Brad Setser

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China’s Reserves Fell by Around $45 Billion in December (Using the PBOC Data)

by Brad Setser

The pace of decline in China’s foreign reserves matters.

Not because China is about to run out.

But rather because China will at some point decide that it doesn’t want to continue to prioritize “stability” (against a basket) and will instead prioritize the preservation of its reserves, and let the yuan adjust down. Significant voices inside China are already making that argument.

And I fear that if the yuan floats down, it will stay down. China will want to rebuild reserves, and—if exports respond to the weak yuan—(re)discover the joys of export-led growth. Relying on exports is easier than fighting the finance ministry’s opposition to a more expansive (on-budget) fiscal policy, or seriously expanding the provision of social insurance to bring down China’s savings.

I thus disagree with those who argue that the “China” shock is over. It depends a bit on the exchange rate. China’s exports of apparel and shoes have probably peaked. But China’s exports of a range of machinery and capital goods continue to remain strong—and at a weaker exchange rate, China could supply more of the components that go into our electronic devices, and export far more auto parts, construction equipment parts, engines, generators, and even finished autos than it does now. “Mechanical” engineering writ large continues to be a significant part of the U.S. economy, and even more so the European economy.

china-fx-settlement-cny

One of the main indicators—PBOC balance sheet reserves—that I follow for tracking China’s reserve sales is now out for December, and it points to around $45 billion in sales. I prefer to look at all the foreign assets the PBOC reports on its balance sheet rather than just its reported foreign exchange reserves. That variable was down $43 billion in December, and $133 billion for q4. Actual foreign exchange reserves fell by a bit more—$46 billion in December and $141 billion in q4. The difference between foreign exchange reserves and all of the PBOC’s foreign assets is primarily the foreign exchange the banks hold at the PBOC as a result of their reserve requirement.
The loss of reserves in December was a bit smaller than in November. But only just. The average monthly fall in q4 was over $40 billion.

That is a pace that is ultimately unsustainable. I think China would be fine with $2 trillion in reserves, given how little foreign debt it holds. Others say $2.5 trillion. If reserves are falling by a steady $40 billion a month/$500 billion year, it is only a matter of time before China hits its limit. With China, it may be a long time though…

However, there are two reasons why I am not yet convinced that it is only a matter of time before outflows overwhelm the PBOC’s reserves and other exchange rate defenses.

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China’s Q3 Balance of Payments Data Helps Explain Why Q3 Reserves Fell So Much

by Brad Setser

I want to step back a bit from the rather extraordinary moves in the offshore yuan market over the past few days. It seems quite clear that China’s authorities felt the need to signal that the yuan isn’t currently a one way bet against the dollar. And stepping back in this case means taking a deep dive into the details of the balance of payments data — details that come out with a quarter lag, and thus provide information that is stale from the point of view of a forward-looking market. A lot, and I mean a lot, changed in the fourth quarter.

I generally like it when China’s data series line up. Line up with each other. And, when possible, when China’s data also lines up with data reported by China’s trading partners.

So I have been bothered for some time by the large discrepancy between the fall in China’s foreign exchange reserves (as reported on the PBOC’s balance sheet, $108 billion in the third quarter) and the much smaller net sales of foreign exchange by China’s banks (as reported in the FX settlement data, $50 billion in the third quarter without adjusting for the forwards reported in the settlement data, $63 billion with the forward adjustment). Fx settlement includes all the banks, not just the central bank. Historically, though, it has been very correlated with overall reserves.

The initial balance of payments (BoP) data for the third quarter showed large reserves sales ($136 billion), sales on a scale that was consistent with the PBOC balance sheet numbers. The BoP reserves sales thus seemed to suggest a big pickup in capital outflows in the third quarter.

est_chi_off_asset_growth

However, the detailed balance of payments data suggests that the signal from the FX settlement data may be more accurate. Much of the q3 fall in China’s reserves seems tobe explained by the buildup of foreign assets by other state controlled financial institutions, not “private” capital outflows. I see a likely increase of around $85 billion in the foreign assets of state institutions other than the PBOC in q3.

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China’s November Reserve Drain

by Brad Setser

The dollar’s rise doesn’t just have an impact on the United States. It has an impact on all those around the world who borrow in dollars. And it can have an enormous impact on those countries that peg to the dollar (Saudi Arabia is the most significant) or that manage their currency with reference to the dollar. China used to manage against the dollar, and now seems to be managing against a basket. But managing a basket peg when the dollar is going up means a controlled depreciation against the dollar—and historically that hasn’t been the easiest thing for any emerging economy to pull off.

