Brad Setser

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What keeps Zhou Xiaochuan up at night

by Brad Setser
April 27, 2008

Friday’s Lex column highlighted the possibility that China’s real reserve growth may be far higher than the published increase in its reserves – and thus a lot more hot money may be flowing into China than the published increase in China’s reserves implies. Michael Pettis – drawing on the work of Logan Wright of Stone and McCarthy – and I have both published online estimates of the “true” pace of Chinese reserve growth. Wang Tao – formerly of the Bank of America – and Stephen Green of Standard Chartered have done similar work.

Hot money flows matter for two reasons.

For China, the scale of hot money inflows are key measure of the sustainability of China’s current policy course – and the efficacy of China’s capital controls. China has hoped to combined higher interest rates than the US with a steady (neither too fast nor too slow) pace of renminbi appreciation. That makes the RMB about as close to a one-way bet as exists in today’s financial markets. Unless the RMB falls against the dollar, an RMB deposit will deliver higher returns than a dollar deposit just because of the interest rate differential. And if the RMB appreciates, the gains are quite large.

That in turn means that the sustainability of China’s current monetary and exchange rate policy rests on the efficacy of its capital controls – controls that keep everyone in the world from trying to profit from a one way bet on China’s currency. Absent effective controls China would have to adjust its policy by either:

  • Lower Chinese interest rates to reduce the incentive to hold RMB in spite of ongoing inflationary pressures;
  • Stop the RMB’s appreciation against the dollar, again, despite inflationary pressures;
  • Or accept a large one-off revaluation, one large enough to end expectations of further RMB appreciation. See Wang Tao’s analysis in Caijing.  Frank Gong of JP Morgan seems to be thinking along similar lines.

For the rest of the world, capital inflows matter both because of their implications for the sustainability of China’s exchange rate regime and because the scale of hot money inflows – combined with the scale of China’s trade surplus and FDI inflows – determines the pace of growth in the foreign portfolio of China’s state.

That matters for a host of reasons. Suppose fx traders see the PBoC selling $60 billion worth of dollars for euros and pounds in a single quarter. If China’s reserves are increasing by $120 billion, that kind of scale would suggest diversification at the margin – i.e. China is trying to reduce the dollar share of its overall portfolio. If China’s reserves – counting the funds in the CIC and state banks – are growing by $200-240 billion, such sales would be consistent with maintaining the current dollar share of China’s reserves. China’s purchases have an impact on a host of asset markets.

So what is going on –

In the comments on an earlier post, a reader requested a graph showing the contribution of valuation gains to China’s reserves growth. I have consequently plotted both China’s “headline” reserve growth against the likely sources of its reserve growth – valuation gains on its existing holdings, its trade surplus, its estimated interest income and FDI inflows. The gap between reserve growth and these known inflows is the standard measure of “hot money”.

I have also added the likely increase in the banks foreign assets due to the “suggestion” from the PBoC that they meet their reserve requirement by holdings dollars. This has emerged as significant sources of additional “quasi-reserve” growth over the past nine months. Transfers to the CIC reduce reported reserve growth, and foreign exchange held by the banks at the request of the PBoC has the same effect. The precise timing of the transfers to the CIC isn’t known – I have assumed that all the RMB1.55 trillion the CIC raised was transferred by the end of q1 and further assumed that the $67 billion the CIC spent buying Huijin still shows up in the reported reserves of the People’s Bank (i.e. the CIC’s total purchases, net of huijin, are roughly $135-140 billion)*

Basically, this is the same data that Michael Pettis reported in early April, just presented graphically.*


What does this data show? Well, if the CIC received large sums in q1 – as seems likely – China’s foreign asset growth is really very, very high. The increase over the last 12 months is close to $750 billion – and only about $65 billion of that increase is explained by valuation gains (note: if China has a higher euro share of its portfolio than I have assumed, valuation gains would explain more of the increase)


To make the increase in hot money flows more obvious, I plotted the “hot money” inflows implied by China’s reserve growth and the hot money inflows implied if the bank’s reserves and the CIC transfers are taken into account in a separate graph.


As Fan Gang hints, there has been a significant increase in inflows to China as the US economy has slowed and the Fed cut US rates.

Note that both measures imply large “hot money” outflows in 2006. That is almost certainly a by product of a set of measures that China adopted in 2006 that led “private” investors in China to add over $100 billion to their holdings of foreign debt. Once the increase in private outflows is taken into account, there wasn’t a real “hot money” outflow from China. Rather, the PBoC seems to have shifted a lot of funds through the use of swaps to the state banks to manage. As I noted above, I haven’t figured out how to reconcile the set of adjustments needed to capture this shift with the more set of adjustments needed to pick up the growth of the CIC and the increase in dollar holdings associated with the rise in the reserve requirement.

