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China’s reserves are still growing, but at a slower pace than before

by Brad Setser
April 13, 2009

If China’s euros, pounds, yen and other non-dollar reserves were managed as a separate portfolio, China’s non-dollar portfolio would be bigger than the total reserves of all countries other than Japan. It would also, in my view, be bigger than the portfolio of the world’s largest sovereign fund. That is just one sign of how large China’s reserves really are.

Roughly a third ($650 billion) of China’s $1954 billion in reported foreign exchange reserves at the end of March aren’t invested in dollar-denominated assets. That means, among other things, that a 5% move in the dollar one way or another can have a big impact on reported dollar value of China’s euros, yen, pound and other currencies. China’s headline reserves fell in January. But the euro also fell in January. After adjusting for changes in the dollar value of China’s non-dollar portfolio, I find that China’s reserve actually increased a bit in January. Indeed, after adjusting for changes in the valuation of China’s existing euros, pounds and yen, I estimate that China’s reserves increased by $40-45b in the first quarter — far more than the $8 billion headline increase.

That though hinges on an assumption that China’s various hidden reserves — the PBoC’s other foreign assets, the CIC’s foreign portfolio, the state banks’ foreign portfolio – didn’t move around too much.*

The foreign assets that are not counted as part of China’s reserves are also quite large by now; they too would, if aggregated, rank among the world’s largest sovereign portfolios. They are roughly equal in size to the funds managed by the world’s largest existing sovereign funds. That is another indication of the enormous size of China’s foreign portfolio.

Clearly, the pace of growth in China’s reserves clearly has slowed. Quite dramatically. Reserve growth — counting all of China’s hidden reserves — has gone from nearly $200 billion a quarter (if not a bit more) to less than $50 billion a quarter. Indeed, reserve growth over the last several months, after adjusting for valuation changes, has been smaller than China’s trade surplus.

As Michael Pettis notes, that implies ongoing speculative — or “hot” — outflows.

But there is some evidence that the pace of the “hot” outflows has started to slow. Indeed, the evidence showing a turn here — assuming the data on the state banks’ doesn’t have any surprises — is better than the evidence showing a turnaround in trade flows.*** The non-deliverable forward market is no longer pricing in a depreciation of China’s currency, and in the past, changes in the NDF market have corresponded reasonable well with hot money flows.

I consequently wouldn’t be totally surprised if the pace of China’s reserve growth started to pick up again over the next couple of quarters. The fall in reserve growth over the past two quarters has corresponded to rise in capital outflows — not with a sustained fall in China’s trade surplus.

But even if reserve growth picks up a bit, China’s government will likely buy fewer US assets than it did in 2008. Some of those assets though were in a sense bought with “borrowed” money — the hot inflow. This adjustment though isn’t a bad thing; we all should want China to buy more of the world’s goods and fewer of the world’s bonds.

For now, though, the available data indicates that China is still buying US assets: in January, China’s US holdings rose by about $20 billion (almost all deposits and short-term Treasuries).**** Keith Bradsher’s lede focused on the headline change in China’s reserves in January and February — the fall in reserves wasn’t adjusted for valuation changes, and thus overstates the actual change in China’s dollar holdings. Yves Smith consequently is a bit more worried than I am. China’s purchases have slowed, but — if the TIC data is accurate — they haven’t stopped.

One last point: As Bradsher notes, China’s trade surplus can help to finance the United States (now reduced) trade deficit even if it doesn’t flow directly into China’s central bank. The hot money leaving China has to go somewhere, and no doubt a large fraction currently flows into US dollar-denominated assets. A decent chunk of the outflows seems to be showing up in Hong Kong’s reserves for example, and the HKMA likely holds a dollar-heavily portfolio.

Sustained hot money outflows pose more problems for China than for the US. They imply a lack of domestic confidence in China’s economic prospects. The risk to the US would come if China’s government decided to suddenly stop buying US assets — or sell its existing assets — at a point in time when private Chinese investors didn’t want to hold US dollars or US assets.

