Merrick Chapman is Director of Hedge Analytics and former Portfolio Manager at Elliott Management.
The Fed is causing chaos in China. Driven by the rapid rise in US interest rates, Chinese banks are rapidly shrinking their dollar balances.
The decline in dollar holdings in China largely reflects the decline in global dollar carry trade. This strategy was a response to the zero interest rate policy from 2009 onwards, and necessitated borrowing of low interest currencies and lending of high interest currencies. A BIS paper from 2015 outlines how a version of this trade encouraged issuance of dollar-denominated bonds:
Non-financial corporations from emerging market economies (EMEs) have used US dollar bond issuance to counter financial exposures that have the attributes of a dollar carry trade, in addition to any use of such funds for real investment.
This version of the trade was titanic, with the side effect that the Chinese banking system accumulated large dollar deposits and loans. In fact, China has acted as the largest dollar region.
All things must pass, and the Fed’s monetary tightening has made carry trading very unprofitable. The unwinding means a sharp drop in dollar balances owed in the Chinese financial system.
Flows from Chinese dollar holdings closely match the behavior of the renminbi against the dollar. When dollar balances are converted into renminbi, this leads to an increase in China’s money supply, which is equivalent to devaluing the renminbi. It is by no means the only factor, but it is not surprising that the renminbi has lost value against the dollar in line with lower Chinese dollar holdings.
Another noteworthy factor is that the decline in the dollar accelerated significantly after the invasion of Ukraine in February of this year. The sanctions imposed on Russia may have panicked the Chinese monetary authorities into decreasing the dollars in their system. Divestments of dollar loans from the end of February to the end of September were $170 billion, while dollar deposits fell by $140 billion, which together equates to a decrease of $5 billion per week. The discount was more or less equal between domestic dollar customers and foreign customers.
The effects of Chinese deleveraging extend far beyond China. Only a small part of Chinese banks’ balance sheets is denominated in foreign currency – about 3 percent. However, most of the deposits and loans in Chinese banks owed to foreigners are denominated in dollars. In the past decade, the Chinese financial system has brokered massive amounts of dollar carry trade to other emerging economies, no doubt taking a commission along the way.
Foreign dollar holdings in the Chinese system are now collapsing faster than domestic holdings. Remarkably, foreign customers’ deposits and loans remained unchanged this year if denominated in RMB, while domestic deposits and loans rose. It appears that foreign clients were forced to sell dollars to keep up with the appreciation of the renminbi. This is due in part to the process of unbundling the carry trade, but the stability of balances in renminbi suggests that the Chinese authorities may have instructed their banking system to limit foreign exposure to some renminbi limits.
This trolling of Chinese banks’ balance sheets leads to a diversion. Most worrying, if speculative, are the questions arising from the change in the composition of dollar assets.
Three asset classes account for all changes in the dollar balance sheet since February 2022. External borrowings and reverse repos are down, and portfolio investments are up. Taken together, these categories fully reflect the behavior of total dollar deposits on the liability side. Therefore, if banks were indeed required to hold fewer dollars, these categories indicate the main path in which they made that decision.
It is not clear exactly who is facing Chinese banks on the other side of the reverse repo – but for our purposes it does not matter. The definition of a reverse repo is clear enough; Buying securities with an agreement to return them at a specific future date. A reverse repo is a loan, usually short-term against a security. In short, Chinese banks have reduced both foreign loans and short-term dollar loans while continuing to accumulate portfolio investment. In terms of the balance sheet, Chinese banks have swapped debt for equity.
We have no way of knowing whether the banks of the previously accumulated equity were owned by foreign borrowers whose loans have now been scaled back. But it will make sense. There has long been a suspicion that Chinese lending to emerging economies comes on unpalatable terms.
As global economic and monetary conditions continue to deteriorate, perhaps we should expect the ‘portfolio investment’ category to increase while the external loan category continues to decline. It is at least possible that Chinese banks are fleeing from dollars while disguising their flight in part by piling up emerging economy assets. Debt-for-equity swaps may be just getting started.