Reserves

You are currently browsing the archive for the Reserves category.

New trade and reserve numbers from China

April 13, 2009 in Balance of payments, Consumption and production, Exports and imports, Hot money, Reserves by Michael Pettis | 53 comments

Exports in March dropped a less-than-expected 17.1% from the same time last year \’96 below expectations of 20% and the 21.1% drop for the first two months of 2009. Most of the articles I read in the Chinese and foreign press including, not surprisingly, comments from the customs bureau, hailed this as a sign that the export slump is bottoming out. According to an article in Saturday\’92s South China Morning Post, for example:

Many economists said the export slump of the past five months was finally showing signs of abating, with the Administration of Customs describing the latest export figures as a \’93marked improvement\’94. However, they cautioned that imports would remain weak in the near future, overshadowed by prevailing low commodity prices and the de-stocking of mainland factories and overseas importers.

\’93It is the beginning of stabilisation,” Citibank economist Ken Peng said yesterday. “We should have seen stronger import numbers last month. We had more money in place, but we’re not importing more and that’s surprising.\’94

A Bloomberg article had the following:

The \’93collapse of global trade and China\’92s exports in the last few months was not in small part due to a freeze in trade credit and aggressive de-stocking abroad as a result of extreme uncertainty,\’94 said Wang Tao, an economist at UBS AG in Beijing. \’93As expectations start to stabilize, we expect to see export orders rebound in the coming months.\’94

I guess that different people have radically different ways of forecasting export growth. To me, it is completely meaningless to look at recent trends in China\’92s export performance in order to forecast the future. The only thing that matters is what will happen to net demand from the trade deficit countries \’96 most of which is represented by US net demand \’96 and so the recent improvement in China\’92s export performance (not really an improvement, of course, but an improvement in the rate at which it is deteriorating) really tells us very little.

The real question is will US gross and net demand continue to contract? Almost every serious economist I have spoken to believes that it will, with disagreements only on the speed, intensity and duration of the contraction. Someone whose blog I have been reading a lot lately (I like him because, aside from his Minsky-Fischer orientation, he has the audacity to claim that if you don\’92t know economic history then you don\’92t know economics and, what\’92s worse, he even insists that history extends to beyond the past twenty years), University of Western Sydney professor Steve Keen, suggests that from what he calls a non-orthodox, Hyman-Minsky point of view we should think of aggregate demand as \’93the sum of GDP plus the change in debt.\’94

That sounds right to me. Certainly debt accumulation seems to have represented the difference between the growth in US consumption and the growth in US GDP over the past decade, as I discussed in Wednesday\’92s post. If he is right, we should expect US consumption (and that of many other deficit countries, for that matter) to grow less than GDP by the amount of the deleveraging taking place. That is a lot of deleveraging.

In that case the export performance of countries like China can only get worse because the ability of deficit countries to consume China\’92s export of excess production will be contracting quickly, and in that light it doesn\’92t matter how successful you think the Chinese stimulus package may have been. Export growth depends on someone else\’92s import growth, which depends on their consumption growth, and in a world of contracting GDP, if consumption growth is even underperforming GDP growth, it is a little hard to be optimistic about export growth forecasts. The domestic stimulus is irrelevant.

Talking about the stimulus package, there has also been a lot of talk about its success as being evidenced by the way a number of indicators have bottomed out or even turned. Unfortunately it seems to me that most of those indicators fall into one of two groups. In some cases there were special circumstances that caused a surge, but whether the surge is sustainable, and in some cases whether it won\’92t be reversed in the future, is questionable. For example car sales have finally started to rise: China\’92s passenger car sales rose 10% in March from a year earlier. But this was after tax cuts and government subsidies boosted demand, and there are lots of rumors about government agencies and state-owned enterprises being persuaded to anticipate vehicle purchases. If that is the case, the surge in purchases may soon peter out, and in fact may slow sharply to the extent that planned purchases for later this year were accelerated.

The second group of positive indicators I would describe not as evidence that the fiscal stimulus is working but rather as evidence that some people are behaving as if they believe the fiscal stimulus will work. For example rising steel and concrete inventories and increased purchases of equipment suggest to me not that end demand has been created but rather that many producers are anticipating that end demand will be created. Perhaps they are right, in which case we should see more positive indicators in the future, but if they are wrong then we are likely to see nothing more than a temporary buildup that will have to be reversed.

But to get back to exports, China\’92s trade surplus for March was $18.6 billion. That sums to $62.6 billion for the first quarter, compared to $41.7 billion for the first quarter of 2008 and $114.3 billion for the last quarter of 2008. Although lower than the astonishing heights of January and late last year, the trade surplus is still much higher than this time last year. That means China\’92s export of overcapacity is still increasing, especially if you think, as I do, that February\’92s very low trade surplus ($5 billion), and possibly part of March\’92s, was caused by commodity accumulation to replenish strategic reserves.

More capacity?

In that light articles like this one from Friday\’92s Financial Times are not encouraging:

The aluminium industry has been hit hard by the global economic crisis with sharp falls in sales across the automotive, construction and aerospace industries. \’85However, a recovery has emerged in recent weeks and prices are 18 per cent off their lows. The concern in the industry now is that the nascent recovery could be nipped in the bud because Chinese smelters are busy ramping up production at a time when demand is continuing to fall.

As China accounted for about 35 per cent of global aluminium production and consumption last year, its supply and demand developments are of huge significance for the world market. Industry leaders warn that the outlook for demand remains weak

\’85However, Wen Jiabao, China\’92s premier, has made it clear that Beijing will do whatever is needed to maintain economic growth at \’93about 8 per cent\’94. This has led to huge pressure on local governments to ensure growth targets are met. One result is that aluminium smelters have been offered tax cuts and subsidised bank loans to encourage production to restart.

Last year\’92s price crash forced China to close about 3.1m tonnes (22 per cent) of its total aluminium production capacity as many of the country\’92s smelters fell into the red. But analysts at Macquarie estimate that 500,000-600,000 tonnes of capacity has recently been restarted in Henan province. \’93Local government officials, especially in Henan, have been urging the aluminium industry [the key income tax payer of the province] to restart spare production capacity immediately,\’94 says Bonnie Liu of Macquarie.

China\’92s government has also been providing significant levels of support to the domestic market. The State Reserves Bureau, which has already bought 590,000 tonnes, is expected to expand purchasing up to 1m tonnes. The State Grid Corporation has bought about 400,000 tonnes and provincial governments have indicated they will buy up to 900,000 tonnes.

Too many people who should know better assume that trade policies are limited to raising import tariffs or devaluing the currency, and since both of these were addressed in the recent G20 meeting, we can all more or less relax. This is wrong. Anything that alters the gap between total production and total consumption must have a trade impact, and if capacity is boosted in the face of falling demand, that is as likely to force up the trade surplus as import tariffs or currency devaluation.

I do not believe that will go on much longer. Over the next few months we should start seeing even more pressure on China\’92s exports as either trade friction or exhaustion (on the part of countries who have had to bear more than 100% of the brunt of the contraction in US demand) forces continued global demand contraction to switch to China.

How important will that be? Ever since The Economist came out with a consensus-busting piece last year that China is much less reliant on exports than many people think (whatever that means), well-informed people have been assuring each other that \’93China is much less reliant on exports than many people think.\’94

Maybe. But it is still very heavily reliant on exports. When your total production exceeds your total consumption by 7% of GDP (in the past 12 months China\’92s trade surplus was $320 billion, while its 2008 GDP was $4.3 trillion), you rely very heavily on foreign demand to absorb a big chunk of your output.

According to a recent Andrew Batson article in the Wall street Journal, a trio of researchers at the Hong Kong Monetary Authority revisits the whole question of China\’92s dependency on exports. I was not able to find the cited piece, so I can only limit myself to the comments in the article, but, and sorry for the long quote, here is what they find:

The paper builds on previous work by one of the authors, Li Cui, who in a 2007 working paper for the International Monetary Fund presented evidence that China was becoming more dependent on external demand over time. Indeed, net exports contributed about 20% of China\’92s economic growth from 2005 to 2007, compared to less than 10% in the previous five years. But the authors of the new paper try to go beyond that number to capture the total effect of the export manufacturing sector on the economy, including investment in new factories by exporters, and spending by people employed in those factories. That leads them to conclude that the spill-over effects from the export sector are in fact quite large.

The authors estimate that a decline of 10 percentage points in export growth would be associated with a decline of about 2.5 percentage points in GDP growth. \’93This is about at least twice as large as what could have been expected if only the direct impact of exports is considered,\’94 they write. Part of the explanation, they say, is that exports are extremely important to a group of Chinese coastal provinces, which themselves account for the majority of the national economy. So changes in export demand can cause dramatic fluctuations in those regional economies, even while the inland provinces are less affected.

But of course, China\’92s exports have recently slowed by a lot more than 10 percentage points. In volume terms, export growth rates have swung from around positive 20% in 2007 to nearly negative 20% in the first part of this year. The biggest effect of a decline in exports, the authors find, is on corporate investment, as companies scale back expansion plans. And since the sharp drop in exports is just a few months old, the full magnitude of the subsequent drop in capital spending may not yet be evident.

Foreign currency reserves

Besides export numbers the other piece of important news for me was the release of first quarter reserve numbers. According to Xinhua\’92s account:

China’s foreign exchange reserves rose 16 percent year-on-year to 1.9537 trillion U.S. dollars by the end of March, said the People’s Bank of China on Saturday. It represents an increase of 7.7 billion dollars for the first quarter, but the increase was 146.2 billion dollars lower than the same period of last year.

In March alone, the foreign exchange reserves rose by 41.7 billion U.S. dollars. The increase was 6.7 billion U.S. dollars higher than the corresponding period of last year.

This is the smallest quarterly increase we\’92ve seen in a long time. The first quarter of 2008, for example, saw reserves grow by an astonishing $153.9 billion, and 2008\’92s fourth quarter, the weakest quarter of the year by far, nonetheless saw reserves up by $40.4 billion.

