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What cann’t go on still hasn’t slowed, let alone stopped (Chinese reserve growth)

by Brad Setser
May 29, 2008

This is Brad Setser once again. Thanks to Rachel Ziemba for filling in while I was away. A couple of regular readers have reported some difficulty posting comments at the cfr.org blog. My apologies for any lost comments. We are working on it. In interim, though, please keep commenting — some comments seem to be directed into a “awaiting moderation” file for reasons that have yet to be determined but I can moderate them manually.

Back in 2004, it was considered rather stunning when China added close to $100 billion to its reserves ($95 billion) in a single quarter, bring its total reserves up to around $600 billion.. The dollar’s fall against the euro (and associated rise in the dollar value of China’s euros) explains around $15 billion of the rise. But at the time, $80 billion was considered a very large sum for China to have added to its reserves.

Now China has $1756 billion in reserves, after a $74.5 billion April increase. The dollar rose against the euro in April, so the underlying pace of increase – after adjusting for valuation changes – was more like $82 billion.

In a month.

And not just any month – in a month when oil topped $100 a barrel.

$82 billion a month, sustained over a year, is close to a trillion dollars. A trillion here, a trillion there and pretty soon you are talking about real money. If a large share of China’s reserves is going into dollars, as seems likely, this year’s increase in China’s dollar holdings could be almost as large as the US current account deficit.

The fact that one country’s government – and in effect two institutions (SAFE and the CIC) – are providing such a large share of the financing the US needs to sustain large deficits (particularly in a world where Americans want to invest abroad as well as import far more than they export) is unprecedented.

The real surprise in some sense is that the increase in China’s April preserves isn’t that much of a surprise. At least not to those who have been watching China closely.

Wang Tao – now of UBS – estimated that China added $600 billion to its foreign assets in 2007, far more than the reported increase in China’s reserves. Logan Wright (as reported by Michael Pettis) and I concluded that Chinese foreign asset growth – counting funds shifted to the CIC – could have topped $200 billion in the first quarter.

China hasn’t disclosed how much it shifted to the CIC, let alone when it shifted funds over to the CIC. But it seems likely that the surprisingly low increase in China’s reserves in March stems from a large purchase of foreign exchange by the CIC. Indeed, the CIC’s March purchase may have used up all of the RMB 1.55 trillion the CIC initially raised.

As a result, all of the increase in the foreign assets of China’s government seems to have showed up at the PBoC in April. Or almost all. China raised its reserves requirement in April, and the banks may have been encouraged to meet that reserve requirement by holding foreign exchange.

China’s current account surplus – adding estimated interest income to its trade surplus – was no more than $25 billion in April. FDI inflows were around $7.5 billion. Sum it up and it is a lot closer to $30 billion than $40 billion. Non-FDI capital inflows – hot money – explain the majority of the increase.

No wonder Chinese policy makers were so focused on hot money this spring. Hot money flows seem to have contributed to their decision to stop the RMB’s appreciation in April. But interest rate differentials still favor China – so it isn’t clear that a slower pace of appreciation will stem the inflows.

It certainly though helps to sustain the underlying imbalance that has given rise to massive bets on China’s currency.

The scale of China’s reserve growth suggests that China’s government is no longer just lending the US what it needs to buy Chinese goods. And it is now lending the US – and indeed the world – far more than the world needs to buy Chinese goods. Vendor financing is a fair description for China’s reserve growth in 2003 or 2004, but not now.

China’s government is increasingly acting as an international as well as a domestic financial intermediary. It has long borrowed — whether through the sale of PBoC bills of Finance Ministry bonds to fund the CIC – rmb to buy dollars, effectively taking the foreign currency domestic Chinese savers do not want to take. Now though it is borrowing from the rest of the world to lend to the rest of the world.

Most intermediaries though make money. Or at least try to. By contrast, China’s government is almost sure to lose money on its external financial intermediation. Selling RMB cheap to buy expensive dollars and euros is not a good business model.

China cannot be entirely comfortable with all the money that is pouring into China. But it isn’t at all clear that Chinese policy makers are willing to take the steps needed to shift decisively toward a new set of policies. It is clear that the costs of China’s current policies are rising.

