China is hiding $3 trillion of foreign currency in 'shadow reserves,' adding unknown risks to the global economy, former Treasury official says

• China has more foreign exchange reserves than reported, a former Treasury official wrote.
• An additional $3 trillion is hidden in "shadow reserves," such as state commercial and policy banks.
• "Not everything that China does in the market now shows up in the PBoC's balance sheet."

Half of China's currency reserves are "hidden," a situation that may add risks to the global economy down the road, former Treasury Department official Brad Setser wrote.

While the country's State Administration of Foreign Exchange reported $3.12 trillion in foreign assets last December, Setser estimates that foreign exchange reserves actually sit at around $6 trillion.

"China is so big that how it manages its economy and currency matters enormously to the world," he wrote in The China Project. "Yet over time the way it manages its currency and its foreign exchange reserves has become much less transparent - creating new kinds of risks for the global economy."

A key indicator about China's reserves is a sudden pause in its reported activity. From 2002 to 2012, China's foreign exchange reserves steadily rose as the central bank bought US dollar assets to prevent China's yuan from appreciating too much, allowing exports to remain cheap.

But over the last 10 years, China's reserves stopped rising, which is puzzling as China's trade surplus has continued growing, and currently stands at an all-time high, he said.

Setser, who previously was deputy assistant Treasury secretary for international economic analysis and is now senior fellow for international economics at the Council on Foreign Relations, has an idea of what's going on.

"Just as China has 'shadow banks' — financial institutions that act like banks and take the kind of risks that a bank might normally take but aren't regulated like banks — China has might be called 'shadow reserves.' Not everything that China does in the market now shows up in the PBoC's balance sheet," he said.

China's state banking system is the main way Beijing hides its reserves, Setser said. That includes state commercial lenders like the Bank of China, Industrial & Commercial Bank of China or ICBC, China Construction Bank, and the Agricultural Bank of China as well as policy banks like the China Development Bank and the Export-Import Bank of China.

China's State Administration of Foreign Exchange did not immediately respond to Insider's request for comment.

The vast amount of China's reserves carries enormous weight in financial markets and represents a risk.

For example, Setser said China's earlier accumulation of US Treasurys and agency bonds — such as Freddie Mac and Fannie Mae securities — helped give rise to the 2008 financial crisis, by pushing investors further into riskier mortgage-backed securities.

"China's lack of transparency here is a bit of a problem for the world," he said. "China structurally is so central to the global economy that anything it does, seen or unseen, will eventually have an enormous impact on the rest of the world."