247wallst.com
By Rafi Farber December 8
November marked a record month for China in terms of the pace of its
liquidation of foreign exchange reserves. The People’s Bank of China
reported on Monday, December 7 that foreign exchange reserves, which
mostly consist of U.S. Treasury debt, dwindled by another
$87 billion in November. This constitutes a stunning 2.5% drop in one month.
Since peaking at $3.99 trillion in June 2014, China’s central bank
has sold off more than half a trillion dollars of (mostly) U.S.
treasuries, accounting for 14% of its entire stockpile. At this rate
China’s foreign exchange holdings will be liquidated within nine years.
While there is no reason to assume the current rate will continue for
that long, it does illustrate how fast the debt and currency markets are
moving, hinting at possible instability ahead.
Right behind the largest U.S. Treasury holder is the second largest, Japan. Japan’s Ministry of Finance
also reported
a sharp drop in its own foreign exchange reserves in November, likewise
also mostly U.S. Treasuries. Japan’s stockpile is now $1.233 trillion,
down from $1.244 trillion last month for a drop of 1%. Since peaking,
Japan’s hoard has dwindled by 6%, and the decline has so far lasted four
years.
Why the sell-off? Central banks tend to sell foreign currency when
their own domestic currency is under too much selling pressure. China is
currently experiencing capital outflows as investors abandon their yuan
for U.S. dollars and euros to take out of the country and invest
elsewhere. That floods the Chinese markets with extra liquidity that the
People’s Bank of China is trying to soak up before it results in price
inflation. They do this by selling foreign currency in order to buy the
extra yuan. It’s the same story, though to a lesser extent, with Japan.
The longer term implication of these sell-offs is that they
eventually will affect global bond and currency markets. With the two
biggest holders of U.S. Treasuries now net sellers, and the Federal
Reserve about to hike interest rates, there will be little buying
pressure to counteract a sell-off caused by any possible disturbance.
Regarding the probable upcoming Fed hike, keep in mind that the Fed
does not simply dictate its own overnight rate by fiat. Also, the rate
itself is not what the Fed charges member banks for funds. The actual
rate is the rate at which Fed member banks loan to one another. In order
to tweak this rate higher, the Fed must sell bonds to banks and absorb
the dollars to lower the dollar supply. This is the actual mechanism by
which the federal funds rate is raised.
The conclusion being that once the target rate is finally raised,
presumably next week, the top three bond-buying central banks will all
be net sellers. These are the People’s Bank of China, the Bank of Japan
and the Federal Reserve. What happens then? Nobody knows, but we’ll soon
find out.
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