* The main issue here is what happened to the state banks’ dollar reserve requirement; those dollars seem to be held on deposit at the PBoC, where they are counted as part of the PBoC’s balance sheet as “other foreign assets.”
** I am also assuming that China doesn’t mark its bond or equity portfolio to market, and thus changes in the market value of China’s existing investments have no material impact on China’s reported reserves.
*** A fall in the reserve requirement and the PBoC’s other foreign assets reduces reserve growth, and thus would increase estimated hot money outflows. Adding in FDI outflows (Chinese mining companies expanding abroad) and the Rosneft loan, if it wasn’t financed out of the state banks existing pool of foreign exchange, by contrast, would tend to reduce estimated hot money outflows.
**** The fall off in China’s recorded dollar purchases has actually lagged the fall in China’s reserves. This likely reflects a shift in China’s portfolio toward safe dollar assets, but it is striking that China’s recorded US portfolio has increased by more than its reserves recently. That though is a topic for another post.

18 Comments

  • Posted by charlie

    I think China’s reserve growth is directly correlated to how much it has to grow to maintain their USD, I mean basket, peg.

    The reason their reserve growth has slowed is with a smaller trade surplus, they don’t have to acquire as many USD to maintain their currency peg.

  • Posted by anon1
  • Posted by Twofish

    bsetser: Sustained hot money outflows pose more problems for China than for the US. They imply a lack of domestic confidence in China’s economic prospects.

    No. That’s not what is happening.

    If you look closely at what has caused hot money outflows, they have been mostly cases of “pull” versus “push.” What has happened is that Western banks and investors have ended up with huge losses and have been cashing in their China investments and not extending anymore credit.

    I haven’t seen a single investor that thinks that China’s investment environment is worse than that of the United States, and the reason that people are withdrawing money is that they fear that the US is going to have big problems in which case they want as much cash as they can get.

    Also my sense is that very little of the money that is going out is “domestic”. Lot’s of Western money went into China over the last few years, and it’s that money that is now flowing out.

    The other thing is that people going into pawn shops and carrying suitcases of cash makes a nice image, but you just are not going to move $100 billion in suitcases and pawn shops.

    All that money is flowing through investment banks in Hong Kong, and I think that one of the ironies of this is that Western banks are going to be hit harder by new Chinese NPL’s than Chinese banks.

  • Posted by bsetser

    Actually, most of the inflows seem to have come from the overseas Chinese community and HK residents, given China’s controls. And most of the outflows todate seem to reflect the reversal of early bets on RMB appreciation rather than a loss of confidence in China. Ergo, they are the mirror image of big inflows in late 07/ early 08. But if the outflows are sustained, that would be something different —

    Note as well that I do not expect the outflows to be sustained, ergo i expect more reserve growth going forward than in q4 08 and q1 09.

  • Posted by Namke von Federlein

    @ Twofish – I think that you are one of the few people in the entire world that has earned the right to use the word ‘no’ to start a sentence. However, this gives me an obvious question – losing face is crime number one in China? I love question marks? Get the right question – you have 90% of the answer? Prevent a war, start a peace?

    @brad – Perhaps the outflows are just a USD carry-forward unwind? I would appreciate a blog post about the USD issued debt – and whether the carry-forward is unwinding or the Treasury situation is simply creating a bubble catastrophe of epic proportions. If I was running China or a Chinese corporation – I would not issue a single contract or bond in USD. Not one penny. But, hey, I’m a bit eccentric?

    @Twofish – Serendipity. Brad does what he can (like all of us – in the limits of his self-policing conceptual framework) but the link from my blog to brad’s blog is called ‘Twofish comments Council’. To be funny : China is not a blob? I still remember the first time I saw an ethic map of China in color. The Art of Peace = My Own Land?

    @Brad – the name I was looking for in an old blog post about a letter to the World Bank was Simon Johnson – when he started blogging at the IMF it was wonderful. Mr. Johnson’s strong opinions and fairness got him kicked out? I will ‘pull a Simon’ here and ask – as politely as I can – are you getting intellectually inbred? In my opinion – peace is how statistics offer a perspective on the integrity of an investment climate and the people who report on it?

    May all beneficial wishes come true in beneficial ways!

    A famous Namke expression : Patience is a virtue until it becomes some sort of weird psychological disease?

    May we soon all look back on this credit crisis as nothing more than a way to encourage our children to invest with wisdom!

  • Posted by DJC.

    Brad: And most of the outflows to date seem to reflect the reversal of early bets on RMB appreciation rather than a loss of confidence in China.