2009

January

February

March

Headline reserve growth

-32.6

-1.4

41.7

7.7

Trade surplus

39.1

4.9

18.6

62.6

Net FDI

7.4

5.8

8.4

21.6

Currency gains or losses

-31.0

-16.0

15.0

-32.0

Interest income

6.8

20.4

Unexplained amount

-54.9

-2.9

-7.1

-64.9

With Logan Wright\’92s help I put together the above table to try to understand what is going on with reserves. The key thing on which to focus is the \’93Unexplained amount,\’94 which is a proxy for hot money inflows or outflows. Of course my estimates for currency gains or losses and for interest income are nothing more than estimates and may be, especially in the former case, substantially off.

Nonetheless the picture the table shows is pretty clear and pretty consistent with what we would expect. January, a time of deep gloom, saw a large unexplained outflow at least part of which may represent flight capital from nervous Chinese businessmen. Confidence seemed to rebound in February and March, with widespread (but to me doubtful) claims that the fiscal stimulus was \’93working\’94 and with the stock market rocketing up. During that time unexplained outflows collapsed to nearly zero. The only conflicting evidence was reports in the Hong Kong press of a serious increase in the amount of currency transactions among border money changers, in which the number of Chinese buying US and Hong Kong dollars with RMB rose to suspiciously high levels.

The overall picture is consistent with two different and popular predictions. First, the stimulus package is working and that China will soon emerge from the worst of the crisis. Second, that the fiscal stimulus represents a risky bet on the duration of crisis abroad, and if sustainable and recovery in global demand does not occur in the next few quarters, it will set the stage for a deeper contraction late this year and next year.

Trade determines reserve currency status

Finally, for those who might be interested in today\’92s version of my biweekly South China Morning Post piece, here is the original, pre-edited version:

People\’92s Bank of China Governor Zhou Xiaochuan generated huge controversy when he argued two weeks ago in favor of an international reserve currency to cure distortions in the global balance of payments. Although his reasons for worrying about excessive reliance on the dollar were probably correct, his proposal for an alternative currency based on SDRs was more problematic.

The SDR is not a currency. It is an accounting unit based on an artificial currency \’93basket\’94. As of January 1, 2006, the SDR valuation basket had the following weights based on their roles in international trade and finance: U.S. dollar 44%, euro 34%, Japanese yen 11%, and pound sterling 11%.

If countries accumulated reserves in the form of SDRs, they would effectively accumulate a basket of the above currencies. But of course no one needs SDRs to accomplish the same thing directly. If the People\’92s Bank of China, for example, felt that the SDR represented a more balanced and appropriate portfolio composition for its reserve holdings, nothing could have prevented it from apportioning reserves according to the SDR basket.

And yet informed observers believe that the US dollar accounts for anywhere from 65% to 70% of the PBoC\’92s total direct reserve holdings \’96 even more if we include foreign assets of state-owned enterprises and minimum reserves held by China\’92s commercial banks.

But if holding more than 44% of a country\’92s reserves in dollars distorts the global balance and creates excessive currency concentration, why do the People\’92s Bank of China and other central banks willingly do just that? Dark mutterings about US hegemonic power notwithstanding, there are no legal or physical restrictions on the ability of central banks to choose the assets they purchase. For the past decade they could easily have purchased fewer dollars assets and more euro, sterling and yen assets.

The answer has little to do with geopolitics. It is a necessary requirement in global trade that capital and trade flows balance. Countries running trade surpluses must recycle their surpluses to the countries running trade deficits. Normally this is done through private investment flows, but following the 1997 Asian crisis a number of central banks, especially in Asia, began accumulating such large amounts of international reserves that their purchases of foreign assets completely dwarfed private investment flows.

Assets which the central banks of trade surplus countries purchase will to a significant extent determine which countries run trade deficits. If central banks mostly buy US dollar assets, the US will run the corresponding trade deficit. Contrary to popular opinion, financing flows do not necessarily follow trade flows. It is often the other way around..

Let us assume that over the past decade Asian central banks had decided to acquire reserves in the amounts described by the composition of the SDR. This means, assuming trade surpluses were constant, that they would have purchased between one-half and two-thirds the amount of dollars they actually did. The balance would have gone into euro, yen and sterling.

One likely consequence is that with less demand the dollar would have been weaker relative to the other three currencies then it has been. This would have cause a relative expansion in the tradable goods sector of the US, and a relative contraction in the tradable goods sector of Europe and Japan. With the expansion in the US tradable goods sector, and its positive impact on employment, the Federal Reserve would have kept interest rates a little higher, and US consumption would have been a little lower relative to GDP. Of course the exact opposite would happen in Europe.

Lower consumption means lower imports, and vice versa, in which case the US trade deficit would have been lower and the European and Japanese trade deficits higher by roughly the difference in the amount of dollar reserves purchased. By choosing to buy euros instead of dollars, in other words, Asian central banks would have forced a large part of the US trade deficit to migrate to Europe.

But could Europe have sustained a large trade deficit for any long period of time? For both political and economic reasons too complex to discuss here, it is reasonable to assume that Europe would not have been able to bear the burden of a substantially larger trade deficit. Most Asian policymakers know this.

That is why the US dollar is the world\’92s reserve currency, and most especially the reserve currency of Asian countries using foreign demand to boost domestic growth. In the distorted trade environment of the post-1997 world, the US was the only economy large and flexible enough to absorb the trade deficits that Asian countries required for their growth. US hegemonic power or deliberations had very little to do with it. Asia had to accumulate dollars if it wanted foreign demand to power domestic growth, and SDRs would have prevented this from happening. That is probably a good thing for the world, but a bad thing for China and Asia.

Tags: Steve Keen

Did China experiencing January hot money outflows?

March 17, 2009 in Balance of payments, Hot money, PBoC, Reserves by Michael Pettis | 33 comments

The market (or at least that part of the market that obsesses over balance of payment flows) has been swept with rumors today that foreign exchange reserves were down in January by $30 billion. \’a0My experience with these sorts of rumors is that they tend to be fairly accurate, and I suspect they will soon be confirmed.

\’a0

If true, what does this imply about hot money flows? \’a0The PBoC\’92s accounts have been more opaque than ever and it is extremely difficult to figure out what is really happening, but let me give try at least to bracket the range of outcomes.

\’a0

China\’92s trade surplus in January was $39.1 billion. \’a0It probably earned another $6-7 billion in interest income plus the reported $7.5 billion in FDI. \’a0This means that absent other effects reserves should have risen in January by $52 to $54 billion.

\’a0

But there were other effects. \’a0China holds part of its reserves in currencies other than the dollar, and these declined in dollar terms January (the dollar appreciated). \’a0The total loss here may be around $30-40 billion.\’a0 That means that absent other effects reserves should have risen by at least $15-20 billion. \’a0If reserves in fact declined by $30 billion, it would indicate at least $40-50 billion in unexplained outflows. \’a0Is this all hot money?

\’a0

Brad Setser recently wrote a widely-read entry in his blog in reference to an article by Jamil Anderlini of the Financial Times about SAFE investments in equity markets that may have lost them $80 billion or more. \’a0If this is true, and it seems plausible, some of those losses may have occurred recently, although since the most vicious equity markets were last year, very little of that loss should have occurred in January \’96 and it is anyway an open question whether the PBoC would value these investments at book or at market. \’a0Perhaps a small part of the unexplained $40-50 billion represents equity losses, but this cannot explain much of it.

\’a0

We also know that China has stepped up its purchase of foreign commodities, either directly (which would have shown up already in the trade numbers) or indirectly via investments in commodity producers. \’a0The latter would have caused \’93unexplained\’94 dollar outflows from the PBoC. \’a0It is not clear that much, if any, of this happened in January, but perhaps some of the outflow represents new outward investment of this sort.\’a0 We don\’92t know.

\’a0

Against that there is the question of whether December\’92s 150 basis point reduction in minimum reserves represents a reversal of dollar assets held at the central bank by commercial banks (remember that earlier increases in minimum reserves in 2007 and 2008 had been redenominated into dollars, and so their reduction should have reversed that process).\’a0 If it did, and this would consist of about $30-40 billion, it would actually increase the unexplained amount. For the sake of conservatism, let\’92s assume that this hasn\’92t happened.\’a0 We should know when the PBoC release its balance sheet numbers if the \’93Other dollar assets\’94 account changed significantly.

\’a0

Where does that leave us?\’a0 There are about $40-50 billion in unexplained outflows and however you look at it there it is hard to believe that we haven\’92t seen at least $20-30 billion of hot money outflows in January. \’a0From my many years experience in developing markets I should say that the informational content of hot money flows is often wider than many people at first think. \’a0Much of the discussion about whether Chinese businessmen are bringing in or taking out money hinges on their perception of whether or not the currency will appreciate or depreciate (and in spite of the popular view of evil foreign speculators masterminding the flows, the truth is that the vast majority of this money is likely to be controlled by local businessmen).

\’a0

But I would argue that usually a much bigger driver of hot money flows is the local perception of risk in the country experiencing the flows. \’a0If hot money is flowing out of China, it could be because local business owners believe the currency will depreciate, but I think it is more likely that the flows represent their concern that local investment opportunities \’96 for example their businesses \’96 have become increasingly risky and uncertain.\’a0 Hot money flows tell us at least as much about risk perceptions as they do about profit opportunities, especially when the world is in trouble.

\’a0

By the way, this exercise should indicate yet again why all the discussions and debate in China and the US \’96 about whether or not China should continue financing the US fiscal deficit \’96 are wholly beside the point, as I have been arguing almost monomaniacally for years.\’a0 China cannot finance the US fiscal deficit, nor can any other country.\’a0 China can only finance the US trade deficit, and it must do so by recycling its current account surplus, either via Chinese investors, or via central bank purchases of US dollar assets.\’a0

\’a0

If there are hot money outflows from China large enough to cause the central bank to lose reserves, the central bank will not only stop buying US Treasury bonds and/or other dollar assets, it will have to sell something, which is most likely to be US dollar bonds.\’a0 It has no choice.\’a0

\’a0

Chinese investors who have taken money out of the country, on the other hand, will now effectively be responsible for recycling the Chinese current account surplus.\’a0 They might decide to buy US Treasury bonds (and I suspect indirectly and directly many will), but they could also\’a0buy gold, Venezuelan bolivares, Moroccan real estate, or in fact anything else they choose, and it is their buying that will determine how the Chinese trade surplus gets allocated among China\’92s trading partners.

