from Follow the Money

$1.5 trillion, not $1.1 trillion - and rising fast

March 20, 2007

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China's formal reserves were a bit under $1.1 trillion – think $1.066 trillion – at the end of last year.  No doubt they are close to $1.1 trillion, if not above it, now.    No wonder China’s central bank government  just made it quite clear that the PBoC doesn’t really want any more reserves.   Zhou, quoted by Reuters:

“Many people say that foreign exchange reserves in China are (already) large enough … We do not intend to go further and accumulate reserves

Zhou’s statement is probably yet another sign that the growth in China’s reserves this year has been kind of fast -- and that the PBoC doesn't really want to continue to absorb the lion's share of the all the dollars that are now piling up in China.

But even now, the PBoC (though SAFE) is not the only Chinese institutions that have been adding to their foreign assets.   James McCormack of Fitch just released a quite interesting new report (registration with Fitch required) that estimates that China now holds $1.55 trillion in foreign assets.    And by China, Fitch effectively means China, Inc.   Most foreign assets not held by SAFE are held by various state companies and state banks.   Especially the state banks – Fitch, drawing on data from IMF, estimated China’s banks hold $273b in foreign assets, a $50b increase last year.   And it isn’t clear if that total – or for that matter China’s balance of payments data – counts the funds the banks raised in their offshore IPOs.  What happens in Hong kong may stay in Hong Kong. 

McCormack estimates that China added $342b to its foreign assets last year.  And even before China created the “People’s Investment Company” nearly $100b of the increase was coming from outside the central bank and wasn’t taking the form of reserves.    That squares with my own estimates – Chinese reserve growth, as large as it was, has been well below what it should be, given China’s burgeoning current account surplus and ongoing net inflows of FDI.    Large hot money outflows could explain the difference, but, well, all the evidence suggested that private money wanted to get into China and its booming equity market, not get out.   The other explanation: the state banks, state insurance companies, state pension funds and state companies all helped the PBoC out.

That is what makes Zhou’s comment that the PBoC is through accumulating reserves so interesting.   I don't think that the pace of growth in China’s foreign assets has slowed from last year.  If anything it probably picked up on the back of the still growing trade surplus.   So keeping something like the status quo in place – and by status quo I mean the current  exchange rate regime and ongoing Chinese openness to greenfield FDI – requires that someone in China add $400b or more to their stock of foreign assets.

Private Chinese citizens don’t seem very keen on adding to their foreign assets.  Not when those assets yield even less -- in RMB terms -- than domestic deposits.

And if the PBoC doesn’t want to add to its foreign assets either, well, the People’s Investment Company will get really big fast.   It would need to go from zero to $400b in a year to absorb all the foreign exchange coming into China.   Or if the bureaucratic battle between the Ministry of Finance and the PBoC for control of the new investment authority is resolved by creating two competing investment authorities, both would need to go from zero to $200b fast.

Three other interesting points emerge from McCormack's analysis, especially when that analysis is considered together with some of the points that have emerged out of the discussion surrounding plans for China's new investment authority.

1. McCormack notes -- drawing on IMF data -- that the reported foreign assets of China’s banks rose $50b to $273b (last data point, end-December) while Chinese banks’ deposits in BIS reporting banks fell by about $10b to around $100b (last data point, end-September).   That implies that China’s banks hold around $175b in foreign securities, and added up to $60b of foreign securities to their portfolio in 2006 – though the banks also could have fleshed out their external balance sheet by making external loans.   I suspect a lot of those purchases were funded by swaps with the PBoC – swaps where the PBoC lets the banks buy its dollars (for RMB) but promises to buy the dollars back at a pre-set price, liming the banks foreign exchange risk.   I wonder if shifting dollars – and I mean dollars, not euros – to the banking system, both through the transfer of assets to Central Huijin and swaps – is one way that the PBoC has held the dollar share of its reserves down.     If my suspicions are right, the overall share of dollars in China’s total external portfolio may be larger than the dollar share of China’s reserve portfolio (Richard McGregor of the FT has recently put the dollar share at 75% -- which seems right to me). 

2. Simon Derrick of the Bank of New York has made explicit something that has long been rumored, namely that the Europeans have asked China not to add to their euro portfolio, or at least not to increase the euro’s share of their portfolio.    Derrick notes that “Market News International was reporting back in September that “Germany has told China that it would be undesirable for Beijing to sell its existing reserve holdings of USDs to buy currencies such as the EUR.”  The question is whether the Chinese have listened.    It is possible that they have.  The last thing the PBoC wants right now is even faster reserve growth.  And if shifting into the euro pushed the dollar and the RMB down, well, that is what it would get.  Premier Wen’s comments about China’s continued interest in dollar-assets may have been directed, in part, at Europe.  

3. There is a lot of chatter about the impact of the new investment authority on equity markets globally.  It will be big after all.  If the PBoC really isn’t going to add to its reserves (which generally are invested in a fairly diverse set of bonds) and China’s foreign assets will flow exclusively to investment authority and then into equity markets, that would be a pretty big shift.    But if China doesn’t immediately shift all of its foreign asset accumulation toward equities, and continues to add a mix of bonds and equities to its portfolio, my guess is that the overall impact of China’s shift won’t be as large as some thing -- for a couple of reasons.  First, more rapid growth in Chinese foreign assets in 2007 will in part offset less rapid growth in the foreign assets of the oil exporters, and maybe 1/3 of the overall increase in oil exporters foreign assets came from oil investment funds, not central bank reserves – to a degree, rising Chinese demand for equities will offset a fall in oil state demand for equities.  Second, the huge flow from central banks into the bond markets and the world’s banks already has indirectly supported the prices of a lot of riskier assets.   When SAFE buys a bond from a US pension fund, the fund puts the money to work elsewhere.  And private equity firms have used the dollars central banks have on deposit in the world’s banks to bid up the price of a lot of equities as well … 

But perhaps the biggest and most interesting issue – at least to me – that McCormack raises is the most obvious one.   China now has a very large portfolio of foreign assets.  It now has $1.55 trillion.  That is likely to rise to close to $2 trillion by the end of the year.  Lots of other countries also have large external holdings -- such holdings are part and parcel of financial globalization.  But most of the foreign assets of countries like US and the UK and even France are in private hands.  Most of China’s assets, by contrast, are controlled in one way or another by China’s state.   Reserves account for an unusually large share of China’s foreign assets.  And most of the non-reserve assets are held by state firms and state banks.   

Scratch one country, two system.  Think two systems, one global economy.    And two systems, one global financial system.   China Inc's investment decisions are going to have the capacity to move markets for a long time.