The previous charts imply that the pace of growth in China’s foreign assets picked up substantially in q4 2007 and q1 2008. That increase is easier to see by looking at the 3m change in China’s reserves and foreign assets relative to known sources of reserve growth.


I realize that the implied growth in China’s foreign assets in q1 is very, very high — almost too high to be credible. On the assumption that the CIC received around $25billion in the fourth quarter and $100 billion in the first quarter, the q1 increase in China’s foreign assets looks to be in the $220-240 billion range. If the CIC received more funds in Q4 and fewer in Q1, the increase would be smoothed out a bit. If China has more euros and fewer dollars, valuation changes would explain more of the increase. But even taking these sources of uncertainty into account, there is enough evidence to think that China faces a very acute problem.

The world too. If Chinese foreign asset growth continues at its current pace, China’s government, the Bank of Russia, the Saudi Monetary Agency and a few Gulf sovereign funds will pretty much be the global financial system.

*The estimates for China’s foreign asset growth presented here should not be compared to my earlier estimates of Chinese foreign asset growth. My earlier estimates used a different methodology — one that picked up (I think) the funds the PBoC shifted to the state banks in 2006. However, that methodology doesn’t seem to pick up the rise in the banks foreign exchange holdings as a result of the reserve requirement. I haven’t found a way to reconcile the two methods in a way that I am sure avoids double counting. China also hasn’t released the 2008 data needed to update my earlier estimates.


  • Posted by Mick Rolland

    The facts that you present show mind-boggling numbers. 750bn$ is an amount of roughly 25% of Chinese GDP in foreign asset growth PER YEAR. As you say, this is now not only an ‘imbalance’, it is a symptom of a massive transfer of wealth and the entire financial system from other countries.

    Given the fact that China has invested quite a bit of money in securing natural resources in Africa, do we know how much of its foreign assets is being invested in commodities?

  • Posted by Guest

    I was the one who suggested the graph with valuation – interesting to see the effect in context.

    Suggest for additional clarification on the second graph using (if the wording can fit), “hot money implied from … “, etc. (I know its in the title.)

    Good graphs. Probably a lot of work, but here’s another suggestion for later – separate graphs showing the trend in reserves expressed in each of Euros and the Dollar index. For each, you could show a comparison of reserve value against what it would have been using some fixed dollar baseline, thereby highlighting the cost of dollar depreciation as a gap between the two.

  • Posted by HZ

    Seems like the key is how CIC asset is accounted for at this moment.

    "If Chinese foreign asset growth continues at its current pace, China’s government, the Bank of Russia, the Saudi Monetary Agency and a few Gulf sovereign funds will pretty much be the global financial system."

    If it sounds too incredible, maybe it just is.

    Trade still accounts for the largest share of inflow. There is real sign of Chinese export slowdown. So will we see that part come down later this year?

  • Posted by Stefan, Tallinn

    Foreigners’ assets IN China are huge. And I think they will flow out en masse when Chinese trade numbers shock markets as the the surplus evaporates. Considering over- and underinvoicing there may not be much of a surplus at all currently.

    Thus I must say I am a bit puzzled about the talks of a revaluation from Mr Pettis and Mr Setser. Instead I think one needs to be prepared that China will have to sell out its AMerican treasuries and agency bonds, as speculators take their money out of China.

  • Posted by Guest

    The process of PBOC sterilization always seems vague.

    Is there any quantitative data on the breakdown of instruments used for sterilization?

  • Posted by Twofish


    4) allow hot money to flow into China creating inflation

  • Posted by Twofish

    I think that the RMB appreciation is only one factor in the mushrooming reserve growth. The other factor is the collapse of the credit and real estate markets in the US last summer, which lead people to run to anything else.

  • Posted by bsetser

    guest — yes, there is data on the composition of sterilization. broadly speaking, there has been a shift toward the use of the reserve requirement rather than the sale of sterilization bills. The Minfin bonds issued to fund the CIC were intended as a sterilization tool as well, but my sense (admittedly one that I have confirmed over the past two months) is that most of the minfin bonds are still held by the PBoC and haven’t been sold into the market and thus haven’t been used as a sterilization tool.

    re: trade — last I checked, y/y export growth was constant in $ terms (at around $250b — tho I would need to look at my spreadsheet) but falling in % terms. However, the overall increase in exports seemed to have continued — driving by Europe and other emerging economies (exports to the uS have slowed). the fall in the overall surplus in q1 comes from higher imports, and that seems largely to reflect higher prices on commodity imports. I need to develop a better way of guaging the likely impact of the rise in commodity prices, but my general expectation is that the surplus will be constant or perhaps fall slightly in $ terms (the slight fall comes from the ongoing commodity shock) and fall a bit more rapidly as a % of GDP. over time tho, as the commodity exporters start to spend more and commodity prices stabilize, i would (barring additional policy changes) expect china’s surplus to continue to rise over time.