\’a0

The other point to consider in all this is the impact on Chinese monetary conditions. \’a0A net outflow from the central bank has to be financed by retiring central bank bills or \’93destroying\’94 RMB. \’a0This implies monetary contraction, and it is still difficult for me to see how this would not have a contractionary effect on underlying money.

\’a0

Note 1:\’a0 Wednesday’s edition of the New York Times has an interesting article\’a0on Pingyao, a stunningly beautiful town about an hour from Taiyuan, in Shanxi province which, if it weren’t for the coal-dust-infested air, would remind me of San Miguel de Allende or some of the other old and protected silver-mining towns north of Mexico City.\’a0 I visited three years ago and plan to go back because of my interest in Chinese financial history.\’a0\’a0Pingyao was probably China’s first financial center (although temples already operated as early banks thousands of years ago) and headquartered the largest and most famous piaohao –\’a019th Century merchant trading companies whose businesses had expanded to taking silver deposits in one city and making them available in other cities (travelling was dangerous), collecting the emperor’s taxes and transferring revenues, and ultimately to making loans.\’a0 This is only marginally related to my blog, but for those readers interested in this kind of stuff, I encourage you to read about Pingyao and the piaohao.\’a0 It is a fascinating story.\’a0

\’a0

Note 2:\’a0 Once again my site is blocked in China.\’a0 I don\’92t know why\’96 I hope it only has something to do with last week\’92s NPC meeting and will be fixed soon\’a0\’96 but\’a0until it is resolved my formatting will be screwed up and I won\’92t be able to respond to comments.\’a0 For China-based readers, I think you can access this site easily on SeekingAlpha.com

There are monetary echoes from the 1930s too

January 21, 2009 in Balance sheets, Currency regime, Hot money, PBoC, Reserves by Michael Pettis | 29 comments

I have been on the road for the past few (and next ten) days, in part because of Spring Festival, so I haven’t been able to post as much as I normally do, but I was asked to write an article for a Chinese magazine, which I recently finished, on comparisons between today and the beginning of the 1930s.\’a0\’a0 As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it.\’a0 I and a few others have discussed one of the similarities so many times and in so many different places that I think by now the whole issue of the trade impact of US overcapacity in the 1920s and 1930s and how it relates to China today is pretty widely recognized.

But there is more.\’a0 I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history).\’a0 One of the points he makes \’96 in fact it is probably the main point of the book \’96 is the way currency policies (i.e. adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis.\’a0 It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis.\’a0 Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold.\’a0 They were also the ones most harmed by the 1930s crisis.\’a0 I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions.\’a0 Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

The first I have discussed many times.\’a0 Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports.\’a0 However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries.\’a0 As international trade collapsed \’96 especially after the US tried to force the adjustment abroad by the passage of import tariffs \’96 domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically.\’a0 It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending.\’a0 This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment.\’a0 Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.

To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending.\’a0 The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract.\’a0 When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster.\’a0 According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all.\’a0 The first and most obvious is the scale of China\’92s overcapacity problem.\’a0 China\’92s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 \’96 roughly 0.5% of global GDP \’96 but its economy is less than one-fifth the relative size of the US in 1929.\’a0 Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts.\’a0 For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods.\’a0 In that direction lays trade friction, which would have a devastating impact on Chinese businesses.

Perhaps not nearly as strong as the US in 1930, China is nonetheless in a reasonably strong position fiscally \’96 although municipal reliance on land sales for revenues, contingent liabilities in the banking system and in provincial and municipal borrowing, and overall lack of transparency, make it difficult to judge.\’a0 More importantly, however, there is widespread recognition among policymakers, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand.\’a0 Unfortunately it is not yet clear exactly how aggressively the Chinese government will expand fiscally and whether it will do so fast enough to replace declining US and European imports.

The second point may be the more important.\’a0 Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth.\’a0 When this happens the financial system often responds by taking on excessive credit risk and over-investing.\’a0 Given the complexity of the China\’92s formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry.\’a0 Warren Buffett once quipped that you can never know who is swimming naked until the tide goes down.\’a0 The tide is receding and we are about to see how many naked bankers there are.

How the PBoC will respond to any signs of sharp money contraction is probably the most important question to answer and also the most difficult.\’a0 On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk.\’a0 The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy.\’a0 In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management.\’a0 This is one of Eichengreen’s key points.\’a0 Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain.\’a0 Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently?\’a0 Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency.\’a0 This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.

The PBoC has other tools: most importantly its influence on credit creation (I am skeptical about the usefulness of open market operations) which it can expand partly by reducing the minimum reserve requirement for banks and partly by moral suasion within the banking system, but I am not sure how effective this is likely to be.\’a0 Remember that much of the credit expansion from previous years seems to have migrated off the balance sheets of commercial banks (including into the informal sector) when the PBoC tried to constrain credit growth.\’a0 In my opinion when underlying monetary conditions are consistent with rapid credit expansion there, is little the regulators can do to prevent this from happening.\’a0 At best they can decide whether it happens in the regulated parts of the system or whether it simply migrates to other areas.

The reverse is also likely to be true.\’a0\’a0 Attempts by the PBoC and other policy-makers to force banks to expand credit may result in higher loan growth reported on bank balance sheets, but overall credit growth within the economy is likely to be much less.\’a0 If the underlying money supply is consistent with contracting credit, the system will most likely see contracting credit (and I am saying nothing about the possibility that much of the formal credit expansion reported by the banks will consist of empty lending into future NPLs).

With international trade falling, it is probably only a question of time before China\’92s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave.\’a0 This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces.\’a0 We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency\’a0 terms, the PBoC has limited ability to manage the domestic money supply.\’a0 If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending.\’a0 This would undoubtedly worsen China\’92s difficult economic adjustment to the problem of overcapacity.\’a0 It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans.\’a0 China can learn a lot from the mistakes of US policy in the 1930s.

\
By the way whenever I say that money outflows could become a problem for China, inevitably someone rushes in to pour scorn on the idea that China is vulnerable to a 1997-style Asian crisis.\’a0\’a0 I agree it isn’t, and I will repeat (again) that this is not and never has been the point of my concern about hot money outflows.\’a0\’a0 China does not have a currency mismatch risk worth bothering about.\’a0 The reason to worry about hot money outflow is that it has a domestic monetary impact.

Tags: Eichengreen

Can parochial concerns undermine the global adjustment? They have before

December 22, 2008 in Hot money, PBoC, Reserves by Michael Pettis | 23 comments

Between the holiday slowdown and the number of writing commitments I have it has been a little too easy to neglect my blog. What free time I have has been spent reading, and I am reading for the third time what I think is one of the best books ever written on financial history \’96 Barry Eichengreen\’92s Golden Fetters: The Gold standard and the Great Depression.
\

\
Eichengreen\’92s book has an awful lot to tell us about our own current crisis, as does any good book on financial history. In spite of all the unending nonsense written about what went caused the financial crisis this time around \’96 derivatives, securitization, deregulation, greedy bankers, overpaid traders, fraudulent behavior \’96 the fact is that financial crises going back over at least 2000 years are disconcertingly familiar, and have nearly identical consequences and processes, even when they include none of the conditions blamed for the current mess. To focus on those particular triggers as being the main causes of the crisis is what I would call the \’93trigger fallacy.\’94 They are merely the symptoms of the underlying problem \’96 excess liquidity, which the financial system is forced into accommodating by taking on increasingly levels of risk, either inside or outside the regulated areas.
\

\
Not surprisingly then it is impossible to read Eichengreen\’92s book in the current economic climate without several \’93aha!\’94 moments, but this passage (pp. 11 of the 1992 edition) I found particularly interesting:
\

The arrival of the Fed on the international scene was a significant departure from the pre-war era. Disputes between New York and Washington rendered the new institution unpredictable. Until the Banking Act of 1935 consolidated power, considerable influence was wielded by reserve city bankers from the interior of the country with little exposure or sympathy for international considerations.

\
Eichengreen is discussing how the advent of the US as a major financial center changed the \’93rules of the game\’94 involving cooperation between the major European central banks \’96 mainly the UK, France and Germany \’96 when the closest thing to a US counterpart was the very well-managed and internationalist House of Morgan. During the end of the 1920s and beginning of the 1930s the Fed\’92s role became increasingly prominent and increasingly erratic especially after the death of Benjamin Strong, who ran the New York Federal Reserve Bank and who had a very strong relationship with Montagu Norman, the Governor of the Bank of England.
\

\
The point is that before power was consolidated under the Chairman of the Federal Reserve System in Washington DC, the US central bank consisted of 12 regional banks with quite a lot of independent power, and the regional banks tended to be, not surprisingly, more parochial, more beholden to the dominant economic interests of their region, less understanding of the US role within the global system, and less sympathetic to the need for the US to behave in a manner befitting what was later dubbed a \’93global stakeholder.\’94
\

\
This had consequences. It was very hard for the US central bank to act in a consistent way to manage its proper role within the global context, and this failure not only created a very debilitating uncertainty, but also ensured that parochial interests trumped international interests even when the US was better off parochially from understanding its role within the international context. For example US trade policies aimed at helping regional economic interests at the expense of the outside world ultimately ensured both a collapse in international trade and, as result of the US position of overcapacity, a brutal collapse in US capacity.
\

\
What does this have to do with China? Perhaps nothing, but I am of course not the first to observe that the PBoC has very little independence and is largely beholden to the State Council and senior officials within the Standing Committee for its policy decisions. This is, in itself, not a problem and might even result in better coordination between the country\’92s treasury and central bank functions. However there are persistent rumors of serious disagreements among senior policymakers and especially a split between one camp, dominated by provincial leaders more concerned about social issues arising from unemployment and income inequality, and another camp, based in the major international center and more concerned about macroeconomic imbalances at both the national and global levels.
\

