Is China Losing Its Appetite for External Surpluses?

After years of piling up huge foreign exchange reserves, China is increasingly seen by many analysts as entering a new phase. These analysts, who have been examining new data on China’s official holdings of foreign exchange reserves, have concluded that China is now experiencing substantial capital outflows and that Chinese reserve growth has essentially stopped. The Wall Street Journal has gone so far as to state that the outflows are so massive that Chinese authorities are “in the unusual position of having to rebuild market confidence in the strength of one of the sturdiest Asian currencies.” For the United States, according to the analysts, the implication is that since China’s external surplus is no longer growing, China’s purchases of US securities will slow dramatically.

Analyzing China’s foreign exchange reserves is an art rather than a science, in part because of the lack of transparency in China’s accounting of its reserves. Periodically the central authorities have entered into swap agreements with banks, which push the holdings of dollars and other foreign currencies purchased by the authorities in the foreign exchange market into the banks and out of reserves.

And starting in September 2007, whenever China’s central bank has raised the required reserve ratio for banks (the share of bank deposits that must be deposited with the central bank and thus cannot be lent) it has also mandated for the larger banks that the increase in reserves be deposited in foreign exchange rather than in domestic currency. So the central bank has the foreign exchange, but the amount is not included in the reserve figures.

Of course, swap agreements expire and more recently the central bank has reduced the required reserve ratio, so the effects on official reserve holdings can be reversed. But tracking these changes real time is difficult since the swap agreements are only disclosed by the banks after a long time lag. The magnitude of official foreign exchange reserves, which is reported in dollars, is also affected by changes in the value of the euro, the Japanese yen, and other currencies vis-à-vis the US dollar. When these currencies depreciate (or appreciate) vis-à-vis the dollar, the reported magnitude of official foreign exchange reserves falls (or rises) even when there has been no change in the foreign currency denominated assets held in the official foreign exchange reserves. But estimating these valuation effects is difficult since the central bank does not disclose the composition of the foreign currencies in which reserves are held.

Officially reported reserves at year-end 2008 were $1.9 trillion, a mere $40 billion increase compared to the figure at the end of September. In contrast, the average quarterly increase in reserves in the first three quarters of the year was $126 billion. Taking into account the trade surplus in the fourth quarter ($114 billion) and foreign direct investment inflows, and then adjusting for some of the other factors mentioned above, many analysts concluded that there were large outflows of “hot money” (money that chases higher interest rates) in the fourth quarter, “big, scary FX outflows,” according to Standard Charter’s report of January 14.

But the recent analyses and news reports appear to overlook the use of foreign exchange to clean up the balance sheet of the Agricultural Bank of China (ABC). The ABC is the last unreformed, large state-owned bank. It acknowledged that its nonperforming loans at the end of 2007 were RMB 818 billion, almost a quarter of its loan portfolio. But by the end of November 2008 ABC had shed RM 800 billion in nonperforming loans and its nonperforming loan ratio was down to 4 percent. If official reserves were used to clean up ABC’s balance sheet, then it would be the case that official intervention in the foreign exchange market was much greater than suggested by the modest increase in reserves. And the true magnitude of foreign exchange reserves expanded substantially more rapidly than the reported $40 billion increase in official reserves in the fourth quarter of last year. Thus the conclusion of Brad Setser that “Chinese reserve growth has essentially stopped” may not be warranted and the Wall Street Journal’s assertion that China is now faced with the challenge of restoring market confidence in the renminbi may be a vast exaggeration. The details, for those that are interested, follow.

The Chinese language People’s Bank of China (PBOC) reports of January 13, 2009, and December 15, 2008, (available at on lending by Chinese banks in November and December used the phrase “an kebi koujing,” i.e., “according to comparable scope,” when they give the percentage increase in RMB lending compared to the same month in the prior year. This phrase did not appear in any of the earlier monthly PBOC reports in 2008. PBOC has used this phrase in the past when there was a discontinuity in the time series data on loans outstanding. Specifically it was used a number of times in the late 1990s and again a few years ago at the time of the restructuring and listing of three large state-owned banks. On these occasions there has been a significant reduction in the volume of loans outstanding from the financial system due to a centrally financed write-off of nonperforming loans. Thus the numbers on loans outstanding before and after these write-offs are not comparable.

Specifically, the January 13 report said that RMB loans outstanding at year-end 2008 were RMB 30.35 trillion, up 18.76 percent in “comparable terms.” That implies that loans outstanding at the end of 2007 were RMB 25.56 trillion. But prior reports placed that number at RMB 26.17 trillion. I believe that means that write-offs of loans in 2008 must have been about RMB 610 billion. An analysis of the December 15 report implies a somewhat higher number, around RMB 720 billion. These numbers are roughly consistent with the reported RMB 800 billion reduction in nonperforming loans of the balance sheet of the ABC by November 2008 compared with year-end 2007 on the assumption that a portion of the write-offs was financed from ABC loan loss reserves.

This large amount of write-offs is almost certainly in connection with the restructuring of the Agricultural Bank of China. The bank was converted in the fourth quarter last year to a shareholding ownership structure, in advance of a hoped-for initial public offering. In November the authorities reported that Central Huijin had injected $19 billion dollars (equivalent to RMB 130 billion) to bolster the capital of the bank. This is the same model followed earlier by the Industrial and Commercial Bank of China, the Bank of China, and the China Construction Bank. At the time those banks were restructured, there was a centrally financed (via Central Huijin) write-off of nonperforming loans and an injection of capital to clean up the balance sheet of these banks prior to listing. Foreign exchange funds were used in these transactions, meaning bank holdings of foreign exchange went up and official holdings in foreign exchange reserves went down.

In the past clean ups of the balance sheets of state-owned banks, the forex used was not transferred from official reserves to Central Huijin (which is now part of the China Investment Corporation, China’s sovereign wealth fund) until just before the clean up was undertaken. I believe this practice has not changed and that centrally funded write-offs of nonperforming loans of the Agricultural Bank of China could account for $90 billion to $100 billion of the “unexplained capital outflow” in the fourth quarter of 2008. Thus the combined centrally financed injection of capital, which has been reported, and nonperforming loan write offs, which have not been reported, for the Agricultural Bank of China could have reduced officially reported official foreign exchange holdings by $110 billion to $120 billion.

Thus, I believe the conclusion that Chinese reserve growth has stopped may be incorrect. Properly accounted, it appears that official intervention in the foreign exchange market has not waned and reserve build-up has not stopped. The increase in reported reserves in Q4 is probably significantly understated (as it has been at several times in the past) because of the transfer of forex from official reserves to Central Huijin for bank recapitalization, i.e., actual exchange market intervention and reserve build-up in Q4 was $110 billion to $120 billion more than implied by the official data. And the “unexplained” outflows of “hot money” in the fourth quarter of last year, estimated at $164 billion and $150 billion by Brad Setser and Standard Charter, respectively, may be far too high.

Originally published at the Peterson Institute and reproduced here with the author’s permission.