from Follow the Money

Show me the money (really, show me China’s reserves)

September 12, 2005

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China's Alan Greenspan (Zhou Xiaochuan) has indicated China won't roil financial markets with "active composition adjustments of the foreign reserves."  fine.   But any central bank adding about $20 b a month to its reserves has ample scope to change the composition of its reserves over time without selling any of its existing holdings.

Zhou also indicated that the central bank "will reduce its purchases of foreign exchange in the market, while companies will keep more foreign exchange."  (Quotes for Wu and Carew of Dow Jones, in today's Wall Street Journal, on p. A14).

Count me a skeptic.  I want to see what has happened to China's reserves since the July 21 revaluation - and China, unlike most other Asian economies, has still yet to release its end July or end August reserve data.   But we know that China posted large trade surpluses in both July and August, which suggests continued strong reserve growth. When it comes to transparency, China's central bank lags behind other Asian central banks ...


If a Chinese company expects the RMB to rise over time, why would it prefer to hold dollars rather than RMB, unless it is looking to go on a shopping spree?  Of course, China's government owns a lot of firms, and it could always tell them to hold more of their profits abroad.   That is a bit unusual though - most countries with capital controls try to force their firms to repatriate their overseas profits.  But most countries are not seeing their reserves surge at China's pace either ....

Higher dollar holdings by state firms sounds like a messy internal compromise - something that China's state council accepted in the face of central bank complaints about the pace of its reserve growth.

We cannot look at China's reserve data to see if the pace of reserve growth has slowed since July.  But we can look at the reserves of two "China" proxies - Malaysia, which also moved from a peg to a (heavily) managed float in July, and India, which has long managed its float.

Malaysia's reserves surged by $3.5 b in July, and rose another $1.85 b in August, reaching $80.1 billion.    That is not much of a falloff.  Even if Malaysia kept ½ its reserves in euros, valuation changes would only have added $0.6 b to its reserves in august.  The central bank also intervened in the market.

The same is true for India.  Its reserves surged by around $5 billion in August, reaching $145.6 billion.  And by my rough calculations, valuation gains (the euro rose from 1.212 to 1.230) only explain about $1 billion of the $5 billion increase in India's reserves.  The Reserve Bank of India clearly was active in the market.

All that - plus the fact that China's exports often peak in the early fall --  suggests the PBoC's reserves will continue to rise rapidly.  The latest data confirms continued export growth of 30% y/y (with import growth of only 15%) - a stunning pace.   Of course, state firms are now being told to keep their profits offshore, artificially slowing reported reserve growth.

In order to understand China's exchange rate policy, I think it is becoming increasingly important to understand China's exchange rate politics.   Sometimes US commentators assume that an omnipotent, rational Chinese state quietly executing a long-term plan designed to optimize China's economic development.

That story seems to overstate the coherence of Chinese policy.  China is a one-party state.  But that does not mean that the state is monolithic.  Different parts of the state have different interest.  That is true with oil.  The state oil companies would prefer higher retail prices.  China's central planners (and political rulers) are not so sure. Same with the exchange rate. 

The central bank fairly clearly wants a stronger exchange rate, accelerated banking reforms and more monetary policy independence.   It is worried that China's economy is too dependent on investment and exports - and thus is dangerously unbalanced.  Other parts of the Chinese state are not so sure.

After all, the Chinese communist party (through the state) owns a fair number of exporting companies.   And parts of the state like the current way of doing business.

I don't think China's unwillingness to let the exchange rate move more is just normal prudence, and evidence of sensible economic management.  After all, there are times when not moving is more risky than moving.

I think this is one of those times.  It never made sense for the RMB to follow the dollar down from 2002 to the end of 2004.  Yet China's decision making process was gummed up, so China sat still.   It made a small move in 2005, perhaps pushed by an implicit threat from the US.

But, in my view, that move was both too little and too late.  And now China has a problem.

The combination of faster productivity growth in China than in the US, which improved China's competitive position in the US market even with a stable RMB/ dollar and the fall in the dollar/ renminbi v. Europe led to a surge in investment in China's export sector from 2002 on.  By the end of 2005, exports will account for 40% of China's GDP, up from about 20% a few years ago.  About 2/3s of those exports (including goods shipped to Hong Kong that are then reexported) go to the US and Europe.   That is an enormous sum.  More importantly, China is investing over 50% of its GDP, and a very large of that investment is going into the export sector.  China is gearing up to export 60% of its GDP - with most of that output going to the US and Europe.  Listen to Chen Xingdong of BNP Paribas:

BNP Paribas economist Chen Xingdong said China's robust exports -- which have recorded growth rates above 30 pct since early 2003 -- show no sign of slowing.  'Not only is external demand for Chinese goods still very strong, domestic production capacity is building up to a level that is exceeding domestic demand,' he said.  'It's very hard for China's exports to fall any time soon,' he said.

Any change to the exchange rate will have an impact on an enormous swath of the Chinese economy.  It won't have the huge impact some claim - Chinese firms should be able to raise their dollar prices, and imported components will be cheaper.  But the impact of any (real) change is already potentially so big that many are worried.  They are more than capable of lobbying the government to try to protect their short-term interests.

It is widely known that the central bank wanted a bigger move in July, but was overruled by the State council.  See "Behind Yuan Move, Open Debate and Closed Doors: Two-Year Saga Included Secret and Staged Meetings, Weeks of Quiet Diplomacy," by James T. Areddy, Neil King Jr., Mary Kissel and Jason Dean, Wall Street Journal, 25 July 2005, p. A1. (crappy link here)

And many in China are worried about any policy changes that would increase the central bank's clout, and are still pushing back.  A market news international story last week reported:

The source [a government advisor], who works with various government ministries and agencies, told Market News International that powerful factions are fighting to stall further yuan. He said they are concerned about the  potential impact on the economy and on their own power, which they worry  could be eroded by a more market-oriented currency regime overseen by the central bank.   "The problem with policy-making in China is that there is no unified policy-making body, and every ministry within the State Council is fighting for its own rights," the source said. He said that while the State Council has approved the central  bank's broad strategy on reform, vested interests within the government are now bickering over the fine print, with the result that currency reform has largely stalled.

Yet the longer China waits, the bigger the impact of any change will be.  The more China invests, the more unbalanced China's economy becomes - the more vulnerable it becomes to a global slump, or to a political tsunami that would reduce the openness of the US and European markets.   Sustaining 30% y/y growth in Chinese exports to the US implies an additional $75 billion in additional US imports in 2006, $100 b in 2007 and $125 b in 2008 ...

 Because the exchange rate is so far (in my judgment) from equilibrium now, absent continued government intervention, it could rise even if China's economy slows.  That is the price China could pay for resisting the natural tendency of the RMB to rise amid its (huge) boom over the past couple of years. 

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