The Fate Of King Dollar In Global Reserves

So yeah, people are talking about reserve diversification.

While this is a topic that is in no way new to people who are inclined to pay attention to potentially epochal shifts in the dynamics that perpetuate the global status quo, it’s not something your average E*Trader or CNBC commentator is prone to delving into because you know, who fucking cares about the critical dynamics that underpin the existing global financial order, right? Right.

But as they’re prone to do, Bloomberg decided to make people think a little bit earlier this month by publishing a story that suggested China was set to “slow or halt” their purchases of U.S. Treasurys going forward.

Again, there was nothing particularly “shocking” about that story, but it quickly rippled through markets, driving the dollar swiftly lower, the euro higher, and of course exacerbating a selloff in Treasurys.

Importantly, the timing left something to be desired in terms of that story breaking just as the market was attempting to digest the BoJ trimming JGB purchases and amid jitters about what the tax bill is going to mean in terms of increased Treasury borrowing needs. Throw in a little dash of Bill Gross pontification, and the stage was set for a pretty notable selloff. Here’s an annotated chart that also shows you the push-pull dynamic between the central bank-related news flow, strong demand at auction, and U.S. econ:

Ok, so on the heels of that, reports that the Bundesbank is set to include the yuan in its reserves only served to make the reserve diversification discussion even more “urgent” (scare quotes are there for a reason because this isn’t really “urgent” in any real sense).

We talked a good bit about this last week (see here on the euro, here on the RMB, and here on why China may not have too many options when it comes to eschewing USD reserves), but we wanted to highlight a couple of excerpts from a new BofAML note on the subject.

For one thing, BofAML notes that the yuan is going to become better represented regardless. “In the long run (over the next decade or so), we expect the share of China in global reserves to increase to similar levels as to GBP and JPY, both of which represent about 4.5% share as of September 2017,” the bank writes, adding that “assuming global reserves grow 5% over the next decade, this would imply about $570bn of foreign reserve flows in the next 10 years (or an average of $15bn monthly) [and] this would probably be at the expense of the G4 currencies, including the USD.” Here’s the chart on that:

As far as the shift away from USD reserves specifically is concerned, BofAML reminds you that this has been going on in slow motion for years, but the pace is “glacial” for two reasons. First, it’s still the dollar. So there’s that. But second, “diversifying quickly is harder than it looks given the size of global FX reserves [because] a concerted effort by global central banks to reduce the USD share in reserve portfolios for instance would likely lead to an undesired collapse in the US dollar.”

There’s an interesting discussion about that dynamic, but in the interest of brevity, let’s skip to what the bank says about the idea that China will be the “marginal diversifier”. To wit:

While the market perception is that China invests the majority of its reserves in US assets, our analysis shows there has been a pronounced change after the global financial crisis. The data show China held about $1.56tn US securities as of September 2017, of which long-term UST $1180bn, stocks $188bn, agency bonds $178bn, corporate bonds $16bn, and short-term Treasuries $2bn. This means the share of US assets in China reserves was about 50.2% (without FX valuation adjustment). This implies a 19ppt decline from 69% as of June 2007, before the global financial crisis. There are of course several unknowns, particularly custody holdings of Treasuries (via Belgium for instance). But the broad dynamics indicate a strategic diversification in reserve allocation has already materialized (Chart 13) and China may not be the marginal “diversifier” at this point.

In other words: this has already happened.

Beyond that, BofAML underscores the points made by Morgan Stanley earlier this month. Even if China wanted to “punish” Trump for being a big (or I guess “small” is better) orange dick on trade, the bottom line is that “the overall level of FX reserves is a function of economic considerations [and] any changes have direct spillovers that will dominate political motivations.”

So you can take all of that for it’s worth, but do note that this discussion will invariably come up more often going forward.