Brad Setser

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China’s call for a new international financial system

by Brad Setser
March 24, 2009

I spend a lot of time tracking — or trying to track — what China is doing with its reserve portfolio. I consequently tend to interpret the public statement of China’s government through the lens of recent shifts in the composition of its reserves.

And to be honest, China’s recent rhetoric hasn’t tracked its portfolio, best that I can tell. SAFE clearly has increased its holdings of Treasuries over the past few months. China’s visible Treasury purchases have exceeded its reserve growth over the past few months. I am not sure of this is clear evidence that the dollar share of China’s portfolio is rising, as the shift towards short-term Treasuries may simply have increased the share of China’s reserves that show up cleanly in the US data. But it hardly suggests a shift out of the dollar.

I have tended to put more weight on what China has done over the past several months — including pegging tightly to the dollar — than on what China has said over the past few months. But I increasingly think that the apparent rise in the Treasury and dollar share of China’s portfolio may have led me to discount Chinese rhetoric expressing concern about its dollar exposure a bit too heavily.

China’s shift toward Treasuries clearly is a reaction to a legacy of a series of bets that China’s government made back in 2006, 2007 and 2008 that went bad. China hoped to offset the dollar’s depreciation against the RMB with higher returns on its dollar assets. But in general, taking more risk produced lower not higher returns — as Chinese investors bought risky US assets at the wrong time. China also seems to have concluded that its huge Agency bet was a mistake. Scaling down that bet also has meant buying Treasuries in huge quantities.

But China is now — some might argue belatedly — worried about the scale of its resulting exposure to low-yielding dollar assets. Plan A, taking on more credit and equity market risk to offset the dollar’s decline while continuing to add massive quantities of dollars to its reserves, didn’t work. The end result has been more Treasury exposure than China really feels comfortable with; if nothing changes, China soon really will have a $1 trillion Treasury portfolio.* It already has over trillion dollars of Treasuries and Agencies. China consequently does seem to be looking seriously for a Plan B.

PBoC governor Zhou has made that clear by putting a set of serious proposals on the table, proposals that should — and no doubt will — be considered carefully. The hint that China might be interested in multilateral management of a portion of its reserves alone should get attention.

China has tended to argue that it had no choice but to build up dollar reserves so long as the dollar occupied a central place in the global financial system. Analytically, I don’t think this is true — China didn’t have to peg to the dollar, it didn’t have to keep its peg to the dollar at the same rate as the dollar fell from 2002 to 2005 and it didn’t have to limit the pace of RMB appreciation against the dollar in 2005 and 2006. A different set of choices would have produced smaller Chinese current account surpluses and a smaller Chinese reserve portfolio.

The dollar has been a reserve currency for the entire post-war period, but that generally didn’t produce the kind of central bank demand for US financial assets that marked the past few years. Indeed, as recently as 2000, China’s annual reserve growth was something like $15 billion. In 2008, it was north of $600 billion, counting all of China’s hidden reserves.

The United States shouldn’t — in my view — be opposed to the development of an Asian reserve currency, or a set of Asian reserve currencies, that generally float against the dollar and the euro. After World War 2, the DM — and then the euro — emerged as Europe’s reserve currency. And European countries moved from pegging to the dollar to managing their currencies against the DM and then to the euro. That hasn’t been bad for the US. Moves in the euro/ dollar have allowed needed economic adjustments between the US and Europe to take place. The US current account deficit with Europe has fallen dramatically over the past couple of years.

A world where key Asian economies add ever growing sums to its already large dollar reserves because they feel compelled to maintain large current account surpluses and huge reserve stockpiles ultimately doesn’t serve the United States’ interests; as Martin Wolf notes, it almost guarantees a world that will rely too heavily on a large, sustained US fiscal deficit to support demand. It thus sets the stage for future trouble.

The US government has an interest in a world where it can finance itself in dollars — just as European governments have an interest in being able to finance themselves in euros, and emerging economies have an interest in financing themselves in their own currencies. But the US shouldn’t want a world where a host of countries keep their currencies pegged to the dollar at too low a level, in the process generating both cheap financing for the US Treasury and large macroeconomic imbalances. Zhou is right: Excessive reserve growth poses problems for the US as well as the countries adding to their reserves.

