The PBoC announced yesterday that total reserves at the end of June reached $1.809 trillion (around 45-50% of annual GDP). Brad Setser wrote an excellent post on this topic yesterday, and although we have some disagreements on specific numbers, they are pretty small and my conclusion doesn’t differ much from his. Still, I think it is worth making a few points.
We’ve had $153.9 billion growth in the first quarter of 2008 and a $126.6 billion growth in the second. The PBoC do not release monthly figures officially, but we get pretty good unofficial leaks and, according to today’s Xinhua, this implies that reserve increases in the month of June were $11.9 billion.
Given that the trade surplus and FDI for the month were $21.3 billion and $9.6 billion, respectively, June’s $11.9 billion number is almost certainly going to cause some unnecessary excitement about flight capital. June’s increase is the lowest monthly increase in a long time, and a lot less than the $54 billion average for the first five months of the year, but most of us were expecting June’s number to be a lot lower than average – in my July 9 entry I guessed it would be about $20 billion. The main reason for this was June’s 100 basis point increase in minimum reserve requirements, which we believe was redenominated into dollars, thus bringing headline reserve growth down by about $45 billion.
That means the actual amount of net inflows purchased and monetized by the PBoC in June was actually around $57 billion, which is a lot lower than the $67 billion average for the first five months of the year, but this average number includes the two extraordinary months of January and April. Excluding these, June’s numbers are fairly typical. The table below shows what really happened, as far as I can piece it together:
|Headline reserve growth||154||75||40||12||281|
|Adjusted reserve growth||183||93||58||57||391|
|Transfer to CIC||75||–||–||–||75|
|Adjusted reserve growth||258||96||58||57||467|
We shouldn’t be too concerned with interpreting changes in the month-to-month data because there are timing lags and accounting transactions that we don’t know about, but in the aggregate the total increase in reserves this year would have been about $465-70 billion if nothing had been “outsourced” to proxies, more than last year’s total increase in headline reserves of $462 billion. About $60-70 billion of this did not need to be purchased by the PBoC because it represents valuation gains and interest income on their portfolio.
Of the roughly $400 billion that the PBoC did purchase this year (thereby creating domestic money and central bank bills for an equivalent amount), the relatively stable FDI and the trade surplus accounts represent about 38%, with the rest consisting of other inflows, including hot money. I estimate that FDI has about $15-20 billion of hot money and accelerated disbursals buried in the numbers, and the trade surplus should have at least $10 billion of disguised hot money inflows (assuming average under- and over-invoicing equal to just 1% of total exports and imports), which suggests that trade and FDI may account for significantly less than one-third of the money the PBoC was forced to purchase.
What was the rest of the $260-70 billion or so? Some of it represents official loans, transactions on the services account, income on investments, and a bunch of other things, but clearly there is a lot of other, less stable, money coming into China. Is it hot money? That depends on what you mean by hot money. If you define hot money as any money that came into China or whose disbursal was accelerated largely because of rising RMB expectations, than a lot of this is “hot”. If your definitions are more restrictive – money that can come in quickly or leave quickly – less is “hot”, but Logan Wright’s guess of $160-180 is not unreasonable, and is perhaps even a little low, since he doesn’t count hot money buried in FDI and trade.
Yesterdays’ data release had unfriendly implications for today’s stock market. After a decent day Monday (up 0.7%) the market today took a beating today, with the SSE Composite closing at 2779, down 3.4% for the day. The decline was probably partly caused by mortgage fears in the US (insurance companies and banks, who may be big holders of Freddie Mac and Fanny Mae, led the declines), but worries about a slowing domestic economy were likely to be the biggest concern.
There has been mixed news on the whether or not inflation is still the top worry. There have certainly been a lot of statements that suggest that the authorities are very worried about a slowdown, and even some suggestions that they are willing to put the fight against inflation on hold, but a statement released by the NDRC yesterday, in which they said that “upward pressure on prices remains strong” seemed to dampen at least some expectations that the government would loosen up on the monetary side.
