from Follow the Money

Zhou v. Spence (and all the steps Zhou is taking to manage China’s surging surplus)

January 8, 2007

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Casual conversation and commentary lead most Americans to think that this accumulation of reserves corresponds to a large trade surplus in China, achieved by holding the value of their currency down. In fact, the Chinese trade surplus is not that large.


``The data from 2006 show that China's trade surplus has been increasing, and if this situation continues, then I think the flexibility of the exchange rate will be increased,'' People's Bank of China's Zhou told reporters in Basel, Switzerland, today during the bi-monthly meeting of central bank governors from the Group of 10 nations.

Reuters even reports, based on Zhou’s comments, that China “has accumulated a huge current account surplus -- notably with the United States -- that has reached about 9.2 percent of GDP in 2006.”   That is large in my book.

Zhou is, of course, the Governor of the People’s Bank of China.  He sees more data than the rest of us.   I’ll take his word on this. 

China’s 2006 trade surplus (customs basis) is now estimated at $177b, a level that implies a current account surplus in the $230-240b range. We should know the 2006 trade number soon enough (see Business Week for more) China will release its trade data later in the week.   Moreover, if the expected y/y export and import growth rates for 2006 are projected out through 2007, China’s trade surplus will rise even further.   Exports are expected to be up 27% y/y and imports up 20% y/y.   Apply those growth rates to China's growing export and import base, and China’s 2007 trade surplus could surge by $100b, to (gulp) $280b.   That seems high, but the y/y growth rate so far in the fourth quarter has actually been well above 27%.

China’s rising trade and current account surplus suggests to me that China’s current policy framework – one based on very controlled RMB appreciation while maintaining a stable rate of inflation – requires, as Martin Wolf has argued, that Chinese policy makers adopt policies that keep Chinese savings above Chinese investment.  For example, China has relied on controls on bank lending rather than RMB appreciation to keep China’s overall economy from overheating and inflation from rising.   And despite Zhao’s encouraging comment about increasing flexibility in the exchange rate, it isn’t clear that China is really ready to let the exchange rate move enough to matter.

Zhao presumably already knows something I would love to know: how many dollars and euros the PBoC had to buy in November and December to keep the RMB from rising by more than it did against the dollar.

My guess is that it took a lot of intervention.  China’s rising trade surplus is now the primary source of China’s rapid foreign exchange reserve growth -- and China’s q4 trade surplus should top $65b. There are plenty of indirect signs as well.  The PBoC will be conducting a huge auction of central bank bills this week.  It also recently raised reserve requirements to try to take some of the RMB it has sold as it buys dollars out circulation (sterilization).    Denise Yam of Morgan Stanley reports that the Chinese banks now have a stunning RMB 3.8 trillion (@ $500b) on deposit with the PBoC. 

China is now practically begging Chinese citizens to move more of their savings abroad.  China once again loosened controls on capital outflows, while showing no sign of loosening controls on inflows.  Even inflows from China’s own state banks. That tells me something. 

The Chinese don’t want the RMB to rise too fast.  The PBoC doesn’t want its reserves to rise too fast.  The only way to square that circle is to convince someone else in China that they want the dollars and euros the PBoC doesn’t want. 

Yet if the RMB rises by 4-5% against the dollar – as the market now expect – it isn’t clear why private Chinese savers should want to hold dollars.  A 5% dollar depreciation would wipe out the roughly 5% you get on Treasuries; you are better off holding RMB deposits even if they only pay 2% and change.  And with the Chinese stock market now rising faster than the US market, it isn’t clear that Chinese savers want US stocks either.  My guess is that Chinese citizens – who put $17b into domestic mutual funds in 2006 – are more keen to buy Chinese stocks than US debt.    

Sure, “private purchases” of foreign debt by Chinese citizens rose in 2006, or at least in the first half of 2006.  But that rise seems to reflect purchases by state banks, pension funds and insurance companies trying to help the PBoC out (The FT: “Stephen Green at Standard Chartered said there was a $45bn outflow of investment in the first half of the year, mostly from Chinese banks, which reduced some of the strain on the authorities. “Some people are wondering whether informal pressure was exerted on the banks to take funds offshore”).  I also would bet -- and it is nothing more than hunch -- that the Chinese did some swaps with the banks to keep the PBoC’s reported reserves down and give the banks more dollars to play with.  The banks like swaps because they get dollars without having to take the exchange rate risk.   China’s Development Bank is ready to lend dollars to any Chinese firm looking to expand abroad. 

The absence of evidence suggesting that private Chinese citizens want to hold foreign assets rather than Chinese assets is the major problem I have with now very trendy academic theories arguing that emerging economies cannot create financial assets fast enough to keep up with the demand for safe financial assets that arises as their economies grow.   These theories argue that emerging market financing of the US is natural consequence of fast growth in economies that cannot create a store of (financial) value that their citizens want to hold.

But the data I look at seems to suggest the opposite.  Recently China has had no trouble creating financial assets its citizens want to hold.  Rather China seems to be having trouble convincing its citizens (and its banks) that they want to hold dollars. 

China’s banks have had no trouble creating financial assets – call them deposits – that Chinese citizens want to hold.    And they have had no trouble offsetting their liabilities (deposits) with loans.  The current constraint on the bank’s ability to back deposits with loans collateralized by new construction is very clear: the central bank.  It won’t let the banks lend out all the money Chinese citizens have voluntarily placed on deposit in the banking system because of concerns about excessive investment growth and the like.  

Some argue that the PBoC is effectively holding Treasuries for private Chinese citizens who are precluded from owning dollars by China’s capital controls.  But the data indicating repressed private Chinese demand for Treasuries and safe dollar assets seems pretty thin to me.  China's controls leak – and there isn’t any real sign that Chinese citizens are desperate to move funds out of the banks any more.   There was, by contrast, good evidence that Chinese citizens did want to move funds abroad in 99 and 00, after the Asian crisis.    But those funds came home in a big way in 2003 and 2004.    And they don't seem to be leaving now even though Chinese interest rates are well below US and European interest rates.

Domestic household dollar deposits have been trending down as a percentage of total deposits over time (this news story is old, but it is indicative – back in 2005, China raised the interest rate on domestic dollar deposits to encourage its citizens to hold dollars rather than shift into RMB).    Domestic interest rates have been held below dollar and euro interest rates.   Controls on outflows are being loosened. And yet Chinese citizens still aren’t moving enough money offshore to keep the central bank’s reserves from growing faster than the PBoC wants.

Rather than keeping Chinese funds out of the international financial system, China’s controls increasingly keep international funds out of the Chinese financial system.  2-3% from Chinese state banks and 4-5% appreciation tops the current yield on Treasuries. 

That isn’t the conventional view, I know.  But I would argue that it is the view that best fits the available data.   Outflow controls are being loosened.  Inflow controls are not. Chinese interest rates are lower than US interest rates -- and China banks would still rather hold RMB than dollars.   I doubt the banks are alone.

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