Shifting too a more balanced world economy may not require something as ambitious as an international reserve currency; a bit more exchange rate adjustment, a bit more floating and a bit less reserve growth might do the trick.

But the set of currencies in the IMF’s SDR basket — currently a mix of dollars, euros, pound and yen — also should not be frozen in time. As key emerging markets assume a larger place in the global economy, some of their currencies naturally should emerge as global reserve currencies. The currency composition of the world’s reserves isn’t fixed. It isn’t all that hard to imagine a world where a convertible RMB places a much larger role in the global financial system — and is something of an anchor for a group of Asian currencies that float against the world’s other major currencies.

Zhou’s proposals lead naturally to a discussion not just of reserve currencies, but exchange rates, exchange rate regime and reserve growth. That is a discussion that the G-20 ultimately needs to have.

And several of Governor Zhou’s more concrete proposals seemed to suggest that China is prepared to contribute to global efforts to help stabilize troubled emerging economies — as not all emerging economies have China’s reserves stockpile.

Selling an SDR-denominated bond to China is one way the IMF can raise the money it needs. Buying such a bond is also a very concrete way China could use its large reserves to help stabilize a troubled international financial system. China seems open to that possibility; Zhou both called for centralized management of part of the world’s reserve stock by a “trustworthy” international institution and “[the creation of] financial assets denominated in the SDR … The introduction of SDR-denominated securities, which is being studied by the IMF, will be a good start.”

And if Ted Truman’s oped in the Financial Times (summarized by Reuters Paul Taylor) is any indication, the US government may not be opposed to Zhou’s call for an SDR allocation — a way of quickly increasing the world’s reserve stock by handing SDR denominated reserves out to the IMF’s members. Truman wrote:

“A one-time SDR allocation of $250 billion would dramatically build confidence in cooperative solutions to the economic recession and financial meltdown that is affecting all countries. The SDR mechanism in effect leverages the low current borrowing costs of the major industrial countries to finance the immediate, financial needs of developing countries experiencing a sudden disruption of their normal international financial inflows.

An allocation of $250 billion would provide immediate assistance, about $17 billion, to the poorest countries—substantially more than their total, annual disbursements from the International Development Association, the World Bank’s soft loan window. More than $80 billion would flow to other developing countries. These countries have besieged the multilateral development banks for large amounts of quick disbursing credits with little or no economic policy conditions, threatening to distort the banks’ normal mode of operations.

Industrial countries would benefit by receiving—in return for their intermediation of a flow of credit to countries that choose to use their SDR allocations—an asset backed by the full membership of the Fund.

Equally important, a large SDR allocation would help allay a systemic danger posed by countries that conclude from this crisis is that their holdings of international reserves were too small. The risk is that their likely response will be to try to manage their exchange rates to generate large trade surpluses and build up their reserves. Such policies of competitive exchange rate depreciation, or non-appreciation, cannot be successfully followed by all countries at the same time. However, in the attempt, they can set off trade wars. Some countries may be successful and promote a new build-up of global imbalances, which many people point to as one of the principal causes of this crisis. A large, SDR allocation can help meet this demand for reserves.

Truman, incidentally, is now advising the US Treasury. His call for an SDR allocation though came earlier, back when he was at the Peterson Institute.

There is a need to think creatively about ways of avoiding the risk of a world with too few reserves and too many emerging market crises — and the risk of world where countries over-insure and, though the expansion of the reserve portfolios, finance large and ultimately destabilizing macroeconomic imbalances in issuers of the world’s reserve currencies.

The US received enormous inflows from central banks over the past six years. Those inflows didn’t exactly produce a world or a US economy that is in rude health.

p.s. It is sort of interesting that the graphics on global reserve growth and the composition of countries reserves that accompany Andrew Batson’s excellent story on Governor Zhou’s proposal don’t include China’s reserve portfolio. China doesn’t report the currency composition of its reserves to the IMF, so its reserves are in the “unallocated’ portion of the IMF data — and the Journal didn’t plot the growth in the world’s unallocated reserves. There is a deep irony there.

* At the end of January, the US data indicates China had $740 billion of Treasuries. China also likely accounts for some of the buildup of Treasuries in the UK, so its end-January portfolio is likely a bit over $740 billion. And if hot money outflows subside and Chinese reserves grow in line with its current account surplus — or if China continues to reduce its Agency holdings — its Treasury portfolio will only grow.