    DJC: Western Banks are massively divesting of Chinese assets. From Reuters,

    ” Bank of America (BAC.N) has sold part of its stake in China Construction Bank (0939.HK), while UBS (UBSN.VX) and Royal Bank of Scotland (RBS.L) each sold their entire holdings in Bank of China (3988.HK)(601988.SS). ”

    http://uk.reuters.com/article/hongkongMktRpt/idUKHKG25847920090401

  • Posted by don

    Brad -

  • Posted by don

    Brad –
    I am curious as to what is happening to the eruo zone’s trade balance. If China’s surplus is still growing and the U.S. deficit is shrinking, someone must be facing a large decline in the contribution of trade to aggregate demand.

  • Posted by Twofish

    bsetser: Actually, most of the inflows seem to have come from the overseas Chinese community and HK residents, given China’s controls.

    I find this extremely implausible except in the most trivial sense that a lot of clients and employees of investment banks are overseas Chinese and Hong Kong residents. What happens is that you see people stuffing suitcases with cash and or going in pawnshops and that makes for a more interesting story than people doing a bank wire transfer.

    However, movements of $150 billion over three months in and out of China *have* to be mediated by the large global banks. There is only about US$300 billion in paper RMB cash, and if you look at other stores of wealth it is simply impossible for this much money to flow between two points without going electronic through the standard bank wire transfers.

    Also overseas Chinese and HK residents simply don’t have that much total funds to be moving hundreds of billions of dollars in and out of China.

    Finally, foreign exchange regulations are much more leaky than you might think. It’s not that hard for a lawyer and banker (or more accurately in multi-billion dollar transactions, teams of lawyers and bankers) to think up of ways of money cash from point A to point B while being completely legal.

  • Posted by Twofish

    Nameke: However, this gives me an obvious question – losing face is crime number one in China?

    Edward Said wrote an entire book about “orientalism” in people have this image of the mysterious and exotic East. It’s all bunkum. If you do business with a large Chinese company they are likely to care about as much about “face” as an American company (which means that care a lot), but whether the deal goes through depends on things like cash flow.

    My experience has been that things like national culture matter a lot less than things like class, age, and profession.

  • Posted by Judy Yeo

    Interestingly, if one puts twofish’s stance and brad’s stance side by side , there is the possibility that, learning from money-laundering experts, investors who were eager to cash in on the RMB fever in 07/08 probably , via legal consultants, “cooperated with” Chinese nationals (and overseas Chinese) to set up accounts and investments and are cashing out in a similar fashion – fiction or stranger than fiction reality?

  • Posted by Tono

    Dr. Setser:

    I’ve asked you this before, but is there any way to estimate the maturity distribution of China’s of Treasury Reserves? In the absence of data, should be just assume they have roughly the same maturity as the total issuance since the own so many of them?

    bsetser: This adjustment though isn’t a bad thing; we all should want China to buy more of the world’s goods and fewer of the world’s bonds.

    As always what concerns me in this environment is that if China reduces their purchases of Treasuries and other bonds, then the “reserve currency” economies will have to ramp up Quant Easing. Much of the money inflows, as has been pointed out has been due to either cash hoarding or deleveraging (ie: margin calls). There is still scant evidence, other than MM funds, of domestic purchases of those bonds, which will only leave the central banks to purchase them and ramp up QE.

    More on that here:

    http://www.debtorsprisonblog.org/journal/2009/4/2/quantitative-easing-and-its-relationship-to-foreign-exchange.html

  • Posted by guest

    An off-topic question:

    Why Kansas universities import teachers like Willam K. Black and Michael Hudson, and export economists like bsetser?

    I’m a fan of Pat Metheny… and Missouri… but…

    WTF?

  • Posted by bsetser

    DJC — if the western banks sold their shares in Chinese banks to other foreign investors (say by selling in HK), their outflow would be offset by another inflow.

    2fish — do take a look at the rise in HK and Taiwan’s reserves recently. that suggests much of the outflow from china found its way there. HK was a big source of inflows for a while as HK residents had the capacity to put funds on deposit in rmb legally. that inflow and the reverse outflow clearly was mediated by the banking system. with some other flows, i am not so sure.

    tono — the detailed survey data has data on the maturity distribution of central banks holdings of treasuries. the last data point is mid-07 tho. my operating assumption has been that china held a larger share of longer term (5 year and up) treasuries than the central bank norm. that tho is an assumption based on the anecdote more than anything from hard data. certainly china has more “liberal” reserve management guidelines than the guidelines many other countries have that preclude holdings bonds with a maturity of over 3 or over 5 years.

    over the last 6 months, though, we know that china has been shifting heavily toward t-bills, so the survey data doesn’t tell us all that much about the current maturity distribution of china’s holdings

  • Posted by Twofish

    bsetser: do take a look at the rise in HK and Taiwan’s reserves recently. that suggests much of the outflow from china found its way there

    We are looking only at rises of $50 billion. Some of the outflow did make it to Taiwan or Hong Kong, but not most of it. Taiwan and Hong Kong were “along for the ride” but the major investment flows were driven elsewhere by global banks.

