Brad Setser

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In an attempt to be fair and balanced

by Brad Setser
October 31, 2005

Here is a link to a paper by two IMF economists (Aizenmann and Lee) that concludes China really is building up its reserves as a precaution against a crisis, not just to support its export sector (impeding global adjustment in the process).

Personally, I think the choice of variables dictated the study's results, and I don't particularly like the choice of variables.  China has an unusually high broad money to GDP ratio, so its reserves to broad money ratio is not all that high, even though its reserves to GDP ratio is very high for a major continental-sized economy.   And since China trades a lot for a continental economy, it imports are a lot for a large economy that too keep keeps China from being an outlier.   The model basically assumes that since Chinese imports/ GDP is about two times those of a country like the US (for the record, Chinese exports/ GDP are about four times that of the US, 40% v 10%) it should have more reserves than the US.   Since small city states like Singapore and Hong Kong trade a lot and have high levels of reserves, the source of the more trade/ more reserves correlation is not hard to find.
Consequently, by looking at imports/ GDP and M2 (broad money) to reserves, the author's happened to pick the variables most likely to show that China really is just accumulating reserves for precautionary reasons.

However, I am not convinced that trade flows are the best way of measuring reserve adequacy; I prefer short-term debt to reserves.  For dollarized economies with open capital accounts, i would add in a measure that includes the potential outflow of domestic dollar deposits — but this is not an issue for China, which has a closed capital account and very few domestic dollar deposits. 

China's huge M2 to GDP ratio reflects financial underdevelopment (all savings in the financial system take the form of bank deposits, and thus count as money; securities markets are underdeveloped) reinforced by extensive capital controls.  Yet those same capital controls reduce China's external vulnerabilities – Chinese depositors with RMB cannot convert their savings into dollars, or euros.  So I am also not convinced M2/ reserves is the right measure for China — it is low because both M2 to GDP and reserves to GDP are unusually high.

If you look at a variable that is left out of the Aizenmann and Lee study —  reserves to short-term debt, China clearly has far more reserves than it needs.   Hell, China has far more reserves than it has external debt, let alone short-term external debt.   Consider this graph, which shows China's reserves to short-term external debt at the end of 2004 v. the reserves to short-term debt of selected Asian economies at the end of 1996.  A number below one is a sign of danger.  But, setting aside heavily dollarized economies, I am not sure that you need more than 2 times as many reserves as short-term external debt (for wonks, on a residual maturity basis) either.

The World Bank put more emphasis on reserves to short-term debt in their assessment, and came to a rather different conclusion in their spring report on Global Development Finance.  Indeed, the World Bank, to be honest, seems a bit ahead of the IMF on this issue.  I should emphasize though that the output of a couple of economists in the research department does not reflect the collective judgment of the IMF.  But I have not seen a clear statement from the IMF that China now has more reserves than it needs either.

Both China's overall reserves to GDP ratio (heading toward 50% at the end of the year) and the pace of its reserve accumulation (near 15% of GDP) are way high for a major economy.  China makes Japan look massively under-reserved, since Japan's reserves are less than 20% fo its GDP.  And it certainly makes the US look under-reserved.  The US holds less than 1% of GDP as reserves (and getting close to 1% of GDP requires a pretty generous definition of reserves).  I can accept that China needs ten times as many reserves as the US, even twenty times as many.  But fifty or more?


  • Posted by ErikR

    “Chinese depositors with RMB cannot convert their savings into dollars, or euros”

    Not today. Maybe in a couple years? Could that be one reason for building up reserves?

  • Posted by Charlie

    The argument that China is building dolar reserves as a protection against a crisis is rediculous. Obviously they are doing it to keep their export machine growing. If they were doing it for protection, why would they have a peg? Wouldn’t it make more sense to let their currency appreciate so they could buy more dollars with a given amount of Yuan?