Remember, China looses money on its reserves. More isn’t better.

21 Comments

  • Posted by KnotRP

    > Selling RMB cheap to buy expensive dollars and euros is not a good business model.

    Economists always start from the premise that
    everyone is in “business” even with governments, then they wonder why
    the conclusions don’t match reality. Change
    your premise, in this case. Try using the premise that China is making foie gras, instead. Now — are you still suprised by the apparent waste of perfectly good feed on the already overstuffed duck? What should alarm you is
    what’s in store for the duck, not the money
    that seems to be “lost” on excessive feeding.

  • Posted by jin

    Well, if they can count trade surplus and FDI, then they got to have means to identify the hot money inflow. It seems to me that it is a matter of political will to take necessary step to curb hot money.

  • Posted by cas127

    Yes, but the trillion dollar question is *why* – why is China continuing to behave in this fashion (inconceivable accumulation of reserves).

    The conventional answer is that the Chinese government simply will not let its export sector endure anything like a slowdown or decline (which would be the natural result of a freely floating currency – which would be the natural result if the Chinese government weren’t accumulating the largest, fastest growing reserves in the history of the world).

    But that just shifts the question – why does the Chinese government value the export sector to the exclusion of all else in the Chinese economy (like, say, domestic consumption – which is stifled, due to artificially high exchange rates discouraging imports).

    Why is the Chinese government willing to ship hard goods to every corner of the planet and yet be utterly content to simply sit on the corresponding mountains of paper debt?

    Here’s a paranoid take:

    1) The export sector has created unprecedented productive capacity within China – at a rate never before seen in the history of the world

    2) At some future date, the Chinese Government starts to dump its inconceivable amount of foreign reserves – triggering enormous financial market disruptions in rival “free economy” nations (like the US).

    Don’t think this can/will happen?

    Check out what the Chinese government merely hinted at *the day before* the current credit collapse started in August 2008.

    3) In order to reassert stability (and well aware that the imbalances in productive capacity – at that time – will never allow the US/others to actually make good on the ocean of paper the Chinese government holds) the US and other governments initially limit redemption of foreign-held Treasury securities. Ultimately, the US government is forced to renounce the foreign held debt.

    4) Over a billion Chinese see the backstop of their extremely hard-earned savings evaporate due to the economic perfidy of the US and other Western governments.

    5) The resultant mass outrage among the Chinese population forges a loyalty to its own current government that could *never* be won in light of that government’s actual domestic policies/control.

  • Posted by Emmanuel

    Dr. Setser: Try juxtaposing regional trends with what is happening in China. Not to toot my own horn [honk-honk], but it seems I am the only one who has made much of South Korea, Taiwan, Indonesia and the Philippines intervening in the currency market recently–to prop up their currencies and not the dollar.

    How does this relate to China’s reserve accumulation? My guess is that China is really keen on maintaining a gradualist strategy towards RMB appreciation, come hell or high water. If China is indeed the regional pied piper as I think we agree, then what’s important to note is that other countries wouldn’t have contemplated selling $ to prop up their currencies had China not been on a steady path of RMB appreciation. As the yuan is up nearly 20% since floating in 2005, other export-competing countries in the region are allowed some breathing space for fulfilling domestic policy objectives, i.e., attempting to control inflation at home.

    Actually, USD/CNY has resumed its downward trajectory as the rate went below 7.00 on 15 May, although this has received little mention. Of course, inflation is not really that much of a concern in a totalitarian regime like China–let them eat galloping inflation–but it’s a real concern for other countries in the region where leaders are wary of political disturbances over rising prices for key commodities. Remember 1997.

    Given this scenario of other Asian countries actually defending their currencies by selling dollars, surely there is a good opportunity for the burghers of Beijing to accelerate the rate of RMB appreciation in order to fend off more speculative inflows?
    The question of course is to what extent the capital account tsunami you seem to suggest would actually be reduced by such an action. The timing seems to be right, though.

