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Earlier today, Bloomberg - citing the ubiquitous "people familiar with the matter" - confirmed what we’ve been pounding the table on for months; namely that China is liquidating its UST holdings.

As we outlined in July, from the first of the year through June, China looked to have sold somewhere around $107 billion worth of US paper. While that might have seemed like a breakneck pace back then, it was nothing compared to what would transpire in the last two weeks of August. Following the devaluation of the yuan, the PBoC found itself in the awkward position of having to intervene openly in the FX market, despite the fact that the new currency regime was supposed to represent a shift towards a more market-determined exchange rate. That intervention has come at a steep cost - around $106 billion according to Soc Gen. In other words, stabilizing the yuan in the wake of the devaluation has resulted in the sale of more than $100 billion in USTs from China’s FX reserves.

That dramatic drawdown has an equal and opposite effect on liquidity. That is, it serves to tighten money markets, thus working at cross purposes with policy rate cuts. The result: each FX intervention (i.e. each round of UST liquidation) must be offset with either an RRR cut, or with emergency liquidity injections via hundreds of billions in reverse repos and short- and medium-term lending ops.

It appears that all of the above is now better understood than it was a month ago, but what’s still not well understand is the impact this will have on the US economy and, by extension, on US monetary policy, and furthermore, there seems to be some confusion as to just how dramatic the Treasury liquidation might end up being.

Recall that China’s move to devalue the yuan and this week’s subsequent benchmark lending rate cut have served to blow up one of the world’s most popular carry trades. As one currency trader told Bloomberg on Tuesday, "it’s a terrible time to be long carry, increased volatility -- which I think we’ll stay with -- will continue to be terrible for carry. The period is over for carry trades."

In short, the music stopped on August 11 and to the extent that anyone was still dancing going into this week, the PBoC’s decision to cut the lending rate along with RRR buried the trade once and for all.

Estimating the size of that trade should be a good indicator for just how expensive it will be - i.e. how much in Treasurys China will have to liquidate - to keep the yuan stable. The question, as BofAML puts it, is this: "can China afford the unwinding of carry trades?"

The first step is estimating the total size of the trade. Although estimates vary, BofAML puts the figure at between $1 trillion and $1.1 trillion. Here’s more:

As analyzed above, the size of RMB carry could be quite high and thus exert downward pressure on RMB. But the PBoC should have scope to defend its currency if necessary. The PBoC’s toolbox includes its $3.65tn FX reserves (at end-July), as well as measurements to tighten FX controls on individuals, corporate and banks, if necessary, including imposing stricter requirements on NOP, among others.

That said, we doubt if the PBoC will persistently intervene as rapid decline of FX reserves undermines market confidence anyway and imposes challenges to the PBoC. Alternatively, the PBoC could impose stricter FX controls but that would be considered as a backward move of capital account opening up. Nevertheless, we believe the PBoC intervention will still have spillover effects on the market.

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