from Follow the Money

A trillion dollars here, a trillion there and pretty soon you are talking about real money

October 17, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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I have written extensively about China and Chinese reserve growth recently. 

So I won’t use Tuesday’s Wall Street Journal article as the spring board for another long post.  Just a sort of long post.

The evidence suggesting that 70% of China’s (augmented) reserves were in dollars in the middle of 2005 is pretty strong.   The Treasury's survey of foreign portfolio investment in the US indicates that total Chinese holdings of US long-term debt in June 2005 were around $484b.   Treasury data also shows that China’s short-term deposits/ custodial holdings in the US were $59b in June 2005.  $40b of these holdings were short-term debt securities.  That means total Chinese holdings of debt securities were $524b and total claims on the US were around $541b. 

China’s total reserves – counting reserves nominally shifted to the banks – stood at around $771b.   Total claims on the US -- from the US data -- work out to be about 70% of China's reserves.   If China had any additional dollar deposits in the international banking system, its total holdings of dollars would easily top 70%.  The US data doesn't distinguish between private Chinese holdigns of US debt and SAFE's holdings, but I think it is safe to assume that SAFE accounts for the lion's share. 

We don’t have survey data for Chinese holdings right now, and the flow data has some problems (it is hard to track the ultimate ownership of bonds bought through intermediaries).   But the flow data is consistently picking up fairly strong inflows from China.   So I would be surprised if the dollar currently accounts for less than 70% of China’s portfolio.  And with China’s reserves, using my measure, standing at around $1,050 at the of September – that works out to dollar holdings north of $700b.

I consequently am far more confident claiming that China holds at least 70% of its reserves in dollars than I am trying to estimate the currency composition of China’s non-dollar holdings.  I would guess China's non-dollar reserves are mostly in euros – they almost have to be.  There aren’t many markets big enough to hide $300b.   But I certainly don’t know what fraction is held in euros and what fraction is held in Norwegian krone, Swedish krona, British pounds, Swiss francs, Australian dollars, Korean won and Japanese yen. 

It is now fairly widely reported that China has invested – often using fund managers – in dollar denominated emerging market debt as well.

In some sense, though, the debate over where China has placed its existing reserves misses the key point.   The real story is that China added about $500b to its reserves, roughly doubling its total, in the last two years.   Its reserves at the end of q3 2004 were around $500b.  They are now around $1 trillion. 

And so far – despite all the talk of “rebalancing Chinese growth” – China has been reluctant to take the policy decisions needed to slow its pace of reserve growth.   Trivial changes in the RMB/ $ that are fully offset by inflation differentials and the dollar’s slide v. the euro won’t cut it.    And efforts to encourage capital outflows do not seem to have generated big enough flows to offset ongoing infows and China’s (rising) current account surplus.    A current account surplus that Nick Lardy now estimates at 9% of China’s GDP.

That to me is the real issue.  David Altig argues that there is no sign China is about to change.  I tend to agree.  Bretton Woods 2 – right now China  and the Gulf -- has proved more stable than I expected.  Score one for Mike Dooley, Peter Garber and David Folkerts-Landau.    

That doesn’t mean there aren’t strains though.

Right now China is on track to add at least another $1 trillion to its reserves over the next four years.   I suspect the pace is more likely to accelerate than decelerate barring more policy changes.   And China is on a trajectory that implies its monthly exports will rise from $90b to something like $220-260b over the next four years.  That is what sustained 25-30% export growth implies.

I am far more confident that Chinese export growth will slow than I am confident that Chinese reserve growth will slow.    $200b plus in monthly goods exports -- twice what the US exports -- doesn't strike me as plausible, particularly if Chinere firms aren't (yet) poised to start exporting autos (auto parts, maybe -- particularly if the big parts suppliers set up shop).  I am not sure that China will be willing to increase government spending enough to bring the current account deficit down -- a policy course advocated by, among others, Nick Lardy, Martin Wolf and Olivier Blanchard

But I also would bet that China won’t be able to double its reserves over the next four years quite as smoothly as it doubled its reserves over the past two years.    I still doubt Chinese financing of the US provides the basis for a stable new financial order.   And that an unbalanced world will permanently remain a world lacking in volatility.

One interesting tidbit from the Wall Street Journal story – US concerns that China may muscle into US turf.   US turf in Latin America.  The US used China’s borrowing from the World Bank as the basis for excluding China from the Inter-American Development Bank.  And US crisis management turf.   The US has – through its dominant position in the IMF – long played a dominant role deciding which troubled emerging market gets bailed out, and on what terms.   China is clearly in a position to change that. 

There is a reason why the rules of the global financial game are usually set by the world’s biggest lender – not its biggest borrower.   

Richard Haass argues that US influence in the Middle East has now peaked – the ironic result of Bush Administration policies intended to reassert US primacy.  I suspect the same is true in other realms. 

One last note: RGE premium subscribers who want to look at my somewhat more detailed analysis of Chinese reserve holdings and foreign holdings of US Treasuries should look my work with Casson Rosenblatt on China's reserves and my work with Elisa Parisi-Capone on the maturity distribution of central bank holdings of Treasuries.

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