Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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A trillion dollars does tend to concentrate the mind …

by Brad Setser
July 25, 2006

Statistical agencies usually are not the authoritative source of information on a country’s reserve portfolio.  Nor do they usually comment on exchange rate policy or the investment decisions of a country’s firms.  But then again China may be different.    

There is no doubt that China would love to see its companies invest more abroad, slowing its reserve growth.    And China clearly has figured out that buying an asset that is likely to decline in value has a cost, even if the carry is positive.   That said I am more confident that the RMB will rise in value v. both the euro and the dollar over time than I am that the euro will rise (further) in value v. the dollar. 

It does seem like the amount of noise about China’s reserves has picked up recently (hat tip Macroblog).  I don’t think it is entirely random noise either.  I suspect – without knowing – that there is an active debate inside China’s leadership about Chinese reserve growth.

A trillion dollars is just a number.  But it is a big number.  And a big milestone.   By my count China already has over a trillion dollars in reserves and reserve-like assets.  But I am counting the funds the PBoC shifted to the state banks.   In a couple of months, though, China will formally announce that its reserves now top a trillion dollars.   So it isn’t exactly a surprise that Chinese policy makers would be spending a bit of time thinking about how to use those funds.

The key fact for the global economy is not that China holds a trillion dollars in reserves.  It is that those reserves are growing at a pace of around $20b a month/ $250b a year.   This reserve increase has continued even as interest rate differentials have moved steadily in the dollar’s favor.   China constantly struggles not just to invest its existing reserves productively, but to find new places to park its ever growing reserves.

Right now, there is no reason to think that China won’t have $1,500b in reserves in about two years time.   Not unless Chinese policy makers show an ability to act far more decisively than they have so far. 

$250b is a lot of money to invest every year.    I suspect there are some constraints on how China can invest it.  There aren’t many – strike that, there aren’t any – emerging markets that could absorb inflows on that scale.    Modest sized industrial economies like Australia and the UK are also too small to absorb more than a small fraction of the total.    Look at their respective current account deficits in dollar billions.   

Japan’s government debt market is very, very big.   But JGBs don’t pay much interest, and the PBoC likes a bit of carry.   So China really is left looking at the US and the European market.  I don’t really buy the notion that European debt markets are too small and illiquid for China.  China likely has been placing funds in some smaller and less liquid debt markets in the US, not just the most liquid of instruments.   But I do think that it would be hard for China to continue to peg to the dollar and dramatically increase its euro allocation.   

Suppose China now invests 25% of its reserve growth in euros.  That is $60b a year or so.  Real money.   Suppose it decided it wanted to invest 50% in euros.  That is $125b a year.  I suspect that a $60b increase in net flows to Europe would have an impact on the euro/ dollar exchange rate.   And if it did, China’s peg implies that the RMB would depreciate along with the dollar.   That would force China to buy more reserves.

I do think – particularly after the survey data came out – that China has a relatively large dollar allocation of its reserves.    Probably above the global average.  The TIC data – for all its limitations – shows that China has been buying a broad range of US assets, not just Treasuries.  As its reserves have increased, it has gotten a bit more adventurous with its dollar portfolio.   That is one kind of diversification.  I suspect (and god knows I don’t know) it holds some dollar denominated emerging market debt.    The gory details of what is known and not known are found in the latest Rosenblatt/ Setser reserve watch (subscription required) 

China also holds a lot of euros and other currencies.  It has to.  With $1 trillion in reserves, a 20-30% non-dollar portfolio implies holdings of $200 to $300b.   That is bigger than the total reserves of all but a handful of other countries. 

That leads me to one point where I disagree with Lex.  

Lex argues – echoing lots of academics – that China’s dollar reserves finance a net flow of FDI back into China.   “China has benefited from the recycling of capital through foreign direct investment, which has supported growth.” 

I disagree, at least in part.    China’s growing dollar reserves don’t finance US investment in China.  They finance US imports of Chinese (and other) goods.    The US current account deficit is quite large relative to US FDI outflows.   That means that in aggregate, Chinese inflows support US domestic consumption, not US investment abroad. 

The picture of central bank inflows financing FDI works – but for Europe.    Europe attracted a ton of reserve inflows in 2005.  Maybe $200b in total, and at least $50b from China.    That financed a good chunk of Europe’s FDI.    And who knows, in future, the income streams that result from such intermediation may even generate a bit of European dark matter.   

Europe is now to the world what the US was during the heyday of the original Bretton Woods system: growing euro reserves finance Europe’s growing investment abroad.   The US, by contrast, needs those reserve inflows to finance a big current deficit.  There is a difference.


