Aegon AM: Russia sanctions could drive US Treasury-exposed China into the arms of the West

The seizure of Russia’s central bank reserves could force China closer to the West thanks to its enormous exposure to US Treasuries, according to Aegon Asset Management.

Phil Torres, an Emerging Markets Debt manager at Aegon AM, says with a third of China’s assets held in US Treasuries, China is exposed to the weaponization of the global financial system and is getting a front row seat to the effectiveness of this in Russia.

“China presently has no good alternatives to the US dollar or the euro for its ever-increasing savings pile,” he says. “We believe the move on the Russian Central Bank (CBR) will potentially drive China closer to the West and could force a hard wedge between the growing economic bloc of China and Russia.

“China holds vast external savings in the United States as well as in the EU. Each quarter, China adds to its savings in the accumulation of large and persistent trade surpluses. In our opinion, China has no real alternatives to the US dollar or the euro for its ever-increasing savings pile.

“At the end of 2021, China held at least one-third of its central bank reserves in US Treasuries, valued at USD 1.1 trillion. Until there are serious competitors to the USD reserve status, the freeze on CBR assets could be one of the most effective foreign policy tools the US has deployed at China in the last 25 years.”

US companies can take major reassurance at the effectiveness of these types of sanctions, says Torres. As China’s heavy exposure to US Treasuries function as an “insurance policy” for US corporates.

“For US-based companies to want to invest heavily in China, they require an affordable insurance policy. China’s accumulation of international reserves held in US Treasuries are that insurance policy,” he says.

“If in the future the Chinese government were to illegally seize US corporate assets in China, the US could counter seize China’s sovereign assets. China is locked into this system until it liberalises, and the renminbi graduates to reserve currency status.”

China may now be reminded of its exposure to a loss of access to its reserves, however Torres believes China has no good alternatives to the current regime of USD dominant reserves.

“China could revalue its currency to make its exports less competitive as a means toward ending its trade surpluses. This would force a rebalancing of the economy resulting in slower growth, rising unemployment and could have political consequences. Additionally, this doesn’t address the existing savings pile still at risk.

“It could also exchange USD and EUR for stockpiles of gold, oil, and other of commodities. But there are limits to both the supply of these commodities and the damage this transaction would do to the Chinese economy through the likely extreme price impact.

“China could dramatically expand the size of the Belt and Road initiative to deploy the accumulated USD and EUR into infrastructure projects across friendly non-Western compliant countries. By most accounts, too many existing Belt and Road projects are already failing that China has already reversed this effort.”

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