  • Posted by Stormy

    When they release that peg, their export machine tumbles—receives a healthy shock—, an eventuality for which they must plan. By disallowing conversion to dollars or euros, are they not creating sudden “wealth effect” when the shock comes? They will lose money on T-bills, lots of it. The magnitude of the reserves will cushion the blow.

    We all know the shock is coming. The question is “when,” in what form, and at what magnitude. As Brad has pointed out time and again, the longer everyone waits, the harder the fall.

    We can argue whether China is being foolish or wise; one thing is certain, they do plan ahead. Both a mercantilist and a precautionary strategy are being dovetailed here. And it really helps when your finger is on the economic trigger.

    This is the lull before the storm.

    A very interesting paper.

  • Posted by Gcs

    ” I can accept that China
    needs ten times as many reserves
    as the US, even twenty times as many
    But fifty or more?”

    quick calc

    — don’t even need an envelope —

    say the fair exchange rate is
    2 to 1
    not 8 to 1


    the prc’s gdp is 4 times larger
    putting their reserves in line



  • Posted by bsetser

    Erik — perhaps. it is one reason why I think China might want reserves = 20% of GDP, for example. but right now, China is building up its reserves in large part because Chinese (and offshore Chinese) savers want to move their savings out of dollars into renminbi — reverse capital flight. See Prasad and Wei’s IMF paper on capital flows into China.

  • Posted by Gcs


    “China’s huge M2 to GDP ratio
    reflects financial underdevelopment
    (all savings in the financial system
    take the form of bank deposits
    and thus count as money
    securities markets are underdeveloped)
    reinforced by extensive capital controls”
    result :
    “those same capital controls
    reduce China’s external vulnerabilities –
    Chinese depositors with RMB cannot convert
    their savings into dollars, or euros”

    and see how well it works for em

    talk about ease of sterilization

  • Posted by Gcs

    the problem for the prc comes when fdi ers
    want as good a highway out as they now have in

    then the trans nats will exclaim

    your primitive cap controls

    “must go !!!”

  • Posted by Guest

    Hey Brad,

    This is a little off topic, but related.

    You are a savvy guy. Do you have any insight as to what is going on regarding the “settlement fails” in treasuries leading to the bizarre consideration of the U.S. Treasury to begin to provide EVEN MORE treasuries (as if $4 trillion outstanding isn’t enough) to allow the short-sellers to have something to deliver? (I have heard rumors that Fannie MAe is knee-deep in doo-doo and is shorting treasuries to hedge interest rate risk).

    Also, what are your thoughts on today’s (Nov. 1) article in Financial Times regarding the fact that there are TWELVE TRILLION DOLLARS in outstanding credit default swaps outstanding on only five trillion dollars in total outstanding corporate debt?

    For that matte, what are your thoughts on the $TWO-HUNDRED SEVENTY TRILLION DOLLARS on notional outstanding derivatives worldwide? Do you see any dangers here?

    Enquiring minds want to know…


  • Posted by Gcs

    “China is building up its reserves
    in large part
    because Chinese (and offshore Chinese)
    savers want to move their savings
    out of dollars into renminbi
    — reverse capital flight”

    nicely put

    get inside what you want in side
    before the peg pops
    and the dollar devaluation slide begins

    but still
    its a one way street

    you check into yuan
    you can’t check out

    “in large part ”
    as to source perhaps
    but not policy

    the prc cbers
    could crank up the exchange rate
    ie revalue on this flow

    so the peg is the policy

    the massive inflow merely
    the “enormity ” of it all
    in both senses of that word

  • Posted by TI

    I think we have had a discussion of the real size of the Chinese economy. And I think everybody agreed that we don’t really know, but probably the Chinese GDP was larger than the statistics show. So we should be very cautious comparing reserves/GDP or anything GDP-related.

    Nevertheless the Chinese reserves are big. Another question is, how that happened – was that in purpose. And yet another what they will do with their reserves in the future. (What the Japanese will do?) One answer is to buy oil and raw materials, buy energy and raw materials producing companies around the world – and invest in multinational corporations abroad to create channels for their exports. The Chinese needs their own network of international corporations quite as the US does. All this takes time.