\
Is there a possibility that the PBoC will find itself, like the Federal Reserve in 1929-31, riven by very different understandings of the country\’92s role within the global crisis and with different priorities in resolving the crisis \’96 ones that misconstrue how the global adjustment will affect China\’92s adjustment? I have no idea, and perhaps the game of finding parallels between 1929 and 2008 gets a little carried away at times, but it is worth considering that monetary policy-making in China has not always been consistent and, like most major policy-making, can be easily subject to competing views of Chinese political priorities and China\’92s role within the crisis.
\

\
This is not to say that the illusionary triumph of parochial over global interests is inevitable, as occurred in the US in the 1930s, but it certainly is a possibility. This is yet anther reason why I am convinced that US, European, Japanese, and especially Chinese leaders need to get a clear macro picture of what the global balance of payments adjustment will mean for each country, and give up the silly blame game to work out a reasonable long-term period (at least three or four years), during which time China can adjust to the global adjustment. Any quick adjustment will be bad for the world and devastating for China.
\

\
But the prospects for understanding don\’92t look good. Local newspapers are filled with worried articles about rising unemployment, and on Saturday Premier Wen made an unscheduled and very surprising visit to one of our academic neighbors. According to an article in today\’92s People\’92s Daily:
\

Chinese Premier Wen Jiabao has pledged to university student that the government would seek to provide more jobs for graduates and “put the issue of graduate employment first.” “Your difficulties are my difficulties, and if you are worried, I am more worried than you,” Wen told the students at the Beijing University of Aeronautics and Astronautics. Wen made the remarks in a surprise visit on Saturday afternoon.

\’85He said the country is in a difficult period as the global financial crisis has continued affecting the country’s real economy. The government has begun measures to sustain the economy, such as the four-trillion-yuan stimulus package and interests cuts. “We are considering taking more measures at proper time. But currently we are most concerned about two issues, migrant workers returning home and employment for graduates,” Wen said.

The financial crisis and China’s slowing economic growth has forced 4 million migrant workers to return to their rural homes, according to a report from the Chinese Academy of Social Sciences. The report also said as of the end of this year, 1.5 million graduates are likely to have failed to find jobs, and the country could see an ever tougher employment situation in 2009 as there will be about 6.1 million seeking jobs (from 5 million last year).

\
Other headlines fret about the mass migration \’96 well before the traditional Spring Festival period \’96 of unemployed workers returning to their rural homes. According to an article in Friday\’92s South China Morning Post:
\

Up to 9 million migrant workers have left coastal areas this year amid diminishing job prospects and falling wages, prompting fears that unemployment in inland provinces may increase sharply next year. Home-bound migrant workers have packed major railway stations in major cities, catching the central government by surprise because the traditional passenger peak arrives just before the Lunar New Year, which is late next month.

\
There is still more about the rise of criminal gangs, more protests, and all the other indications of social tension. In these circumstances it is not hard to see why policymakers may decide that short-term unemployment pressures trump the global balance of payments adjustment, and push to subsidize and encourage more production, rather than worry about rapidly expanding domestic consumption. This would, of course, only exacerbate the Chinese overcapacity problem and increase the likelihood of trade tensions which, if they lead to global protectionism, could scuttle any chances of China\’92s recovering from the crisis. I guess this is exactly what they mean by \’93between a rock and a hard place.\’94
\

\
One other thing to discuss before I finish this long posting \’96 Bloomberg posted the following article today:
\

China\’92s foreign exchange reserves dropped for the first time in five years as a result of the global financial crisis, Market News International reported, citing Cai Qiusheng, head of the investment management bureau under the State Administration of Foreign Exchange. The current figure must be lower than the peak of about $1.9 trillion, Cai told a trade forum in Beijing over the weekend, the English-language wire service said. He didn\’92t specify which period he was referring to or give a figure.

\
I am not really sure what is going on. We used to get regular and reliable monthly leaks about reserve figures but these have pretty much dried up since June, just as we needed the numbers more than ever. The last official numbers were released for September \’96 they are released on a quarterly basis \’96 and put reserves at $1.9056 trillion. The latest \’93leak\’94 claims reserves are at $1.89 trillion, which with rounding suggests that reserves declined in two months by somewhere between $10 and $20 billion.
\

\
Of course we are all very eager to get a better breakdown of the recent figures so that we can estimate hot money flow directions. But given the we have had two world-record-smashing trade surplus months in a row since September, amounting to $75 billion (and three monthly world records before that), not to monition positive FDI inflows of $14 billion and about $10 billion of interest income in the past two months, it is very unlikely that the dollar value of the various non-dollar reserves can have declined by even a significant fraction of $99 billion increase in reserves from trade, FDI and interest income in the past two months (or the $110-120 billion implied by the new reserve numbers). Does this mean there has been significant hot money outflow? Perhaps, but without real numbers it is tough to want to conclude anything. January\’92s central bank data release promises to be very, very interesting.
\

\
But there\’92s more. My friend Victor Shih published a very good Op Ed article in the Wall Street Journal Asian last week. You can find it on his blog. He discusses how the new fiscal expansion plans \’96 which are seriously constrained by structural impediments in the economy \’96 are likely to cause significant pressure for bank \’93participation,\’94 and this pressure is unlikely to lead to improved banking practices. He concludes:
\

In any event, everyone is too preoccupied with their own losses to comment on Chinese policies. Which is a problem, not least for China itself. With enormous political pressure from the central government to pump money into the economy and silence from the rest of the world, much of the work in the past decade is being undone.

\
What will happen to all this money? Stephen Green \’96 one of the best bank research analysts on China, in my humble opinion \’96 just published a research report called China \’96 The best-laid plans of mandarins and ministers in which he tries to tabulate the various spending plans being proposed at the national and provincial levels. Not surprisingly, he has a hard time figuring out the numbers \’96 one section of his report is titled \’93CNY 4trn, CNY 18trn, or CNY 320bn?\’94
\

\
The government is so worried about a slowdown that there is almost a feeding frenzy over who can proclaim the most spending \’96 with very poor Hunan proposing $1.2 trillion in expenditures that surpass the entire US fiscal plan, as Green notes. Even if most of these proposals are rejected, clearly an awful lot of money is going to be spent awfully quickly with an awfully small amount of oversight. Elsewhere in the report Green notes:
\

One suspects that corners are now being cut to get the money flowing again. The bureaucracy must also be exceedingly happy; it is commonly believed that 15-30% of the cost of a project is absorbed by \’91administrative\’92 fees, \’91consultancy\’92 fees, and the like (which raises the question of whether we should be discounting the CNY 4trn by 20% or so, and assuming these other funds will form part of 2009\’92s FX capital outflows). The Party\’92s corruption inspectorate is already preparing teams to monitor the use of public and bank funds. But it is, as they say, a big country.

\
It certainly is. And yes, we should be increasing our estimates of hot money outflows next year.
\

\
Happy holidays to all my readers. Unless there is a lot of important news in the next few days I will probably not post anything for a week. For those living in Beijing, we do have an outstanding Christmas Eve show at my music club, D22, and another outrageous night on New Year \’92s Eve. If you want a good feel for some of the best new music in China (and the world), don\’92t miss these two nights. Sorry for the advertisement, but the Beijing music scene is truly exciting.

Tags: Eichengreen

Why is the balance of payments constraint such a mystery?

November 23, 2008 in Balance of payments, Reserves, Trade protection by Michael Pettis | 27 comments

Fareed Zakaria usually writes very interesting pieces on international policy issues, but it seems to me that there is so much mystery about how the global balance of payments works that he, like so many others, makes simplifying assumptions that don\’92t take the balance into account, and for that reason just don\’92t make sense. In his latest piece for the current issue of Newsweek, for example, he says the following:

There is a consensus forming that Washington needs to spend its way out of this recession, to ensure that it doesn’t turn into a depression. Economists of both the left and right agree that a massive fiscal stimulus is needed and that for now, we shouldn’t be worrying about deficits. But in order to run up these deficits-which could total somewhere between $1 trillion and $1.5 trillion, or between 7 and 11 percent of GDP-someone has to buy American debt. And the only country that has the cash to do so is China.

In September, Beijing became America’s largest foreign creditor, surpassing Japan, which no longer buys large amounts of American Treasury notes. In fact, though the Treasury Department does not keep records of American bondholders, it is virtually certain that, holding 10 percent of all U.S. public debt, the government of the People’s Republic of China has become Washington’s largest creditor, foreign or domestic. It is America’s banker.

But will the Chinese continue to play this role? They certainly have the means to do so. China’s foreign-exchange reserves stand at about $2 trillion (compared with America’s at a relatively puny $73 billion). But the Chinese government is worried that its own economy is slowing down sharply, as Americans and Europeans stop buying Chinese exports. They hope to revive growth in China (to levels around 6 or 7 percent rather than last year’s 12 percent) with a massive stimulus program of their own.

The spending initiatives that Beijing announced a few weeks ago would total almost $600 billion (some of which include existing projects), a staggering 15 percent of China’s GDP. Given their focus on keeping people employed and minimizing strikes and protests, Beijing will not hesitate to add tens of billions more to that package if need be.

At the same time, Washington desperately needs Beijing to keep buying American bonds, so that the U.S. government can run up a deficit and launch its own fiscal stimulus. In effect, we’re asking China to finance simultaneously the two largest fiscal expansions in human history-theirs and ours. They will probably try to accommodate us, because it’s in their interest to jump-start the American economy. But naturally their priority is likely to be their own growth.

While I agree strongly with the thrust of Zakaria\’92s piece (cooperation between China and the US is extremely important to both countries), I disagree with his claim that \’93someone has to buy American debt, and the only country that has the cash to do so is China.\’94 I was hoping that Brad Setser had already killed this argument, but apparently not.

Zakaria argues that the US needs a plan of massive deficit-financed fiscal expenditure in order to pull the US out of recession. This may or may not be true, but if it is true, the reason for the recession is that US households and businesses have found themselves overleveraged after years of excessive consumption, and must now cut back sharply on their spending as they increase savings. US fiscal expansion, in other words, will occur to offset the economic impact of a rise in US savings.

