China’s Surplus and the Bid for Bonds

According to some commentators, China’s reserve managers are gradually stepping back from the US Treasury market, removing what was once an important source of demand for government bonds.

But this narrative is incomplete. The task of recycling China’s massive current account surplus has shifted from the central bank to the country’s largest state-owned banks. These banks are using the surplus to repay foreign debt and accumulate large portfolios of US dollar bonds. China’s exit from US dollar assets has been greatly exaggerated.

However, banks are different from reserve managers in one crucial way: they must manage their market risk. Unlike a central bank, they cannot simply plough every surplus dollar into long-duration bonds and hold them to maturity. They must mitigate their exposure to interest rates, credit spreads and funding costs via duration strategies and derivatives. As a result, the shift from official reserve managers to state-owned banks has transformed China’s recycling flow from a largely price-insensitive buyer into a more commercially driven, price-sensitive buyer of global bonds that actively manages its duration exposure.

Here’s the full story.