China: $154b in q1 reserve growth
Neither the fact that China added $154b to its reserves in the first quarter ($153.9b) nor the fact that the RMB (briefly) broke through 7 was exactly a surprise. China’s reserves were heading up quite nicely in January and February, and the RMB was steadily marching up (at least against the dollar) as well.
Breaking 7 though is to my mind a non-story. Yes, the pace of RMB appreciation against the dollar has picked up. But the RMB still isn’t appreciating fast enough against the dollar to offset the dollar’s depreciation against other currencies. The RMB hasn’t appreciated in nominal terms against a basket of G-3 currencies. It depreciated against the euro in the first quarter.
The US Treasury has gone out of its way to praise the increase in China’s pace of appreciation against the dollar. I think that is a mistake. The G-7 recently has called for broad-based RMB appreciation not just appreciation v the dollar. That broad-based appreciation has yet to happen. Right now the US should be supporting Europe in putting pressure on China to end the RMB’s depreciation against the euro. So long as the RMB doesn’t appreciate in nominal terms against a broad basket of currencies, all of its real appreciation will have to come from high levels of inflation.
The $154b in reserve growth in q1 is both a little less and a little more than meets the eye. I would estimate that $34b of the increase reflects valuation gains. That could well be an under-estimate of China’s valuation gains, as it is based on an assumption that China has 70% of its reserves in dollars. Netting out $34b leaves an underlying increase of around $120b.
The trade surplus in q1 was $41.4b, FDI inflows were $27.4 and a conservative estimate of China’s interest income would add another $16b (assuming $1600b in reserves and an average interest rate of 4%, or 1% a quarter). That works out to roughly $85b in reserve growth, leaving about $35b of the overall increase unexplained. Bigger valuation gains or more interest income would reduced the “unexplained” portion of China’s reserve growth - -and thus reduce the estimate of hot money inflows.
However, there is also good reason to think that China’s reported reserve growth understates the overall increase in China’s foreign assets. After adjusting for valuation, China added $53.9b to its reserves in January (when the trade surplus was large), $47.7b in February (when the trade surplus was small) and $15.8b in March (when the trade surplus was moderate).
The increase in January if not all that large relative to the underlying flows (FDI of $11b, a trade surplus of close to $20b and $5-6b of interest income). The increase in February is quite substantial — large enough that it raises question about whether the January data reflects all the underlying flow. By contrast, the $15.8b increase in March (a level that implies large hot money outflows) is suspiciously small.
The key question is what might be left out of the reserve data, or more precisely who else inside China might be adding to their foreign portfolio to take pressure off the central bank.
There are two potential candidates: the state banks and the CIC.
It is widely thought that the state banks added something like $18-20b to their foreign portfolios in January (See Michael Pettis, among others), when they likely met the increase in the required reserves by increasing their foreign holdings. They may also have met the March increase in their reserve requirement by increasing their foreign holdings. That implies that China’s foreign assets could have increased by $36-40b more than reported reserves. $120b in reserve growth (after adjusting for valuation changes) might be $160b of reserve growth, counting the “fx reserves” the banks have been ‘encouraged” to hold to keep the fx off the central banks books.
And then there is the CIC. The Ministry of Finance issued a large bond to finance the CIC in late December. If the Ministry of Finance used the proceeds of that bond to buy fx from the central bank in q1, it could have taken $100b off the books of central bank. The unusually low March reserve growth number reminds me of the unusually low numbers in September and October of last year – months when funds were clearly shifted to the CIC. If all of the big December bond was converted into foreign exchange in q1, that could have subtracted something like $100b from China’s foreign exchange reserves, and added $100b to the overall increase in China’s foreign assets.
If valuation gains were larger than my current estimate, China’s “true” reserve increase might have been as low as $110b. If the banks increased their foreign holdings by $35b and the CIC increased its foreign holdings by $100b, the “true” increase in China’s foreign assets in q1 could have been as big as $245b. Michael Pettis has a similar estimate.
It would be nice to know. So far, the creation of the CIC — together with the likely rise in the foreign exchange holdings of the state banks — has made it far harder to determine how heavily China has to intervene in the market to maintain its current exchange rate regime. As a result, the overall level of transparency in the international financial system has gone done.
