Brad Setser

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The intent is good …

by Brad Setser
January 26, 2006

The Governor of the China's Central Bank said pretty much all the right things at Davos – at least from my point of view.    China does need to base its growth far more on domestic consumption.  And it is not in China's interest to continue to add $200 b (a bit more actually, once you factor in funds transferred to ICBC, the currency swap and valuation effects) to its reserves every year from now until eternity.  Chris Giles of the FT:

China is committed to slower foreign exchange reserve accumulation, Zhou Xiaochuan, the governor of the People's Bank of China told the World Economic Forum, in rare comments about China's exchange rate policy.

 Mr Zhou said that his country was committed to increasing domestic demand, rebalancing the economy gradually away from net exports, promoting consumption, particularly in rural areas, all of which would reduce the pressure on the country to keep increasing the rate of reserve accumulation at an annual rate of $200bn a year.

He said: "We need to make a change to stabilise the [foreign exchange reserve] situation".

"China has no intention of faster acceleration of foreign exchange reserves," he said, adding that he believed "the pace of foreign exchange reserves will be reduced".

But he damped hopes that China was on the verge of another, more substantial, currency revaluation. Speaking to Reuters, he said: "our foreign exchange policy is already in a good position".

Dooley, Folkerts-Landau and Garber should take note: China's central bank doesn't think continuing to add to its reserves at the current pace is in China's interest.  

I'll even excuse Zhou for not stating more forthrightly the need for additional RMB appreciation.  I think he still wants further appreciation – he argued for a bigger move in July.  But what you can say depends on where you sit – Zhou has to defend the existing parity until he changes it.

There are certainly plenty of rumblings that further changes could be in the works.   The Washington Post reported on January 10:

China has resolved to shift some of its foreign exchange reserves — now in excess of $800 billion — away from the U.S. dollar and into other world currencies in a move likely to push down the value of the greenback, a high-level state economist who advises the nation's economic policymakers said in an interview Monday.

Alas, China cannot push down the greenback without pushing down the RMB.  And a weaker RMB is not exactly the most obvious way to slow reserve growth.  That is why I suspect that China will need to modify its currency regime if it wants to significantly modify the composition of its reserves.

Yes, the PBoC has also denied any intent to change its reserve composition.  But there is enough smoke to think that there just may be a fire somewhere.  Yu Yongding certainly doesn't seem to be alone in arguing that China should not be adding to its stock of dollar reserves. 

Unfortunately, there also is a significant gap between the central bank's statements of intent and observed outcomes.   Last spring, it was not hard to find Chinese government officials and academic economists alike making the argument that China needed to base its growth more on domestic consumption and to reduce the pace of its reserve accumulation.

What actually happened in 2005?  Net exports contributed more to China's growth than in 2004 or 2003, China's current account surplus ballooned, China continued to peg to the dollar (for all intents and purposes) and total reserve accumulation rose – particularly if you adjust the 2004 and 2005 totals for valuation effects.

Good words.  But not (yet) good deeds.

One unsolicited suggestion: China's credibility would rise if Chinese officials stopped making statements that are rather difficult to square with reality.

Like arguing that the market sets China's exchange rate.  The Assistant Governor of the People's Bank (via Mark Thoma and Bloomberg):

People's Bank of China Assistant Governor Ma Delun said the market is determining the yuan's exchange rate

It doesn't.   The central bank determines China's exchange rate.  The market clears at the point where the central bank steps in to buy dollars, or at the point where private actors think the central bank will step in to provide dollars.

A couple of weeks ago China made some technical changes to the operation of its peg.   The reference band for one day's trading is still very small, but that band is no longer tied to the RMB's closing price the previous day. 

That in theory allows more RMB appreciation, since one day's opening price is no longer tied down by the RMB's closing price the night before.  

But there still will only be more appreciation if the central bank wants more appreciation.  It doesn't change the fundamental nature of China's regime.

Thomas Stolpher of Goldman gets this absolutely right:  

"In practice, the PBOC will remains the all-important player in the Chinese FX market and therefore any appreciation remains conditional on the implicit approval of the authorities ..  As before the actual spot rate will depend almost exclusively on the amount of appreciation acceptable to the PBoC.  The State Administration of Foreign Exchange is likely to remain the most important counterparty in the Chinese foreign exchange market, and, as the rapid pace of reserve accumulation illustrates, SAFE is by far the largest seller of CNY.  SAFE will therefore directly and indirectly control the quotes submitted to the new fixing process" 

Fixing here is the process for fixing the day's exchange rate. 

