from Follow the Money

Why did China only add $100b to its fx reserves in the third quarter?

October 14, 2007

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Chinese reserve growth, on the surface, seems to be slowing.   The q3 headline increase was “only” $101b – down from $135b in q1 and $130b in q2.  

The actual slowdown is even more dramatic.    If China has around 30% of its reserves in euros, pounds and other currencies it held about $400b of those currencies in September – when the dollar’s value dramatically increased the dollar value of those holdings.     I would estimate that valuation gains alone added about $20b to China’s reserves in q3.    

The valuation-adjusted increase in China’s reserves consequently came in at $82b in q3 – $45-50b below the total in q1 and q2.    So something changed.

The fall in reserve growth came even as China’s trade surplus increased to $73b (relative to $66b in q2 and $46.5b in q1).   China’s current account surplus has been about $15b above its merchandise trade surplus (in no small part because of the interest income on its reserves).  If you add $15b in known FDI inflows to an very-roughly-estimated $88b q3 current account surplus, China’s basic balance was around $103b.

“Only” $82b in valuation-adjusted reserve growth consequently implies about $20b in “hot money” capital outflows.   

Or perhaps large FDI outflows from Chinese firms investing abroad.

Or, most likely, China’s new investment company -- the CIC -- bought some reserves from the PBoC.      

After adjusting for valuation gains, China only added $10b to its reserves in September – the lowest monthly total since early 2004, and well below the $35b expected from the trade surplus, interest income and FDI inflows.    That suggests to me that a significant sum was shifted to the CIC. 

We just don’t know how much.   China has not – to my knowledge – provided a detailed accounting of the sources of its very strong reserves growth in q1 and q2, or for that matter a clear explanation for its very subdued reserve growth in late 2006.    But there is little doubt that fx swaps with the banks shifted some reserves off the central bank’s balance sheet in 2006, and that some of those reserves returned to the central bank’s balance sheet in early 2007.    But without more details, it is hard to know how much true “hot money” is flowing into China.

In q2 China’s valuation-adjusted reserve growth was about $30b more than implied by the sum of its roughly estimated current account surplus and FDI inflows.     Let’s assume another $30b entered China in q3.    Expected reserve growth would then be around $133b, or about $50b more than what China reported. 

Consequently, I would estimate that $50b was shifted to the CIC. 

I could though make a case for more; look at all the money that flooded into India and some other emerging economies in September.   And China’s equity market is even hotter than the Sensex.   Plus the CIC sold has sold RMB 700b (a bit over $90b) in bonds – mostly, though not entirely, through a special placement with the central bank facilitated by the Agricultural Bank of China.   Consequently, the CIC could easily have bought more than $50b from the central bank if it wanted to. 

Or I could make a case for less.   There are other potential sources of drain on the PBoC’s reserves – notably overseas acquisitions by Chinese companies and Chinese purchases of foreign stocks.

Logan Wright – who blogged at Survived SARS before taking a real job at Stone and McCarthy – notes that the rise in RMB interest rates encouraged Chinese firms to borrow in dollars.  He thinks this may have held down reserve growth, as banks who previously sold any dollars they bought from Chinese exporters to the central bank as soon as possible held on to the dollars and used them to finance dollar-based lending.    


Domestic foreign currency lending – according to Wright – is rising.   If Chinese firms can borrow in dollars at say 6% and if the dollar is expected to depreciate by say 5%, Chinese firms effectively can borrow in dollars for domestic investment at around 1% -- well under the RMB lending rate.    

That creates a strong incentive for them to borrow in dollars – whether from banks abroad or from the local banks -- to invest domestically.    

China has to rely on its capital controls to contain such pressures.  Those controls limit the ability of both banks and firms to borrow abroad.   

However, I don’t quite see why it makes sense for any bank to lend out dollars at 6% if it doesn’t have a source of dollar financing.    Taking in RMB deposits, trading the RMB for dollars, and then lending the dollars at US interest rates seems like a recipe for a bank to lose money …   

The bank lends in dollars at 5-6%.  If the dollar depreciates by 5-6% (the expected depreciation in the NDF market), the bank’s RMB return on the loan is close to zero.  The dollar’s depreciation offsets the interest income.   And even Chinese banks have to pay some interest on their deposits. 

The CIC faces a similar problem.  Say the CIC borrows in RMB at 3% and the RMB is expected to appreciate by 5% against the dollar.  Its effective cost of dollar financing is around 8%.    You cannot get 8% returns with a “safe” portfolio.   Borrowing at 8% to buy bonds that yield 4-5% is a sure way to lose money.   Borrowing at 8% to buy bonds that yield 8% only works if there are no defaults …

One last, related point.   If exports and imports grow at the same pace in q4 as they did in September, China’s 2007 trade surplus would be around $280b.   That though seems a bit high; it implies monthly trade surplus of over $30b in q4.   

And there is a good reason to think that mechanically projecting out current rates of import growth will understate Chinese imports in q4.    Last year, the price of oil fell sharply in the fourth quarter, lowering China’s import bill (and creating a small base for the y/y comparison).   A similar fall in the price of oil doesn’t seem to be in the cards this year.   $80 a barrel oil will cut into China’s surplus even as it adds to the oil surplus.   A $260b trade surplus looks a bit more likely – 

That could pull the 2007 current account surplus down to around $350b.

A lot though depends on how much the income balance increases.   China has $1435b or so in reserves.  It has – or rather had -- another $67b at Central Huijin.   The CIC now has that $67b and probably a bit more – maybe $50b – that it recently bought from the central bank.  The banks may have $100b, if not a bit more, in international debt.   And all that is collecting interest …

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