But if there is a rise in US household savings, don\’92t these increased savings need to be invested? Where will Americans put their savings? In fact almost all of it is likely to be invested in the US, and therefore the increase in savings is going to offset the need to finance a higher deficit (by the way, even if Americans decide to invest their incremental savings abroad instead of in the US, the net impact is the same). This is just another way of saying that the money that used to go towards financing private US consumption will now go to finance public US consumption, and we all hope (I think) and expect that overall US consumption declines from its clearly excessive levels of recent years, so the total financing will be smaller.

The net impact is that the US doesn\’92t need foreign savings to finance the fiscal expansion unless the expansion is so great that the US economy surges and Americans (private and public) spend more than ever, in which case the problem is not a recession but a boom.

There is more to it. The $2 trillion in reserves that China has is already invested, so it cannot be used for additional investment. If the US really needs larges amounts of Chinese financing in the future, this is simply another way of saying that China must run significant trade surpluses with the US in order to accumulate the dollars necessary to lend to the US government (remember, China doesn\’92t finance the fiscal deficit, it finances the trade deficit).

Basically what Zakaria is implicitly saying is that in order to boost the US economy \’96 which means boosting US production of goods and surpluses \’96 the US must run very large trade deficits with China so that fiscal deficits can be financed by the Chinese. But a trade deficit, by definition, is consumption supplied by foreign production, not domestic production, so insisting on a large trade deficit with China cannot be the way to boost US production. And of course if the US does not run a large trade deficit with China, then China simply cannot fund the US fiscal deficit.

Zakaria continues:

\’93People often say that China and America are equally dependent on each other,” says Joseph Stiglitz, winner of the 2001 Nobel Prize in Economics. “But that’s no longer true. China has two ways to keep its economy growing. One way is to finance the American consumer. But another way is to finance its own citizens, who are increasingly able to consume in large enough quantities to stimulate economic growth in China. They have options, we don’t. There isn\’92t really any other country that could finance the American deficit.”

I have a huge amount of respect for Stiglitz but I also wonder about the logic of this claim. He says that China can either finance its own consumption or American consumption, and we should somehow hope they are kind enough to finance American consumption. As I have tried to argue in several previous posts, we should actually hope for the opposite. If China boosts domestic demand sufficiently, that will go a long way towards adjusting the global imbalance between excess US consumption and excess Chinese production. The main purposes of US fiscal expansion, I think, would be a)to slow down the US adjustment process so that it does not fall into a downward spiral, and b)to give the Chinese fiscal boost more traction \’96 program of coordinated fiscal expansion by the world\’92s major economies would be better, I think, than leaving any one country to try to bear the brunt alone.

By the way the view that the Chinese authorities will have an easier time in this crisis than the US because \’93They have options, we don\’92t\’94 is not, fortunately in my opinion, universally held among Chinese authorities. It is increasingly obvious that policy-makers here are very worried. Yesterday\’92s Bloomberg pointed out that the RMB is depreciating:

The yuan headed for the biggest weekly decline in almost two months on speculation China is seeking to protect exporters and prevent a recession in the world’s fourth-largest economy. Bonds fell. \’85\’94There is some pressure for depreciation as the dollar is strong and other Asian currencies are softening,\’94 said Patrick Bennett, a foreign-exchange strategist with Societe Generale SA in Hong Kong. \’93Still, record trade surpluses and strong investment flows suggest appreciation pressure is intact.\’94

The currency declined 0.17 percent this week to 6.8356 a dollar as of 11:44 a.m. in Shanghai, according to the China Foreign Exchange Trade System. The yuan is allowed to trade by up to 0.5 percent against the dollar either side of the so- called central parity rate, which was set at 6.8317 today.

Tags: Zakaria

Congratulations Mr. Obama, but its tough out there

November 8, 2008 in Hot money, Reserves by Michael Pettis | No comments

I always seem to be traveling when exciting things are happening. I just got back this morning from four days in Paris, where I had to go for our annual Board of Directors meeting (and took the opportunity in addition to meet a number of investors and government officials), and so I was in a Paris hotel for the US elections.

I am delighted with the results, of course. Obama is a brilliant thinker and a charismatic figure, and has shown himself to be willing to listen to people who know more than he does, however without fobbing onto them the ultimate responsibility for making the decision. More importantly, he graduated from Columbia University, and so he definitely owns my loyalty. But like many others I seriously worry about whether he can even come close to realizing some of the fantastic expectations placed on him by Americans and by people around the world.

It was interesting to see the results in France. Of course in discussing this I am stepping away from any discussion of Chinese financial markets, but this seems to be enough of an historical event that it merits some digression. Most French seem to support Obama, but perhaps he has unfortunately become almost a messianic figure to some. I watched a television report from one of the poorer northern towns heavily populated by immigrants and their children, and the rapture and excitement of his election exceeded even the happiness in Hyde Park. Men and women were screaming with happiness, the halls exploded with dancing and cheering, and hundreds of those present chanted \’93We have our president, we have our president!\’94 But he is not their president, and they may be seriously overestimating what Obama can do for them.

In the program the journalists interviewed two young Frenchmen \’96 one black and one Muslim. They were very smart, very serious, and the point they were making worried me a lot. They explained that for years France was way behind the US in racism and its treatment of ethnic minorities. With the election of Obama, they said, the US had taken a huge step forward, leaving France even further behind, and they expected that France, too, had to take a major step forward. Obama was their inspiration to expect more from France (I suspect this kind of thinking is happening everywhere in Europe).

Of course they are right, but in the US the discourse on race and ethnicity is an old and fiery one, and far more advanced than any in Europe \’96 when I grew up in Spain and France we were able to say and do things without thinking that, I later learned when I moved to the US for university, should have been completely unacceptable. Saying or doing many of those things still isn\’92t unacceptable in most of Europe.

I am enough of a realist to know that racism isn\’92t resolved by friendly dialogue and feel-good announcements by official bodies, but rather by confrontation, disputation and hard work. (That is why, by the way, I am afraid that the racism and discrimination in a country like China will persist for a painfully long time \’96 it is practically forbidden even to acknowledge racism here, let alone fight over it.) But here is the problem. The world is in the midst of a financial crisis \’96 one that will almost certainly see a significant reduction in global growth. Historically, disadvantaged minorities do worse during periods of low or negative economic growth than does the population as a whole. During these periods anti-immigrant feelings almost always rise.

I am afraid that for those two young men in France \’96 and for many of those others who screamed and sang with delight and thankfulness Tuesday night \’96 the next few years are not only going to see their welfare decline in nominal terms, but also even in relative terms. But expectations are for the opposite, and it seems to me that they have gotten so far ahead of reality that the next few years are going to be politically very difficult in the many parts of the world.

In the long run this is a good thing. Let minorities and the systematically excluded demand more everywhere, no matter how good or bad economic conditions are. It is only by demanding that they will get anything. In the short term, however, it won\’92t be easy.

But enough pontificating \’96 Obama\’92s election has been so exciting that it has made philosophers of us all. There was a lot happening in terms of China\’92s economy and financial system, too, although not a whole lot of good things. I will disucss more of the really interesting stuff I have been looking at over the next week, but for now I will bring up just a few general points.

The first thing I want to bring up seems at first to be a good thing. The IMF says that China will be an oasis of stability in the global turmoil, and it sort of reaffirms its 9.3% prediction for 2009 GDP growth, but there may be less here than meets the eye. This, of course, is the same IMF that predicted in November 1997 that in spite of the surrounding turmoil South Korea was immune from the troubles afflicting its neighbors and in 1998 it\’92s economy was going to grow by 5-6% (fortunately they managed to pull the report just before it was due to be released, after the won collapsed). For those who are interested, South Korea\’92s 1998 growth rate was actually -6%.

Cheap shot, maybe, but the IMF \’96 perhaps because it is a political institution \’96 has a very weak track record in predicting trouble. Their economists also, I am afraid, have had an even worse track record in understanding the relationship between the economy and the structure of the national balance sheet \’96 even though they did write an interesting report in 2003 or 2004 on the subject (which I suspect none of them subsequently read). Here is what the South China Morning Post said on Tuesday:

David Burton, the head of the IMF’s Asia-Pacific department, said that despite China’s own economic slowdown, the country had many ways to shore up its economic growth. Mr Burton said China’s export-driven economy had been dragged down by dwindling demand from the United States and Europe, and it could even miss the IMF’s forecast of 9.3 per cent growth next year. But the country was still sitting on almost US$2 trillion in foreign exchange reserves and had a relatively strong financial system.

\’93The global economy is slowing sharply and [the mainland] and Hong Kong are going to be significantly affected,\’94 Mr Burton told the South China Morning Post before meeting Chief Executive Donald Tsang Yam-kuen yesterday. \’93With its robust reserves, I have no major worries about China, which will be a source of stability for the globe for the next year or two.\’94 He said both the mainland and Hong Kong would be well positioned to get through the crisis.

I have no doubt that 2009 growth expectations are going to be sharply revised downward several times. They are probably going to lag the investment banks, who themselves are going to lag the independent analysts, but ultimately I expect all of us will soon reach the point where no one is predicting anything above 7%.

Meanwhile Bloomberg yesterday had the following article:

The yuan completed its best week in more than two months on speculation policy makers are allowing some gains to prevent money leaving as overseas investors pull out of emerging markets amid the economic turmoil. Bonds rose.

I hadn\’92t heard these rumors but of course after the third quarter PBoC numbers came out it was pretty clear that not only was China no longer seeing massive hot money inflows, but in September it was seeing outflows. I am curious to see the fourth quarter numbers. It would be worrying if hot money outflows really were becoming a problem.

Finally I saw another interesting Bloomberg article on Friday.

China’s Finance Minister Xie Xuren was called back from an international economic conference in Peru before the meeting began, following orders from Beijing to help resolve problems at home, an organizer of the event said.