A few graphs might help (they follow below the fold)
The following graph shows China’s trade surplus, FDI inflows and estimated interest income along with the increase in China’s reserves all on the rolling 12m basis. Reserve growth has been adjusted to strip out valuation gains.
I have also included an estimate — roughly $20 billion — of the funds shifted to the CIC in q4 2007. I have NOT included an estimate for the funds shifted to the CIC in q1 because I don’t have enough data to make a good estimate. I also have not included an estimate the funds accumulated by the state banks — including the funds the CIC injected into the state banks in q4. I am not sure that I have found a data sources that captures all of the increase in 2007 — and there is no data yet for 2008. The graph consequently shows the minimum level of intervention that China has done to support its exchange rate regime.
The gap between reserve growth and the sum of the underlying sources of reserve growth is – of course – one measure of hot money inflows. My personal view is that the overall increase in China’s foreign assets, counting the rise in the foreign assets of the state banks, over the past 12 months has been closer to $600b than to $450-500b. That implies much larger hot money inflows that suggested in the graph above. remember, this graph doesn’t capture the increase in the foreign assets of China’s banks or the q1 increase in the CIC’s foreign assets.
The next graph shows the same data – again without an estimate of the rise in the banks foreign assets over time or the CIC’s foreign assets in q1 – on a rolling 3m basis. Not that the pace of growth in China’s visible foreign assets has swung around wildly. The very low pace of increase in the assets of the CIC and SAFE together in q4 likely reflects an enormous accumulation of foreign exchange by the state banks, not a reversal in capital inflows.
My personal view is that hot money inflows were at least as strong in the first quarter of 2008 as in the first quarter of 2007 — and that the overall increase in China’s foreign assets in q1 was over $150b, and perhaps substantially more than $150b.
And finally a comment on China’s trade data. The rise in China’s import bill shouldn’t be a surprise. It reflects higher oil and commodity prices above all else. The y/y increase in March exports was quite strong (30% y/y). But overall q1 export growth was around 20% — something of a slowdown. However, in dollar terms, the y/y increase in China’s exports hasn’t actually changed much. It has been around $250b for several months.
That is why I find it hard to believe that China’s export sector has really been squeezed by the RMB’s appreciation. The RMB hasn’t appreciated against China’s largest trade partner. And the increase in China’s exports – measured in dollar billion – remains very very strong.
The following chart plots the y/y increase in China’s exports (in $ billion) and China’s trade surplus (as a rolling 12m sum).
China’s trade surplus has stabilized, largely because of higher commodity prices. Over time, the IMF still expects China’s trade surplus to continue to grow. Export growth has slowed in percentage terms, but has only stabilized in dollar terms.
Draw your own conclusions!
UPDATE: Michael Pettis has produced an excellent table showing how the various possible adjustments to reserve growth would increase China’s estimated intervention in the foreign exchange market in q1, and thus increase estimated hot money inflows. He also draws attention to the excellent work Logan Wright has done to try to pin down how the state banks have been used to limit formal reserve growth and to estimate the timing of the transfer of foreign exchange to China’s reserves. I suspect Pettis’ table is easier to follow than my words; do check it out. It hardly needs to be said that the upper end estimates for China’s foreign asset growth in q1 are truly extraordinary. Not so long ago we marveled that China had amassed more than $1000b in reserves; the upper end estimates now suggest that China could end up having to add $1000b to its foreign assets (reserves, state bank’s foreign assets and the CIC) in a single year to control the pace of RMB appreciation. Even low-end estimates would put Chinese intervention in the $600-700b range.
"So long as the RMB doesn’t appreciate in nominal terms against a broad basket of currencies, all of its real appreciation will have to come from high levels of inflation."
True. Did RMB appreciate against Euro in real terms during Q1? Why should Europeans care which form it is taking?
"The gap between reserve growth and the sum of the underlying sources of reserve growth is – of course – one measure of hot money inflows."
You don’t show valuation gains/losses as an underlying source. Am I missing something?
Guest — I have adjusted reserve growth for valuation gains, so it is not shown as a source of reserve growth. I should have noted that.
HZ — I have not sat down and down the math, but i don’t think the difference in chinese and european inflation in q1 would have been large enough to offset the RMB’s nominal depreciation, so I would bet the RMB depreciated against the euro in real terms as well as nominal terms.