  • Posted by DOR

    “In a couple of months, though, China will formally announce that its reserves now top a trillion dollars.”

    You may well be right. Somehow, I tend to think they will find a way to justify not announcing the trillion dollar figure soon. Maybe there is some huge investment deal in the pipeline that will knock $100 billion off the reserves. Huge purchase of ADB paper, anyone? Another banking system bailout. But, for the sake of face I tend to think they would just as soon Japan got their first.

    Anyone have a nice pharma company for sale?


  • Posted by Guest

    Bristol-Myers or Schering. Both probably cheap at the moment. Would the US Congress permit it? Glaxo? Would the UK permit it?

  • Posted by Guest

    they should just start a private equity fund… or maybe they already have?

  • Posted by MrBill

    Brad, I wrote this piece for another forum, but I will not post it here because it is long and probably littered with inaccuracies. However, please have a look if you have time in any case. Thank you.


  • Posted by groucho

    any comments on Jim Jubak’s take on china

  • Posted by psh

    What happens when the fat man cannonballs into the pool and and gets that trillion bucks sloshing around? The portfolio effects will be fun: low asset-price volatility, low currency volatility – and vice versa. Currencies’ volatilities have converged, as though global factors are swamping individual country situations. But RBC says country idiosyncrasies will regain importance. Like, JPY volatility goes up when the yen rises against the dollar (unlike GBP volatility, which goes up more when the currency depreciates.) The Euro, by contrast, seems to go with the flow. The direction of drift doesn’t change its vol. And the Euro doesn’t jump as much – it lacks fat tails, like a textbook Wiener process. You could plug it right into Black-Scholes. Inviting. So say provisional AR models. Despite convergence, June’s tremors didn’t bring contagion; they didn’t even pick off all the CAD weaklings, as the Antipodes got off easy along with the US. For us the wages of CAD sin have been less dramatic, just a long slow slide throughout 06. A little rebalancing’ll change that.

  • Posted by Guest

    psh – seems to be a problem with the second and last links (?) If you can be kind enough to provide either, they’re always interesting.

  • Posted by bsetser

    I have a lot of sympathy for Jubak’s analysis.

    DOR — any idea where China might be investing?

    the obvious ploy would be to transfer a bunch of reserves to ABC. it sure needs a recap. tho it needs to have a lot of bad RMB loans moved off its books more than it needs fx.

  • Posted by Dave Chiang

    Hi Brad,

    The US government doesn’t seem to have a problem with the Chinese owning ever larger quantities of “paper” US Treasury Bonds that are rapidly depreciating in “real” wealth. However, the US government quickly moved to block the CNOOC acquisition of Unocal under the “National Security Threat” canard. In fact, CNOOC was primarily interested in Unocal’s huge energy production assets in Southeast Asia (ie, Thailand and Indonesia). Unocal’s energy assets in the Gulf of Mexico only amounted to approximately 2% of US oil production, and would most likely have been quickly divested by CNOOC had the takeover bid been successful. The CNOOC and the Dubai ports fiascos demonstrates that the Neo-liberalism globalization policy by the Washington Consensus was never envisioned to be a “two-way” street for foreign investors.


  • Posted by bsetser

    Dave — you hcve a point. All I will say is that China hasn’t stopped financing the US even after the US made it clear that China wasn’t able to buy everything it wanted with its dollars.

    Mr. Bill — nice piece; one small quibble — not even i think China finances the entire $ 1 trillion US financing need ($900b deficit +100b equity outflow now looks likely); it covers about $200b of it, max (we know of $180b between june 04 and june 05). the oil exporters cover a very big chunk as well.

    a favor — could you remind me of the end 04 and end 05 levels for the dutch stock market; forget to save your info in a place that i remember!

  • Posted by OldVet

    US refusal to sell any and all assets is not unusual. China has many restrictions of its own, as does India and most other countries. What surprised observers was that the US would enforce any restrictions at all. Only a handfull of deals has been blocked out of several thousand scrutinized in past years. Selective barriers to market entry are not unique to the US, and the US has nothing to apologize for in that regard. For example, I don’t want China to have anything to do with US internet access, given the record of abuse in China.

    Recently read an article saying the US cotton industry was hurting, and that millions of US acres were wasted on cotton production via subsidies. How about inviting China to experiment with dry weather crops for export to China? Or increase mining capacity in the US for export to China? There are lots of “green field” investments available that would serve some useful purpose and recycle some of those trillion dollars.