    One terminology point. Neither Taiwan or HK Chinese are regarded as “overseas Chinese.”

    bsetser: HK was a big source of inflows for a while as HK residents had the capacity to put funds on deposit in rmb legally. that inflow and the reverse outflow clearly was mediated by the banking system. with some other flows, i am not so sure.

    And Hong Kong and Taiwan export businesses have pretty extensive authority to move currency in and out to cover trade credit. Once you have any ability to change currency, then lots of people suddenly are interested in being friends with you, and it becomes rather trivial to “resell” your authority.

    Something that would be interest would be to see the extent to which HK and Taiwan were just conduits for money from the rest of the world. So you have $150 billion going through HK, but only about $20 billion stays there.

    As far as where all these Chinese currency reserves are ending up. One notes that there has been this suddenly flood of domestic money in the United States buying Treasuries.

    Once the flows got into Mainland China, then it enters the informal banking system, but getting the money in and out of Mainland China appears to be quite formal.

    I do suspect that at the end of all this, we’ll find the Western banks and hedge funds have a lot more exposure and connections to informal banking systems than Chinese banks ever did.

  • Posted by Twofish

    Yeo: Investors who were eager to cash in on the RMB fever in 07/08 probably , via legal consultants, “cooperated with” Chinese nationals (and overseas Chinese) to set up accounts and investments and are cashing out in a similar fashion.

    Lots of Chinese work in investment banks, and the point of a banking system is to move money from point A to point B. If you have the authority from SAFE to exchange RMB and dollars, then pretty soon you’ll want to talk to a global bank and a global bank will want to talk with you.

    I mean, if you are a rich Hong Kong or Taiwanese tycoon, you aren’t going to keep your money in suitcases under your mattress or going in pawn shops, you are going to have a talk with private bankers at Goldman-Sachs, JPMorgan, Morgan Stanley, HSBC etc., who more than likely if they are working in Hong Kong or Taipei are Chinese.

    Curiously, private banking for hyper-wealthy people is something that very few Chinese banks are terribly interested in, and hyperwealthy Chinese tend not to be interested in local banks, because they don’t have global reach. If you are a hyperwealthy tycoon, you might want to invest your money in Kentucky horse farms. A global bank will let you do that. Most Chinese banks can’t do that (yet).

    If you happen to have the ability to move currency in and out of southern China, at that point the big global banks will want to talk to you, with lots of rather highly paid lawyers figuring out what can be done and what can’t be.

    There’s nothing illegal or even particularly nefarious about this. Investment banks are very keen to follow the letter of the law and regulations, lest Chinese regulators shut them down. However at the same time, banks will push the law as far as it will go which is actually pretty far.

    Because it is costless to move money (just a few keystrokes on a computer), if you have to go through twenty steps to move dollars in and out of the PRC, you will take those steps.

    I do think that there are some “exotic” stereotypes that don’t accurately represent what is really going on.

    When people think “Chinese people moving money”, I think people get the image of Chinatown pawn shops and suitcases full of cash, rather than a conference room in Hong Kong or Shanghai with Harvard MBA’s and lawyers (most of them Chinese) sitting in front of laptops on a conference call with people in New York and London staring at a white board, although for the really really big sums, the second picture is a lot more accurate.

  • Posted by Tamas

    Brad: Aren’t at least part of the Chinese flows directly linked to the *expectation* of future performance of the Chinese economy? Thus is your forecast for the reserve accumulation to pick up as much about the expectations dynamics as it is about real processes?

  • Posted by DOR

    No one has divested out of China, anymore than the rest of the world divested out of itself in the past 25 years in order to invest in China.

    As Twofish says, cashing up a foreign company isn’t the same as pulling out of China.

    .

    Twofish: “Face” is personal, not corporate. Companies don’t lose face, but people most certainly do. Classify under “to be avoided, if at all reasonable.”

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