in other street names (see D. Scissors). Tic data does not show if matured/sold UST is replaced by other dollar assets.

Second, China has a huge trade surplus and the U.S a huge deficit. It is very difficult for China to reduce holdings of US assets and impossible without foreign supply to replace them.

China is not Washington's Banker

China runs a current account surplus - which means it necessarily accumulates net foreign claims by the same amount. And the entities of which it accumulates those claims must run a corresponding deficit. Given China had the largest current account surplus ever as a % of GDP (global GDP) and the US current account deficit the largest ever as a % of GDP - China had to buy dollar assets, and given the sheer size of the amounts, they had to buy UST.

This is not a discretionary lending decision, it is the result of China's currency regime. In order to fix its currency, China must take the opposite side of the market. Everyone else is a net seller of RMB (buyer of $), so the PBoC must do the opposite. As soon as the PBoC stops buying dollars, the market will clear the price for RMB (so, the PBoC cannot stop buying $ in anticipation of rising RMB).

The PBoC funds, $ purchases by borrowing in domestic money markets, selling PBoC bills, repos, or by creating money by crediting accounts of commercial banks that sell it $. Thus, the PBoC runs a mismatched balance sheet, assets $, Liabil in RMB. Reserves are borrowed money.

Reserves are not usable within China - it can only be used to import goods (so long as the country can afford them) and to repay foreign debt and investment. So, if USD assets drop by 10% relative to RMB, so does the value of foreign goods relative to RMB, with less PBoC borrowing to pay for it. So the real value of the assets hasn't changed, just the accounting value in RMB.

So, the PBoC has a mismatched and levered balance sheet long dollars and short RMB, but the rest of China has the opposite, long RMB and short dollars. In RMB appreciation, PBoC loses in the form of increase in net debt. Exporters (rev in $, cost in RMB) lose, because they are long dollars. Companies with foreign assets in excess of debt lose too.

Everyone else wins because they are short dollars (import from abroad) and long RMB.

So a revaluation represents a shift in wealth from the PBOC, exporters, commodity hoarders and foreign asset holders to the rest of the people.

Unfortunately, because the PBoC holds 3tril $, a 10% revaluation is a 300bn loss, which ultimately increases government debt. That increase in government debt will be paid for by explicit or implicit tax on households, which makes rebalancing even more difficult. This also has implications for other balance sheet assets like large banks who have lent to SOE, exporters, and investment companies. The distribution of losses could very well be extremely focused.