June 30, 2011
Over the past two weeks, we have been suggesting, tongue in cheekily, that despite the relentless desires of everyone to sell the EUR, it has continued to drift higher, due to some inexplicable force with bottomless pockets, which, after some deductive logic, we assumed was China. It turns out we were correct. Naturally, figuring out what China does with its $3 trillion in foreign reserves is sometimes more complex than brain surgery (except what it does every time it sees a barrel of oil for sale: then it is pretty much guaranteed what it will do). But when it comes to preserving its 3 rounds of horrendous European down payments, it was pretty logical that China would do everything in its power to prevent a waterfall effect that would result in Europe imploding in a ball of illiquid singularity. The WSJ has confirmed that China’s SAFE is actively doing all it can to transfer billions of its dollar-denominated holdings into euros. And while this does not mean the EUR is the new reserve currency, it certainly means that China has now become the deciding factor as to just who is (much to the chagrin of Markel, and delight of Geithner… for the time being).
China’s deep pockets are momentarily keeping the euro supported.
But with Greece’s financial future still uncertain even after lawmakers passed an austerity package on Wednesday, and the single currency’s long-term prospects far from assured, Beijing risks learning a lesson about trying to fight a market more inclined to sell than buy.
For months, whispers of “Asian official buying” have permeated markets when the euro fell below certain levels. That talk has kept euro/dollar hemmed into a tight seven-cent range since late May, even as fears of a Greek default make traders disinclined to hold the single currency.
China, the world’s biggest holder of foreign-exchange reserves, has pledged financial support to the distressed euro-zone periphery while touting its economic links to Europe.
And with the PBoC not having a bloated balance sheet, courtesy of trillions of Chinese bad debt being held off balance sheet, nobody dares to step in front of a train whose EUR buying capacity is, at least in theory, limited only by the notional amount of how much garbage America’s gadget-addicted middle class will buy from a very mercantilist China. To wit:
There are perils to China’s strategy, however. Most market observers agree that it is never a good idea to fight the market. Just ask the European Central Bank which spent months buying distressed periphery bonds to calm markets–only to have yields surge amid fears of a Greek default.
However, investors appear reluctant to go against China’s vast economic resources.
China holds more than $3 trillion in foreign-exchange reserves, with an estimated 60% of those in dollars. Its strategy toward the beleaguered euro zone helps it accomplish two goals: expanding its global reach and satisfying the need to diversify its vast reserves.
Anyone who has followed the EURUSD on an intraday basis will be familiar with the following trading pattern:
“The market is inclined to sell the euro on rallies [whereas] China wants to buy it on dips,” said Michael Woolfolk, senior currency strategist at BNY Mellon in New York. “It maintains the current range-bound conditions until we get clarification on the long-term outcome for Greece.”
How much EUR is China buying (and how many USD is it selling)? A lot.
Analysts point to official data showing that Chinese U.S. Treasurys holdings have fallen by at least $300 billion recently. Analysis of flows by Bank of America-Merrill Lynch shows that monetary authorities have been net sellers of dollars over the past four weeks, translating them into euros.
By looking at the rate of China’s foreign-asset accumulation, Woolfolk estimates that authorities sell about $2 billion per trading session, with roughly a third converted into euros.
That dovetails with research by Douglas Borthwick, a managing director at currency broker Faros Trading.
Based on asset-allocation trends by the China Investment Corporation (CIC), he estimates the country could invest 500 billion euros ($722 billion) overall in Europe over five years, with 20% devoted to euro-zone peripheries. “That would buy a large amount of goodwill and lubricate other sensitive purchases throughout Europe,” he said.
That doesn’t mean China’s largesse comes without limits.
And just as we have suggested before, the only thing that will prevent China from layering more money after bad, is a terminal event, which however China will do everything in its power to prevent by entwining the fate of Europe’s banks with its own, as we suggested over the weekend.
Analysts see a remote but growing possibility of two worst-case scenarios. Greece dropping out of the euro, or fears about insolvency bringing the troubled economies of Spain, Ireland or Portugal to their knees.
If either of those come to pass, it may give China pause about throwing good money after bad.
The irony is that it is no longer the US which is pursuing a weak dollar, but its currency pegged partners, for whom a strong euro is just as critical important, China, that is doing all it can to boost US exports, which, however it knows, do not exist (aside from financial innovation of course).
The question now is: how long before Germany says it has had enough of China manipulating the European currency to a level that would almost make more sense for Germany to get out of the currency (which is costing the CDU and Merkel endless political credibility) and just return to the DEM. Alas, since Germany’s banks are just as reliant on China as they are on the Fed, Merkel, or rather gher export sector, has now found itself between the Fed FX swap line Scylla and the Chinese mercantilist model charybdis.
Good luck with that Angela.