Xie left Trujillo, Peru, where Asia-Pacific Economic Cooperation finance officials are meeting this week, shortly after arriving at 11:00 a.m. on Nov. 5, Gladys Otero de Swinnen, protocol director for the conference, said in an interview. \’93They told him he has to resolve an economic problem and that he’s the only one who could do so,\’94 de Swinnen said.

\’85Deputy Finance Minister Li Yong stayed in Trujillo. Li declined to comment on measures to boost China’s growth. Xie arrived in Beijing to take care of some \’93urgent business,\’94 two finance ministry officials, who declined to be named, said today. They didn’t elaborate.

I have no idea of what this is about, and I have not been able to find any further references, but in the cloaked, gossipy world of Chinese politics I am very curious to know why he was suddenly called away. I suppose we may hear more in the next few days. Perhaps one of my readers may have better information than I do.

In 30 minutes we have the weekly meeting of the Guanghua Students Monetary Committee. Last week\’92s meeting was pretty good and I am very interested to see what the students conclude today about monetary and credit conditions in China. I will of course report anything that comes out of there

Tags: Hot money, IMF

The last few days of Olympic fever

August 15, 2008 in Reserves by Michael Pettis | No comments

The stock market had its best day in a long time, with the SSE Composite rising 7.6% on the day to close at 2522. \’a0Most of the run-up came in the morning, and several financial sector firms, which were the best performers, had to stop trading when they hit their 10% price-change limit, suggesting that tomorrow there will be early upward momentum. \’a0Add today\’92s rise to yesterday\’92s 1.1% gain, and since Monday the market has recovered more than half of the 14.9% drop it suffered since the beginning of the Olympics.

\’a0

There is less here than meets the eye, I think. \’a0Two things seemed to have driven the market up today. \’a0First there are a lot of rumors going around that the securities regulators are planning an important meeting with China\’92s major stock brokers tomorrow, to discuss market-boosting measures. \’a0Regulators actually made announcements over the weekend about steps they were taking to support the market, but these had almost no positive effect on the market at all \’96 on the contrary they were judged to be so disappointing that Monday\’92s market was down 5.3%. \’a0In fact none of the measures announced during 2008 have affected the market by more than a few days. \’a0Perhaps rumors about an announcement are far more powerful than any actual announcement.\’a0

\’a0

Second, Frank Gong, JP Morgan\’92s chief China analyst, sent a note to clients in which he claimed that China\’92s leaders are considering a RMB 200-400 billion stimulus package and further easing of monetary policy. \’a0With GDP of around RMB 30 trillion, this would represent a stimulus of around 1% of GDP.

\’a0

I am not sure a 1% stimulus \’96 which was not exactly unexpected given all the fears of an economic slowdown \’96 should have had such a massive impact on the market, but after plummeting so quickly perhaps it was time for a bounce, and participants just needed a good excuse. \’a0We have seen lots of big 10% or more bounces in the past several months, and it will be interesting to see if this time around it lasts longer than the others.\’a0 I am skeptical.

\’a0

According to the South China Morning Post\’92s article on the JP Morgan note:

\’a0

On the perpetual debate of how China should manage its US$1.81 trillion of foreign-exchange reserves, Gong said Beijing may have intensified sales of some dollar assets. But it aims to keep the bulk of its reserves in dollars \’96 even if they are not invested in the debt of US mortgage agencies Fannie Mae and Freddie Mac \’96 because it favours a strong US currency.

\’a0

Gong said it was unlikely that China would diversify into the euro, yen or commodity currencies in a big way as these currencies may already have peaked. \’a0Instead, policy makers were studying a number of suggestions put forward by government researchers, including: Repatriating the money and investing it in on physical and social infrastructure to boost consumption; Using some of the money to set up a fund to stabilise the stock market, which is down 62 per cent from October\’92s record high; Diversifying into dollar-bloc currencies such as the Hong Kong dollar and other Asian markets.

\’a0

I think there is an awful lot of confusion about what can and cannot be done with the PBoC reserves. \’a0The authorities cannot take the reserves and use them for the first two suggestions \’96 spending on physical and social infrastructure, or supporting the local stock markets \’96 simply because foreign currency cannot be spent in China.

\’a0

Let us assume for a moment that the government wanted to take $100 of reserves and spend them domestically \’96 whether to build hospitals or to buy stock.\’a0 Once it received this money from the PBoC it would have to exchange these $100 dollars into RMB before it could spend them, and since the market is a net seller of dollars, who would do the exchange with them?\’a0 The PBoC, of course, who would have to buy the dollars back and pay for them either by creating or by borrowing RMB.\’a0 The net result would be no change in the total amount of foreign exchange reserves held by the PBoC.\’a0

\’a0

So where did the money come from?\’a0 If the government purchased the dollars from the PBoC, either taxes or its net domestic borrowing would have to increase by that amount. \’a0If the PBoC were forced to donate the money, either its own debt would rise (if it borrowed the RMB by issuing central bank bills) or the domestic money supply would rise (if it simply created RMB).

\’a0

Either way, the Chinese government could only spend the money if it financed it by raising taxes, by borrowing \’96 either directly or through the PBoC \’96 or by simply creating money. \’a0It turns out that no matter how high or low the level of reserves, the Chinese government can only fund domestic spending by raising taxes, borrowing, or inflating. \’a0All three of these things the government can do without the need for PBoC reserves.

\’a0

The only reason the reserves matter in this case is that if China were to reduce its net savings significantly by a large amount of government-related spending, so that total consumption exceeded total production, the result would be that China would run a trade deficit, which would draw down reserves.\’a0 With reserve accumulation running at 20% of GDP, however, it would have to be a pretty large dollop of spending before it began to cause a decline in reserve growth, and with $2 trillion of reserves, China could survive a large trade deficit for quite a long time.

\’a0

I am not arguing that China cannot or should not spend much more aggressively at the government level, although I would not want to see such spending directed at the stock market, since that would pretty much ensure that China\’92s stock markets would be inefficient and ineffective for several years more. \’a0On the contrary, although I am less optimistic than most other analysts are about the strength of China\’92s fiscal position, nonetheless I think China badly needs to alter the balance of factors affecting economic growth, and clearly domestic spending needs to be much stronger \’96 preferably consumer spending.\’a0 The point is that this spending cannot come from PBoC reserves.

\’a0

In a few days the Olympics will be over, and we will probably see more serious measures and debate on economic issues.\’a0 Over the last few days there has been a flurry of front-page articles and speeches by government officials assuring everyone that the economy will do very well after the Olympics. \’a0They seem worried.\’a0 Electricity prices are moving up and fuel prices will probably do so too, given how severe the shortages have been.\’a0 A number of analysts are arguing that hot money inflows are slowing and will perhaps even begin to reverse very soon, but I think they are wrong.\’a0 The RMB is still undervalued, and if the economic stimulus measures have any impact at all, in the short term they will fuel the kind of growth that creates monetary pressure for revaluation and profit opportunities for investors. \’a0RMB non-deliverable forwards traded up sharply today, perhaps in response to news about the fiscal stimulus.\’a0 The monetary debate has been put on hold, but it is far from resolved.

Of course Chinese dollar holdings rose, but something changed drastically

June 22, 2008 in Balance of payments, Currency regime, Reserves, Savings glut by Michael Pettis | No comments

There is an interesting, if perhaps predictable, June 17 Bloomberg article by Patricia Lui that discusses China\’92s holding of US dollar reserves. According to the article:

\’a0

China is adding to its holdings of U.S. assets, data from the U.S. government showed yesterday, easing concern the Asian nation will sell dollar investments. \’a0Total holdings of U.S. equities, notes and bonds among foreign investors rose by a net $115.1 billion in April from $79.6 billion the previous month, the Treasury Department said yesterday in Washington. China\’92s holdings of Treasuries gained $11.4 billion to $502 billion, holdings of U.S. agency debt rose $11.9 billion and U.S. corporate bond investments increased $6.9 billion, data showed.

\’a0

The discussion about whether or not China will continue funding the US deficit by buying dollar assets has been going on for a long time, and has caused an unnecessary amount of alarm among analysts worried about the consequences of a possible Chinese decision to stop buying dollar assets \’96 without Chinese purchases of US securities, they worry, how can the US possibly finance its ballooning trade deficit?\’a0 Yet time after time the data show that China continues to add to its dollar hoard \’96 sometimes in amounts close to or even greater that the US deficit, as Brad Setser recently implied\’a0\’96 and so for a little longer those concerns \’93ease\’94.

\’a0

If you believe that the explosive growth in the US trade deficit since the late 1990s was caused primarily by a sudden massive increase in the desire of US consumers to consume, then it may make sense to worry about how the deficit must be financed.\’a0 After all according to this view, the cost of out-of-control consumption by Americans exceeds American income, and so this requires some foreign saver to finance the consumption.\’a0 At the individual level it was the wealth effect of rising stock markets and real estate prices that allowed Americans to increase their consumption, but in the aggregate a country running a current account deficit by definition needs external financing.\’a0 Should this financing stop, US consumption would have to drop drastically in order to eliminate the current account deficit, and with it the US (and world) economy would slow sharply.

\’a0

But if you believe, as I do, that the global balance of payments disequilibrium is driven primarily by the increase in external savings of a number of developing countries \’96 mostly East Asian and OPEC, with China being by far the largest player \’96 then worrying about how the deficit will be financed shouldn\’92t take up a lot of anyone\’92s time.\’a0 The deficit exists primarily because of the need for China and other countries to invest the current account surpluses their monetary and fiscal policies were designed to create (or the windfall current account surpluses from high commodity prices, if they are commodity exporters).

\’a0

I have explained why I think the latter is a better description of the global balance of payments disequilibrium several times in my blog, the last time in a June 4 entry (\’93Chinese savings and US deficits\’94) and in two longer entries on September 15 (\’93China and the savings glut\’94 Parts One and Two).\’a0 As I pointed out in those entries, I think a very plausible argument can be made that the 1997 Asian financial crisis created such a strong impression on Asian policy makers that their decision to protect themselves from a reoccurrence prompted them to put into place very strong mercantilist policies guaranteed to save them from a future external debt crisis.\’a0 This implied substantial trade surpluses and rising reserves.\’a0 It also required that some other country or countries be willing and able to run corresponding current account deficits.