Among the "assets" the Chinese bought today was a picture of Carla Bruni-Sarkozy, the French first lady, for $91,000…
I won’t post a link but the object of controversy is there everywhere in the mainstream French media.
I guess Europe does want it can to limit its trade deficit.
Brad, one fairly obvious source of inflow into China comes from….Hong Kong, where local punters can deposit up to RMB 20,000 per day into an RMB denominated account and earn 1% p.a. Now, 1% p.a. sounds puny, but it essentially allows HKers to go short USD/RMB with virtually no negative carry, as opposed to the -10% /-12% negative carry available to offshore punters through the NDF market. It’s the closest thing you can come to free money these days, so it’s unsurprising that RMB deposits in HK are growing exponentially. It almost certainly doesn’t account for all of the missing $ reserves, but it does represent a flow of probably several billion quasi-US dollars into RMB per month now.
600 a year… then.
I wonder how China will manage rising exports rising payment balance surplus in the face of US and Europe recession…
I mean it s impossible.
So the next step is of course China ceasing to buy dollars and euros. That means the RMB shooting up.
That’s gonna be nasty… Nasty nasty.
"Guest — I have adjusted reserve growth for valuation gains"
I thought so after I sent the comment.
A suggestion - you may wish to consider putting a valuation gain/loss estimate as a final component in a final graph - i.e. a reserves plus CIC plus valuation graph - could be quite interesting - although I’m guessing you’ve decided against this because the info/noise tradeoff isn’t worth it - although it should be getting more material over time and you could restrict it to one final set of graphs.
E.g.
your first graph with ‘reserves plus CIC plus valuation’, INSTEAD of ‘reserves’, might be interesting
Guest — interesting suggestions. What I would like to do is something shows reserves (somehow showing the effect from valuation) + the CIC + the increase in the state banks foreign assets. I have held off b/c I don’t feel like i have solid enough data to do a graph of the increase in the assets of the state banks/ the cic in q1. Even for 2007, there are two methods for estimating the increase in the foreign assets of the state banks. One is to look at a line on the pboc’s balance sheet that logan wright, stephen green and wang tao (all analysts based in china) think corresponds with the banks fx holdings as part of their reserves (don’t ask why this shows up on the pboc’s balance sheet); another, which i have used, is to look at a couple of lines in the banks fx balance sheet (as reported by the pboc) that seem to show the banks fx liabilities to the banking system. a third would look at the banks holdings of foreign securities, also as reported by the pboc. those tho are falling even as fx liabilities are rising, suggesting the banks have found other ways of investing the fx (like the cdb lending to chinalco … ). I aim to do something comparating these different estimates, but would like to include q1 — and as of now there isn’t even jan or feb data on the pboc’s website.
hence my complaint in the post the the net effect of recent changes in the way china manages its state assets has been a loss of transparency …
Right now the US should be supporting Europe in putting pressure on China to end the RMB’s depreciation against the euro.
How, exactly, would China do that? What you’re asking for, in practice, is for China to support the dollar against the euro. I can think of only one way for the PRC to do this: end any tentative experiments in euro-buying, and stick to a strict diet of dollar accumulation. Surely this is not a step in the direction of rebalancing.
So long as the RMB doesn’t appreciate in nominal terms against a broad basket of currencies, all of its real appreciation will have to come from high levels of inflation.
I know what you mean, I think, but as an Austrian this still leaves me slightly dizzy. I still marvel at how this CPI variable, which is admittedly of some political use but has no conceivable causal interpretation, became so intertwined with macroeconomic models whose specific purpose is causal prediction - right down to the use of words like "real" and "nominal."
Basically, what you’re saying is that if X does not increase, (XC / C) cannot increase. This is certainly true, but it sheds little light on either X or C, or on your reasonable intuition that XC has some tendency to increase. We could replace the CPI with any price index - the Dow, the CRB, the PPI, the Baltic Dry, the price of plums in Persia, any number that has currency as its denominator - and observe more or less the same phenomenon.
If I can temporarily revert the phrase "real" to mean "actually happening in the actual world" rather than "divided by CPI," the real phenomenon here is a large net flow of Western currencies into China. That the result is an increase in the exchange rate between Western currencies and the goods that China demands should not be terribly surprising.
