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Chinese Reserves: Boiling Over Again?

by rziemba
July 15, 2009

This Rachel Ziemba, filling in for Brad Setser. I’m having technical upload issues so will add charts later but for now some thoughts on reserves

Chinese reserves data released today seem to be one more sign that the Chinese stimulus might be working a bit too well. China’s reserves stood at $2.13 trillion up from $1.95 trillion at the end of March 2009. Although reserve accumulation was likely lower than the headline $178 billion, it implies that hot money is back in China. Adjusting for valuation, Chinese reserve growth was likely about $140 billion, much higher $60-70 billion of China’s trade surplus, FDI and interest income in this period. This accumulation also suggests that China continues to have a hard time diversifying its holdings away from the U.S. dollar.

Adjusting for valuation — the changes in value of the non-dollar holdings in China’s reserves — would imply reserve growth of around $135-140 billion. This accumulation rivals that of Q2 and Q3 2008 for the highest quarterly level.

It is one indicator that suggests that parts of China’s economy may be overheating as China tries all measures to stoke growth. It seems well in line with almost 40% y/y urban fixed investment in May 2009, and loan growth equivalent to 25% of 2008 GDP. However, it just underscores some of the difficulties in both stoking growth and avoiding future distortions.

China’s rapid reserve growth is but one of many indicators that might be worrying monetary policy makers. While consumer prices are still falling on a y/y basis, as companies can not pass on higher costs to consumers, the current lending growth and money supply growth could lead to inflationary pressures ahead. China is again trying to ease and tighten its monetary policy at the same time. It recently began issuing sterilization bills again to try to mop up the liquidity generated by buying the foreign exchange. And investors anxious to get a part of the new IPOs and worried about inflation have been reluctant to buy some recent low-yielding bond issues. Despite the risk of overheating, other parts of China’s economy continue to be weak, suggesting that tightening could be politically difficult especially if it contributes to asset market correction

The potential risks stemming from the Chinese monetary (mostly lending) and fiscal stimulus is one of the reasons that we at RGE are still somewhat cautious about the mid-term outlook for Chinese growth (as summarized in this excerpt today). There is a risk that China might be forced to use rather blunt policy measures to try to cool the overheating in some parts of the economy and, especially, its asset markets before the real economy gets on to a sustainable growth path. Or, they might not reign in the spending and it could contribute to asset bubbles and inflation that could lead to a double-dip, if as RGE fears, the U.S. and global recovery is sluggish.

But back to the reserves. Given the size of China’s reserve growth in Q2 — in the face of a shrinking trade surplus and lower foreign direct investment than in 2008 — the country is likely experiencing short term capital inflows “hot money” again. Economists tend to sum the trade surplus (the largest component of the current account) and FDI. What is unexplained by these inflows is often deemed to be hot money – short-term capital inflows. China’s trade surplus fell to $35 billion in Q2, about half that of Q1. FDI was about $21 billion taking the total to $55 billion.

Income on China’s past investments could explain part of the increase. Given the stock of China’s assets, even low yielding assets could garner a significant absolute figure, but it seems insufficient to make up the difference. Moreover, despite the mid-Q2 increase in bond yields, income on bonds remains relatively low. China’s stock of equities likely saw a bounce from Q1 levels. Yet, it is thought that China does not mark its portfolio to market. Moreover, much of the $100 billion in U.S. equities China holds were acquired between June 2007 and June 2008.

Remittances also might account for another part. These are only reported with a significant lag making comparability difficult. However, given the scale of Chinese reserve growth and adding up all the “explained capital inflows”, it seems likely that China has received hot money inflows of around $60-$70 billion. A reversal from the approximately $70 billion in outflows in Q1!

Unlike many other emerging economies, China remains quite closed to foreign equity investment. Thus, it seems likely that Chinese (including Hong Kong-based Chinese) may be trying to get money back into China again. Foreign investors may be contributing to the property market revival. Although currency appreciation is not expected in the short term given weak exports, consensus expects a stronger RMB over the course of the next few years. 12 month non-deliverable forwards, albeit not necessarily the best indicator of future levels, are barely pricing in an increase. However, there is general agreement that the RMB will have to appreciate.

