from Follow the Money

If your reserves are growing by $300 billion a year

July 18, 2005

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China indicated its reserves have increased to $711 billion at the end of June -- up $101 billion from the end of December 2004. Actually, they are up more than that. China transferred $15 billion to a state bank, and valuation losses from the falling euro and yen probably subtracted another $15 billion to its reserves (that would be roughly consistent with a 75/25% dollar/ non-dollar spit in China’s reserves). That implies an underlying increase of $130 billion, give or take a few billion, in the first half of the year -- a bit over $20 billion a month.

That pace could increase in the second half of the year. China’s trade surplus is almost always bigger in the second half of the year than the first half of the year, so the same pace of capital inflows -- both FDI inflows and more speculative flows -- would push the pace of reserve accumulation up a bit.

Taking into account valuation losses, an increase of $240 billion or so is almost guaranteed, and a $300 billion increase is not out of the question. That is not just my opinion -- Jonathan Anderson of UBS has long forecast that China’s 2005 reserve accumulation would top its 2004 reserve accumulation by a signficant margin, and Stephen Green of Standard Chartered recently made a similar call.

So I have to take issue Brad DeLong’s back of the envelope estimate that China will spend around 10% of its GDP intervening in the FX market this year. I think that is too low!

China’s official GDP will be a bit under $2 trillion, say $1850 billion, at the end of 2005. I think there is a reasonable chance China will add $280 billion or more to its reserves this year -- or 15% of its GDP.

That is why I am a bit flummoxed by the argument that US manufacturing industries that are complaining about China just don’t like fair competition. Some industries and some sectors and some firms may not be able to compete with Chinese production even if China stopped all intervention. But right now, in some sense, US labor in US manufacturing industries is competing both against Chinese labor and the government of China.

I cannot think of another major manufacturing power - China’s goods exports are now comparable to US goods exports -- that has run a current account surplus of more than 5% of its GDP while spending close to 15% of its GDP to add to its already substantial reserves. Some oil exporters may have responded to a surge in oil export revenues with similar reserve accumulation, but oil is a bit different. Malaysia may have done something comparable, but that only reinforces my argument, since it too has stubbornly retained its dollar peg. And Malaysia has a bit of oil too.

China’s reserve accumulation seems every bit as unprecedented at current account deficits of close to 7% of GDP in the world’s largest economy, and the issuer of the world’s reserve currency.

Let’s look forward a couple of years. Suppose China’s reserves continue to increase by $300 billion a year, China’s exports continue to grow by 30% y//y, and China’s GDP continues to expand by more than 10% a year in dollar terms. By the end of 2006, China’s reserves would reach $1210 billion -- more than twice their level at the end of 2004. And by the end of 2007, they would top $1500 billion, more than twice their current (mid 2005) level. That assumes that the pace of reserve increase does not continue to accelerate, and hence something of a break from recent trends. China’s 2005 reserve accumulation will top its 2004 accumulation, and its 2004 reserve accumulation topped its 2003 reserve accumulation.

China’s (goods) exports would rise from $590 billion or so at the end of 2004 to $1300 billion at the end of 2007, 55% of its GDP. Its exports to the US would rise from $190b to $420b, or about 18% of China’s estimated 2007 GDP (assuming 2007 GDP is around $2.3 trillion).

China’s reserves would reach about 65% of its end 2007 GDP. Or at least they would if China’s is not able to spend some of its cash hoard on US companies. China’s end 2007 reserves might only be $1300 billion if it could spend $200 billion on US companies -- US companies bought by Chinese state firms in a sense substitute for US bonds bought by the Chinese central bank.

Just to be clear, I don’t think all this will happen. That is the core insight behind the piece Nouriel and I wrote arguing that the Bretton Woods 2 system is unstable. This may be an equilibrium, but it is an unstable one -- both politically and economically.

Which brings me to last Friday’s FT story, the one saying the US thinks China will revalue in August.

Nouriel has already laid out his take on the FT story

I have long thought that there was a reasonable chance Chine would make at least a small move in August (ask Menzie Chinn!), and not just because one other formerly communist country let its exchange rate move in August (Russia, in 98). Rather, i thought an August move made sense for a range of largely tactical reasons.

1) President Hu is visiting the US this fall. If China does not move before his visit, President Bush would almost certainly have to repeat the US line -- the time to move is now -- with President Hu at his side. That imagery might not play so well in China ...

2) If China doesn’t move, the fall G-7 and the IMF annual meetings will be about nothing else ... Ok, maybe oil too. The deal on debt relief, aid flows and similar issues was done in the summer.

3) In mid-October, the US will declare China a currency manipulator if it does not move.

4) There will be a vote in the US congress on Schumer-Graham at some point this fall.

"Once the U.S. Congress recess ends, you’re bound to get more and more political noise about China’s lack of moving," said Simon Flint, a currency strategist at Merrill Lynch in Singapore. "

5) China’s global trade surplus -- and its bilateral trade surplus with the US -- will be very, very large this fall.

6) And even though China currently earns more on US treasuries than its pays out on the sterilization bills that the People’s Bank of China issues, the stock of sterilization bills is still growing rapidly -- and China will have to issue a ton more if its reserves are on track to rise from $711 billion now to $1500 billion in two and half years. Stephen Green estimates that China’s existing stock of sterilization bills totals $215 billion -- and China will have to issue $60 b of new bills in the second half of the year just to refinance existing bills at they mature. As the stock of bills outstanding keeps growing, the PBOC’s exposure to domestic interest rate risk only will expand.

Of course, that has to be weighed against the possibility that China’s economy is slowing a bit more than desired, current low inflation in China, and the fact that the RMB has already appreciated substantially against the Euro. Though -- as recent data suggests -- all China has to do to spur a bit more growth is to relaz restraints on bank lending (and reduce the pace of sterilization, letting the money supply grow a bit more).

``The authorities clearly targeted a slowdown in money and credit growth during the boom and they have achieved that,’’ said Tim Condon, chief Asia economist at ING Bank in Singapore. ``They may now be thinking that things have slowed down too much and they are sending a signal that lending more is okay.’’

There are always reasons not to move in the short-run. That is why emerging economies consistently cling to outdated exchange rate pegs for too long. However, in the long-run -- or for that matter the medium run -- it doesn’t really make sense for China, a major creditor country with a large and growing current account surplus, to tie its currency to that of the US, a major debtor country, with a large and growing current account deficit.

The US government no doubt agrees with that assessment.

However, I am also not sure it makes sense for a creditor country like China to have so much of its external wealth denominated in the currency of a major debtor country. China would be far better off if more of its external assets were denominated in RMB and fewer in dollars or, for that matter, if more were denominated in "oil" and fewer in dollars. I doubt the US government would like all the implications of that judgment ... The US still seems to me to be banking on the continuation of a lot privileges that normally accrue to creditor - not debtor - countries.

There are many ways the system could break down. Protectionism in the US, whether from workers in US manufacturing industries that don’t like competing with Chinese labor subsidized by vendor financing from the PBOC or from US firms who don’t like competing with Chinese firms also subsidized by the PBOC in the "M&A" market. Chinese protectionism. A US consumer that finally gives in, particularly in the face of the deflationary impact China currently exerts on US wages, at least in some sectors (the size of the impact can be debated, the direction of the impact is pretty clear). The domestic consequences of China’s ballooning reserves. The growing US current account deficit.

No surprise: I think DeLong somewhat overestimates the chances (four in five?) of avoiding a crisis of some sort, though I agree with his assessment that the odds of a crisis are rising.

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