This flow is not an artifact of currency manipulation. It reflects real differences between China and the West. This can be seen by a simple thought-experiment: admit China as the 51st state of the US, following of course the successful principle of "one country, two systems." Convert all RMB to dollars, effective immediately at the current exchange rate.
You will see that, though the West-to-East currency flow is no longer international, it continues. Indeed it can be expected to accelerate, because there is no longer any "RMB appreciation" at all. Thus, this flow must represent a phenomenon which is "real," ie, reflects some actual difference in the real world.
In my opinion, the "real" phenomenon behind the flow is the fact that China has a healthy, competitive, and relatively capitalist productive sector, and the West has a moribund, uncompetitive, and relatively socialist one. Ergo, the Western regimes are bleeding out their financial system in a desperate attempt to keep their loyal citizens satisfied with cheap consumer goods from the East. The parallel with Warsaw Pact behavior in the ’70s and ’80s can probably be overstated. But it can be understated as well.
To take our thought-experiment further, imagine that this monetary flow was not from America to China, but from New York to California. Assume the same cause: California’s industries are healthy, New York’s are not.
Would a sensible economist suggest that the right approach to this problem is for California to secede from the dollar, issue its own currency (the calo?), and allow it to appreciate against the dollar? Actually, I think some economists would recommend exactly that. But I’m still not sure it passes the sanity test. (Though California did once have its own currency: it stayed on gold during the Civil War.)
Moldbug - an alternative to ending China’s euro purchases would be a much faster pace of appreciation v the $. if the rmb appreciates by more v the dollar than the euro, it will appreciate v the euro as well as the dollar.
the obvious difference between California and China is that California is part of the political unit of the united states and there is free mobility of labor and capital within that political unit. That isn’t true for china and the US. And i think most optimal currency theories would argue that china should have its own monetary policy, as it isn’t exposed to the same shocks as the US.
i doubt you will buy this, but i would argue that the extension of credit to households (or now to the government to give to households via the rebate) is driven in part by the high level of savings in china and the gulf.
And i would take issue as well with the characterization of China as capitalists — capitalists banks don’t accumulate depreciating dollars to help the government out. nor do they happily accept super-high reserve requirements that crimp lending growth. state ownership of the banks is critical to china’s ability to use the banks as a tool to support its exchange rate policy.
and then there are the price controls and the government monopoly on land ownership …
I dont get this balance of payments stuff. current account should equal capital account( and financial account) but why? ok, it does have something with double-entry bookkeeping but its still confusing to me. first, i figured its goes like this: country x sells bananas to country y for $50 so country x have current account surplus of $50 and capital account deficit of $50. country y vice cersa. but it isnt like this. is there anywhere simple explanation with number of examples? i found something but it confuses me even more. why country that has current account should have big capital inflows? what if nobody wants to invest in it. does current account deficit cause capital account surplus or is it other way around.
Balance of Payments Challenged Anonymous (and Brad):
I am a human being.
I declare myself a nation, called “MyNation”.
My GDP is equal to the value of my services to my employer. It is also equal to the income I receive from him.
My employer is part of another nation I’ve constructed, called “TheRestofYou”.
Together, MyNation and TheRestofYou constitute the entire world.
My GDP consists entirely of an export to TheRestofYou (the value of my services).
All my expenditures are imports from TheRestofYou (everything I buy).
Unfortunately, my expenditure exceeds my GDP. My finances are in full balance, except for one thing.
I bought a big screen TV that I put on my credit card.
Along with everything else, I imported the TV from TheRestofYou.
But I had no income left to pay for it, so TheRestofYou financed my big screen TV.
MyNation has a current account deficit equal to the cost of my big screen TV.
MyNation has a capital account surplus equal to my credit card bill.
I’m OK with all this except for one thing.
Every so often, a guy knocks on my door.
I answer, and he says,
“Hi. I’m from TheRestofYou, and I’m here to help you. We have money to blow – in fact we have a global savings glut.”
I’m puzzled. I say, “So what?”
He says, “We want to you borrow more of our money.”
I say, “I don’t need it right now. I have my TV and I’m OK for now. I’ll let you know when I want to spend some more. Besides, I use my credit card.”
Moral of the Story:
Current account deficits cause capital account surpluses.
