China FX Reserve Diversification
Bottom line: Though Chinese holdings of U.S. government securities continued to fall in May, this is part long-term diversification and part switching into higher-yielding U.S. agencies. Multiyear, China will likely diversify away from U.S. Treasuries.
Figure 1: China (mainland) Holdings of U.S. Treasuries ($bn)
Source: U.S. Treasury
Fewer Treasuries, More Diversification
Mainland Chinese holdings of U.S. Treasuries continued to fall in May (Figure 1), which has raised questions of whether China has accelerated reserve diversification away from the USD in the wake of sanctions on the Russian central bank. Market sources have also reported that China has been reducing JGB holdings in recent months as well.
The effectiveness of Western sanctions on the Russian central bank will make China reconsider whether FX reserves would be accessible in a truly adverse situation (e.g., sanctions if China were to invade Taiwan). This would argue for diversification of FX reserves based in western countries. The problem is that non-DM reserve alternatives are limited. The Indian rupee, Brazilian real and Russian ruble could be alternatives, but suffer from illiquidity relative to the USD or EUR. Additionally, central banks are conservative, and a heavy portion of BRICS in FX reserves appears unlikely.
Gold is an alternative, despite Russian gold transactions being impacted by Western sanctions. Domestically held gold can be a store of value in a geopolitically challenged situation. China only has around 1,948 tonnes of gold in July, according to the World Gold Council (here), or approximately 3.5% of FX reserves. More importantly, the World Gold Council has not reported any change in China's gold holdings in recent months. China does not appear to be in a hurry to diversify into gold.
Figure 2: Gold Holdings as a % of Total FX Reserves
% of reserves | |
Brazil | 2.1% |
Mexico | 3.4% |
China, P.R.: Mainland | 3.5% |
Saudi Arabia | 4.1% |
India | 7.5% |
Poland | 8.7% |
South Africa | 12.5% |
Russian Federation | 21.4% |
Turkey | 30.8% |
Source: World Gold Council
It is also worth pointing out that an invasion of Taiwan is very low probability in the next five years, as China's navy is not strong enough for a seaborne invasion, according to military experts. The failed full-scale attack on Ukraine by Russia will also have provided food for thought for some within China's leadership. Finally, President Xi Jinping's policy focus is more on domestic goals.
Returning to the U.S. Treasury TICS data for May, it is noticeable that the Chinese mainland has been buying U.S. agencies at the same time as selling U.S. Treasuries, which perhaps reflects more traditional yield picking after spread widening. Notice that Japanese institutions also reduced U.S. Treasury holdings in May, which likely reflects a reaction to the sharp rise in yields since the start of the year.
This is not to say China is not diversifying FX reserves, as data is difficult to interpret. We do feel that China has an incentive to diversify FX reserves away from DM government bonds, both for geopolitical diversification and as real yields are poor. This will likely be a long-term process, however, and we will watch data releases to see how this evolves in the coming quarters.