Brad Setser

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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 Vision for a Regional Trading Block Has its Own Challenges

by Brad Setser

One oft-made argument is that with Trump’s decision not to move forward with the TPP, China has an opportunity to fill the regional trade void. Chinese policy makers are certainly pushing their regional comprehensive economic partnership hard. Nick Lardy of the Peterson Institute, in an article by Eduardo Porter.

“China is the one major power still talking about increased integration,” said Nicholas Lardy, a China specialist at the Peterson Institute. “China is the only major country in the world projecting the idea that globalization brings benefits.”

Perhaps. But I also suspect there are significant obstacles to a Chinese-led regional trading block, obstacles that are independent of the United States.

One. If (almost) all Asian economies are running trade surpluses, they cannot just trade with each other.

There is an old fashioned adding up constraint – one country’s surplus is another’s deficit, and if Asia is running a large surplus collectively, it mathematically has to be selling its goods to the rest of the world. And Asia’s collective surplus in goods trade is now very large.

asian-goods-trade-balance

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China’s Dual Equilibria

by Brad Setser

A couple of weeks ago, Daokai (David) Li argued that the “right” exchange rate for China isn’t clearly determined by China’s fundamentals. Or rather that two different exchange rates could prove to be consistent with China’s fundamentals.

“Currently, the yuan exchange rate regime yields multiple equilibrium. When we expect the yuan to depreciate, investors will exchange large amounts of yuan into dollars, causing massive capital outflow and further depreciation. If we expect the yuan to remain stable, cross-border capital flow and the exchange rate will be relatively stable. The subtlety that causes the equilibrium is that liquidity in China is the highest in the world. If there is any sign of change in exchange rate expectations, the huge liquidity in the yuan translates into pressure on cross-border capital flows.”

If China’s residents retain confidence in the currency and do not run into foreign assets, China’s ongoing trade surplus should support the currency at roughly its current level.

Conversely, if Chinese residents lose confidence in the yuan, outflows will overwhelm China’s reserves—unless China’s financial version of the great firewall (i.e. capital controls) can hold back the tide.

I took note of Dr. Li’s argument because it sounds similar to an argument that I have been making.*

I would argue that there aren’t just multiple possible exchange rate equilibria for China, there are also at least two different possible macroeconomic equilibria.

In the “strong” yuan equilibrium, outflows are kept at a level that China can support out of its current goods trade surplus (roughly 5 percent of GDP), which translates to a current account surplus of around 2.5 percent of GDP right now, though it seems likely to me that an inflated tourism deficit has artificially suppressed China’s current account surplus and the real surplus is a bit higher.**

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China, Manipulation, Day One, the 1988 Trade Act, and the Bennet Amendment

by Brad Setser

President-elect Trump has said that he plans to declare China a currency manipulator on day one.

I am among those who think this is a bad idea. This isn’t the right time to signal that China’s long-standing exchange rate management has crossed over the line and become manipulation. If China responded by ending all exchange rate management—no daily fix, no band, no intervention, a true float—the renminbi would certainly fall, and potentially fall by a lot.

yuan-indexes

Uncomfortable as it is to say, right now it is in the United States’ economic interest for China to continue to manage its exchange rate. Subsequent to the yuan’s August depreciation last summer, China has been selling large sums in the market—sums that increased in q3, after falling in q2—to control the yuan’s decline.

A freely floating yuan makes long-term architectural sense: the other SDR currencies float against each other, and China’s monetary policy shouldn’t be linked to that of the United States. But for China to be in a position where it can transition to a free float in a way that stabilizes the world economy, it needs both to do a serious recapitalization of its banks and to introduce a set of policy reforms that would strengthen the domestic base of China’s economy. Such reforms should include policies aimed at lowering China’s still exceptionally high level of savings.

That said, there currently seems to be a bit of confusion about what it takes for the Treasury to name China a manipulator, and what a designation of manipulation means.

My read of the Treasury’s April foreign exchange report is that this semi-annual currency report now satisfies two distinct statutory requirements.* The 1988 Omnibus Trade and Competitiveness Act (section 3004), and the 2015 Trade Facilitation and Trade Enforcement Act (and specifically the Bennet Amendment; Section 701).

