FT Alphaville " China's mega dash for the dollar We noted last week that there was a rising tussle over dollars in China, spurred by capital outflows and RMB-denominated selling on signs that the world's key economic powerhouse may be slowing. A situation which was arguably thrusting China into a dollar short position. While that might seem counterintuitive given China's substantial longer-duration dollar assets, it is possible because of China's substantial short-term dollar liabilities. Essentially, we're talking about a major dollar-denominated duration mismatch on the mainland at a time when China is running one of its largest outstanding external debt positions for 27 years. On Monday, Bloomberg reports that the dollar rush may be being magnified by the fact that Chinese citizens are gathering dollar-denominated deposits at their fastest pace in five years: May 21 (Bloomberg) - Dollar-denominated deposits in China are rising at the fastest pace in at least five years and government debt is rallying, reflecting waning confidence in the world's second-biggest economy. Foreign-currency deposits increased $89.4 billion in the last four months to $364.5 billion, the biggest jump in data going back to 2007, People's Bank of China figures show. Chinese banks sold a net 60.6 billion yuan ($9.6 billion) of foreign currency in April, reflecting capital outflows, according to a separate PBOC report. The government's benchmark one-year bond rallied the most in six months last week, driving its yield down 34 basis points to 2.42 percent, as property prices and foreign investment fell. China's currency has dropped 0.5 percent this year and waning expectations for appreciation have prompted investors to sell yuan-denominated bonds in Hong Kong, driving yields to a four-month high. Dim Sum bonds lost 2 percent in the past year as U.S. Treasuries gained 8.9 percent, reflecting increased appetite for dollars amid Europe's debt crisis. And what's really exceptional: "Demand for dollars is rising and the central bank even has to sell dollars in the market to meet such demand," said Li Wei, an economist at Standard Chartered Plc in Shanghai. People's interest in holding yuan assets will decline further because the worst of the economic slowdown is not over. Now if this trend of the central bank having to sell dollars to the market continues, it is very possible that even China's longer duration dollar-assets will start having to be sold. The only alternative, as we pointed out last week, is that China manages to encourage internationalisation of the renminbi which either encourages new foreign capital into the country or allows Chinese companies to settle dollar-liabilties in yuan. In the mean time, if China is to handle its growing dollar shortage issue without liquidating its Treasury holdings, it may arguably have to either engage in swap lines with Fed - which we presume would be unlikely- or more likely consider repo-ing its dollar denominated assets in exchange for short-term dollar liquidity. This can make sense if repo rates are low enough. We've looked into the possibility of China doing this, and it seems there is nothing in principle that should stop it, especially if it engages via the over-the-counter markets. Of course, if it does engage in repos, one could expect short-term US repo-rates to stay very well supported if not rise considerably. Related links: External debt highest since 1985: SAFE report - ChinaDaily Why China's RMB exodus IS the story - FT Alphaville China equilibrium *alert* - FT Alphaville Chinese CNH - YOURS! - FT Alphaville This entry was posted by Izabella Kaminska on Monday, May 21st, 2012 at 9:37 and is filed under Capital markets. Tagged with china, dollars, PBOC.