Canadian data casts doubt on China-U.S. bond ‘conspiracy,’ National Bank says

Some bond-market watchers believe China is disguising the full extent of its ownership of U.S. debt by holding hundreds of billions of dollars of securities through accounts in Canada. That idea is off base, according to research from one major Canadian bank.

Three analysts at National Bank Financial took aim at the China-Canada link in a report this week, saying there are more logical explanations for figures that show Canada’s holdings of U.S. debt rising sharply while China’s fall — including the rapid growth of Canadian financial institutions.

Official U.S. data suggest that China has cut its holdings of U.S. Treasuries in half over the past decade or so. The theory circulating in the market is that Chinese entities, in fact, are choosing to obscure how much they own by spreading them around through custodians in other nations, including Canada.

“Who doesn’t love a good conspiracy theory?” National Bank’s Warren Lovely, Taylor Schleich and Ethan Currie said in their report.

If true, it would mean China’s share of U.S. debt isn’t shrinking as rapidly as thought, that Canada’s appetite for it is significantly overstated, and that the latter’s financial system is being used to conceal the ultimate ownership of the world’s most important debt securities.

But Canadian data point to a simpler, less exciting explanation, the National Bank analysts said.

Combing through Statistics Canada data on financial flows and balance sheet accounts, they note that Canadian entities held foreign bonds worth more than $1.1 trillion as of the second quarter of this year. Most of that is concentrated in several groups: banks, insurers, pension plans, mutual funds, other private funds and social-security plans such as the Canada Pension Plan.

The value of foreign debt held by Canadian investors has risen by nearly $500 billion over the past five years, Statcan data show.

About half of that increase reflects net purchases, the analysts said in the report. The rest came from “revaluation effects,” including currency movements — meaning the increase in Canada’s reported holdings also overstates the amount of new money actually flowing into foreign bonds.

Investors have a number of reasons to want to hold more US Treasuries, including higher yields, balance sheet growth and a desire for geographic diversification, according to Lovely, Schleich and Currie.

Canadian banks are responsible for the largest portion of the increase in foreign bond holdings in recent years, which the analysts said is “partly the flip side of a growing pool of liabilities” as they attract more foreign-currency deposits.

“It would seem a stretch to suggest that Canada’s heavily regulated banks are somehow complicit in masking the true nature of China’s U.S. Treasury holdings,” they wrote.

Non-bank financial firms in Canada are another big source of growth in foreign bond holdings, the National Bank analysts calculated. This group, which includes lightly regulated hedge funds, has seen those holdings jump $63 billion in two years.

It’s not totally clear what’s driving that, but the National Bank analysts noted that such funds are getting bigger and that there’s ample evidence that hedge funds have quickly become larger players in Canada’s government bond market.

“For leveraged players, the superior liquidity afforded by Treasuries can enhance the efficiency of relative-value trading strategies,” the National Bank analysts wrote. “This deep-liquidity argument helps explain the growing involvement of foreign hedge funds in Canada’s own sovereign bond market.”