    It is obvious that the Chinese imports will rise in the future as the economic growth increases energy and commodities consumption beyond the domestic capacities. The trade balance will not be very long as advantageous as today. But still I think that the Chinese economy is on a fairly solid ground and will continue growing for some years at the present pace.

  • Posted by Stormy

    If I were China and knew I had to revalue or face quota’s, I certainly would be doing what this article says is planned:

    “Quotas send China’s ragmen southeast”

    The interesting item here is that foreign manufacturers in China are looking to do the same.

    China is starting to learn how to play the FDI game from the other side of the board, so to speak.

    Put this article next to Aizenmann and Lee’s and you have an interesting long-term strategy. Reposition at least some of your manufacturing; then revalue. Manufacturing continues unchallenged; yuan profits by revaluation. Yup, there is enough cheap labor to keep these dominoes falling for some time yet.

  • Posted by sun bin

    US does not need foreign reserve. Its currency is other people’s reserve.

    let’s compare with Korea or Indonesia.

  • Posted by DOR

    Overall, I find the concern over the size of China’s forex reserves oddly disjointed. There doesn’t seem to be any good reason why large and rapidly growing reserves are not good . . . and lots of history that shows small and rapidly diminishing reserves are very, very bad (Asia, Latin America).

    Yes, there may be an opportunity cost, but that is off-set by an opportunity loss: the lost opportunity to have a current-account crisis. Seems like a fair trade off to me.

    Convertibility: Why the assumption that Chinese depositors with Rmb cannot convert their savings into dollars, or euros? Why the “you can check into the yuan, but you can’t check out?” Where does this come from?

    I haven’t heard about a problem changing money in China — either direction — in over 10 years. Don’t assume that the early 1990s regulations are still in force. Don’t assume that the lack of legal euro-denominated bank accounts means Zhou can’t hold his money in euros. Zhou is much smarter than that; if he really wants euros, he’ll find a way.

    Charlie, you got it backwards: the export machine generated the reserves. The peg prevented the crisis (remember 1997-98? We in Asia certainly do!). The goal isn’t to buy more dollars; it is to keep the boat afloat.

    Gcs, perhaps it is the US dollar that is overvalued, rather than the Rmb that is undervalued.


  • Posted by bsetser

    sun bin — tis true that the fact that the dollar is the reserve currency reduces the us need for reserves. plus, the US could in pinch borrow the euros or yen it needs from the ECB or BOJ if it wanted to intervene by selling euros or yen. Still, reserves occasionally come in handy — limited intervention as a market signal (rubin did this effectively i think on two occasions) for one. bailing out countries for another — the us financed its big loan to mexico out of its reserves.

    Still, the US sets the floor for reserves to GDP.

    What is the upper bound of reasonableness for a large economy?

    China is on track to have reserves to (measured) GDP of 70% in a few years — probably by the end of 07. Even there is a devaluation of the $ v. China by say 50%, it will still have reserves equal to 35% of its GDP. And if you follow all my discussions about capital losses, it also will have issued RMB and RMB debt over the past few years to buy up all those dollars, so the central bank will have a big capital loss (paper loss to some) on its balance sheet. Buying dollars, selling low is a recipe for paper losses. If it already has enough reserves for prudential reasons, why keep adding to the reserves, and adding to the mismatch on the central bank’s balance sheet?

  • Posted by bsetser

    Bruce — Good questions. Not sure I have good answers. Look at the delphi situation for one potential solution for those circumstances when the number of default swaps outstanding exceeds the number of deliverable bonds. rather than bidding up the price of the underlying bond (since you need to present the bond to collect the insurance on the default, and there are not enough bonds to go around … ) they are going toward cash settlement.

    Still, the fact that market norms are not well developed here, and they assume more bonds than insurance when often now there is more insurance than bonds is a problem — one that worries me.

