Beware a Chinese ‘dollar avalanche’

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Brad Setser’s paper on how China has stashed away almost $3tn worth of unofficial currency reserves in local commercial banks and other parastatal entities has naturally generated a lot of attention.

After all, these “shadow reserves” are larger than the formal reserves of Japan, the world’s second-largest reserve holder according to IMF data. It’s almost three times larger than the assets of Norway’s sovereign wealth fund.

In a recent note, Eurizon SLJ’s Stephen Jen and Joana Freire also observed that Chinese companies have been hoarding dollars lately: increasing their greenback deposits from $758bn at the end of 2019 to $912bn at the moment.

But they also reckon this undercounts the accumulation, given the balance of payments over that period. They put China’s overall dollar accumulation at $2tn, and estimate that Chinese corporate dollar deposits are now actually closer to $1.78tn (of which about half is held in accounts with Chinese banks).

“Fresh snow continues to build up, raising the risks of an avalanche one day,” they warn.

Chinese corporates continue to hoard dollars. The total stock of dollars held by Chinese entities continues to rise. The dollar’s high carry may at present seem enticing to Chinese entities, but this configuration is fundamentally unstable. Prospective rate cuts by the Fed and/or an economic reacceleration in China could lead to a precipitous fall in USDCNY, as corporate treasurers in China scramble to sell the dollars they don’t need to have. We believe this is a major risk for H2 2023.

Jen and Freire see three potential triggers for this “too large to be stable” dollar overhang to become an avalanche.

Trigger 1. The Fed turning dovish later this year. We believe the Fed remains behind the inflation curve. Core CPI should soon decline with headline CPI, since there is no obvious reason why that should not be the case. The chart on the left below shows headline CPI and core CPI since 1958. Eye-balling this chart, one would struggle to conclude that, at any point during this period, core inflation in the US led headline inflation. The chart on the right below shows the 5-year rolling correlation of headline and core CPI.

One could see that, whenever US inflation rose due to a shock (in the late-1960 due to strong demand growth arising from tax cuts, in the early-1970s due to the Saudi embargo of crude oil, and in the late-1970s due to the Iranian Revolution), the correlation between these two variables was close to 1, both when inflation surged as well as when inflation normalised. It is, in particular, unclear how big a role such large and sharp interest rate hikes have played in pushing up interest costs of mortgages in the US, and subsequently rents. Housing costs are estimated to account for 61 percent of core CPI’s yoy inflation. Could US core inflation appear sticky ironically because of the Fed’s rate hikes, in turn raising the mortgage interest rates? We believe the Fed is likely to be wrong in being concerned about stickiness in core inflation, just as they were wrong in being concerned about persistent disinflation in 2020-2021.

Trigger 2. A recovery in confidence in China. China currently suffers from an acute case of a lack of confidence resulting primarily from the domestic policy shocks since the summer of 2021. Notwithstanding the declarations made by the new Premier Li Qiang on the primacy of economic growth and development, households, businesses, and investors in China remain unsure whether the Xi Administration has pivoted left politically to embrace Maoist ideology of hard-core communism that would, from now on, favour SOEs (state-owned enterprises) at the expense of POEs (privately-owned enterprises) and to strictly constrain the property sector to only play the role of a ‘commodity’ for the populace to use and consume rather than an investment. Since properties accounts for 80 percent of household wealth – a draconian change in the nature and the dynamics of the property market permitted by the Xi Administration would significantly undermine the ability and the willingness of Chinese households to spend, with logical implications for the economy at large and investors’ outlook. On June 16th, the State Council, however, announced that stimulus measures would be deployed to ensure that China reaches its growth target of 5.0 percent for the year. A prospective restoration of general confidence in China would be positive for Chinese equities, Chinese bond yields, and the Chinese RMB. At the same time, a better economic prospect should also entice Chinese producers and exporters to engage in capital expenditures funded out of the hoarded dollar deposits. A large overhang of dollars could then trigger a sharp sell-off in USDCNY, we believe. 

Trigger 3. A normalisation of US/global services demand. During the Pandemic, the US and the world’s demand for goods surged while demand for services waned because of the lockdowns. However, relative demand for services and goods switched after the re-opening of the economies. This is particularly clear in the US, where relative demand for services is now materially stronger than that for goods. Services inflation, commensurately, has surged relative to goods inflation. This helps explain why services-centric economies like the US, Italy, and Greece are out-performing the goods-intensive economies like China and Germany. This is a good explanation of some of the dichotomies we are seeing in the global economy, but it is not something that will persist, in our view: if one feels the urgent need to go to Disney World because they hadn’t been there in three years, it is unlikely they will visit Disney three years in a row to ‘make up for the lost time’. More likely is a normalistion in demand for goods and services back to the pre-Pandemic norm, permitting Triggers 1 and 2.