from Follow the Money

Reserves to protect against everything short of the Apocalypse

April 14, 2005

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That quote comes from the IMF’s chief economist in today’s Financial Times:

A number of emerging markets, especially in Emerging Asia, have built up reserves to protect against everything short of the Apocalypse," Mr Rajan said, "The reserve build up is now undermining monetary control as well as the soundness of their financial systems.

I think it is far to say that most Asian emerging economies now have war chests far in excess of any reasonable estimate of what they need to avoid future financial crises. Indeed, the biggest risk most emerging Asian economies face comes not from the risk an international crisis may reveal that they have too few reserves, but rather from the risk that their rapid reserve growth will lead to the rapid expansion of money and credit and a domestic financial crises.

No where is that more true than in China, which just reported that its reserves rose by about $50 billion in the first quarter, to $659 billion. Since China’s trade surplus tends to be larger in the later part of the year than in the first part of the year (a reflection of all the Chinese goods that appear in Christmas stockings, among other things) and China’s exports are growing EXTREMELY rapidly, the pace of China’s reserve accumulation is likely to pick up during the course of the year -- even if "hot money" inflows (at least $19 billion in q1) do not accelerate. Realistically, China’s reserves are on track to hit $860 billion by the end of the year (more than Japan?), and perhaps even $900 billion (if hot money flows pick up).

China’s reserves would then equal about 50% of its GDP. Just for the record, that is insane -- the central bank cannot use its balance sheet to subsidize China’s export-led growth forever. It means an enormous fraction of China’s national wealth is being kept in low-yielding US dollar denominated assets that are sure to fall in value (in local currency terms) over time. Rather than chasing yield, China is chasing future losses -- and in the process, making it harder, not easier, to maintain domestic financial stability. China says it cannot adjust its exchange rate peg until its financial system is ready, but in my judgment, the longer it waits, the bigger the likely problems in its financial system (more on this later).

Suffice to say that CSFB is dreaming if it really thinks China will only have $1 trillion in reserves in the summer of 2008 (the Beijing Olympics). Unless it changes its currency policy -- really changes its currency policy (a 3-5% move in the renminbi doesn’t count), China should hit $1 trillion in reserves sometime in 2006.

A small aside. China’s reserves rose by $95 billion in q4 and about $50 billion in q1. But that total includes the rise in the value of China’s euro denominated reserves in q4, and the fall in their value in q1. If China keeps 80% of its reserves in dollars, its "underlying" pace of reserve accumulation was around $85 billion in q4, and $55 billion in q1. If it keeps 60% of its reserves in dollars, its "underlying" pace of reserve accumulation was only $75 billion in q4, and was $60 billion in q1. While I don’t really know, my guess is that dollars make up closer to 80% of China’s portfolio than 60% -- in part because I do think "hot money" inflows into China slowed in q1, and thus China’s underlying pace of reserve accumulation really did slow. It would not surprise me if hot money inflows pick up again later in the year.

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