Chinese government reports rare decline in foreign investments

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The Chinese government report on monetary conditions Tuesday included a record decline in foreign exchange reserves, increasing focus on research estimating that Chinese corporations currently hold an approximately $800-billion (U.S.) short position in U.S. currency.

The rare decline in foreign assets provides yet another sign of a slowing global economy that will affect Canadian companies.

The People's Bank of China's reported $3.24-trillion in foreign assets suggests that China's government finances will never be confused with those of say, Greece. Projections, however, had pointed to $3.31-trillion.

Changes in China's foreign asset holdings are a notable issue for Canadian investors, in that China's massive hoard of dollar-denominated assets was generated through global trade, as a consequence of heightened levels of economic activity. A reversal of the trend is a sign that the Chinese economy, and the country's demand for Canadian raw materials, may be declining.

The possibility that Chinese corporations are currently holding a massive U.S. dollar short position is a new aspect of the story. Strategist Pierre LaPointe of Brockhouse Cooper explains how the short position came about in a report released Wednesday.

"Until mid-2011, it made perfect sense for Chinese companies to borrow dollars in order to pay for imports rather than to purchase dollars directly," LaPointe wrote in the report.

"If one expected the dollar to continue to depreciate (both on a trade-weighted basis and versus the yuan specifically), one would have definitely wanted to borrow in dollars and/or to convert dollars into yuan as quickly as possible – helping to explain China's growing dollar-short position."

In other words, rather than exchange existing yuan holdings for dollars when the invoice appeared for overseas goods, Chinese companies held on to the local currency and borrowed U.S. dollars from the bank.

The expectation was that the greenback would fall in value, making the loans cheaper to repay in yuan terms. Unfortunately, this trade has gone against them.

$800-billion sounds like a lot of money, but it is unlikely that the unwinding of these short positions will cause anything resembling a national economic catastrophe.

Certainly, the People's Bank of China is not about to run out of assets convertible to U.S. dollars in order to provide liquidity.

However, further appreciation in the U.S. currency will put Chinese corporate balance sheets further offside. The possibility exists that a number of companies will capitulate at the same time, paying off the American currency loans in order to stop the bleeding. This would cause a significant, if temporary, spike in the U.S. dollar.

The surprise decline in China's foreign asset holdings confirms suspicions that global trade activity has slowed. It is likely also symptomatic of a dollar shortfall within the Chinese economy, as corporations begin to repay speculative U.S. dollar loans.

Canadian investors will be waiting for a return to dollar hoarding by the People's Bank of China as a sign of economic recovery, and should be on the lookout for a short, sharp rally in the U.S. dollar.