And there is no such thing as a global savings glut.
if a country has high interest rates or offers high returns on capital, i think it is fair to say that it is pulling capital in from abroad, and the current account deficit (shortage of domestic savings v investment) is driving the capital inflows. if a country has low interest rates but still attracts large inflows, tis the opposite. the current account and capital (or financial) account are jointly determined, so it is hard to say which drives the other — if you are running a deficit in the current account, the financial account has to be in surplus (or you need to be drawing down your reserves). to make a judgement about casuality, i think you need to look at other variables, like the price of financial assets/ interest rates.
hope this helps.
Since as a disciple of the Austrian cult I believe that any supply of money is optimal, and any level of monetary dilution is suboptimal, I am not terribly attracted by the various models of floating currency areas (eg, Mundell). The hypothesis that there is such a thing as a stable floating exchange-rate regime is arguably self-contradictory. It certainly demonstrates little historical support. These kinds of theories, which are all model-driven and lack micro foundations, strike me more as a post hoc attempt to rationalize 20th-century political and financial conditions than anything else.
It’s rather fortunate, at least from an American perspective, that there are barriers to the free flow of capital and labor between the US and China. I suspect that most of both would move from the former to the latter. "Relatively" capitalist is the operational word - while I’m certainly under no illusions that China is some kind of libertarian paradise, nor was the US in the days of Coolidge, when "the business of business was business" - a motto I suspect would appeal greatly to the PRC’s oligarchs, if somehow it could be attributed to Marx.
If I had to single out one salient cause for the disparity, I’d say it’s that America’s most talented young people, in my experience, have little interest in productive employment. Either they want to be scholars or artists, or they seek to wield power via the political system (mostly in NGOs these days), or they are satisfied with mere hedonism. The contrast with China today, or America a century ago, could not be more stark.
moldbug you are right about the most talented people. BUt you could also ask yourself this :
why would any talented american or european work for a western firm, knowing that it will be asked to close the US and european factories and move them to asia. There is no growth to share in the western world now.
Besides capitalist growth is under question with all the ecological crisis hitting us (global warming, no more fish, soil erosion, air pollution …)
It s better either to flee that capitalist system or to try to get control of the political system and change the rules to make them more adverse to the "free business" that is destroying our planet.
In China it s different, they are gaining world dominance through business. Of course they are also destroying their environment big time, but well, still much less than any US citizen does.
Brad - where do these $80bn of hot flows fit into your numbers? Are they additional to them?
http://www.chinadaily.com.cn/bizchina/2008-04/14/content_6615277.htm
moldbug,
labor would flow from China to the US, of course, if there would be free movement. As long as the wages in the US are higher than in China the suppliers of labor - most humans of age before retirement - would like to get the higher wage, not the lower wage. There would be a motivation for Chinese to move to the US, until the productivity differences are gone.
But another issue is of course, that the federal gov will transfer money from California to New York, via taxes, not via borrowing.
complement:
the share of trade with China of the GDP is not so immense. Your sentence
"Ergo, the Western regimes are bleeding out their financial system in a desperate attempt to keep their loyal citizens satisfied with cheap consumer goods from the East"
is simply wrong. And as there is still unemployment in the west, it would be not too difficult to make even most of this tradeable goods.
The main reason for western "lazyness" is, that most people in the west are so rich, that they have everything they really need. Why should we work more than necessary to earn enough to buy everything we need?
The disinterest in the productive sector by the way is in anglo-american phenomenon, not a western one.
labor would flow from China to the US, of course, if there would be free movement. As long as the wages in the US are higher than in China the suppliers of labor - most humans of age before retirement - would like to get the higher wage, not the lower wage. There would be a motivation for Chinese to move to the US, until the productivity differences are gone.
Sure - probably a lot of the low-end jobs done by Mexicans and other immigrants, who don’t have an ocean to walk across, would be captured by Chinese. But who would they work for? GM? What’s left in the US is service industries. China could house Americans, working or retired, at a quarter of the cost of living in Las Vegas, with minimal taxation and crime, and make a profit at it. In a fantasy world in which these barriers are gone, other countries would be sucking the whole population out of North America.
The disinterest in the productive sector by the way is in anglo-american phenomenon, not a western one.
Well, it’s not a German one, in any case! Except to the extent that Germany has been Anglo-Americanized…