\’a0

The data show that after 1997-1998 Asian current account surpluses grew so quickly, and central bank reserve accumulation along with it, that for the first time developing countries as a group became net exporters of capital when reserve accumulation exceeded net private capital inflows (you can find the actual numbers in Jorg Bibow\’92s \’93The International Monetary (Non-)Order and the Global Capital Flows Paradox\’94).\’a0 China was by far the biggest factor in this process, and of course as long as China was running such a policy, it needed to invest those surpluses.\’a0 They were invested in the US.

\’a0

The point is that China had no choice but to finance the US current account deficit.\’a0 As long as it ran mercantilist policies aimed at generating trade surpluses only four things could happen:

\’a0

1.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 China finances the US current account surplus directly by buying US dollars assets.

2.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 China finances the US current account surplus indirectly by buying euros and yen, and Japanese and European investors (most probably their central banks), buy US dollar assets.

3.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 China buys euros and yen and Europeans don\’92t compensate by buying dollars, in which case China\’92s current account surpluses shift to Europe and Japan, who end up running current account deficits to replace the rapidly declining US current account deficit.

4.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 China stops buying foreign assets, in which case its current account surplus disappears.

\’a0

Since the whole point of the exercise was to generate current account surpluses and foreign currency reserves, China could not choose Option 4.\’a0 In addition, as its currency regime locked it into a self-reinforcing system in which rising trade surpluses forced more surpluses (I explain why in \’93The value of the RMB does matter to the trade balance\’94 Parts One and Two) there was no way for China to choose Option 4 without a serious adjustment to the currency regime and the possibility of a sharp and difficult collapse in exports.

\’a0

Either China had to finance the US trade deficit, or it had to find someone else willing to accommodate its trade surpluses.\’a0 The only important question, then, was whether Europe could absorb the necessary current account deficits or not.\’a0 If so, China could begin to shift its reserve holdings into euros and so cause enough strength in the euro relative to the dollar that the US trade deficit would shift to Europe.\’a0 To a certain extent this has been happening, but I am not sure it can continue for too much longer.

\’a0

So as I see it, the question of whether the US trade deficit can be financed or whether China can suddenly \’93change its mind\’94 about financing the deficit is not a very worrying one because the US trade deficit and, increasingly, the European trade deficit are consequences of foreign financing, not their cause.\’a0 However something very important has changed recently, and I am not completely sure about its implications.

\’a0

Specifically, for many years China\’92s burgeoning reserves were powered primarily by its burgeoning trade surplus (with net FDI playing a secondary role).\’a0 In that case it was pretty easy to trace out the balance of payments flows and their consequences.\’a0 I agree with most pessimists that the balance of payments numbers were becoming unsustainable, but not mainly because the US current account deficit was unsustainable.\’a0 In fact I don\’92t think it is, for reasons I explain partly in \’93Demographic projections and trade implications\’94.\’a0 For me the biggest problem with the existing balance of payments relationships was that China\’92s reserve accumulation was becoming unsustainable because of its domestic monetary impact.

\’a0

Recently this has become an even bigger problem.\’a0 In the past few quarters China\’92s reserve accumulation has mushroomed to levels that make the 2006 and 2007 numbers, as incredible as they seemed back then, almost laughably small today.\’a0 And yet China\’92s trade surplus and net FDI have not grown to nearly the same extent \’96 in fact the trade surplus, while still incredibly high, has actually shrunk, and FDI, which is much smaller but has grown sharply, probably includes a healthy dose of speculative inflows disguised as FDI (as does, many of us suspect, the trade surplus).

\’a0

It now seems that China\’92s rate of reserve accumulation, seemingly unsustainable even two years ago, has reached even higher levels, but what is powering it now is not the (relatively) stable trade surplus and FDI accounts but rather highly unstable speculative inflows (for an explanation of how reserve accumulation has been generated see \’93What? $74.5 billion? Is this a mistake?\’94).\’a0 If I am right, it seems to me that there has not just been a quantitative change in China\’92s and the world\’92s balance of payments accounts in recent months (i.e. even more rapid growth in an already unsustainable rate of Chinese foreign currency reserve growth), but also a qualitative change \’96 the cause of China\’92s reserve growth has shifted significantly.\’a0 The old mechanism, large trade deficits in some countries balanced by rapid reserve accumulation in others, has been converted into something much more complex and maybe even pro-cyclical (hence volatility enhancing): large trade deficits in some countries plus massive speculative inflows in others are being balanced by even more massive reserve accumulation in the latter countries.

\’a0

I still need to work out in my mind what some possible implications are, but I would be lying if I said I didn\’92t find this change worrisome.\’a0 My instinct is that because of the intensely pro-cyclical nature of speculative inflows, this new system is a lot less stable than the old one.

What? $74.5 billion? Is this a mistake?

May 26, 2008 in Reserves by Michael Pettis | No comments

An article just came out on Reuters claiming that inside sources have revealed that China\’92s foreign currency reserves at the end of April were $1.7567 trillion. \’a0If this is true that means that reserves grew in the month of April by $74.5 billion, the biggest one-month reserve jump in China\’92s history (and probably in the history of the world).

\’a0

These Reuters reports have been correct in the past, but I am reluctant to believe the article because this number blows out anything I was expecting (although in retrospect China\’92s attempt to slow RMB appreciation in April may have had the effect of forcing even greater intervention). \’a0Had you asked me yesterday, I would have told you with some confidence that April\’92s reserve growth would have been alarmingly high, but that the rate of growth would \’96 simply had to \’96 be lower than the average monthly pace for the first quarter.\’a0

\’a0

First quarter reserve growth of $154 billion was unbelievable.\’a0 China has a number of regulations that limit money inflow, and these are usually set according to quotas for the calendar year, and so I had assumed that this would have boosted first quarter results relative to the rest of the year as investors filled their annual quotas immediately. \’a0But I would have been wrong.

\’a0

To get a sense of scale, in 2006 reserves were up $247 billion for the whole year.\’a0 This, at the time, was a number guaranteed to shock. \’a0No central bank in history has seen reserve growth at anywhere near this scale. \’a0Nonetheless in 2007, the growth in reported reserves nearly doubled over the previous year — $462 billion \’96 and more than doubled if we backed out a series of transactions that reduced headline reserve growth but had no net impact on the monetization of currency inflows. \’a0

\’a0

But that wasn\’92t the end of record-busting reserves growth. \’a0In the first quarter of 2008 headline reserves grew by $154 billion, nearly one-third of last year\’92s total growth, and if you back out all the non-relevant transactions that reduced headline growth, it represented a significantly larger share of last year\’92s reserve growth.

\’a0

But $74.5 billion in April is equal to 48% of the total reserve growth for the first three months of the year.\’a0

\’a0

What is going on?\’a0 I am reproducing a table I made in my April 12 entry (\’93So many questions about PBoC reserve growth\’94) in which I try to put these numbers in some sort of context so as to understand the true monetary impact on China\’92s domestic money supply, and more importantly to get some sense of the hot money problem. \’a0I have made one change to the table \’96 Stone & McCarthy\’92s Logan Wright told me two weeks ago that around $20 billion of the PBoC transfer to the CIC may have been in the form of ownership of shares in Chinese securities companies, so I have removed $20 billion from the March \’93Transfer to CIC\’94 column.

\’a0

We can make some pretty good estimates of several components of this reserve growth. \’a0Logan Wright does a lot of the work already and I quote the following from his May 26 report:

\’a0

The trade surplus in April was $16.7 billion, and foreign direct investment totaled $7.6 billion, so we can only account for $24.3 billion of this increase through these channels. Add in an estimated $6.6 billion in interest income, and that leaves a residual of $44.2 billion.

\’a0

Even more surprisingly, under our working assumption that SAFE foreign exchange reserve figures are adjusted for currency movements, the dollar rebounded in April, meaning that the foreign exchange reserve figures were likely adjusted down, as the PBOC’s non-dollar assets depreciated in dollar terms during the month. Assuming a portfolio of around 20% in euros and 7.5% in yen, this would mean that China’s reserve totals should have been $11.6 billion higher during the month, leaving an astonishing residual of $55.2 billion in unexplained capital flows.

\’a0

Adding these to my table shows the following:

\’a0

January

February

March

April

Total

Headline reserve growth

229

Trade surplus

FDI

Currency gains

(12)

Interest

Unexplained amount

(11)

\’a0

Reserve hike

Adjusted reserve growth

296

Unexplained amount

155

\’a0

Transfer to CIC

\’a0-

-\’a0

Adjusted reserve growth

134

371

Unexplained amount

230

\’a0

As the table indicates, headline reserve growth for the first four months of the year was $229 billion, or 49% of all of last year\’92s growth. \’a0When we add back the reduction in headline reserves caused by the redenomination of minimum reserve requirements, this rises to $296 billion \’96 which means we are already running at well over 50% of last year\’92s adjusted growth in reserves.\’a0 When we add back the transfer of PBoC reserves in 2007 and 2008 to China\’92s \’93other\’94 central bank, the CIC, reserve growth for the year probably equals two-thirds or more of last year\’92s astonishing number (I am assuming that adjusting last year\’92s $464 billion to account for the redenomination of minimum reserves and the CIC transfer would have resulted in real reserve growth of around $550 billion).

\’a0

It is really hard to know what more to say about all of this. \’a0\’a0Last week Brad Setser was marveling at the Chinese balance of payments and wondering if there was any definition of \’93sustainable\’94 that could possibly accommodate this level of reserve growth \’96 almost certainly not, he concluded, and it is hard to disagree.

