RGE - Richard McGregor on China’s (huge) reserves

リンク: RGE - Richard McGregor on China’s (huge) reserves.

Richard McGregor on China’s (huge) reserves
Brad Setser | Sep 25, 2006
The one trillion dollar mark is a perfect hook. Richard McGregor's excellent story in today's FT is the first of no doubt many stories on China’s phenomenal stockpile of reserves.

McGregor highlights my argument that the composition of China’s reserves is a second order issue, at least from China’s point of view. Shifting reserves from dollars to euros won’t prevent China’s central bank (the PBoC) from taking losses if the RMB appreciates against both the euro and the dollar. And, as my regular readers know, the RMB sure looks undervalued against the euro. The size of China’s capital losses will be primarily a function of the size of China’s reserves – not the composition of China’s reserves.

But that is not the reason to read McGregor. I don’t have any influence over Chinese policy. But a lot of the other folks that McGregor quotes do. He provides a great window into the internal Chinese debate, and that is really the only debate that matters.

What struck me?

The PBoC’s worries that it will be blamed for taking big losses on its foreign exchange portfolio, even though those losses were basically “baked in” -- to use Dr. Swagel's phrase -- at the moment China bought its current holdings of dollar bonds at an inflated price.

The PBoC’s concerns are understandable. The last Chinese reserve manager who took large losses (by betting on the euro a bit too quickly) took those losses hard. And the Bank of Korea has come under pressure for the capital losses (more here) it has taken as the won has risen against the dollar.

At the same time, so long as the state council instructs the PBoC to resist pressure for the RMB to appreciate against the dollar, losses are unavoidable.

China Foreign Exchange’s Mr Zhong is right:

“We cannot blame the US Treasury [for future losses]” he says. “No one forced us to buy dollars.”

I think McGregor’s reporting on China’s internal debate– which really is worth reading closely -- raises two important issues.

First, China’s large financial stake in the US economy could be a source of future tension, not a source of shared gains that lubricates the overall US-Chinese relationship.

The argument that China’s huge holdings of US debt (which now dwarf US FDI in China) give it a stake in America’s success is a bit off. It is true, but it misses a key point. The interests of a creditor are not always the same as the interest of a debtor. China (at least its central bank) would rather see the US take policy actions that minimize the scale of China’s capital losses by minimizing the needed adjustment in the RMB/ dollar. The US, on the other hand, has traditionally taken the view that the dollar is our currency but your problem --- it has never promised to direct its policy to maintaining the dollar’s external value. And it certainly has never promised China that if China keeps financing the US, the US will look after China’s financial interests.

That could be a point of future tension, particularly if the PBoC starts taking capital losses and feeling the heat.

Second, I think DeLong may be underestimating the costs of China’s current policy. He argues that China is basically taking a one-off 3% of GDP capital loss (on its 10% of GDP annual reserve accumulation) in exchange for a permanent increase its exports and its income. I would argue that sustaining China’s current level of exports requires ongoing financial flows from China to the US. If Chinese reserve growth slows and China stops financing the US, the US wouldn’t be able to afford its current imports from China. Consequently, China has to take an annual capital loss to sustain its current (inflated) level of exports.

China doesn’t just have a $1 trillion in reserves. It has put itself on a course that requires adding at least another $1 trillion to its reserves over the next four years. I actually suspect the pace of Chinese reserve accumulation might pick up to around $300b a year, which would imply Chinese reserve would hit $2 trillion in 2009.

Basically, I suspect that China will need to keep financing the US (on subsidized terms that imply losses for the PBoC) even after the pace of Chinese export growth slows – just to sustain its already high level of exports.

That raises another point where I think I differ from DeLong. DeLong argues that China’s policy of using the balance sheet of its central bank to subsidize its exports has generated a permanent increase in China’s income. I would argue that it more likely has pulled China’s future export growth (and investment growth) forward – very, very rapid export growth now will likely be offset by far slower export growth in the future. And very, very rapid investment growth now likely will be offset by far slower investment growth in the future. That means a higher level of income now, but not necessarily a higher level of income in 10 or 20 years.

Given the size of the PBoC’s balance sheet -- $1 trillion is a bit under 40% of China’s GDP – and the impact China has had on the world economy, these questions obviously matter, for both China and the world.

Comments

What would be the consequences of China choosing to use say 25% of its reserves to fund health care, unemployment insurance, and a social security system?

Would this allow China to revalue the currency by lessening the political consequences of a slump in export led growth?

thanks!

