from Follow the Money

What can not go on forever seems to be going on forever: China’s amazing January reserve growth

March 5, 2008

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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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Let’s just say that Wang Qishan has his work cut out for him.

Reuters reports that China’s reserves increased by $61.6b in January alone.

That is a stunning sum. $60b is roughly the size of the US monthly trade deficit. Annualized, the implied increase in China’s reserves tops $700b.

And the real increase in China’s foreign exchange holdings could be even bigger. We don’t know what happened with the banks’ (large) fx position. It could have fallen, increasing the reserves of the central bank. Or it could have increased. My friend Logan Wright told Michael Pettis that China hiked its reserve requirement in January and the banks were required (oops, encouraged) to meet that requirement by holding even more dollars. If Logan is right, the total accumulation of foreign exchange by China’s state then could have topped $80b.

To be precise, the $61.6 increase includes some valuation gains. Strip out the effect of the euro’s January rise, and the "real" increase in China’s reserves was "only" $55b -- or about $20b more than can be explained by FDI inflows and China’s January trade surplus. Some of the difference -- maybe $6 to $7b -- is explained by interest income on China’s existing reserves.  Some likely reflects ongoing "hot money" inflow.

A $55b monthly increase works out to an annual increase of around $660b. That is big -- but not implausible. In my January paper on China’s foreign asset accumulation I estimated that China’s state added at least $500b and perhaps as much as $600b to its foreign assets in 2007, with much of the increase "hidden" in the state banks. $660b is only a modest acceleration.

The sums involved are so staggering that I suspect that they have lost their ability to shock.

But think of this:

China added $55b to its reserves.

Saudi Arabia added $18b to its foreign assets in January.

Those two countries combined to add around $73b to their central banks portfolios. That means that those two countries alone could have supplied the $62.5b a month the US needs to sustain a $750b current account deficit and still had a bit left over to buy euros. Or they could have provided enough money to finance capital outflows from the US along with a current account deficit.

It kind of makes you wonder why the US goes through the motions of selling Treasury and Agency bonds on the open market rather than doing direct placements with a few big central banks.

China after all wasn’t the only emerging Asian central bank to add to its reserves in January. The other emerging Asian central banks added something like $30b to their reserves -- bringing the regional total up to $85b.

That is a one trillion dollar annual pace of reserve growth from a region that is a large net importer of oil. They did so without being asked by the US - and without asking anything from the US in return.

If oil averages around $100 a barrel and the oil exporters only need $50 a barrel oil to cover their import bill, the current account surplus of the major oil exporting regions and Norway would be in the $700b range. Most of that will end up in the hands of central banks and sovereign wealth funds.

Moreover, some of the oil exporters are attracting inflows of private capital.

If US rates cuts put more pressure on the yen than Japan can bear and Japan
ends up intervening, my ballpark math suggests that it is not beyond the realm of possibility that total official asset accumulation could reach $2 trillion this year.

That is a stunning sum -- and probably is too high. It assumes January’s reserve growth in the emerging world will continue for the entire year -- a huge assumption. But it actually doesn’t seem all that out of line with the available data from January.

Paletta and MacDonald made a pretty strong case that the US needs to reconsider its existing bank regulatory framework on A1 of yesterday’s Wall Street Journal:

"Did banks know how much risk they were taking? Did they know how much capital they needed to cushion them from sour loans? Did they prepare themselves adequately for the evaporation of "liquidity," or their ability to easily sell their securities or loans? The answer to all three questions appears to be "no."

I would suggest that China’s January reserves data provides an equally compelling case for a reconsideration of the world’s global monetary architecture. An international monetary system that requires this kind of official intervention - and likely will lead to more inflation in the emerging world than the emerging world wants and more government ownership of financial assets in the US and Europe than the US and European public wants -- strikes me as hard to sustain for much longer.

Rodrik and Subramanian have put forward one proposal for rethinking the global financial system. I am sure there are other interesting proposals as well. Jeff Frankel, for example, presumbly has thought about this question.

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