And China’s ability to sustain its current system of currency management—which has looked similar to a pretty pure basket peg for the last 5 months or so—matters for the world economy. If the basket peg breaks and the yuan floats down, many other currencies will follow—and the dollar will rise to truly nose-bleed levels. Levels that would be expected to lead to large and noticeable job losses in manufacturing sectors in the U.S. and perhaps in Europe.

Hence there is good reason to keep close track of the key indicators of China’s foreign currency intervention.

fx-settlement-cny-pboc-reserves

The two main indicators I track are now both available for November:

The PBOC’s yuan balance sheet shows a $56 billion fall in foreign exchange reserves, and a $52-53 billion fall in all foreign assets (other foreign assets rose slightly). I prefer the broader measure, which captures regulatory reserves that the big banks hold in foreign currency at the PBOC.

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The November Fall in China’s Reserves and Rise in China’s Real Exports

by Brad Setser

China’s reserves fell by $69 billion in November.

With the notable exception of Sid Verma and Luke Kawa at Bloomberg, Headlines generally have emphasized the size of the fall

The Financial Times was pretty restrained compared to the norm, and the FT still highlighted that the November fall was “the largest drop since a 3 per cent fall in January.”

But the fall was actually a bit smaller than what I was expecting.

Valuation changes on their own knocked $30 billion or so off reserves (easy math—$1 trillion in euro, yen and similar assets, with an average fall of 3 percent in November).

It isn’t quite clear how China books mark-to-market changes in the value of its bond (and equity portfolio).

My rough estimate would suggest mark to market losses on China’s holdings of Treasuries and Agencies of about 1.5 percent, or $20 billion (Counting the agency portfolio and Belgian custodial book, per my usual adjustment). Bunds and OATs (French government bonds) also fell in value—but SAFE likely has a couple hundred billion in equities too, and their value rose. But it isn’t clear that all of China’s assets are marked to market monthly, so there is a bit of uncertainty here not just about the overall performance of the portfolio, but also how the portfolio’s value is reported.

Sum it all up and it is possible valuation knocked somewhere between $30 and $50 billion off China’s headline reserves.

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Do Not Tell Anyone, But the Case For Naming Taiwan a Manipulator Is Stronger than the Case For Naming China

by Brad Setser

Taiwan has an extremely large current account surplus. Over 14 percent of GDP in 2015, and over 10 percent of GDP since 2012. (See the WEO data or this chart). Relative to its GDP, Taiwan’s current account surplus is far bigger than China’s current account surplus is relative to its GDP.

Taiwan’s central bank clearly has been buying foreign currency in the foreign exchange market. The balance of payments data shows between $10 and $15 billion of purchases a year in recent years, and roughly $3 billion of purchases a quarter this year (data here).

china-taiwan-current-account-gdp-share

And Taiwan’s government clearly has been encouraging private capital outflows—notably from the the life insurance industry—largely by loosening prudential regulation, and allowing the insurers to take more foreign currency risk. Private outflows help limit the need for central bank intervention to keep the currency down, but also require private institutional investors to take on ever more foreign currency risk.

China by contrast has been selling foreign exchange reserves in the market to prop its currency up. Right now, the case that China is managing its currency in ways that are adverse to U.S. trade interests is not strong.

Plus, Taiwan’s real effective exchange rate—using the BIS data—has depreciated significantly over the past ten-plus years, unlike China’s real effective exchange rate. The fact that a weaker real exchange rate has gone hand in hand with the rise in Taiwan’s surplus shouldn’t be a surprise, but there are still a surprising number of folks who believe that real exchange rates don’t matter for trade in an era of global supply chains. In Taiwan’s case, the correlation between a weaker currency and a bigger current account surplus is clear.

china-taiwan-reer-bis

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China’s October Reserve Sales, And A New Reserves Puzzle

by Brad Setser

My preferred indicators of Chinese intervention are now available for October, and they send conflicting messages.

The changes in the balance sheet of the People’s Bank of China (PBOC) point to significant reserve sales (the data is reported in yuan, the key is the monthly change). PBOC balance sheet foreign reserves fell by around $40 billion, the broader category of foreign assets, which includes the PBOC’s “other foreign assets”—a category that includes the foreign exchange the banks are required to hold as part of their regulatory requirement to hold reserves at the central bank—fell by only a bit less. $40 billion a month is around $500 billion a year. China uniquely can afford to keep up that pace of sales for some time, but the draw on reserves would still be noticeable.