I suspect that there is consensus inside China that China has more reserves than it needs.  I am not sure that there is yet consensus that the RMB should be allowed to rise signficantly.   And I am not convinced that China has found a way to cut into its reserve growth while holding on to its current exchange rate, or something similar.  


  • Posted by Guest

    “China has no intention of faster acceleration of foreign exchange reserves,” he said, adding that he believed “the pace of foreign exchange reserves will be reduced”.

    But he damped hopes that China was on the verge of another, more substantial, currency revaluation. Speaking to Reuters, he said: “our foreign exchange policy is already in a good position”.
    How can China reduce reserve accumulation growth without letting its currency appreciate when its current account surplus rises?
    Either China continues to buy ever more dollars or its CA surplus needs to stop growing.

  • Posted by bsetser

    Guest — or the pace of capital inflows needs to slow, or the pace of private capital outflows needs to pick up. So far, China has done more to try to discourage inflows (bank borrowing in particular) and to encourage outflows (FDI by Chinese companies) than to change the current account surplus.

  • Posted by Charlie

    I think it’s all smoke and mirrors. China has no intention of changing the way they do business in 2006. They’re saying what people outside of China want to hear. Clearly, as the first post states, China can’t keep their currency pegged to USD and stop USD reserve accumulation at the same time (Unless miraculously they have a trade deficit with the US, which I don’t see happening). China’s in a tough situation. They have a high unemployment rate and exporting industries are where the job growth is. I don’t think they can increase internal consumption without lowering the unemployment rate. The chinese are saving because they’re insecure about the future. Having some job security via not being easily replaced can go a long way.

    On a side note. Did you see that GDP growth in 4Q was 1.1%? Mainly due to poor auto sales. I think GM is headed for BK. They’re credit rating is going to drop off a cliff and a company that’s losing money by the billions with a junk status rating is almost always doomed. I think poor auto sales are a telling sign that the american consumer is finally straining. Brad, maybe you’re right about 2006 being the year when we finally have to start paying the piper.

  • Posted by Emmanuel

    The more things change, the more things stay the same. Actually, the King Kong-sized deficit is reflected in the latest dismal GDP figures. According to Bloomberg:

    The trade deficit widened to $650.3 billion from $617.5 billion in the third quarter. That subtracted 1.18 percentage point from GDP.

    It’s all downhill from here as external imbalances keep taking bigger bites out of GDP if nothing is done. In the nick of time, really–the Winter Olympics are coming up.

  • Posted by ndk

    i actually believe the chinese are quite sincere in their desire to find a better way to cache — cash? — the proceeds. the attempted purchase of unocal is precisely how i think they’d like to be spending their dollars, essentially state-sponsored FDI. we won’t let them do that for political reasons, so instead they bought nigerian in USD. i’d imagine we’ll see this recycling grow more than anything else, which could in the end provide a lot more poltiical pressure than the original imbalances.

    whether this mercantilism-for-oil has a global effect on the value of the dollar anyway has more to do with the marginal dollar sponges than anything else, e.g. whether the nigerians sock it away.

  • Posted by Dave Chiang

    On several occasions, China’s Central Bank has suggested that the US raise interest rates to slow consumer spending. If the U.S. government were serious in addressing the trade deficit issue, the Federal Reserve should significantly raise interest rates to deflate the Housing bubble that has financed excess consumer consumption. There is an argument to be made that too much capital across the US Economy has been invested in Real Estate speculation. Even at current interest rate levels, the inflation adjusted “real” rate of return on bonds is neutral. Global rebalancing of the World Economy requires both the participation of the United States and China.

  • Posted by bsetser

    Dave — I agree, though i wouldn’t put the entire burden on US monetary policy. US fiscal policy could play a role restraining US aggregate demand growth as well. But China also has a role to play, and part of that role is adapting to a more realistic exchange rate.

  • Posted by Guest

    “I think it’s all smoke and mirrors. China has no intention of changing the way they do business in 2006. They’re saying what people outside of China want to hear.”

    Well, he’s just being a good central banker, isn’t he? That’s what Brad gets paid the big bucks for, to read between the lines.

  • Posted by Joe Rotger


    There’s just one problem with what China is saying and doing. As I mentioned in a previous Rubin post:

    “BTW, I woudn’t discount totally the significance of the inverted yield curve.

    It is basically saying that the Fed’s effort to hamper liquidity through short term rate increases is being unravelled by a loose end at the long term rates; where the PBoC and other foreign CBs are using a different method to remove liquidity, long term lending at very low rates to promote present consumption.