  • Posted by bsetser

    Knot RP — clever analogy. I have never assumed that China was seeking to maximize returns. China’s end game though isn’t really clear. What is striking is that the amount it has to spend to support its export sector is rising — and it isn’t completely clear if China’s population quite realizes the scale of its future currency loss.

    cas127 — Isn’t there a risk that China’s population turns on its government for “wasting” so much of its savings buying US debt? Especially since the US doesn’t need to default; all it has to do is wait for China to conclude that it cannot afford to keep on intervening and allow the RMB to appreciate … reducing the RMB value of all of China’s dollars.

  • Posted by bsetser

    emmanuel — the asian countries now selling $ (a notable change) all tend to have current account deficits. China has a surplus. and to some degree the hot money flowing into china is money that isn’t flowing into the rest of asia.

    To me the surprise is that China is still accumulating at its current rate given how high oil is, not that some fast growing (or just big) energy importers’ currencies have come under a bit of pressure.

    We should have a better sense of the scale of the selling once folks start reporting end may reserves.

    p.s. if there is a slightly delay before comments appear, don’t panic — i have to moderate many of them manually right now for undiscovered reasons …

  • Posted by joan

    glad to have you back Brad!

  • Posted by ajh

    Perhaps the endgame after RMB revaluation is to use all those dollars to buy oil. Doesn’t work out too well if oil exporters depeg first though.

  • Posted by David Pearson

    Hot money flows have not only accelerated but also shifted their global impact. China’s economy is now efficient at translating hot money into export inflation. Further, the flow of hot-money dollars back into Treasuries push U.S. real rates close to zero, which feeds commodity price inflation.

    So, all else equal, an acceleration in hot money flows leads to a pick up in U.S. inflation. This will continue until it is deliberately stopped, either with a highly restrictive U.S. monetary policy or a Chinese maxi-reval.

    The Fed continues to “forecast away” U.S. inflation. It seems to me that this ignores the key U.S./China dynamic at work here.

  • Posted by bobo7874

    Brad Setser,

    No doubt China faces currency losses. However, their mercantilist FX and trade policies seem like a fast and effective way to produce more and higher value job opportunities in China. Do you think there is a faster, cheaper, or more effective way for China to achieve its nationalist objectives of more and better jobs for its people?

  • Posted by Howard Richman

    Thank you, Brad, for keeping track of the latest reports from the Chinese Central Bank. See my blog for a discussion in which I mention the Bush Administrations recent report to Congress that China was not manipulating its currency, and the Heritage Foundation’s “brain dead” arguments against the Currency Manipulation Act of 2008.

    Howard Richman
    trade-wars.blogspot.com

    p.s. Did you see our column, “How to recapture the Republican advantage on trade” in Enter State Right this week?: http://www.enterstageright.com/archive/articles/0508/0508republicantrade.htm

  • Posted by bsetser

    bobo — yes. the amazing thing is that China’s policies haven’t produced strong job growth inside China. Job growth has actually been anemic relative to growth. The export sector is too capital intensive to employ all that many people. Labor’s share of GDP has been trending down in China. More domestic spending/ less use of the exchange rate to provide an indirect subsidy to the export sector should produce more jobs.

    ajh — so long as oil is priced in dollars, a GCC revaluation wouldn’t hurt China much. Not unless China wants to buy domestic GCC real estate. a big Chinese revaluation by contrast would hurt the GCC: it would reduce the RMB value of their dollars and they import a lot from China.

  • Posted by bsetser

    David Pearson — given than imports from China are only around 2% of US GDP (and unlike imported energy, they aren’t a big factor in a lot of other prices) I wouldn’t put too much emphasis on rising Chinese export prices as a source of inflation. The low real rates fueling demand for commodities channel tho seems real to me. Then through in (rumored) Chinese demand for paper oil (via allocations to commodity funds) and the potential — tho hugely debated — impact of demand for paper oil on the spot price and I suspect there is something to your story.

    Or, put more simply, a lot of emerging economies have prioritized exchange rate management over controlling inflation, and have adopted policies that are highly inflationary domestically and increasingly inflationary globally.

  • Posted by Brian Shriver

    Brad:
    Thank you for your informative and recently frightening blog. You are doing a service. I hope more policymakers pay attention.

    I wonder if you could comment on how so much money flows back into the rest of the financial system. Presumably it starts with account balances at the banks used by counterparties in the forex markets where USD is first purchased with newly-minted yuan.

