from Follow the Money

China's June Reserves

No sign of pressure on China's exchange rate regime in the June intervention proxies. Overall intervention in the second quarter is back at pre-August 2015 levels.

July 24, 2017

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Exchange Rate Management

The various high frequency indicators of China’s activity in the foreign exchange market are all in, and they all suggest very modest sales in June, and indeed for the entire second quarter. Stability has, more or less, been restored.

Counting the ongoing growth in the net external lending of the state banks, including the policy banks, I suspect China’s government actually added to its already considerable stock of foreign assets in the first half of 2017 (though it does seem likely, given the data on the foreign currency lending of the state banks, that the banks slowed their pace of lending in the second quarter after rapid growth in the first quarter).

The two most important indicators—the change in the foreign assets reported on the PBOC’s balance sheet and the foreign exchange regulator’s data on the banking system’s net foreign exchange settlement—both point to about $5 billion in sales in June.

The PBOC’s balance sheet foreign exchange reserves fell by $5.1 billion.

Net settlement with non-banks shows sales of about $14 billion. But, as in May, the forwards data changes the total, as the banks’ past forward sales rolled off (e.g. their net forward book shrank). After adjusting for the change in forwards, net sales fall to—drumroll—$5.3 billion.

China: Foreign Reserves and FX Settlement

The most reliable indicator that China is playing overt games with the state banks—having the state banks buy or sell foreign exchange in order to reduce pressure on official reserves—historically has been a gap between the PBOC balance sheet measure and the settlement data. The absence of a gap suggests, at least to me, that what you see is more or less what is happening. There aren’t any signs right now that hidden sales from proxy banks are helping the PBOC out.

And, as I have said in the past, the current $15 billion a quarter ($60 billion a year) won’t exhaust the PBOC’s stock of useable reserves for the foreseeable future.   Especially as China could, in my view, always reduce pressure on its reported reserves by slowing down the growth of the foreign portfolio of the banking system. The state banks’ external lending basically removes dollars from the foreign exchange market. Rather than selling dollars for yuan, exporters put the dollars on deposit in the state banks—who then lend the dollars to the world.  

That said, there are still signs that suggest some underlying pressure on the yuan, largely from residents looking to move their money out of China if given half a chance. The yuan hasn’t appreciated by quite as much as might be expected given the dollar’s weakness. And the “spot” market hasn’t always followed the fix—suggesting that some folks still sell yuan for dollars when the authorities act to strengthen the yuan as they don’t expect the yuan’s strength to be sustained.

Such underlying pressure is one theory for why the yuan hasn’t appreciated by quite as much against the basket as would be needed to fully “undo” the impact of the dollar’s recent weakness. The dollar is now clearly weaker against the basket than it was before Trump’s election; the broad yuan though hasn’t quite returned to its pre-Trump level against the dollar. As a result, the yuan is still a bit weaker against the CFETS basket than it was eight months ago.

Tracking the Yuan

Personally, I think China’s authorities could/should push the yuan up a bit more against the basket to reverse the 2017 drift down in the basket, and see how that changes the behavior of China’s exporters.   Exporters converting China's still substantial goods surplus back into yuan are the main suppliers of dollars to the Chinese foreign exchange market.  Letting the yuan appreciate a bit against the basket would signal that the authorities aren't looking to use dollar weakness as an opportunity to let the yuan slide against the basket—unlike last year.

But these are quibbles. The big picture is that the combination of controls, stronger growth, and an apparent commitment to keep the yuan basically stable (facilitated by the dollar’s own weakness) has brought pressure on China’s reserves down to trivial levels.   

And there may be a broader lesson here. There was a debate last year over whether the expansion in credit in China last year was consistent with stabilizing the yuan (whether against the dollar or the basket).

One school argued that the expansion of credit was essentially a monetary expansion, and thus ultimately inconsistent with exchange rate stability—unless, of course, you believed the controls gave China a great deal of de facto autonomy.

Another argues that the expansion of credit was essentially an off budget fiscal expansion, and—like fiscal expansions in advanced economies—it would raise demand, allow a tightening of monetary policy (higher rates) and thus ultimately help stabilize the currency.

So far I would say the “fiscal” effects trumped the “monetary” effects.

A side note here: the PBOC’s balance sheet hasn’t grown that much recently. It was always big—and a lot of the PBOC’s liquidity injections over last two years served to offset the monetary impact of the fall in the PBOC’s external balance sheet.

And a final point. The yuan’s broad depreciation (the yuan is now down about 10% since mid-2015, using the BIS broad effective index) is having an impact on China’s exports. Export volume growth in q2 (y/y) will almost certainly top 10%, and likely exceed the q2 (y/y) growth in import volumes. Exports to the U.S. have been growing at a fast clip too, pushing up the bilateral deficit—with the rise in imports far exceeding any plausible estimate of the impact of the early harvest U.S. (uncooked) beef for Chinese (cooked) chicken deal, or even increased LNG exports. Maybe Trump’s team took note?

BIS Broad Real Exchange Rates
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