China FX reserve sell-off to soon move beyond U.S. Treasuries: BAML

LONDON (Reuters) - The unwinding of China's foreign exchange reserves could soon extend beyond U.S. Treasuries, with U.S. corporate and euro zone sovereign bonds among the assets most vulnerable to selling from Beijing, Bank of America Merrill Lynch said on Monday.

China sold a record $510 billion of FX reserves last year to counter the damaging impact on an already decelerating economy from the surge of capital fleeing the country.

The lion's share of that came from $292 billion sales of U.S. Treasury debt, followed by $92 billion sales of U.S. stocks, $3 billion of U.S. agency bonds and $170 billion of non-U.S. assets, according to BAML estimates.

China increased its U.S. corporate bond investments by $44 billion last year to $415 billion, BAML strategists estimated, adding that it won't be long before investors turn their attention to other assets Beijing could potentially sell.

"In the next two months I would still say Treasuries. But if the pressure continues beyond that, it's non-U.S. assets, and in the U.S. space it's definitely corporates and agencies," said Shyam Rajan, rates strategist at BAML in New York.

Rajan and his colleagues estimate that China's $3.33 trillion FX reserves comprise $1.15 trillion non-U.S. assets (mostly short-dated euro-denominated bonds), $415 billion U.S. corporate bonds, $212 billion in agencies, $266 billion stocks and $1.29 trillion of Treasuries.

Selling across these bonds may not automatically trigger a sharp rise in their yields though, Rajan said, pointing to the experience of Treasuries in the latter part of last year when swap spreads moved below zero.

"The way to trade the reserve flow story is through relative value trades, such as the swap spread tightening in Treasuries. I would imagine it plays out the same way in other markets too," Rajan said.

Last year's record unwind brought China's total FX reserves to a three-year low of $3.33 trillion. Most analysts expect that to be depleted further this year.

JP Morgan estimates that capital flight from China since the second quarter of 2014 has totaled $930 billion, while credit ratings agency Fitch on Monday put the figure at over $1 trillion.

U.S. investment bank Morgan Stanley on Monday joined Goldman Sachs in lowering its forecast for the Chinese yuan, citing the ongoing flow of capital out of the country and need for a weaker currency to support the economy.

(Reporting by Jamie McGeever; Editing by Toby Chopra)

By Jamie McGeever