  • Posted by Michael Pettis

    Brad, given the rapid increase in other proxies from hot money inflow, it is probably pretty safe to assume that hot money disguised as FDI and/or trade is also growing quickly. Certainly the explosive first quarter growth in FDI suggests speculative inflows disguised as FDI. After all there was no very good fundamental reason for this growth — in fact it is easier to argue that FDI is less, not more attractive today than in the past few years. If this is true and a big chunk of FDI is simply hot money, it is probably also plausible to argue that hot money disguised as trade has also increased significantly.

    From that it follows that the true trade surplus has probably declined much faster than the small decline in headline numbers suggest. If true, this complicates matters. Thanks to deteriorating global conditions China may actually already be running a small trade deficit, which could make the authorities all the more afraid of a maxi-revaluation, and yet for the reasons you and I have been discussing over the past fifteen months the maxi-revaluation is probably inevitable because of the crazy monetary consequences of hot money inflow. The cost of a maxi-revaluation may be rising even as the cost of steady appreciation is. The longer they wait the worse the options become.

  • Posted by Stefan, Tallinn

    We may think that inflows have occurred at a high speed, but that may be nothing compared to the speed of outflows. Rising commodity prices and Chinese inflation are paving the way for this, I think.

  • Posted by bsetser

    Michael — Whoah. I accept that the strong q1 FDI includes some hot money inflows. But I doubt the entire trade surplus is explained by hot money inflows. If that is true — and the increase in bank reserves/ CIC foreign assets is true — then hot money inflows in q1 were around $200b. That seems a bit high.

    Back in 2005 it was often argued that the increase in China’s trade surplus was "hot money" but it turned out to be real — until we have better evidence to the contrary, I think the baseline assumption should remain that china has a large trade surplus. Global conditions haven’t deteriorated that much, at least not yet. See "oil" — which still prices in solid global growth The US isn’t the world. And the RMB hasn’t appreciated in nominal terms on a broad trade weighted basis. I see no reason to think that the ongoing growth in China’s exports to say the Gulf, Russia and the EU isn’t real.

    Stefan — why expect fast outflows? China has tons o’ reserves, and thus plenty of capacity to hold onto its current exchange rate peg even in the face of outflows. If folks know that — and if China has higher interest rates than in the US or Europe, why leave?

  • Posted by Twofish

    China has essentially no controls on capital inflows. The whole capital control system was designed in a period in which capital was scarce and the entire system is designed to prevent capital from leaving, not from entering.

    I keep thinking about the Disney film the Sorcerrer’s Apprentice.

  • Posted by DC

    Including Jim Rogers and I, private investors are divesting their US Dollars and betting on Chinese yuan revaluation. It’s a sure one way bet especially since the Bernanke Fed has "No credibility" left. The US must have discovered a black hole at the Fed. A weakening dollar and rising energy prices but "core inflation" is in check as per Bernanke. Europe has a strong currency, yet they have reported higher inflation than the United States? Reads like a twilight zone episode.

    Investor Jim Rogers also writes, "the US Dollar is a deeply flawed currency. Everyone should get out of the US Dollar as soon as possible". Or as Doug Noland writes, "With the Fed loosening, this will lead to more debt-assumption in the prospect of paying it back in cheaper dollars. In turn, this will fund bubbles in the developing world, especially in China".

  • Posted by Stefan, Tallinn

    If the dollar is flawed, then it is a matter of time before its peg-currencies are flawed.

  • Posted by Guest

    Anyone have any good papers/links on the way round-tripping worked to evade capital controls?

  • Posted by DC


    There are over 250,000 foreign residents living in Beijing China today. Not all of them are Diplomatic and Business personnel. "Good Magazine" profiles the growing American expat community working in China today in an article entitled "Strangers living in a Strange land".

  • Posted by bsetser

    2fish — you are wrong about "no controls on inflows". the regime has changed 180 degrees over the past few years. the controls on outflows have been lifted, and controls on inflows have been tightened. most recently the pboc made it harder for all banks to borrow fx abroad and bring it onshore. there have been a host of other measures as well — read yu yondding’s latest paper for more on this. it also shows up in the pricing of the CNY forwards in the NDF market. in general, the forward price is close to the interest rate differential. but that requires the ability to move money in and out freely. for china, the interest rate differential suggests that there should be an expected depreciation in the forward market and the market shows an expected appreciation.