I am still a monetary pessimistic. I think the balance of opinion, or at least the opinion that matters, is tilted towards putting inflation-fighting on the back seat and worrying more about a possible slowdown. I am worried that our inflation respite is going to be temporary, and certainly the data on money inflows doesn’t make it easy to be optimistic about the ability of the PBoC to control inflation.
On the other hand today’s Sydney Morning Herald has a very interesting article by John Garnaut (“Chinese calls for yuan rise to ease inflation”) that was sent to me by Jonathan Lerner, and I haven’t seen any other reference to the story. The article starts out:
A GROWING number of top Chinese economists are advising their Government to consider a currency revaluation to fight persistent inflation and destabilising “hot money” capital inflows. “The Chinese currency should be revalued as China’s productivity is increasing,” Professor Fan Gang, a member of the central bank’s monetary committee, wrote in a paper that he was to present to the China Update conference in Canberra before being held back for a last-minute meeting with the Prime Minister, Wen Jiabao.
In recent years currency revaluation has been a taboo topic among Chinese policy makers.
The article goes on the quote He Fan, the assistant director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, telling Garnaut that “They don’t need to say they are floating the exchange rate but they can at least test the market’s view. With a one-off appreciation by 10 or 15 per cent, maybe the market will believe that’s the end of the story. But maybe the market will still not be satisfied.”
There have been more and more think-tank and quasi-official comments recently about the one-off appreciation, and I suspect that the debate is fairly intense. Yesterday evening I was with another senior think-tanker, who I have met several times on Dialogue and who has a very sophisticated view of the Chinese economy. He told me flatly that the only hope of protecting China from the ravages of hot money was to peg the currency. Since pegging it at these levels would be problematic for many reasons, he said that the PBoC should “surprise” everybody by first revaluing, and then pegging. He told me that he thought the revaluation should be 5-10%, but agreed that this might be too little.
The Sydney Morning Herald article goes on the describe something that I think is extremely important and has perhaps been under-emphasized in the debate – the destabilizing impact of excessively loose monetary policy on the banking system. Referring to the pressures on bank profitability caused by PBoC strategies to mop up liquidity, the article says:
Mr He said the main state-owned commercial banks were already devoting between 30 per cent and 40 per cent of their assets to such loss-making endeavours. This was creating “ugly” bank balance sheets and encouraging the banks to recoup profits with “dangerous” lending policies that might ultimately jeopardise financial stability and the Government’s efforts to clean up non-performing loans
In his paper, Professor Fan writes that analysts have “correctly and convincingly” highlighted “structural distortions caused by repressed interest rates and an undervalued currency” which “may also lead to economic, financial and social problems”. His comments are significant because Professor Fan was previously a staunch defender of the status quo. Nevertheless, a one-off revaluation is unlikely in the near term because China’s export sector is suffering from a downturn in their major developed-world markets and struggling to cope with rapidly rising input costs.
The idea of “dangerous” lending that is likely to be caused by excess control of parts of the system (their forced piling up of PBoC bills and minimum reserves) and by current monetary and credit conditions is something about which I have had a surprisingly hard time arguing, both with Chinese and with foreign analysts. I am not sure why, since in most markets this is fairly well understood, and given the ongoing crisis in the US, the idea that seemingly smart banks can do some pretty dumb things during optimal times is getting quite a lot of newspaper coverage.
None of this is new. Hyman Minsky in particular, has long argued that it is impossible to protect financial systems from periodic crises because the very conditions designed to prevent instability are the ones that create the incentives for bankers to take excessive risk – usually in less well-monitored areas – that end up ensuring that at some point the system will go through a period of “adjustment” and distress. The empirical evidence that loose monetary conditions and implicit or explicit credit guarantees lead to banking crises is also pretty ample.
I can’t prove it, of course, and no one will be able to prove it until we have our own contraction, but I would be willing to bet that over the last few years the banks and the financial sector in China have been engaging in behavior that will one day seem self-evidently dangerous. That is both the biggest risk of a sudden revaluation and the strongest argument for doing it as soon as possible.