The foreign exchange settlement data for the banking system—a data series that includes the state banks, but historically has been dominated by the PBOC—shows only $10 billion in sales, excluding the banks sales for their own account, $11 billion if you adjust for forwards (Reuters reported the total including the banks activities for their own account, which raises sales to $15 billion). China can afford to sell $10 billion a month ($120 billion a year) for a really long time.

The solid green line in the graph below is foreign exchange settlement for clients, dashed green line includes an adjustment for the forward data, and the yellow line is the change in PBOC balance sheet reserves.*

tracking-the-yuan-v-reserves-v-settlement

As the chart illustrates, the PBOC balance sheet number points to a sustained increase in pressure over the last few months after a relatively calm second quarter. The PBOC balance sheet reserves data also corresponds the best with the balance of payments data, which showed large ($136 billion) reserve sales in the third quarter.

Conversely, the settlement data suggests nothing much has changed, and the PBOC remains in full control even as the pace of yuan depreciation against the dollar has picked up recently and the yuan is now hitting eight year lows versus the dollar (to be clear, the recent depreciation corresponds to the moves needed to keep the yuan stable against the basket at this summer’s level; the yuan is down roughly 10 percent against the basket and against the dollar since last August).

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Inflows from Private Bond Investors Into the U.S.

by Brad Setser

The global capital flows story these days is complex. I wanted to build on Landon Thomas’ article with a set of charts drawing out how I think large surpluses in Asia and Europe are now influencing the TIC data. Obviously, this is a more technical post.

Asia’s surplus is big. In dollar terms, the combined current account surplus of China, Japan, and the NIEs (South Korea, Taiwan, Hong Kong, and Singapore) is back at its pre-crisis levels. China’s surplus is a bit smaller in 2007, but Korea and Taiwan are clearly running bigger surpluses. Yet unlike in the past, very little of Asia’s surplus is going into a reserve buildup. China is obviously selling, and its selling overwhelms intermittent purchases by Korea (Korea sold in q1 2016, but bought in q3) and Taiwan. The outflow of savings from Asia is currently overwhelmingly a private flow.

That is a change. And frankly it makes the impact of Asia’s surplus on global markets harder to trace. The Bank for International Settlement (BIS) data shows that much (I would say most) of the “capital outflow” from China over the last four quarters has actually gone to paying down China’s external bank debt, not to build up assets. It thus just becomes a new source of liquidity for the global banking system (once a dollar loan is repaid, the bank is left with a dollar—which has to be parked somewhere else).

And of course the eurozone and northern Europe also run substantial surpluses. Negative rates and ECB asset purchases in effect work to push investors out of super low-yielding assets in Europe, and into somewhat higher yielding assets outside the eurozone.*

foreign-private-purchases

The combined surplus of China, Japan, the NIEs, the eurozone, Sweden, Denmark, and Switzerland was close to $1.2 trillion in 2015. That is a big sum; one that has to leave traces in the global flow data. The U.S. current account deficit isn’t as big as it was prior to the crisis (and it is smaller than the UK’s current account deficit), but it is still financed, in part, by inflows from abroad into the U.S. bond market.

Total inflows from private purchases of U.S. bonds by foreign investors—together with the inflow from American investors selling their existing stock of bonds abroad and bringing the funds home—actually look to be at a record high in the TIC data (in dollar terms, not when scaled to U.S. GDP). $500 billion in inflows from foreign purchases of Treasuries, Agencies, and corporate bonds by private investors abroad, and $250 billion in financing from Americans bringing funds previously invested in foreign bonds home.

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Large Scale Central Bank Asset Purchases, Versus Supply

by Brad Setser and Emma Smith

In earlier posts, Emma Smith and I added up central bank purchases of G-4 government bonds. This includes emerging market, Japanese and Swiss purchases for reserve accumulation and purchases by the Fed, Bank of Japan, European Central Bank and Bank of England during periods of quantitative easing (QE).

In this post we compare our estimates of official demand for U.S., Japanese and European bonds with changes in the supply of safe assets—that is, purchases by central banks relative to net new issuance of government bonds.

If central bank demand for a particular asset is lower than net new issuance, then private sector holdings of government bonds continue to grow but at a slower pace than would otherwise be the case. And if central bank demand for a particular asset exceeds net supply, then private sector investors—such as banks and pension funds—have to reduce their holdings of safe assets, and move into alternative assets.