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China’s Non-Reserve Official Assets, and How They Might Help Us Understand China’s Forward Book

by Brad Setser

China’s headline reserves fell by around $45 billion in October, dropping to $3.12 trillion. Many China reserve watchers expected a bigger fall. Moves in the foreign exchange (FX) market knocked around $30 billion off China’s roughly $1 trillion portfolio of euros, pounds, and yen assets in October. After adjusting for these valuation changes, China might only have sold a bit over $15 billion or so in October. That is less than my estimates of the true pace of sales in September.

But it bears repeating that the changes in headline reserves often do not provide as good an estimate of China’s actual activities in the market as the PBOC’s balance sheet data and the FX settlement data. Neither is yet available for October. I at least do not yet have confidence that the pace of underlying sales really slowed.*

China’s October reserves, though, aren’t the real subject of this post.

Rather, I want to make two arguments about the non-reserve foreign assets held by Chinese state institutions. The second is a bit speculative. It is meant to encourage more work, not to provide a definitive answer.

One, China’s state sector still has a lot of foreign assets, assets that are not formally counted as FX reserves. The state banks hold foreign exchange as part of their capital, thanks to past recapitalizations. The state banks hold foreign exchange as part of their regulatory reserve requirement (the banks have to set aside a large portion of every deposit at the PBOC). This pool of foreign exchange is not counted as part of China’s formal reserves. The China Investment Corporation (CIC—China’s sovereign wealth fund) holds some foreign assets in its portfolio, and financed the purchase of those assets with domestic borrowing. The China Development Bank (CDB) and the China Export-Import Bank have also made significant loans to the rest of the world. There is room to debate just how big the state’s non-reserve portfolio is, but the balance of payments indicates something like $200 billion in cumulative outflows through the banks and China Investment Corporation, and well over $300 billion or so in offshore loans—mostly, I assume, from the CDB.

china-stock-official-assets

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Can China Reduce Its National Savings Rate with More Social Insurance?

by Brad Setser

Andrew Batson recently pushed back a bit against my attempt to frame one of China’s core macroeconomic problems as “too much savings.” He argues that policies to bring down savings have been tried in China – spending on social insurance rose in the ‘aughts – and it didn’t bring down national savings:

“the hypothesis that stingy social welfare policies are the main culprit, because they induce lots of precautionary savings behavior, was conventional wisdom around 2003-04 but has not held up well.”

Andrew characterizes my concerns (laid out in detail in my recent paper) about high Chinese savings fairly.

I worry that if investment dips and savings stays high China will suffer from a cyclical shortfall in demand. I think that is a good explanation of what happened in China in late 2014 and early 2015, when residential investment was weak (there was a glut of supply at the time thanks to over-building, especially in tier 3 and tier 4 cities) and China tried to curb local government investment. The cyclical short-fall in demand creates pressure for China to look to exports to support growth—rebalancing away from both investment and exports is actually quite difficult. And the cyclical short-fall in demand also creates pressure on Chinese policy makers to loosen curbs on credit to support the economy, creating the stop-go pattern we have observed recently.

And I worry that the combination of a structurally high level of savings and a structural fall in investment will re-create a large current account surplus. Or to be precise, an even larger current account surplus.

So is there no hope?

Will China’s savings fall naturally with investment, either as a result of lower business profits and less business savings, or because – as Andrew argues, drawing on work from Guonan Ma, Ivan Roberts and Gerard Kelly *– the rise in household savings was in part a function of the need to save to make a down payment on an apartment and household savings will fall naturally as more and more Chinese urban residents own their own homes (assuming prices stabilize).

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Asia’s Persistent Savings Glut

by Brad Setser

Back in 2005, when Ben Bernanke first warned of the risk of a global savings glut, the combined savings rate of Asia’s main “surplus” economies (China, Japan, South Korea, Taiwan, Hong Kong, and Singapore) equaled 35 percent or so of their collective GDP.

That number now? About 40 percent.

savings-rates-3-regions

That is obviously a lot of savings—savings which either has to finance a very high level of investment at home or has to be exported to the rest of the world. And with low interest rates around the world, the world doesn’t especially need to import savings from Asia right now.

East Asia’s high level of savings is the subject, obviously, of my new CFR working paper.

