Russia's Dollar Reserves and Putin's Visit to China

Russia is more integrated into the world economy than the Soviet Union. There is clear interdependence, even if it is asymmetrically distributed. The confrontation with Russia over its actions in Ukraine and its unprecedented (post-WWII) annexation of Crimea is being partly waged with financial sanction and visa freezes.

The use of conventional military forces seems limited to some minor troop movements and has yet to include arms, or bolstering Ukrainian forces through non-lethal military goods, such as night goggles. There have been some press reports suggesting that, at least in eastern Ukraine, the non-uniformed Russian-allied forces are being confronted by non-uniformed US/EU-allied forces, like Blackwater.

The latest US Treasury International Capital (TIC) report shows that Russia's holdings of Treasuries fell in March to $100.4 bln from $126.2 bln in February. Some observers suggest this is a sign Putin is implementing a strategy reduce the role of the US dollars. While we recognize this as a declared strategic goal, we suggest these figures are more complicated than the optics suggest.

First, we note that March was the fifth month that the TIC data showed a decline in Russia's holdings of Treasury securities. Half of the decline took place prior to the heightened tensions over Ukraine. As of the end of October, the TIC data showed Russia with almost $150 bln Treasuries.

Second, the TIC data picks up flows on a custody basis running through the US banking system. The extensive use of US Treasuries as collateral and the increase of flows between non-US banks means that there are reasons why what may look like a decline of Treasury holdings may really reflect a shift in custodian and an increase in non-US activity.

As we have noted, this is the most plausible explanation for the continued increase what the TIC data reports as an increase in Belgium's Treasury holdings. Belgium appears to be the third largest holder of US Treasuries after China and Japan. However, the one key difference is that in both China and Japan's case, the public sector dominates the holdings. In Belgium, it is the role as a financial center (see Euroclear), which is to say private sector actors. The TIC report showed Belgium's Treasury holdings increased by a little more than $40 bln to $381.5 bln. In March 2013, their Treasury holdings stood at $188.5 bln.

US Treasuries, especially bills, are used for collateral. Over the past five months, the TIC data has reported an increase in Belgian holdings of US Treasury bills and a decline in bonds and notes.

Third, in the month of March, when roughly half of the TIC-reported decline in Russia's Treasury holdings occurred, the rouble fell 5.5%. This the largest drop in six months and the second to largest monthly loss since September 2012. The Russian central bank likely intervened to support the rouble during this period, which is to say that the dollar was still being used to evaluate the rouble. This is supported by the TIC data that showed Russia's divestment took in the bill market, which is likely where is invests the part of its dollar reserves that are used for such purposes.

With the yield on US Treasuries currently flirting with seven month lows, whatever selling Russia may have done, it was able to be absorbed by the market. The 10-year yield fell from over 3.0% at the start of the year to about 2.6% and proceeded to spend the last three months in a 2.60%-2.80% range before breaking down over the past week. With occasional spikes, bond market volatility has generally trended lower.

Perhaps more interesting and important than the dissection of the bond market entrails, is Putin's visit to China next week. One of the key issues in this regard are reports suggesting a long-term (measured in decades) energy contract. In what currency will China purchase Russia's energy? China no doubt wants yuan. Russia prefers roubles. However, we suspect observers may exaggerate the impact that this is trade is not likely to the dollar. The capital flows dwarf trade flows and this is especially true for large economies. Turnover in the foreign exchange market is sufficient in one week to cover year's worth of global trade.

Russia may be a bit more desperate than China to strike a deal, as Putin is making his own Asian pivot with the Ukraine confrontation a signal of the end of his Eurasian union fantasy. There have been some reports suggesting that Russian energy companies, like Gazprom, are looking to increase their presence in the Dim Sum market (offshore yuan bond market). The prospect of a Russia-China alliance to check or offset the US influence is capturing the imaginations of many observers. In short, it appears that China is simply being opportunistic.

As one Chinese official told me a couple of years ago, "A sick camel is larger than a horse". It means that China recognizes that even though the US has its challenges to be sure, it is still sufficiently strong and powerful, while China is still developing. It is not clear that China really disagrees with US President Obama's judgment that Russia is a regional not a world power.