In the short term this means China’s reserve diversification may have stalled. By putting pressure on the U.S. dollar, Chinese rhetoric about moving away from the U.S. dollar as a reserve currency earlier this year might have added to pressure on the renminbi and actually delayed the Chinese diversification path. China doesn’t release the currency composition of its reserves, but the dollar is thought to make up around 65% of the portfolio. That share could actually have increased slightly in Q2.

Euro assets make up most of the rest, along with a small amount of pound sterling, yen, and likely even a small amount of Canadian and Australian dollars. China has also increased its gold holdings. Despite the increase, gold makes up a less-than 2% share in Chinese reserves, much smaller than its share in U.S. or European reserves.

The U.S. data reflects the fact that China has yet to diversify much from the dollar. In fact as Brad Setser has noted, in Q1, China’s holdings of U.S. dollar assets as reported by the U.S. Treasury rose more than China’s reserves. One explanation – China was shifting within its dollar assets and asset managers, with the net result that more of its assets were captured in the U.S. data. But the data suggests China is still adding to dollar assets. Overall, China increased its short-term holdings immensely at the end of 2008 and early 2009. However, as of March and April it was paring back on its holdings of T-bills and increasing its holdings of U.S. treasuries.

The trend may still be visible in the May data which should be released at the end of this week. The scope of reserve accumulation suggests that, for now at least, China is still buying U.S. assets and helping meet funding needs. In the longer term, much will depend on China’s willingness for a stronger currency.

Given these trends, it may not be surprising that Chinese statements on new reserve currencies grew somewhat quieter in early May. Given the scope of capital inflows, these diversification statements may have seemed, as analysts for the Bank of New York have noted, to be counterproductive.

Given the increase in China’s reserve holdings, perhaps it is no surprise the Chinese investment corporation (CIC) is again becoming active, restarting its investment program. In recent weeks, the CIC announced plans to increase its stake in Morgan Stanley to avoid dilution, took a 17% stake in Canadian metals producer Teck Cominco, and announced a board of economic advisors. Further investments may follow as China continues to try to diversify its holdings.

Real diversification and liberalization of the capital account might be a longer-time in coming. Over time, some of the new capital management regulations – allowing companies to keep more of their foreign funds abroad, to use them to fund subsidiaries – might reduce inflows and funds purchased by the central bank.

So reserve accumulation is back. China is not the only country that added to its reserves again last quarter. Setting China and its estimated $140 billion in reserve growth aside, a group of over 30 countries that RGE tracks reported a valuation adjusted a net increase in reserves of about $40 billion. While not all of the countries have yet reported their June statistics, Q2 2009 is on track to be the first quarter in a year with reserve accumulation. The stocks of global reserves, are rising back towards $7 trillion again.

The pace of accumulation has slowed but the accumulators are the usual suspects –emerging economy exporters wary of currency appreciation. Many experienced sharp inflows into equity, bond and FX markets in the liquidity-fuelled rally in April, May, and early June. Russia, South Korea, Hong Kong and Taiwan account for much of the accumulation. A renewed flight from the U.S. dollar, expect these central banks to resume buying.

While some countries – like Russia -may have managed to slightly pare their dollar share in the face of capital outflows last year, the dollar still dominates reserve portfolios, particularly in Asia and the GCC. The amount of dollar liabilities in some emerging markets contributes to the need for U.S. dollars. Europe’s near abroad is similarly more partial to the euro. However, there continue to be obstacles to the euro as a reserve asset, including a fragmentation of the bond market — and the last thing European officials want is a stronger euro.

All this means Chinese reserve diversification is likely to be happening only at the margin and China (and other central banks) are likely buying U.S. assets


  • Posted by Dennis Redmond

    Yes, it seems that all of the BRICs are once again piling up reserves. Given the size and scale of the BRICs and their tight linkages with global production networks, I suspect this is some of the best evidence we have that the global economy is really and truly bottoming out (the macroeconomic data suggests Russia and China have turned the corner, though I don’t follow India or Brazil closely, so I can’t speak for them). The tricky balancing act here is that the world needs to shift very, very gradually and carefully from US-centricity to multipolarity — a disorderly unwind of the dollar would blow up in everyone’s face. So the BRICs are going to have to spend some of its reserves on domestic services (education and health care) and green energy programs and infrastructure.