Much is often made of the small fall in China’s national savings rate. China’s savings rate peaked at a bit over 50 percent of GDP; in 2015 it dipped to 48 percent. A fall, yes, but not a big one. Remember that the flip side of high savings is a low level of consumption; without high levels of investment, domestic demand growth can easily fall short.

In the aggregate data for Asia’s surplus countries, the rise in China’s share of the region’s output more than offsets the (modest) fall in China’s savings rate. The national savings rate in Korea and Taiwan has also increased over the last five years. Hence record regional savings.

In dollar terms, the jump in savings is even more spectacular. Asian surplus economies saved around $2.8 trillion back in 2005. Now they save around $7 trillion. China’s savings have increased from $1 trillion to more than $5 trillion.

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China’s September Reserve Sales (Using the Intervention Proxies)

by Brad Setser

The most valuable indicators of China’s intervention in the foreign exchange (FX) market are now out, and both point to a pick-up in sales in September, and more generally in Q3.

china-fx-settlement-v-cny

The data on FX settlement shows $27b in sales in September, and around $50b in sales for Q3. Add in changes in the forwards (new forwards net of executed forwards) reported in the FX settlement data, and the total for September rises to $33 billion, and the total for Q3 gets to around $60 billion. FX settlement is my preferred indicator, though it is always important to see how it lines up with other indicators.

The data on the PBOC’s balance sheet shows a $51 billion fall in reserves in September, and a fall of over $100 billion in Q3. I like to look at the PBOC’s foreign assets as well as reserves, this shows a slightly more modest fall ($47 billion in September), as the PBOC’s other foreign assets continued to rise. But total foreign assets on the PBOC’s balance sheet are still down around $95 billion in q3 (with a bigger draw on reserves than implied by the settlement data, which includes the banking system; chalk the gap between settlement and the PBOC’s balance sheet up as something to watch).

$100 billion in a quarter isn’t $100 billion a month—but it is noticeably higher than in Q2.

All in all, the pressure on China’s “basket peg” or “basket peg with a depreciating bias” exchange rate regime (take your pick on what managing with reference to a basket means, it certainly has meant different things at different points in time this past year) is now large enough to be significant yet not so large as it appears to be unmanageable.

China still has plenty of reserves; I wouldn’t even begin to think that China is close to being short of reserves until it gets to $2.5 trillion given China’s limited external debt, tiny domestic liability dollarization, and ongoing external surpluses. $2.5 trillion would still be the world’s biggest reserve portfolio by a factor of two, it also would be roughly 20 percent of China’s GDP, which would be in line with what many emerging markets hold.

The depreciation in October has been consistent with maintaining stability against the CFETS basket, though stability at a level against the basket that reflects the depreciation that took place from last August to roughly July. The dollar has appreciated against the other major tradeable currencies in October this period, and maintaining stability against the CFETS basket meant depreciating somewhat against the dollar.

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China: Too Much Investment, But Also Way Too Much Savings

by Brad Setser

Most analysis of China’s economy emphasizes the risks posed by China’s high level of investment, and the associated rise in corporate debt.

Investment is an unusually large share of China’s economy. That high level of investment is sustained by a very rapid growth in credit, and an ever-growing stock of internal debt. Corporate borrowing in particular has increased relative to GDP. Not all this investment will generate a positive return, leaving legacy losses that someone will have to bear. Rapid credit growth has been a fairly reliable indicator of banking trouble. China is unlikely to be different.

Concern about the excesses from China’s investment boom permeate the IMF’s latest assessment of China, loom large in the BIS’s work, and the blogosphere. Gabriel Wildau of the Financial Times:

“Global watchdogs including the International Monetary Fund and the Bank for International Settlements (not to mention this blog) have become increasingly shrill in their warnings that China’s rising debt load poses global risks.”

Yet I have to confess that defining China’s primary macroeconomic challenge entirely as “too much debt financing too much investment” makes me a bit uncomfortable.

Investment is a component of aggregate demand. Arguing that China invests too much comes close to implying that, as a result of its credit boom/ bubble, China is providing too much demand to its own economy, and, as a result, too much demand for the global economy.

That doesn’t seem entirely right.

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