Written by camille roy on 2006-09-25 11:24:08
there's a plan to do that with SOE dividends...

"The World Bank notes that a 50 per cent pay-out would have allowed the government to increase health and education spending by 85 per cent in 2004. Better welfare provision might give Chinese savers an incentive to switch into riskier assets like equities. For the SOEs it would lead to more disciplined investment, thereby boosting returns." http://www.ft.com/cms/s/183caec8-46f7-11db-83df-0000779e2340.html

Written by Guest on 2006-09-25 11:34:56
China will soon join Japan in the "Dollar Hegemony Victims Anonymous" club.

The whole process reads like a script:

1. China bases its economy on exporting to the U.S.

2. The U.S. (The "Mouth of the World")accepts Chinese real goods and offers "Gladly Pay You Tuesday" bonds denominated in U.S. "Gladly Guarantee You Nothing" dollars.

3. China, also practicing terminal fractional reserve lending and central banking (piled on top of their reserves of "hard currency", ha, ho, ha, ho, ho, don't make me laugh!!! "Hard currency"!!! Man, if THAT isn't an Orwellian oxymoron, I don't know what is!), over-expands, mal-invests in plant, equipment, real estate projects--you name it, only to create it's OWN boom/bust cycle.

4. Sooner or later (but probably sooner) China suffers a Great Depression/Japanese Bust of its own. Hundreds of Billions of Yaun/Rmb loans are defaulted, tens of millions of people are thrown out of work, real estate crashes--you know the drill.

5. Meanwhile, the U.S., if it also doesn't fall into a deflationary abyss of its own, skips merrily down the road, finds another sucker, er "emerging market" to begin the cycle all over again. However, the game is getting more dangerous for the U.S. as:

a. The U.S. consumer is up to his/her eyeballs in debt, much of it collateralized by falling home prices.
b. The "Rest of World" that currently holds a net $4 trillion in U.S. debt just might be getting nervous.

Now, having been screaming for years that "This can't go on!", only to see the whole, bizarre Ponzi scheme find yet another way to perpetuate itself (including the $400 trillion in derivatives bets which I suspect have a nefarious background), I am cautious about stating unequivocally that "This is it.". However, I will state for the record that at some point the U.S. will reach debt saturation or the "R.O.W." will demand higher interest rates, or stop buying U.S. treasuries/agencies, or God-forbid, actually SELL said securities!!!

Written by Butch on 2006-09-25 11:35:02
China cannot directly use its reserves to finance a safety net.

It could borrow funds domestically to finance a safety net (i..e increase the government's fiscal deficit) or finance a safety net out of dividends (reducing business savings). the net effect should be lower national savings -- which, assuming everything else is unchanged -- would lead to a smaller current account surplus/ less need to continue to add to China's reserves.

Olivier Blanchard's paper is great on this topic -- i recommend it.

Butch. I thought so too. At least worried about the risk. About two years ago. I am still waiting for the saturation point though.

Written by bsetser on 2006-09-25 12:13:25
The FT article is thought-provoking -

(a) If the Chinese government actually buys the Stiglitzian theory that accepting American pressure to adjust will lead to China becoming like Japan in the 1990s, there will be strong resistance indeed. If this is the case, join me in the Reserve Pumpkin Patch to watch for the Great Revaluation Pumpkin;

(b) I was going to be Mr. Wiseguy about currency composition mattering less than total accumulation by suggesting that the PBoC buy more JGBs, but then it would be a tradeoff between accepting minuscule yields while waiting for the $ shoe to drop;

(c) Er, what sorts of "risks" are they talking about? China isn't going to endure a BOP problem or a speculative attack anytime soon. Also, a local banking crisis we've learned from RGE cannot be remedied with greenbacks. From the FT article:

The sheer size of the reserves has been the trigger for the new debate about how else the money might be deployed. According to some local analysts, Mr Zhou’s crisp comment – that China has “enough” reserves – is better read as one of a number of signals coming out of the central government that Beijing has settled on an amount it needs to set aside as reserves in the traditional sense, as a national insurance fund against financial risk.

Xia Bin, an economist at the Development Research Council, a think-tank under the State Council, the cabinet, has suggested China needs about $700bn in foreign reserves to this end.

(d) Why does DeLong think that this export-driven reserve accumulation pattern adds to China's GDP permanently? A global recession is unlikely to guarantee growth rates of even 5% as he assumes, and has a good chance of throwing China into reverse gear.