from Follow the Money

A trillion dollars does tend to concentrate the mind …

July 25, 2006

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Statistical agencies usually are not the authoritative source of information on a country’s reserve portfolio.  Nor do they usually comment on exchange rate policy or the investment decisions of a country’s firms.  But then again China may be different.    

There is no doubt that China would love to see its companies invest more abroad, slowing its reserve growth.    And China clearly has figured out that buying an asset that is likely to decline in value has a cost, even if the carry is positive.   That said I am more confident that the RMB will rise in value v. both the euro and the dollar over time than I am that the euro will rise (further) in value v. the dollar. 

It does seem like the amount of noise about China’s reserves has picked up recently (hat tip Macroblog).  I don’t think it is entirely random noise either.  I suspect – without knowing – that there is an active debate inside China’s leadership about Chinese reserve growth.

A trillion dollars is just a number.  But it is a big number.  And a big milestone.   By my count China already has over a trillion dollars in reserves and reserve-like assets.  But I am counting the funds the PBoC shifted to the state banks.   In a couple of months, though, China will formally announce that its reserves now top a trillion dollars.   So it isn’t exactly a surprise that Chinese policy makers would be spending a bit of time thinking about how to use those funds.

The key fact for the global economy is not that China holds a trillion dollars in reserves.  It is that those reserves are growing at a pace of around $20b a month/ $250b a year.   This reserve increase has continued even as interest rate differentials have moved steadily in the dollar’s favor.   China constantly struggles not just to invest its existing reserves productively, but to find new places to park its ever growing reserves.

Right now, there is no reason to think that China won’t have $1,500b in reserves in about two years time.   Not unless Chinese policy makers show an ability to act far more decisively than they have so far. 

$250b is a lot of money to invest every year.    I suspect there are some constraints on how China can invest it.  There aren’t many – strike that, there aren’t any – emerging markets that could absorb inflows on that scale.    Modest sized industrial economies like Australia and the UK are also too small to absorb more than a small fraction of the total.    Look at their respective current account deficits in dollar billions.   

Japan’s government debt market is very, very big.   But JGBs don’t pay much interest, and the PBoC likes a bit of carry.   So China really is left looking at the US and the European market.  I don’t really buy the notion that European debt markets are too small and illiquid for China.  China likely has been placing funds in some smaller and less liquid debt markets in the US, not just the most liquid of instruments.   But I do think that it would be hard for China to continue to peg to the dollar and dramatically increase its euro allocation.   

Suppose China now invests 25% of its reserve growth in euros.  That is $60b a year or so.  Real money.   Suppose it decided it wanted to invest 50% in euros.  That is $125b a year.  I suspect that a $60b increase in net flows to Europe would have an impact on the euro/ dollar exchange rate.   And if it did, China’s peg implies that the RMB would depreciate along with the dollar.   That would force China to buy more reserves.

I do think – particularly after the survey data came out – that China has a relatively large dollar allocation of its reserves.    Probably above the global average.  The TIC data – for all its limitations – shows that China has been buying a broad range of US assets, not just Treasuries.  As its reserves have increased, it has gotten a bit more adventurous with its dollar portfolio.   That is one kind of diversification.  I suspect (and god knows I don’t know) it holds some dollar denominated emerging market debt.    The gory details of what is known and not known are found in the latest Rosenblatt/ Setser reserve watch (subscription required) 

China also holds a lot of euros and other currencies.  It has to.  With $1 trillion in reserves, a 20-30% non-dollar portfolio implies holdings of $200 to $300b.   That is bigger than the total reserves of all but a handful of other countries. 

That leads me to one point where I disagree with Lex.  

Lex argues – echoing lots of academics – that China’s dollar reserves finance a net flow of FDI back into China.   “China has benefited from the recycling of capital through foreign direct investment, which has supported growth.” 

I disagree, at least in part.    China’s growing dollar reserves don’t finance US investment in China.  They finance US imports of Chinese (and other) goods.    The US current account deficit is quite large relative to US FDI outflows.   That means that in aggregate, Chinese inflows support US domestic consumption, not US investment abroad. 

The picture of central bank inflows financing FDI works – but for Europe.    Europe attracted a ton of reserve inflows in 2005.  Maybe $200b in total, and at least $50b from China.    That financed a good chunk of Europe’s FDI.    And who knows, in future, the income streams that result from such intermediation may even generate a bit of European dark matter.   

Europe is now to the world what the US was during the heyday of the original Bretton Woods system: growing euro reserves finance Europe’s growing investment abroad.   The US, by contrast, needs those reserve inflows to finance a big current deficit.  There is a difference.