This is how the portfolio re-balancing transmission channel of asset purchases works: private investors sell to the central bank and are forced to find new places to park their money. Conceptually, it should not matter much if the central bank buying say U.S. assets is the People’s Bank of China or the Fed, at least so long as both are expected to hold on to their purchases for a long-time. When either buys, it reduces the stock of assets in private hands and forces investors to shift into other assets.

Central bank asset purchases aren’t limited to government bonds of course, but, to simplify things, we limited our analysis to new issuance of government bonds. We know this over-simplifies. For example, a lot of “official” demand has gone into Agencies. Before the global crisis Agencies were a favorite of reserve managers globally. But adding in the Agencies to net supply takes a bit (ok, a lot) more work. The Fed also bought Agencies, but Fed holdings of Agencies and Treasuries are reported separately on their balance sheet. The numbers below only count the Fed’s Treasury portfolio.

In the U.S., the supply of Treasuries has exceeded central bank demand since 2010. This is largely because the U.S. Treasury ramped up issuance of Treasury securities after the crisis (offsetting, it should be noted, a big fall in private bond issuance). Even as annual net issuance of Treasuries slowed from its peak of around $1.7 trillion to a little over $600 billion, it has remained above official purchases. Right now there isn’t any official bid for U.S. bonds. Reserve managers on net have been selling and the Fed hasn’t been buying.

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Large Scale Central Bank Asset Purchases, by Currency

by Brad Setser and Emma Smith

In an earlier post, I added reserve purchases by the world’s major emerging market central banks, Japan and Switzerland to the bonds purchases by the Fed, the BoJ, the ECB and Bank of England. I wanted to highlight that the central banks of the world were buying a lot of U.S. and European bonds before the big central banks started quantitative easing (QE). China and others bought a ton of bonds prior to the global crisis.

Emma Smith, an analyst at the Council on Foreign Relations, helped me with the data work for that post; she and I are jointly writing the follow up posts.

In addition to looking at the total number of G-4 bonds bought by the world’s central banks—counting bonds bought in large scale asset purchase programs (QE) alongside estimated reserve purchases—it is interesting to look at central bank purchases by currency. QE results in the purchase of your own country’s bonds; reserve purchases mean you need to invest in bonds issued by someone else—e.g. both the Fed and the PBOC have bought large quantities of U.S. Treasuries and Agencies at different times over the last fifteen years.

Take central bank purchases of dollar bonds. The chart below relies on the Fed’s data on its purchases, and an estimate of the dollar bond purchases implied by global reserve growth.

Before the global crisis, central bank purchases of dollar bonds came from reserve managers. Their accumulation of dollar assets picked up from around 2003—coinciding with the dollar’s depreciation against the euro, the beginning of the rise in China’s current account surplus and a pickup in capital flows to a range of emerging economies. In early 2008, the Fed was actually selling a portion of its bond portfolio—it didn’t want its balance sheet to expand as its lending to the world’s banks rose in the run-up to the global crisis—and after Lehman, reserve managers started to sell. But the Fed soon reversed course, and started purchasing large amounts of Treasuries and Agencies in its QE programs. And emerging economies recovered and resumed large scale intervention of their own—albeit at a lower level than pre-crisis—taking central bank demand to new highs.

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The Scale of Korea’s Intervention in August

by Brad Setser

Folks in the market like to talk about what is happening to China’s forward book. Some think that China (or its state banks) sold dollars forward last fall, and, well, to many the (modest) disclosed short position that China reports in the IMF’s SDDS reserves template isn’t all that convincing. In part because the disclosed forward book never changes much.*

But China also quite clearly isn’t the only country in Asia with a forward book. “Shadow intervention” is actually rather common, in both directions.

At the end of August, Korea had bought about $48 billion in dollars forward, up from just under $45 billion in July.** Technically, the forward book may be the forward leg of a swap contract.*** No matter—the rise in the forward book clearly reflects the central bank’s activities in the market.

Adding in the forward book shows the true scale of Korea’s intervention in August. The balance of payments reserve outflow was just over $3 billion. The balance of payments number should track valuation-adjusted headline reserves. The forward book rose by a bit more $3.1 billion.

I like to watch government deposits and government bond purchases too; they are up $1.7 billion (with a big increase in government deposits abroad). Korea’s intervention hasn’t always only appeared on the central banks’ balance sheet (though some of the portfolio debt comes from Korea’s National Pension Service). Sum it up, and Korea’s government could have bought as much as $8 billion in the market in August.

korea-intervention-by-type

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