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According to the Setser Test, it’s unlikely that China reduced its Treasury holdings in November

According to the Treasury International Capital System (TIC) release, foreigners were net buyers of US securities in November, +$39 billion over the month. Of the $61.7 billion in long-term Treasuries net purchased (notes and bonds), private investors claimed $50.6, while official investors (central banks, sovereign wealth funds, etc.) accrued a smaller $11.1 billion. Over the last twelve months, foreign investors amassed $571 billion of the high-quality US securities: Treasury notes and bonds, agencies, and stocks, which includes the -$12 billion net sale of corporate bonds. Overall, it was a reasonably positive report, indicating that long-term asset sales are roughly in line with the current account deficit (chart to the upper left).

But the pundits follow the table on major foreign holders of US Treasuries. They note that the number 1 holder, China, reduced its holdings of Treasuries in November from just over $900 billion to just under. For some reason, investors and critics of the deficit alike are worried that when China is no longer named the US’ biggest stockpiler of Treasury securities, Treasury rates will skyrocket. Oh, the bond vigilantes.

And this is when I really miss Brad Setser’s commentary (he is now at the National Economic Council). He noted time and time again, that the monthly TIC data tend to under-report the Chinese holdings, especially when they are shifting their portfolio holdings of US Treasuries up the curve. Well, that’s what the Chinese did in November: holdings of US Tbills dropped $21 billion, while longer-term note holdings increased a net $9.9 billion. (more after the jump)

According to Brad Setser, only in the annual survey of US portfolio holdings are China’s measured holdings of US Treasuries accurate:

This is actually a well established pattern. The past five surveys of foreign portfolio investment in the US have all revised China’s long-term Treasury holdings up (in some cases quite significantly) even as they revised the UK’s holdings down. The following graph shows the gap between Chinese long-term Treasury purchases in the TIC data and China’s actual purchases of long-term Treasuries– as revealed in the survey.

Brad Setser’s quote was from 2009, but the story hasn’t changed since. In the 2010 report for 2009 foreign holdings, the level of Chinese Treasury holdings was revised up from the TIC-implied level by near $140 billion, while that of the UK was revised down (by over 100 billion, I might add). Clockwork.

So let’s apply Brad’s test, I’ll call it the Setser Test, to see if China actually reduced US Treasury holdings in November, as the November TIC release suggests. (I highlighted Brad’s test in bold italics, RW is me). The test is listed in the middle of this post.

Brad: First, the TIC data should show a fall in China’s holdings, i.e. net sales of Treasuries.

RW: Yes.

Second, the TIC data should also show limited purchases of Treasuries through the UK.

RW: No. The UK bought near $25 billion in Treasury notes and bonds, which more than offset the drop in Chinese Treasury buying. In fact, if the TIC data is accurate, the UK is amassing a rather large stockpile of US Treasuries. This would be in sharp contrast with the average $48 billion balance of Treasury holdings since 2006 (Table 4 or 5 depending on the year)!

Third, the Fed’s custodial holdings should not be rising at a strong clip — as, given China’s size, it is hard to see how China doesn’t make up a large fraction of all custodial holdings.

RW: The Fed’s custodial holdings increased by a sizable $39 billion. More likely than not, this was due in part to Chinese activity.

So according to the Setser Test, it’s very unlikely that China reduced its Treasury holdings in November. In fact they probably increased their Treasury holdings, given the magnitude of the Fed’s custodial balance.

Rebecca Wilder

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TIC tock; TIC tock; TIC tock

No, the US Treasury’s time is not running out. Where’s Brad Setser when you need him – and the media definitely needed him in reference to the December TIC report.

Okay, okay, we know: China dropped its share of Treasury holdings in December by $US 34.2 bn. China now holds just 20.9% of the total foreign-owned stock of Treasuries, second only to Japan (21.3%).

But China’s share is closer to its average, while Japan’s share is way off – there may be a reversion here, i.e., Japan will grow its stock of Treasuries relative to China (Please see my post yesterday). Except for the period of September 2008 through November 2009, Japan held a much larger share of Treasuries than did China for every month since 2000.

Is there a sinister plot developing? Is China selling off S-T T bills to retaliate against the Obama administration’s push on the renminbi? Or is China simply reallocating its portfolio toward risk?

Perhaps there is a (partial) retaliation scheme underway, as suggested by the 3-month accumulation of short-term US assets (mostly T bills agencies with a maturity of less than 1 year).

But isn’t it just slightly more plausible that the Chinese are – official + private – selling off zero-yielding (practically) Treasuries in exchange for longer-duration, higher-yielding, and riskier assets.

The first bit of the story is this: one should take care in not reading too much into the TIC report. It’s just one month’s worth of data; but more importantly, the data miss a critical component of the capital account, foreign direct investment.

The chart above illustrates China’s one-year rolling monthly flows of long-term, high quality asset purchases – Treasuries bonds/notes, agencies, stocks, and corporate bonds. The Chinese are accumulating stocks, primarily through private investors, but through official channels as well (see press release, lines 8 and 13). This suggests an increasing interest in equity, which could signal growing foreign direct investment flows (not shown in TIC).

Furthermore, the entire year’s shift in assets, long-term Treasury purchases, +$US 98.8 bn fully offsets the drop in short-term Treasuries, -$US 98.8. This suggests diversification.

Finally, everybody’s doing it, not just China – diversifying away from T bills, that is!

The chart above illustrates the 3-month rolling sum of all foreign net flows of ST US assets (mostly T bills). If you invest $US 1 million dollars today in a bill expiring in August 2010, you make about 900 bucks. Man, doesn’t that sound like a wonderful investment?

So the next question is: why do the Chinese care about return on their F/X holdings? Because they have a peg! Here is a great article for all of you who wanted to know about the costs of maintaining a peg. Accumulating FX reserves is a costly business, and T bills are unlikely to finance the type of sterilization that is needed by the PBoC.

Rebecca Wilder

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