  • Posted by bill j

    Rachel remarks that the $1 trillion in lending is 25% GDP growth that’s true annually, but that lending was for the first 6 months only! So that’s an annual $2 trillion or 50% GDP.
    OK so quite a bit of these loans will be speculated in the stock market or used for liquidity purposes, but whatever way you spin it the implication is that GDP growth will be way in excess of even the most optimistic forecasts.

  • Posted by silly things

    Hi Rachel,

    What is your estimate of how much under valued is the Chinese RMB? Can this be estimated by the size of the Chinese reserve of since China is buy dollar to keep the RMB down?


  • Posted by Will

    Why do you assume that it is hot money that explains the diffrence, rather than larger revaluation effects? I have a hard time believing that money is flowing back into China through Hong Kong, as the HKD has sat on the strong end of its intevention band since March. The strength of HKD means it is rather more likely that capital continues to flow out of China.

    If it is not hot money, then it is valuation. Do you suppose that it is possible that China may now be holding 50% of its reserves in euros? And if so, do you think the dollar bears are ready for the moment when China reconsiders the wisdom of that decision?

  • Posted by rziemba

    Dennis – the BRICs – and several other EMs – are back to accumulating certainly. Given capital inflows, its not surprising. But in terms of capital flows its tricky to shift gradually. and as capital flows into EMs they are buying US dollars as part of managing their currencies.

    silly things – Its tricky to estimate the undervaluation. usually one looks at what sort of move in the currency would be necessary to have a shift in the current account. The latest estimates from the Peterson Institute suggest a 40% undervaluation based on fundamental real exchange rates. That seems high to me.

    Will – valuation has an effect, sure. I tried to adjust for this. Even assuming that the dollar makes up only 60% of China’s reserves, there would still some flows unexplained by valuation, trade surplus, FDI and other flows. I think it unlikely that the Euro makes up 50% given the flow of funds data but will be testing out different scenarios in the coming weeks.

  • Posted by eh

    dennis…”the BRICs are going to have to spend some of its reserves on domestic services”

    you are getting fiscal policy mixed up with monetary policy. forex reserves can’t be used in this manner. (just think how the fed has little to do with how infrastrucutre spending is spent/allocated). reserves can only be used to buy the domestic currency and/or other foreign currencies. nothing more.

  • Posted by Qingdao

    Did i miss something? How can you expect inflation and: “However, there is general agreement that the RMB will have to appreciate.”

  • Posted by Rien Huizer


    When will the new IMF country report (rumoured to be circulating in draft form) be published?

  • Posted by Rahul

    Will such reserve expansion continue?

    April – June is period where Chinese manufacturers get lot of orders for christmas consumption. (July-Sep is production time – Sep onwards shipping starts)

    Does anyone have an idea how the orders have been this year?

    If orders are reasonable (about 50% of peak) then possibly we will have further reserve addition in coming months.

    In any case I do not foresee a structured unwinding of the USD domination. Hot money / Big hot money will clamour into China forcing its hand.

    The range of outcomes possible when that happens is mind boggling. But uncertainty is definitely going to be around in near term.

  • Posted by rziemba

    Rien- I wish I knew re the IMF report. I know the board discussed it last week so usually it comes out a few weeks after that. It could be around the time of the US China sit down at the end of the month.

    eh – good point. what the BRICs are doing is utilizing some of their savings to avoid borrowing. Russia in particular is using funds in the reserve fund to limit turning to international markets. but spending the reserves is limited by other policies like a stable exchange rate

    Qingdao – sorry for being unclear about the time frame. I expect appreciation to follow as a result of inflation

    Rahul –
    the challenges to US reserve position are more longer term in nature I’d say. For now the BRICs – and a number of others are being constrained and pushed to buy more dollars

  • Posted by rziemba

    fyi – I’ll post on the TIC data later today, but the trends seem to match with reserve growth. Chinese holdings of T-bills surged in May 2009