\’a0

What makes the process so worrying is that after we have backed out all the things we can easily explain, there is still $230 billion of inflows of which we cannot easily account. \’a0Stephen Green of Standard Chartered Bank argues that foreign currency lending and PBoC swaps may account for a portion of first quarter reserve growth, but even if we accept all his numbers, they still only account for a small share of this massive unexplained amount.\’a0 What else can it be?\’a0

\’a0

Clearly at least part of it must be hot money inflows.\’a0 For most of the past few years it was China\’92s trade surplus that drove the astonishing growth in reserves. \’a0As I argued way back in 2004 and 2005, China had locked itself into a trap in which rising trade surpluses, the consequence of an undervalued and pegged currency, were causing too-rapid monetary expansion as the PBoC was forced to buy the foreign exchange inflows.\’a0

\’a0

This monetary expansion was channeled by the banking system into higher and higher levels of fixed asset investment, and all this investment resulted in soaring industrial production which, since consumption could not keep up, resulted in ever growing trade surpluses (the trade surplus is the gap between production and consumption).\’a0 It was hard to know how China could exit the trap without a much more rapid appreciation of the currency.

\’a0

We have reached what I believe is the end stage of this trap in which the monetary system is forced to adjust through appreciation and inflation. \’a0The problem is that in such a case there is a huge risk that hot money inflows destabilize the adjustment process, and this seems to be exactly what is happening. \’a0Instead of reducing foreign exchange inflows, the appreciation of the RMB is causing massive hot money inflows (which is not at all surprising, but it has been made much worse by China\’92s bad luck of having to adjust in the middle of the sub-prime crisis) and so the adjustment must be much more dramatic and much more painful.\’a0 No matter how quickly China tries to reduce monetary expansion by appreciating the currency, in other words, monetary expansion grows even faster.

\’a0

Right now much of the attention in China is still focused on the results of the devastating May 12 earthquake.\’a0 Two unfortunate consequences of the earthquake\’a0are likely to be reluctance from the authorities to deal aggressively with these out-of-control money inflows, and the granting of indulgences to the banks that will allow them to ignore lending quotas and to forgive debt a little too easily. \’a0An article from today\’92s China Economic Review explains: \’a0

\’a0

China’s banking regulator ordered banks to write off bad loans caused by the May 12 earthquake in order to reduce the debt burden on survivors and help overall reconstruction, state media Open in a new window reported. “If borrowers suffered huge losses that can’t be covered by insurance … the loans should be regarded as bad loans and written off in a timely manner,” the China Banking Regulatory Commission (CBRC) said. The CBRC and the People’s Bank of China previously urged banks to extend loan maturities and not to push for loan repayment if debtors in quake-hit regions fall behind in payments. Zhang Yun, vice president of Agricultural Bank of China, said the preliminary estimate for the bank’s bad loans from the earthquake was US$863 million. Banks have agreed to lend US$11.9 billion to Sichuan province for relief and reconstruction.

\’a0

This is not the right environment in which to deal with such worrying monetary numbers.\’a0 By the way the stock market was down 3.13% today.

So many questions about PBoC reserve growth

April 12, 2008 in PBoC, Reserves by Michael Pettis | No comments

The closer you look at the latest PBoC reserves numbers the more surprising they seem.\’a0 Headline reserve growth of $154 billion in the first quarter of 2008 is an astonishing number by any standard and suggests that the PBoC\’92s ability to manage monetary policy must be under ferocious strain, but it turns out that net foreign currency inflows purchased either by the PBoC or by its proxies may have been much, much higher. \’a0How can they manage?

\’a0

Let\’92s go through these first-quarter reserve numbers again.\’a0 Here is what I think we know with reasonable certainty:

\’a0

1.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 For the first three months of 2008 reserve growth was $61.6 billion in January, $57.3 billion in February, and 35.0 billion in March. \’a0This adds up to $153.9 billion.

\’a0

2.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 The trade surplus for the first three months of the year was $19.5 billion in January, $8.6 in February, and $13.6 billion in March, for a grand total of $41.6 billion.

\’a0

3.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 FDI contributed $11.0 billion in January, $6.9 billion in February, and $9.5 billion in March. \’a0These add up to $27.4 billion.

\’a0

There are other things that we know increased the value of PBoC reserves. \’a0We don\’92t have precise numbers but we can make reasonably accurate estimates.

\’a0

1.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 It is pretty certain that at least part of the PBoC reserves are held in currencies other than US dollars \’96 most experts estimate this portion to be about 30% of reserves, a number that jibes with estimates by CFR\’92s Brad Setser and Stone & McCarthy\’92s Logan Wright, two of my favorite experts on the topic. \’a0Logan went through the numbers and tells me that he believes that valuation gains, which occur as the dollar declines against other currencies in the PBoC portfolio, accounted for $10 billion in January, $10 billion in February, and $18 billion in March.\’a0 This totals to $38 billion.

\’a0

2.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 The PBoC also earns interest on its portfolio. \’a0We are given zero information on the composition of the PBoC portfolio, but let\’92s assume (a safe assumption) that most of it is in government bonds.\’a0 That would add approximately 1% a quarter in interest income, or just under $16 billion for the first quarter of 2008.

\’a0

Now for the part about which we are not sure but have some pretty good circumstantial evidence. \’a0Headline reserve growth may have underestimated the amount of dollars which the PBoC was forced to buy for several reasons. \’a0

\’a0

In January, the PBoC hiked minimum required reserves by 0.5%, and they did so again in March. \’a0This necessarily resulted in an increase in the amount banks had to deposit at the PBoC, which we can reasonably reliably estimate to be the RMB equivalent of $22 billion and $24 billion respectively.\’a0

\’a0

There is a strong circumstantial and market gossip that banks were \’93asked\’94 to redenominate these deposits in dollars. \’a0They would do so by effecting a series of accounting transactions. \’a0As I understand it, the banks would sell RMB to the PBoC and purchase dollars, which would then be deposited as reserves, instead of RMB.\’a0 This accounting transaction would cause a net reduction in RMB assets on the banks\’92 balance sheets of the RMB equivalent of about $45 billion, and a net increase in dollar assets of $45 billion.\’a0 The banks now have more exposure to a declining dollar, unless they have a currency hedge with the PBoC.

\’a0

The opposite occurs at the PBoC.\’a0 Their dollar assets decline by $45 billion.\’a0 Had this transaction not taken place, in other words, the PBoC\’92s headline reserve growth for the first quarter would have been $199 billion, not $154 billion. \’a0Because the banks were forced, in effect, to take on $45 billion of the PBoC\’92s role, they saved the PBoC from being forced to record $45 billion more reserves, but they did not prevent the PBoC from buying these in the market.\’a0 In fact the act of redenominating had no impact on either the amount the PBoC needed to sterilize (although of course the reserve requirement hike did) or on the net amount of foreign currency inflow that had to be purchased by the PBoC.

\’a0

Finally, and this all come from Logan Wright, there is very good reason to assume that the full transfer of $200 billion to the CIC was completed by March of this year, and he believes (for reasons which I prefer he explains, but which seem solid to me) that perhaps $95 billion of this transfer took place in 2008, probably in March. \’a0Let me dump the full amount into March.

\’a0

That leaves us with the following table:

\’a0

January

February

March

Total

Headline reserve growth

154

Trade surplus

FDI

Currency gains

Interest

Unexplained amount

(11)

\’a0

Reserve hike

Adjusted reserve growth

199

Unexplained amount

\’a0

Transfer to CIC

\’a0

Adjusted reserve growth

154

294

Unexplained amount

107

171

\’a0

To read this table, we start with official headline reserve growth at the top of the table. \’a0After adjusting the things we know or can estimate reasonably, we get to an \’93unexplained\’94 amount for each month. \’a0This adds up to $31 billion for the quarter.\’a0 Notice that the \’93unexplained\’94 amount for February is a negative number, suggesting that net other flows, including hot money, left China in deficit. \’a0This is counterintuitive.

\’a0

But not for long. \’a0We then add back the amount we believed was taken out by the minimum reserve redenomination. \’a0If we are right, the \’93unexplained\’94 amount for every month is positive and the real growth in reserves was $199 billion for the first quarter.\’a0 The total \’93unexplained\’94 amount is $76 billion.

\’a0

I am a little bit nervous about the timing of the last assumption, although I am very comfortable that this did happen (the transfer of money from the PBoC to the CIC), but had there not been the transfer to the CIC, headline reserves should have higher, whether in 2007 or 2008.\’a0 Logan believes much of this occurred in 2008.

\’a0

If he is right, actual net foreign currency inflows purchased by the PBoC during the first quarter of 2008 was not $154 billion, the headline number, nor even $199 billion, but perhaps as much as $294 billion.\’a0 Consequently the unexplained amount ranges anywhere from $31 billion to as much as $171 billion.\’a0 How much of this is hot money?\’a0 Who knows?\’a0 But it doesn\’92t need to be a very high fraction for it to be a very worrisome problem.\’a0 In fact I would guess that by now speculative money inflows (included those incorrectly recorded in the trade and FDI accounts) are so high that the trade surplus is less and less the main pump driving out-of-control money growth in China.\’a0 Speculative money is probably the main problem, and only a currency adjustment will be able to resolve this problem quickly enough.

\’a0

By the way annual M2 growth in March declined to 16.3, from 18.9% in January and 17.1% in February.\’a0 This is being heralded nearly everywhere as an indication that the PBoC has been successful in its fight against monetary expansion, but I look at things a little differently. \’a0To me this level of money growth is still much too high, especially given the volume issued of sterilization notes and the 1% reserve hike during the quarter.\’a0 If this is all they can achieve with so much effort, it is going to be a long and difficult fight.

\’a0

« Older entries

Reserves

New trade and reserve numbers from China

Did China experiencing January hot money outflows?

There are monetary echoes from the 1930s too

Can parochial concerns undermine the global adjustment? They have before

Why is the balance of payments constraint such a mystery?

Congratulations Mr. Obama, but its tough out there

The last few days of Olympic fever

Of course Chinese dollar holdings rose, but something changed drastically

What? $74.5 billion? Is this a mistake?

So many questions about PBoC reserve growth

Shows

Categories

Recent Posts

Recent Comments

September 2010
M	T	W	T	F	S	S
« Oct
		1	2	3	4	5
6	7	8	9	10	11	12
13	14	15	16	17	18	19
20	21	22	23	24	25	26
27	28	29	30