Martin Wolf’s series of columns on China has stimulated quite an interesting debate. I have been meaning to highlight it for some time – especially since it prompted Yu Yongding to lay out both his thinking on how China should contribute to global rebalancing and his thinking on the difficulties China faces sterilizing its ongoing reserve growth.
Sterilization is how China keeps its growing reserves from leading to excessive growth in China’s money supply. When China buys a dollar, it effectively trades the dollar for RMB cash. The central bank then either sells debt to remove the cash from circulation. At the end of the process, China’s public ends up holding debt issued by the central bank and the central ends up holding a dollar (which is usually invested in interest bearing US securities) – there is no increase in the money supply.
In response to a comment suggesting that there were few limits on China's ability to sterilize ("Sterilization .... is not merely feasible, but even highly profitable, if one is prepared to ignore the risk of a large ultimate capital loss"), Yu writes:
I am afraid this is not the case. It is not just a matter of capital loss vis-à-vis profits for the PBOC. First, the equity-debt swap in the form of FDI inflows vis-à-vis purchasing US treasury bills will create welfare losses for the nation, despite the profit made by the PBOC in implementing sterilization policy. Second, the continuation of large-scale sterilization by forcing banks to buy low yield central bank bills will damage the profitability of the banks and financial efficiency. Owing to the fear of speculative capital inflows that will increase RMB appreciation pressure, the PBOC somehow has to force commercial banks to buy over-priced central bank bills so as to avoid forcing up interest rates in the money market vis-à-vis the Federal funds rate.
It is very telling that there are many occasions in auctions when the PBOC fixed the price of the central bank bills, the PBOC failed to sell out bills according to plans. As a result, the share of low yield assets in the total assets has been increasing in banks, which in turn will lead to the worsening of banks’ performance. In other words, China is facing a “trilema”: tight monetary policy, good performance of banks and stability of RMB exchange rates. In the past three years, the PBOC has raised reserve requirement rate five times so as to lessen the burden of sterilization. The eventual consequence of this policy measure is the same as the selling central bank bills to banks: lowering financial efficiency.
Yu’s conclusion: There is no way China can fully sterilize its ongoing reserve growth least not without jeopardizing the health of the banking system. Such difficulties are no doubt one reason why China seems to be seriously considering the creation of an investment company to manage some of China's foreign assets, a topic that Simon Derrick and Neil Mellor of the Bank of New York have covered better than anyone.
Yu’s comment in Wolf’s forum is important for two reasons: 1) If China is going to change its exchange rate policy, the most likely impetus is some combination of difficulties sterilizing its rapid reserve growth along with quiet external pressure – a combination that would lead China’s leaders to take on the (strong) domestic interests in side China that support the status quo; 2) Yu was until recently a member of the PBoC’s monetary policy committee. He knows what he is talking about.
There presumably is a strong link between difficulties with sterilization that Yu describes and the very active debate inside China over the creation of an asset management company: an asset management company would be one way to limit the pace of increase in the PBoC's reserves, and thus to reduce pressure on the sterilization process.
Simon Derrick and Neil Mellor of the Bank of New York have been doing an exceptionally good job of covering the political economy of the fx market; they recognize that today’s market is heavily shaped by the actions of governments, not just the moves of private investors. In Derrick’s note on Monday, he noted that there is talk of a big Ministry of Finance bond issue to raise the RMB needed to buy fx off the central bank –
Economist with the Development Research Centre, Xia Bin, says: "The central bank itself is not fully capable of managing the foreign exchange reserves to meet long-term strategic requirements." He proposes that the Finance Ministry issue CNY 200-400 Bn) worth of bonds with at least 10-year maturities to buy foreign currencies from the central bank and invest them abroad. He argues that China's main economic problem is to balance its international trade. The PBOC needs just enough reserves to stabilise the exchange rate and should shift the rest to an asset management company.
He adds: "The conditions for such a move are ripe." Senior researcher with the Chinese Academy of Social Sciences, Li Yang, says: "Singapore, Hong Kong and South Korea all have professionals to control and manage their huge foreign exchange reserves. They are all managed by fund management companies with strong government backing." He also notes that China also needs to reform thoroughly its foreign exchange management system to help the PBOC carry out monetary policy. He adds: "There might be some changes to China's foreign exchange reserve management scheme, which would have a significant impact on China's economy and financial industry."
RMB 400b is only about $50b, so it isn’t huge relative to China’s reserves. But it is a first step
The central bank would be left with a stock pile of government bonds, which it would then likely sell in the ongoing sterilization process; selling government bonds for cash is an option to issuing new central bank debt and selling that debt cash. And the government would be left with a bunch of RMB debt and a bunch of foreign exchange, which it would give to a new investment authority.
The creation of such an investment authority by China – or, for that matter by the Saudis – would likely indicate a desire to diversify. Into equities to be sure. But I would be surprised if the US share of the investment authorities assets would be as high as the dollar share of the PBoC’s – and SAMA’s – reserves. Mellor and Derrick write today:
Although the initial amount apparently being suggested by Xia Bin to be hived off is a modest USD 25 Bn to USD 50 BN (according to MNSI), it is clear that this would just be the starting point for a more substantial allocation over time (given comments made over the course of this year about the ideal size of the FX reserves that the PBOC needs to hold). The longer-term currency implications of such a move are also relatively clear, as many of the voices calling for the establishment of such an agency have also been those calling for a more active shift away from the USD in the composition of the reserves.
But there is the little matter of China’s peg. So far China has been more willing to encourage private capital outflows to reduce pressure on the central bank than to allow the RMB to really move. Those efforts to encourage capital outflows have been surprisingly effective: so called hot money flows have reversed for reasons that remain a bit of a mystery to me (Stephen Green argues that China’s stalled property market is a reason – I am not so sure) and private Chinese purchases of US debt have soared. Those private purchases seem to come from the banking system – not from the qualified institutional investors plan.
But China seems set to encourage a series of state institutions – insurance companies, pension funds -- to joint the state banks in buying more foreign assets. That is one way to reduce pressure on the central bank, though it leaves these state institutions with a bit of exchange rate risk …
I understand the imperative to help the central bank. China’s 2007 current account surplus could easily top $250b, barring a major change. Net FDI inflows typically top $50b. China might attract additional portfolio equity inflows as well. So China will have at least $300b of additional dollars to invest in 2007, and maybe more. The PBoC does want to end up with all of them.
One issue though: decentralizing the management of China’s foreign assets – selling some of the PBoC’s fx to fund an investment authority, letting insurance companies and state pension funds hold more foreign assets, letting the state banks hold more dollars and so on – may reduce the share of the $300b plus annual inflow from the current account and net FDI inflows that China invests in dollar …
Which likely means further pressure on the dollar – and further pressure on the RMB if it follows the dollar.
I suspect Yu has thought of this as well. It is probably one reason why he thinks RMB appreciation is in China’s interest, even if he doesn’t think it will lead to a big improvement in China’s current account.