    For the treasury market, two things to consider:

    1) a big chunk — maybe 40% — of the 4 trillion outstanding is locked up in central bank accounts, and central banks often do not lend their bonds out in the market … some do, but i gather some don’t. So that reduces the effective float of bonds that are outstanding. THinking even more broadly, most treasuries that are outstanding are either non-marketable (they do not count in even the 4 trillion) and in the hands of various trust funds (military retirement, social security) or marketable but in the hands of folks who do not necessarily mark to market/ trade actively (BoJ, traditionally — they may be changing).

    2) almost all other dollar credit markets use treasuries as a hedge in one way or another. RAther than taking interest rate risk, you hedge the interest rate risk in the treasury market and just take the credit risk (or just take the credit risk in the credit default swap market). Various strategies that i don’t fully understand in the mortgage backed securities market also create demand for treasuries as a hedge in some circumstances. the broader point is that there is lots of potential demand for treasuries as a hedge.

    so not much supply v. lots of potential demand from various sophisticated strategies = potential shortages and the like.

    one solution here — particularly for certain derivatives — is to go to cash settlement so that folks don’t have an option to actually collect the underlying treasury security if they want. they just get the cash value of the treasury so to speak.

    am sure others can talk about this with far greater authority tho.

  • Posted by PC

    Check out Steve Hanke’s take on China’s reserve build up – see

  • Posted by bsetser

    hmm. does Dr. Hanke think a currency board is a solution.

    DOR — no doubt the dollar is overvalued, but doesn’t that imply some other currencies are undervalued?

  • Posted by Gcs

    dor great post

    agree almost 1000 %

    but for one point :

    “Convertibility: Why the assumption that Chinese depositors with Rmb cannot convert their savings into dollars, or euros? Why the “you can check into the yuan, but you can’t check out?”

    ” Where does this come from? ”

    latent authority and the means to accomplish same

    sure the party’s cbers
    are playing lasissez allez

    why not
    when flows are overwhelmingly incoming

    check out mexico over the last 30 years
    i recall folks losing a wad or two
    on convertible accounts that were ahh
    suddenly by fiat nolonger convertible

    it happens
    in one party states its even a breeze

    Gcs, perhaps it is the US dollar that is overvalued, rather than the Rmb that is undervalued

    couldn’t agree more

    i see a north south fault line
    n over s under

    its systemic

    when you have a jet stream for capital
    ie flight north is spontaneous and easy
    portfolio wise

    and fdi gets to buy the south for cheap

    high as the sky

  • Posted by DOR

    China’s capital controls leak like a sieve. There are a few commitments to exchange Rmb for dollars (SAFE registered lending to the ITICs, for example), but not many.

    It doesn’t matter. Anyone and everyone who wants to convert Rmb to dollars, euros or yen does it anytime they want to.

    ‘Need Honkies to buy a flat in Kowloon? No problem, sir, just deposit your Rmb with my factory in Dongguan and you can pick up a HK dollar certified bank check at our office in Central tomorrow morning. Oh, no, sir the pleasure is all mine. Very difficult to get Rmb to pay my workers when all my export earnings go to the Cayman Islands.’

    Don’t confuse China with a place where rules are more important than imagination.

    Sure, in a two currency world the dollar is just as undervalued as the Rmb is overvalued. What gets my goat is that no one seems to think the dollar is the problem.

  • Posted by bsetser

    DOR — i certainly think the dollar is a problem. the markets, alas, don’t.

    but i strongly suspect the 05 dollar rally will lead (assuming it is not overwhelmed by other factors that influence imports, namely the real estate/ consumption/ oil/ real wages nexus) the trade deficit to widen, ’cause the lagged impact of 03/04 dollar depreciation on exports will start to fade. if i am right and export growth slows and nothing steps in to prevent non-oil imports from resuming their rise, well, the outcome is pretty clear.

    and long-term, all orderly adjustment scenarios assume a significant dollar depreciation (that includes the fed’s scenarios — read joe gagnon’s work carefully), including a dollar depreciation against china!