Foreign Exchange Reserve Fluctuations

The future trend of government bond yields in major developed economies is expected to continue to decline, and under the dominance of valuation effects, there may still be room for an increase in foreign exchange reserves. In the future, it is more likely that the central bank will use quantitative tools such as reserve requirement ratio cuts.

As of the end of May, China's foreign exchange reserves were $3,232.039 billion, with a sequential change of $31.208 billion. Valuation effects and changes in foreign currency exchange rates may be the main reasons for the increase in foreign reserves, with the decline in U.S. Treasury yields and the depreciation of the U.S. dollar having a significant impact on foreign exchange reserves; it is expected that the bank's foreign exchange settlement and sale will still have a deficit, but it has narrowed.

According to the semi-annual statistics on China's external securities investment assets published by the State Administration of Foreign Exchange (this statistics is for the resident sector, excluding the government and the central bank), at the end of 2023, the countries with the largest scale of China's external bond investment mainly include the United States, Japan, the United Kingdom, Australia, France, and Germany, with these six countries accounting for 43% of China's external bond investment scale.

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We use the changes in bond yields of these six countries to calculate the impact of valuation effects on the scale of foreign reserves and correspondingly expand the multiplier. Considering the availability of data, we use the country-by-country and long-term and short-term bond structure in the statistics on China's external securities investment assets at the end of 2023 to calculate the country-by-country and long-term and short-term structure of foreign bonds in foreign exchange reserves. At the end of March 2024, China held $767.4 billion in U.S. Treasury bonds, and the yield on U.S. Treasury bonds due in May fell, corresponding to an increase in bond prices, which had a significant impact on the valuation effect on the scale of China's foreign exchange reserves; the yield on long-term and short-term bonds of the other five countries rose and fell, and due to limited holding scale and other factors, it is expected that the impact of the remaining five countries on China's foreign reserves will be relatively small, and the change in foreign debt valuation is expected to increase China's foreign exchange reserves by about $29 billion. In addition, the accrued interest on U.S. Treasury bonds held in May is expected to be about $4 billion, so the combined impact of valuation and interest is expected to increase China's foreign exchange reserves by about $33 billion.

In May, the U.S. dollar index fell significantly, and the U.S. dollar depreciated against the yen, pound, Australian dollar, and euro, resulting in exchange gains of about $11 billion due to exchange rate conversion. At the end of May, the U.S. dollar index fell by 1.6% compared to the end of April. Specifically, the exchange rates of the U.S. dollar against the yen, pound, Australian dollar, and euro at the end of May fell by 0.3%, 2.0%, 2.8%, and 1.7% compared to the end of April, respectively. Based on the exchange rates of various currencies against the U.S. dollar published by the foreign exchange administration on May 31 and April 30, it is estimated that the depreciation of the U.S. dollar in May led to exchange gains of about $11 billion when non-U.S. dollar assets were converted into U.S. dollars.

From the perspective of the trade balance, the trade surplus in U.S. dollar terms in May was $82.62 billion, an increase of $10.268 billion compared to April, and correspondingly, the demand for exchange settlement may have increased; on the other hand, the exchange rate of the U.S. dollar against the renminbi continued to operate at a high level above 7.2, and the renminbi depreciated for most of May, and the impact of exchange rate factors on the demand for exchange settlement is still very obvious. Under the situation of one increase and one decrease, the impact of exchange rate depreciation on the balance of exchange settlement and sale may still be dominant. The widening of the trade surplus can offset the impact of exchange rate depreciation to a certain extent. In addition, the balance of exchange settlement and sale is also affected by other demand for foreign exchange purchase and use, and it is expected that the deficit in exchange settlement and sale in May will be around $13 billion, which is narrower than the $38 billion deficit in exchange settlement and sale in the previous month.

In the first quarter, the changes in foreign capital's allocation of Chinese assets were more obvious. Since the second quarter, the fluctuation of domestic asset prices has slowed down, with the monthly change of the Wind All A index in April and May being around ±1%, and the monthly change of the full price index of Treasury bonds being only about 0.1%. Under the influence of the slowdown in the fluctuation of Chinese asset prices, the flow of foreign capital has also significantly decreased, with the average monthly net inflow of northbound funds in April and May being only about 1 billion yuan. It is expected that the impact of foreign institutions' asset allocation effect on the scale of foreign reserves in May will be relatively small.

Looking ahead, since June, the yield on government bonds in major developed economies has continued to decline, and the main foreign currencies against the U.S. dollar have continued to appreciate, and it is expected that the valuation effect will continue to have a positive impact on foreign exchange reserves.

In May, exports valued in U.S. dollars grew by 7.6% year-on-year, an increase of 6.1 percentage points compared to the previous month. It is expected that the positive trend of exports will have some support for the demand for exchange settlement, but it may still not be able to fully offset the impact of the depreciation pressure of the renminbi exchange rate on the demand for exchange settlement. Looking at the exchange rate of the U.S. dollar against the renminbi, it approached 7.25 at the end of May and then fell back, and it rose again in early June, approaching 7.25. It is expected that transaction factors will continue to consume foreign exchange reserves.

As the market's expectation of the Federal Reserve's first interest rate cut approaches, the impact of the downward trend of U.S. Treasury yields is more significant, and under the dominance of valuation effects, there may still be room for an increase in foreign exchange reserves in the short term. In terms of exchange rates, it is expected that the renminbi exchange rate will have a higher probability of short-term fluctuations. The European Central Bank has cut interest rates for the first time, and the resilience of the labor market determines that the timing of the Federal Reserve's interest rate cut may be postponed, with limited external environmental disturbances and little constraint on China's monetary policy.In terms of the central bank's monetary policy tools, we believe that the possibility of quantitative tools such as reserve requirement ratio (RRR) cuts is higher, and the likelihood of price tools like lowering deposit rates and the Loan Prime Rate (LPR) is greater, while the probability of changes in policy rates such as Open Market Operations (OMO) and Medium-term Lending Facility (MLF) is limited.