China Banks Stockpile Record $1 Trillion of Foreign Exchange

(Bloomberg) -- Chinese banks' stockpile of foreign-currency deposits has surpassed $1 trillion for the first time, creating an opportunity for Beijing to allow greater freedom for capital to flow out of the country.

The pool has been growing as surging demand for Chinese goods during the pandemic has beefed up foreign earnings of exporters, while the resilient economy and strengthening currency have lured overseas investors to sell dollars for yuan to buy Chinese stocks and bonds. Bank deposits in foreign currencies jumped more than $260 billion in the year through May, the most in data starting in 2002.

Then a mismatch sets in: despite the increase in inflows, Chinese banks don't have many channels to utilize their foreign exchange. One way is to sell it onshore, but that adds pressure for the yuan to strengthen. The currency is already trading near a five-year high against a basket of its peers -- adding urgency for Beijing to reform its foreign-exchange market and ease capital controls, moves that will act as a pressure-relief valve by letting local investors buy more overseas assets.

“Strong capital inflows offer a good window for China to carry out capital-account reforms and relax two-way capital flows,” said Linan Liu, greater China macro strategist at Deutsche Bank AG in Hong Kong. “I expect further relaxation of capital outflows via investment schemes.”

China's commercial lenders had a record $1.38 trillion of foreign exchange by the end of May, with the majority being held in deposits, according to the People's Bank of China. Lenders used most of the cash to make loans to firms onshore and overseas, the data showed. The PBOC's foreign reserves also rose to a five-year high last month.

The accumulation was a result of rapid capital inflows. Overseas investors snapped up 1 trillion yuan ($154 billion) of onshore bonds over the past year, attracted by the relatively high yields on yuan-denominated debt. At the same time, China's exports surged as its factories returned to operation while the rest of the world was still mired in the pandemic, boosting its trade surplus to a record.

One result of the inflows has been to push down dollar deposit rates in China to near all-time lows -- levels that are only about a third of the equivalent funding costs in the U.S. itself. That divergence is motivating banks to buy the yuan versus the dollar, a situation which is worrying Beijing as too strong a currency may invite hot money inflows and hurt Chinese exporters. The onshore yuan gained for a third straight session on Friday, rising as much as 0.3%.

The PBOC is already taking steps to reduce dollar liquidity, including easing capital controls put in place following a currency devaluation six years ago. The central bank has increased the quota for investors to buy overseas assets to a record in June, and is expected to establish a trading link for wealth products between the mainland and Hong Kong.

An announcement allowing Chinese investors to buy bonds in Hong Kong is also expected soon.

Read: Southbound Bond Connect Sets to Debut, Alleviate China Pressures

Some officials “may see the foreign-exchange liquidity as a feather in China's cap, and some may worry that the surge is flighty,” said George Magnus, a research associate at Oxford University's China Centre. “It's fine when the flows are coming in, but a big problem for financial stability when they try and go the other way.”

For Magnus, the increase in dollar deposits is “random and most likely temporary,” and will slow when other nations recover from the pandemic.

While it lasts though, the situation offers an opportunity for China to implement reforms and loosen its grip over its tightly controlled capital borders.

“China will take the chance of flush dollar liquidity to make its cross-border flows more balanced,” said Becky Liu, head of China macro strategy at Standard Chartered Plc in Hong Kong. “Policy makers in the coming two to three years will keep widening channels for funds to leave the country.”

With assistance from Bloomberg