from Follow the Money

The mystery deepens. China’s June reserve growth is surprisingly low.

July 14, 2008

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China just indicated that its reserves reached $1808.8 billion at the end of June. That is obviously a huge sum -- it is $126.6b more than China reported at the end of March. But the increase in June was surprisingly small -- only $11.9 billion.

Moreover, the euro rose in June. After adjusting for valuation gains, China’s June reserve growth works out to something like $3 billion. That assumes that about 25% of China’s reserves are in euros -- which may be too high. Still, the increase in China’s reported reserves in June is very low, both relative to the increase in past months and relative to China’s still-large trade and current account surplus.

The volatility in China’s reserve growth this year has been extraordinary. Reserve growth -- without considering valuation gains - has gone from a high of $75 billion in April to a low of $12 billion in June. That is a bigger swing than the dip from close to $60 billion in January and February to $35 billion in March.

Adjusting for valuation effects (the dollar value of China’s euro reserves rises when the euro rises, and vice-versa) actually makes the swings bigger. After adjusting for valuation gains and losses, April’s reserve growth is close to $80 billion and June’s reserve growth is less than $5 billion.

Clearly the 100 bp rise in the bank reserve requirement - which may have subtracted $36 billion from June’s reserve growth -- has something to do with the low total in June. But the reserve requirement also was hiked by 50 bp in April, so the bigger-than-usual increase in the bank reserve requirement in June is not the full explanation. Either hot money flows fell, or China has found a new way of keeping reserves from appearing on the central banks books.

Adding in the $36 billion in foreign exchange that China’s regulators likely pushed onto the banks in June brings the monthly total up to around $40 billion. The June trade surplus was about $20 billion, FDI inflows were a bit below $10 billion and interest income on China’s existing foreign assets were maybe $6 billion.

Sum it all up and everything roughly balances, implying modest hot money inflows. At least if the data that was reported captures the full picture. It is hard to know. China has cracked down on hot money inflows. At the same time, the huge swing in the very rough measure of hot money flows most analysts uses from April to June is a bit suspicious.

More tomorrow.

Update: Michael Pettis gets a slightly higher total for (adjusted) June reserve growth than I do: $50 billion v $40 billion. He assumes smaller valuation gains than I do, and puts a somewhat higher dollar value on the increase in China’s reserve requirement than I do. But I basically agree with his analysis. And I fully agree with core conclusion of his FT oped with Logan Wright, namely that the large increase in hot money flows to China over the last year poses a major challenge to China’s central bank, and significant risks to the financial system -- as it is evidence of a highly pro-cyclical monetary and exchange rate policy framework.

The June reserve increase -- whether $40 or $50 billion, after taking into account valuation changes and the rise in the state banks’ holdings of foreign exchange (see Logan Wright’s comments in the FT), brings the total increase in China’s foreign assets in the first half up to around $450 billion. That is $900 billion annualized. China’s current account surplus is on track to be around $400 billion (probably a bit less); FDI inflows are on track to be around $100 billion (probably a bit more actually, as the monthly data has tended to understate FDI inflows in the BoP data). That works out to around $500 billion. $900 billion in foreign asset growth consequently implies very large additional inflows, even if neither the trade nor FDI balances include any disguised hot money flows. The pace of foreign asset growth so far in 2008 implies that hot money flows -- which likely were significant in 2007 -- picked up substantially in the first half of 2008.

We don’t yet know whether the recent policies China has adopted to control these inflows are working. The modest June reserve increase suggests that they may be. But China now has an incentive to disguise its reserve growth to create the perception that these policies are working, and until China fully discloses all of its swaps with the state banks, it is hard to know if reserve growth has really slowed or if China simply is using new ways to move some foreign exchange off the PBoC’s balance sheet.

Andrew Batson of the Wall Street Journal has this exactly right: the lack of transparency about the management and accounting for China’s reserves -- and the low quality of China’s balance of payments data -- creates a lot of room to interpret, and to misinterpret, the Chinese data. China could do the world a favor by clarifying how exactly foreign exchange is moving around in China -- and by doing the basics, likely disclosing its monthly reserve growth in a timely and predictable way. China’s foreign asset growth now matters too much to the rest of the world for it to produce some of the world’s worst reserves data.

So answer Batson’s opening question, China both has too many reserves and too few statistics.

One thing is now I think pretty clear: China seems to carry its dollar reserve portfolio at face value, rather than marking its bond portfolio to market. We know that Japan marks its bond portfolio to market, so falls in US rates tend to push up Japan’s reserves. If China does too, its reserves should move in a way that is somewhat correlated with Japan’s reserves. China has more bonds, and likely has more long-duration bonds, than Japan. Yet Japan’s reserves fell in April and rose in June, while China’s reserve growth was strong in April and weak in June. That is circumstantial evidence, I know -- as market moves could be overwhelmed by other changes. But it is all we have to go on, and it does suggest, at least to me, that falling US long-term rates were not the main explanation for the rise in China’s reserves in q1.

I should have a set of detailed charts showing China’s 2008 foreign asset growth -- or my best estimate of China’s foreign asset growth -- up in the next day or two. Stay tuned.

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