from Follow the Money

Four bits of information to help understand China a little better …

June 19, 2008

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Energy use is subsidized – even though China is a net importer of energy. Even after increasing domestic gasoline prices by 17%, Chinese prices will remain below the world market price. The World Bank estimated that November price hike increased domestic prices to the equivalent of $78 a barrel. My very rough calculations suggest that the recent price hike consequently should raise domestic prices to a per barrel equivalent of the low 90s -- perhaps more if exchange rate moves are factored in.

Exports continue to contribute significantly to Chinese growth. The latest, highly recommended World Bank Quarterly – written in large part by Louis Kuijs -- calculates that net exports contributed 1.5% to Chinese GDP growth in the first quarter, and more in April and May (see p. 4). That is less than in 2005, 2006 an 2007. But it is still a positive contribution. Real import growth has slowed more than real export growth. The (small) fall in China’s trade surplus relative to last year is all due to the rise in import prices.

The World Bank’s data has one surprising implications: Net exports contributed more to China’s growth in q1 than to US growth (1.5% v 0.8%).

Given that China still manages its exchange rate primarily against the dollar and the RMB has depreciated v the euro because of the dollar’s slide, I guess that shouldn’t be a complete surprise. It does though suggest that the hard work of global adjustment hasn’t really even begun. The World Bank forecasts that China’s current account surplus will stabilize at around $370 billion in 2008 before resuming its rise in 2009 once the effect of rising oil prices wears off.

Both China’s government and its state banks are accumulating an amazing amount of foreign exchange. That shines through the World Bank’s analysis. Stephen Green of Standard Chartered reports that the hike in reserve requirements – combined with pressure to meet that requirement by holding dollars -- has led China’s banks to increase their foreign exchange holdings by $160 billion.* Think a bit under $100 billion in 2007 (mostly in q4) and a bit more than $60 billion in the first four months of 2008. If China’s state banks were a sovereign country, they would rank second in the global “reserve” growth league table over the past twelve months – outpacing both Russia and Saudi Arabia. Only the People’s Bank would top them.

The state banks now are sitting on a huge pile of foreign exchange. Far more, incidentally, than the CIC. About $70 billion of the CIC’s $210 billion flowed back to the PBoC when the CIC bought Huijin’s stakes in the big state commercial banks. Another $20 billion was handed over to the CDB. That leaves $120 billion max – less than the fx the state banks have accumulated to meet the reserve requirement. I still haven’t quite figured out what the state banks have been doing with all this cash though; at least in late 2007, they don’t seem to have been buying foreign debt securities.

China isn’t quite to the foreign exchange market what it is to global demand for cement (or coal), but when all the various pots that China has filled with foreign exchange are counted, China’s impact on the foreign exchange market is really quite extraordinary.

Forget the idea that global banks are “offshore intermediaries” for China’s crummy state banks; today China’s central bank and its state banks are intermediating a lot of global funds that have found their way into China. China now effectively borrows from the world at high rates to invest in the world at low rates -- all while taking on the risk of losses if the RMB rises v the dollar and euro.

China’s exchange rate regime doesn’t just influence the foreign exchange market; it also shapes a host of key domestic policies.

Anyone wanting to understand the channels through which China’s undervalued RMB has led to a rise in China’s savings surplus should read Andrew Batson’s account of how China is worried that spending too much on domestic infrastructure would add to inflationary pressures. Batson writes:

Confronted with two big natural disasters before the year is half over, China’s government is having to boost spending to rebuild damaged areas and strengthen infrastructure. But with inflation still high, officials are reluctant to pump too much money into the economy and are limiting the program’s scale.

China has the funds available to invest more at home, but it is choosing not to avoid overheating. However, it has another option to avoid overheating – namely letting the RMB rise and reducing the contribution of net exports to growth. China’s government could be using the funds it has raised by selling the bonds used to finance the CIC to invest in say higher quality schools; it is choosing instead to invest abroad on terms that imply a significant risk of further losses.

There are a couple of other channels as well – the World Bank quarterly reports that China has tightened controls on bank lending, and thus has been able to keep credit growth “contained” despite all the foreign exchange flowing into the central bank and the associated pressure for rapid money and lending growth. China has in effect forced the banks to invest China’s domestic savings in dollars (through the reserve requirement) and to lend to the central bank, loans that the central bank uses to buy dollars and euros. If the banks were shackled, they could lend more domestically.

Stephen Green also reports that the government has CNY 2.5 trillion ($355 billion) on deposit at the PBoC, a sum roughly equal to 10% of China’s GDP. That is real money. There is no need for the government to have that large a cash cushion. China could finance higher levels of government spending by running down its cash balances rather than with new borrowing – or with more taxes. But if it did so, it would undermine one of the ways China has “sterilized” its huge reserve buildup.

Throw it all these points together than they tell a similar story: China’s determination to manage certain key prices – notably the exchange rate – has driven an awful lot of other policy choices. And China is now big enough that its policy choices matter for the world, not just China.

* Both Green and Wang Tao of UBS believe that the "Foreign assets: other" line on the PBoC’s monthly balance sheet corresponds with the dollar reserves the banks are holding. The banks also have foreign exchange from various swaps with the central bank (this was important in late 2005 and 2006, and to the best of my knowledge these swaps have not been unwound) and from the various recapitalization exercises. All told, they manage at least $300 billion -- and probably more like $400 billion.

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