  • Posted by Twofish

    I didn’t say that there weren’t any controls on inflows. I said that there were no effective controls on inflows. The restrictions in what the banks can do to move money back into China is dwarfed by the flows (much of it disguised FDI) that moves in from Hong Kong.

  • Posted by Twofish

    DC: Including Jim Rogers and I, private investors are divesting their US Dollars and betting on Chinese yuan revaluation.

    It’s quite a risk bet since the PBC might just well let the RMB inflate meaning that you are left with RMB whose appreciation matches inflation. As long as price increases are confined to food, the Chinese government is under no particular pressure to reduce inflation since higher food prices and stable non-food prices, effectively redistributed income from urban to rural areas.

    There’s also the risk that PBC will miscalculate and lose control of the situation in which case you have a 15% appreciation on a currency that has dropped 20%.

  • Posted by DC


    So far, even you have to admit that betting against the US Dollar is a winning proposition. I am not a short term speculator, borrowing heavily on margin to short the US Dollar, but I would like to at least preserve the "real" purchasing power of my hard earned savings. What else can I do, invest my capital in the frozen bond market with negative interest rates, or the sinking stock market, or the collapsing housing market? The Bernanke Fed has gummed up the entire US financial system with its low-interest credit scam. The only long-term trend is for the US Dollar to collapse into a black hole. Bernanke won’t raise rates because he doesn’t give a damn about destroying the savings of the American working-class. Writes Mike Whitney, "What matters to Bernanke is making sure that his fat-cat buddies in the banking establishment get a steady stream of low interest loot so they can paper-over their bad investments and ward off bankruptcy for another day or two. Its a joke; it was the investment banks that created this mess with their putrid mortgage-backed securities and other debt-exotica. Still, in Bernanke’s mind, they are the only ones who really count. The US has been gaming the global economic system for decades; sucking up two-thirds of the world’s capital, giving nothing back in return except mortgage-backed junk, cluster bombs, and crummy green paper. Nothing changes; it only gets worse."

  • Posted by bsetser

    2fish — from my point of view, those controls are fairly effective. if you have a connection to HK, obviously it seems like there are ways around them. but they clearly have had an impact on the pricing of CNY forwards.

  • Posted by Twofish

    bsetser: it also shows up in the pricing of the CNY forwards in the NDF market. in general, the forward price is close to the interest rate differential.

    There are lots of things that can cause the forward market not to match up, and capital controls is only one of them. In particular, if the differential were due to capital controls, you’d see markedly different prices in Shanghai than in Singapore/HK, and while there is a difference, it’s not huge.

  • Posted by Twofish

    DC: What else can I do, invest my capital in the frozen bond market with negative interest rates, or the sinking stock market, or the collapsing housing market?

    You could borrow and spend.

    DC: Bernanke won’t raise rates because he doesn’t give a damn about destroying the savings of the American working-class.

    Low interest rates are a wonderful thing if you are up to your ears in debt. It’s the super rich that have huge savings, not the working class, and so this conspiracy theory falls flat there.

    DC: The US has been gaming the global economic system for decades; sucking up two-thirds of the world’s capital, giving nothing back in return except mortgage-backed junk, cluster bombs, and crummy green paper. Nothing changes; it only gets worse.

    And there’s no particular reason to think that this can’t go on for at least the next century, since sucking up the world’s capital allows the US to build 12 carrier battle groups which it can use to continue its control over the world financial system. It’s actually quite a stable system.

  • Posted by Judy Yeo


    very interested in your "controls on outflows have been lifted" comment. Care to elaborate? For instance,should a crisis equivalent to the asian crisis occur, could investors exit with their funds/hot flows as effectively as investors in 97/98? How would that be accomplished?

    Email would be fine too

  • Posted by Guest

    Saw a story in Bloomberg, as I recall, that the Chinese are thinking about a one off revaluation of the Yuan, by 10-15% to reduce inflation. No idea if this is a serious possibility or not.

  • Posted by bsetser

    judy — let me see if i can dig up yu yongding’s paper. the controls that have been lifted impact institutions more than individuals. the banks are being encouraged to hold fx. companies no longer face a surrender requirement and are being encouraged to build up foreign assets. financial management companies are allowed to — through the qualified institutional investor program — invest abroad. the controls that impact individuals are still in place, though these controls seem to be fairly porous. in the event of another bop crisis, i would suspect that the controls on institutional outflows could easily be tightened.