  • Posted by psh

    wow, battin 500

    converged is The Puzzling convergence in Foreign Exchange Volatility from the St. Louis Fed, at
    or HTML is at [you may need your own client]

    AR models is Asymmetric Volatility in the Foreign Exchange Markets, Wang and Yang, a draft, which they beg the gentle reader not to quote, much less take it & run with it like I did. I can’t get the pdf now either. HTML at

  • Posted by Guest

    Might worth estimates be relevant to this discussion? Can’t remember seeing one for the EU.

    “ALMOST 20 YEARS ago, in 1987 the UK was worth a mere £1.7trn, now, for the first time, following an astonishing period of growth, the figure has broken the £6trn mark… The Office for National Statistics said yesterday the total value of the country at the end of 2005 was £6.01trn, up £119bn from the previous year and almost five times the output of the UK economy. The ONS measures wealth by adding up the value of buildings, roads and financial assets, among other things…”

  • Posted by groucho

    “dry weather crops for export to China? Or increase mining capacity in the US for export to China? There are lots of “green field” investments available that would serve some useful purpose and recycle some of those trillion dollars”

    Old Vet, What a hair-brained scheme. Plz, let’s not come up with any productive recycling ideas that might interfere with financing war-mongering and McMansion expansions.

  • Posted by MrBill

    Hello Brad, thanks for the comments. Sorry sloppy writing on my behalf, did not mean to imply that China would finance the whole US C/A deficit on their own. Thanks. Will get those Dutch nos. today again. Royal Dutch Shell has reported some healthy results for a change. Maybe it is on the mend? Cheers. Bill.

  • Posted by OldVet

    groucho, Sorry, I fell on my head and saw things upside down for a moment. I had a vision of productive investment meeting real needs there for a short time. I’ll try not to think “win-win” again. Obeissances.

  • Posted by Lord

    I suggest they frame them and hang them on the wall. 😉

  • Posted by groucho

    OldVet, Hope your head is feeling better. Sounds like you may need some new eyeglasses. Haven’t you seen the new signs in Washington? “Please squander savings glut here”

  • Posted by Guest

    based on IMF survey, the official Forex reserve allocation globally is 66% USD vs. 24% Euro,
    but developing nations ( China,Oil exporters) do have higher Euro bias with 60% vs. 29% USD-EURO weight breakdown,
    OECD nations is 73.8% vs. 19% USD-Euro break. The Japanese preference to intervene USD YEN probabaly screwed OECD USD weight up.

    China’s foreign financial asset is dominated by Central bank, which accounted for 80% of total, especially after 2002, in 2006 central bank is the only one net buyer of Foreign financial asset while coroprate net seller. So we use Central bank reserve as proxy for total foreign financial asset.

    For China, the diversification from dollar asset did not seem to happen after depeg from USD in July 2005.
    Based on TIC data ( we assume Central bank is only net US securities buyer as most non-official institutions did not increase forex asset though this is big decline from 2002’s more than 80% ( 2003 58%), but since 2003, he diversification actually reversed, China allocate 43% of additional reserve into US L-T securities in 2005 ( the JULY Rmb depeg has negliable impact on reserve diversification),5M 2006 China Net purchase of long term US securities still accounted for 52% of Forex reserve addition

    Data did not support view that depeg from Dollar entailed reserve diversifcation, It is clar that Rmb de-peg from US dollar and reference to currency basket has negliable impact on Forex reserve diversification?? if anything, the diversification stopped and reserved under flexible regime?? BUT WHY??

    is there an implicit understanding with US treasury/government, ” if US go easy with Rmb, we wont dump your paper’??? A finacial
    equivalent of nuclear deterrence MADNESS??

    For Russia & opec, it might be perfectly rational and feasible to dump the dollar,as US demand for their export are addictive,but for China’s reliance on US market, China might just too addictive to US consumer for serious diversification?

  • Posted by Will Foster

    What is the source of your 1 trillion dollar estimate of
    the amount of US Treaury Bonds that China owns?


  • Posted by bsetser

    I don’t think China has $1 trillion in treasuries. I think it has around $1 trillion in reserves (it reports $940b or so at the end of June, and it has transferred $60b in reserves to three state banks). Not all those reserves are in dollars, and not all those dollars are in treasuries.

    I suspect China has roughly $700b in US debt (that comes from the $540b in China holdings as of June 2005 reported in the treasury survey, and an assumed $160b of new purchases out of the roughly $250b in Chinese reserve growth since then. around 1/2 of that $700b is in treasuries. The precise total is reported on the treasury’s web page, under the TIC data (there is a table on major foreign holdings of treasuries)

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