    It is hard to understand how flows this big could remain invisible.

  • Posted by jin

    It is normal that the labor share of GDP is trending down during development area, since China is working to move up in the value chain to shift from labor intensive sectors to capital intensive sectors.

  • Posted by Twofish

    Emmanuel: Of course, inflation is not really that much of a concern in a totalitarian regime like China–let them eat galloping inflation

    Actually inflation is a concern for China, though less of a concern than unemployment. Remember 1989. China is not a liberal democracy, but it isn’t a totalitarian regime.

    Emmanuel: My guess is that China is really keen on maintaining a gradualist strategy towards RMB appreciation, come hell or high water.

    I doubt things are that coordinated. Most likely the thinking is “well, after a 100 meetings, we finally decided six months ago to gradually change the RMB, and if we want to revisit that decision, we need a hundred more meetings.”

    The Chinese Communist Party intentionally distributes power across a lot of centers to prevent another Mao Zedong, and so to make any decision on anything fundamental takes time.

    cas127: Why is the Chinese government willing to ship hard goods to every corner of the planet and yet be utterly content to simply sit on the corresponding mountains of paper debt?

    It keeps people in factories and off of the street. Also, this assumes that the Chinese government is much more directed than it actually is. It takes a while for the Chinese government to figure out what it wants to do, and what it wants to do may not always match what actually happens, since you do W for reason X, expecting that Y happens but then Z actually does. I doubt that there was a master plan to make reserves so large.

    bsetser: Isn’t there a risk that China’s population turns on its government for “wasting” so much of its savings buying US debt?

    Doubtful. As long as it isn’t obviously coming out of their pocket people just won’t care what happens. Part of the skill of politics (whether in China or the United States) is to extract wealth in ways that aren’t obvious.

  • Posted by Twofish

    bsetser: yes. the amazing thing is that China’s policies haven’t produced strong job growth inside China. Job growth has actually been anemic relative to growth.

    It’s actually not. A lot of Chinese policy has been to improve productivity and efficiency. While export factories created new jobs, this was happening at exactly the same time the old state owned factories were laying people off in huge numbers.

    If you want job growth, you want to make things *inefficient* and *unproductive*. The trouble with doing that is that you get jobs, but they end up being low paying.

    In the case of China, the number of manufacturing jobs hasn’t increased over the last thirty years. However productivity has increase tremendously and once you have productivity, you boost incomes which then creates a service sector, which then moves people off of farms and into the city. Someone gets a pay raise, and they get their hair done, hires a babysitter, and then remodels their kitchen.

  • Posted by Twofish

    bsetser: But it isn’t at all clear that Chinese policy makers are willing to take the steps needed to shift decisively toward a new set of policies.

    Ever since the Gang of Four got kicked out, China has never done anything quickly and decisively. Even things that look decisive in hindsight turn out to take several years of experimentation and debate. It’s worked quite well so far, and I don’t see much reason to change.

    The story of the turtle and the hare is relevant there.

  • Posted by bsetser

    2fish — stronger labor demand would tend to push up wages. Tis hard to defend the current system when wage growth has lagged productivity, so labor income is falling relative to GDP. I don’t think the overhang for old SOEs can explain slow recent job growth either — my sense is that SOE reform was mostly over by say 03.

    finally, someone decided two months ago to reverse (in seems) the policy of faster appreciation in the rMB (v the $) that was decided last fall. Either that or there was an ex ante decision to slow down and reassess after a few months … and i am not sure that the tortoise and the hare analogy works. the hare and the tortoise were heading toward the same finish line. so far, china hasn’t managed to adopt policies that have even started to direct policy toward a smaller external surplus and less exchange rate intervention.

  • Posted by don

    Brad – “finally, someone decided two months ago to reverse (in seems) the policy of faster appreciation in the rMB (v the $) that was decided last fall.”
    I wonder. Maybe the policy has been consistently geared to promoting a given amount (or a given growth) in exports. Slowing global growth would mean a bigger currency undervaluation needed to maintain the exports.

  • Posted by john

    Re: “Part of the skill of politics (whether in China or the United States) is to extract wealth in ways that aren’t obvious”

    Isn’t THAT the truth.

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