    It further says that the Fed cannot sustain these rates in the face of an increasing trade deficit, brought about by an increase in the USD due to higher Fed rates.”

    Furthermore, note that the real estate bubble is much more closely related to long term rates, short term rates have an indirect effect, they are mostly hitting credit card consumer spending.

    And yes, the debt involved is too big already, so the creditor has to help the debtor find ways to resolve his debt situation.

  • Posted by Gcs

    why can’t
    china just buy stuff:
    real fdi
    and portflio equity
    with its newly generated trade surplus dollars
    i know imports can’t be ramped there much

    but oil reserves and building foreign infastructure can

    that cuts reserve build up

    but 200-300 bills worth
    will be hard to spend eh??

    the question remains i
    will they still keep
    pushing open the trade gap
    super charged
    by the double shot
    low balled rmb x rate

    to get em to revalue
    may not follow
    from getting em to try spending their surplus

    but they sure need to begin the reval now !!!!

    u’ve said often the export expansion has a very limited future
    at this hell bent rate of growth

    the damn thing is too large to keep at this

    internal expansion requirements
    may very soon
    exceed what the external markets will bare
    and triggering
    a protection reaction awaits em

    the party boyz have to decide
    do they want to hit it at high speed
    or by
    lifting the xrate now
    slow that global export penetration rate
    and possibly keep the over reaction
    all the grizzly protective bears
    at bay a little longer

    if so
    have to determine
    how fast and how far
    an expanded fiscal deficit
    can induce a demand compesation
    for x policy induced
    slowed export growth

    my take and i told the deaf adders this:

    better try it out now

    not wait till they hit u in the nose
    with protection barriers

  • Posted by Gcs


    one boner i pulled

    that only sent em off on a
    “we are very different ” tangent
    was to suggest
    they do like japan did
    in the mid 70’s and early 80’s

    let the rmb drift up
    while making some key
    de facto quota pacts
    with the us and the euros

    but that is exactly
    what they need to do

    get the rmb in side ten years
    to a three for one
    with uncle’s dollar

    from todays practical joke rate
    of 8 for one

  • Posted by Gcs

    one of their problems
    instead of doing
    a giant task force size
    team A vs team B
    EACH DOING A monsterCALC

    A fully dynamic non linear model
    2 thousand hours worth of sim runs
    on a super machine

    like climate calcs and earth magnetic field calcs

    things pop up beyond intuitions grasp

    they are like us
    they produce
    dozens and dozens of fairly simple calcs

    well one big calc
    might be horribly off
    or it might
    be worth more then
    100 million pc spread sheet runs

  • Posted by Michael Robinson

    Brad: “But there still will only be more appreciation if the central bank wants more appreciation.”

    Look what happened to the dollar this past week when the RMB unexpectedly slipped infinitesimally outside its band.

    It seems that China is in a situation now where all exchange rate policy moves must be widely telegraphed well in advance so as to avoid spooking the market into a mad rush to the exits.

    So, while what you say is true, the converse (“if the central bank wants more appreciation, there will be more appreciation”) is not.

    I believe that when the next policy move comes, as last time, everyone will be expecting it, and it will only surprise people by being smaller than expected.

  • Posted by Michael Robinson

    Gcs: “A fully dynamic non linear model
    2 thousand hours worth of sim runs
    on a super machine”

    I have a question about that. The hardware to do that is relatively cheap, off-the-shelf, and well understood.

    If the results of such a process consistently produced significantly more accurate insight into market moves than prevailing practice, then it seems to me a private party could arbitrage this into significant excess returns in the futures markets, which would induce others to follow suit, until the new practice became the prevailing practice, and excess returns thereby eliminated.

    Is there a flaw in this line of reasoning, or is every quant house in the world simply too myopic?

  • Posted by bsetser

    Michael — could you explain your point a bit more? I am not sure what will trigger a rush to the exits in the current context. And with a $10b monthly current account surplus, give or take, even $5 b in outflows just means smaller central bank purchases.

    I also am not familiar with the slip at the edge of the band incident — a bit more info (or a link) would help.

    GCS. setting parameters for that kind of huge model poses all sorts of problems. pick up based on the past, and you are assuming that parameters based on a world with $200 b in Chinese exports work for a world with (expected 06) something like $900 b in Chinese exports, and so on.

    but in broad terms, if I understand your argument correctly, i think i agree — given all sorts of lags, it will be far easier to shift the basis for China’s growth if they start now, rather than wait until they hit the economic/ political limits of 20% plus annual export growth off a now very large base.