from Follow the Money

The US government has no idea what China intends to do with its exchange rate …

October 17, 2005

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This Financial Times articles by Andrew Balls and Richard McGregor is worth reading.  It makes two key points:

1. China did not give the US any hints what it plans to do next with its currency next.  Probably because Chinese policy makers themselves don't know; they are still evaluating the impact of the past move (the notion that a 2% revaluation will lead Chinese export growth to slow to 12% in 2006, though, is ludicrous).  That makes drafting the next "Foreign exchange report" harder, or at least politically more risky.  Giving China time and then watching China sit still won't help the Bush Administration.  

Read the B section of Monday's Wall Street Journal and note the strong incentive that Delphi has to shift parts production to China at current exchange rates.  Delphi's man in China makes John Snow look like the paragon of diplomacy.  Mr. Chon [the head of GM's Asian operations] "has been explaining the bankruptcy filing of the US operations to his staff and customers by likening Delphi's Asian operations to the children of a sick American mother.  "Our mother has a tumor.  This tumor is the UAW ..."

2. China's central bank doesn't make foreign exchange policy in a political vacuum, and there are strong domestic political pressures inside China against further moves.   Think state owned companies that have nice little export businesses, and various domestic bureaucracies that are worried about the PBoC's growing influence.

That brings me to Anne-Marie Slaughter's post over at TPM café.  She asked how the US can use economic liberalization to promote political liberalization, and her general tone suggested that US engagement with China was responsible for China's economic success. 

The economic liberty leading to political liberty argument rests on the proposition that the tools of economic liberty ...  build an intellectual, social, and economic foundation for political liberty. Practically, however, it means that the U.S. should be finding as many ways as possible to engage non-democracies in ways that promote their economic growth, as we are doing with China.

"As we are doing with China" struck me as off.  It gives the US too much credit for China's growth.  China certainly has been helped by access to the US consumer market, but China's growth has not necessarily come from following US policy advice.  For example, a state run banking system is not a big part of the development strategy that the US pushes. 

I suspect the more relevant question for most countries is can they "engage economically with the US in the way Chinas has."  My answer is that they cannot - that the forces that propelled China's recent success have about run their course, the US trade deficit cannot continue to expand, and the next generation of success stories will have to rely far more on domestic demand growth. 

One other note: It seems China's reserves only increased by $15.8 billion in September, bringing China's total reserves to $769 billion ($829 billion counting reserves transferred to three state banks).   Does that mean hot money flows to China have tapered off?  In a word, no.

Remember, China's trade surplus also fell in September, to $7.6 billion.  So capital inflows were sufficient to add around $8.2 billion to China's reserves.   Some of that was FDI, but not all.  FDI has been flowing in to China at a $5 billion a month clip. 

More importantly, the euro fell by about 2.2% against the dollar in September, dragging down the dollar value of China's reserves.  If China started the month with $100 b in euros, it ended with $97.8 of euros.  And if it started with $200 b in euros (not unreasonable for a country with $700 b in reserves), it ended with $195.6 billion in euros.

I consequently suspect that valuation losses knocked $3-4 billion off China's reserves in September, and the underlying pace of reserve accumulation remained close to $20 b a month.  Since the trade surplus was smaller, that suggests that hot money flows picked up. 

My estimate of the valuation adjusted reserve increase:  Roughly $18.8-19.8 billion

The reserve increase that is the product of China's trade surplus and FDI inflows: $12.6 billion.   Implied "hot money" flows: $6.2-$7.2 billion.

Valuation gains and losses though should not have played a big role in China's q3 reserve total, since the euro/ dollar was basically unchanged.   So $58 billion seems a reasonable estimate of total reserve growth in q3, or roughly $20 billion a month.   That does suggest some fall off from q2.  It also suggests that overall reserve growth remains quite strong - roughly $60 billion a quarter.   I suspect that reserve growth could well pick up in q4.  We will see.

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