Last week, Sam Jones of FT’s Alphaville wrote:
If the Chinese economy collapses, or even slows dramatically, then the raison d’etre for the country’s huge FX reserves – as a sterilisation measure to dampen domestic inflation – will evaporate. With that, so will China’s US Treasury holdings.
Or alternatively the Chinese could devalue the yuan. Either way, the US will be in trouble.
I like a good China scare as much as any one. But the first concern is, I think, off. A slump in China doesn’t mean an end to Chinese financing of the world, or even necessarily a fall in China’s reserves. Let me see if I can explain why.
Suppose China’s economy slows sharply — a not-impossible development given the rather starling fall in the OECD’s leading indicators for China. How would that impact China’s balance of payments?
The first impact is rather obvious. China would import less. It would buy less. And since the rise in Chinese demand helped push the price of various commodities up, it stands to reason that a fall in Chinese demand would push prices down. It probably already has. That implies a big fall in China’s import bill, and a larger trade surplus. A slowing global economy would hurt China’s exports, but in this scenario China would slow more than the world. That means China’s imports would fall more than its exports. China’s trade surplus would rise.
But, you might say, the current account surplus is determined by the gap between savings and investment. Why would that change in a slowdown? Simple. China’s slowdown reflects a fall in investment (especially in new buildings and the like). Less investment and the same level of savings means a bigger current account surplus. In practice, though, savings would also likely fall a bit — as a slowdown would cut into business profits and thus business savings. It possible that China’s households would reduce their saving rate to keep consumption up as their income fell. But it is also possible that Chinese households might worry more about the future and save more. My best guess though is that the fall in investment would exceed the fall in savings, freeing up more of China’s savings to lend to the world. That surplus savings has gone into Treasuries and Agencies in the past.
The second impact is harder to assess. A big fall in output might lead China’s savers to lose confidence in China, or rather to lose confidence in the RMB bank accounts as a stable store of value. The big fall in output might, for example, create expectations that China would devalue the RMB v the dollar — and Chinese households, anticipating the devaluation, would have a strong incentive to hold dollars. That likely means a rise in capital outflows.
Since reserve growth is a function of both the current account balance and capital outflows, it is possible that the rise in capital outflows could overwhelm the rise in the current account surplus. That seems to be what happened in q4.