Even major investment banks releasing their notes on post-FX reserve analysis have expressed various degrees of bewilderment at the results. Fundamentally, it is becoming increasingly difficult to reconcile the stock value of FX reserves and the flow changes we witness every month.
There are numerous pieces of data that form our picture of the whole as to why we say this. Let’s break this down piece by piece show why there is increasingly contradictory evidence.
- According to our model, which is similar to other estimates of PBOC reserve composition, and general FX reserve holdings, the PBOC USD value of foreign exchange reserves should have remained essentially unchanged between May and June 2016. The rapid rise in the JPY in June should have largely been offset by the rapid fall in GBP. While we cannot know the exact weighting of the three primary non-USD currencies, given a range of reasonable parameters would leave this portion of the basket fluctuating around no valuation change. The only plausible method to arrive at a material USD valuation change between May and June in the non-USD portfolio is to assume extreme parameters in EUR, GBP, and JPY assets.
- Even if we extend this basic valuation change back to the beginning of the year, there should be a relatively minimal change in the USD value of the non-USD asset portfolio of PBOC FX reserves. We estimate the non-USD portfolio, absent non-USD depletion, to have benefited from an approximately $30 billion valuation increase. Foreign exchange reserves however through the first six months of 2016 have only declined $26 billion. Absent other valuation or unrecorded inflows changes, this would imply total net outflows between $55-60 billion.
- However, just according to official SAFE data, the YTD bank receipt less bank payment for international transaction reveals a net outflow of $145 billion USD through May. If we add in the expected value for June, this would give us a forecast net outflow from bank transactions of $170-185 billion USD nearly on par with all of 2015. Given the estimated valuation increase and the official decline in PBOC reserves, this would leave an approximately $115-130 billion USD that we cannot account for in our calculations.
- Even if we look at the net flows by currency type, the numbers tell a story of similar outflows. Looking at just the top two currencies, we see that USD net flows were in surplus by $52 billion while RMB net outflows totaled $106 billion in USD terms. HKD, JPY, EUR, and all other currencies summed to the previously noted $145 billion net outflow.
- Breaking it down by currency however actually gives us a clue as to what is likely happening. The $106 billion RMB outflow in USD terms is leaving China for international transactions. Theoretically, this should result in ever expanding offshore liquidity. Conversely, we actually see quite the opposite happening in offshore centers with RMB trading and deposits. Where RMB deposits have been shrinking, specifically in the primary offshore center Hong Kong relatively rapidly.
- Bank buying of FX from non-bank customer through May totaled $661 billion USD while sales of FX totaled $541 billion USD for net purchases by banks of $120 billion USD. Given the previously mentioned net outflows from bank payments of $145 billion and the approximately $25 billion in revaluation over the same period, we are able to reconstruct the numbers through May relatively closely.
- This conclusion though has a very important implication. This means that commercial SOE banks are essentially acting as a central bank purchasing surplus RMB either on the Mainland or in Hong Kong to prop up the RMB. It is worth noting that the Bank of China acts as the primary settling bank or cross border RMB and takes a small fee for all offshore RMB remitted to the mainland. Given that spreads between the bid and ask is less than the fee BoC takes for remitting offshore RMB back to the Mainland, it is likely they are essentially operating a large churning operation propping up the RMB.
- We actually see evidence of this in the Bank of China Q1 2016 report. They list a 31% drop in “Net Trading Gains” which they attribute to “decrease in net gains from foreign exchange and foreign exchange products.” What makes this so interesting is that even though BoC is the primary settlement bank for the PBOC of international RMB transactions, FX market turnover was up 20%. It seems difficult to understand how with a market up 20% the near monopolist firm see revenue drop 30%. The most likely explanation is that they are essentially acting as a central banker, soaking up the liquidity at the spread, profiting from the repatriation fee, and churning. Though much of their purchases are offshore, forcing them to incur a loss, the repatriation fee compensates them harming their margin but upholding the national interest.
We need to keep an eye on this especially as we move forward and BoC trading revenue and matching up the outflows to the SOE/PBOC churn.