November 29, 2004

The Simple Arithmetic of China's Foreign Exchange Reserve Position

Brad Setser does the math:

Brad Setser's Web Log: Where is China keeping its reserves ...: China indeed faces a real dilemma. Not only does it have a large stock of dollar reserves, but that stock is growing. Yet the value of that stock is also likely to fall in the future. China’s over $500 billion in reserves are currently equal to about 1/3 of China’s [annual] GDP, so a 33% real appreciation of the yuan would generate capital losses equal to 10% of China’s [annual] GDP. That is a big loss, by any measure. Defending the peg right now requires reserve accumulation of $150 billion a year (in the third quarter, China’s reserves increased by almost $45 billion). If that continues, in four years, China’s reserves would easily exceed $1.1 trillion. China’s GDP is rising too – if the exchange rate stays constant and the IMF’s growth path is right, GDP will be @ $2.35 trillion in 2008. Reserves would then be equal to about 47% of China’s GDP.

A 33% real appreciation and reserves to GDP of 45% produces a capital loss of 15% of GDP. But that probably underestimates China’s future losses, since over time, the scale of the real appreciation China needs also is rising. China’s economy is becoming more productive very quickly -- and remember that Japan’s economic miracle in the 50s, 60s and 70s was accompanied by substantial real appreciation in yen. A 50% real appreciation produces a capital loss of above 20% of GDP. That is real money, even for fast growing China.

This is why what Larry Summers has called the balance of financial terror is fundamentally unstable. The “terror” aspect comes from the fact that is China were to start to sell (or just stop buying), the value of its existing holdings would fall rapidly and US interest rates would go up sharply. The balance refers to the fact that to date, China has opted to hold its Treasuries and other dollar assets, not to sell. But for the balance to stay stable, China literally needs to double its bet – and double the central bank’s expected loss -- over the next four years.

Posted by DeLong at November 29, 2004 11:45 AM | TrackBack
Comments

...and then we can go over the cliff together.

Posted by: bakho at November 29, 2004 12:08 PM

OK, but could someone please clarify--how would the central bank absorb the loss? Couldn't they just sterilize, buying PRC government bonds up to the yuan amount of the capital loss? (Or is the amount just too big?) And how would this affect the country's economy?

Posted by: Jim M at November 29, 2004 12:27 PM

Japan already holds nearly a trillion in Treasury obligations. China only holds about $180B (their dollar holdings might be $500B, but that must be mostly in very short term notes or essentially cash).

See graph from Economist:
http://infoproc.blogspot.com/2004/11/japan-china-uk-and-hedge-funds.html

I'm not sure what effect the paper losses would have on Japan or China if the dollar fell against the yen or renminbi. I suspect it is just the price of doing business as an export-driven developing country. (Why not just view it as having sold goods for a lower price than previously thought?) Japan has already been through something like this, as the yen today is worth twice what it was a few decades ago.

Posted by: steve at November 29, 2004 12:28 PM

Reserves/GDP probably isn't as useful as reserves/(imports+exports). Why the comparison to a dollar denominated GDP? Trade is growing more rapidly than output, isn't it?

And how diversified are China's reserves? Not enough, probably, but not all in dollars either. So why peg the analysis to renminbi/dollar?

Anyway, it's a good argument for more diversification.

Posted by: Jim Harris at November 29, 2004 12:42 PM

Gee, with all those reserves and potential financial leverage - you think they could "buy" Taiwan without the US complaining too loudly.

Posted by: peBird at November 29, 2004 12:43 PM

General Glut

China can avoid all capital losses by simply investing its "excess" reserves in real US assets, no? They seem to be quite interested in Canadian oil and gas deposits as well as Brazilian soy fields. Why not buy up US natural gas deposits, factory farms and downtown real estate as well?

Of course, of course, of course.

Posted by: anne at November 29, 2004 12:48 PM

Nine coal ships waiting off Mackay (Queensland, Australia)last night to load another mountain of coal. The Chinese are taking all those inedible dollars and converting them into something thay can use now and in the future.

Posted by: Eunoia23 at November 29, 2004 12:51 PM

When we assume that India or China or Japan will suffer huge losses in foreign cash or short term reserves or Treasury bonds from a loss in dollar value, we are putting out of mind the fact that dollars can be used for American purchases.

Posted by: anne at November 29, 2004 12:57 PM

I do not understand how this would be a "loss".

The Chinese Fed did buy US$ from Chinese producers with issued Yuan. It then did buy treasuries with these US$. Who should care if those treasuries are loosing value? The "reserve" would be lower, but who cares about "reserves" with fiat money?

Posted by: b at November 29, 2004 01:08 PM

Perhaps the real benefits of a stronger Yuan will offset what seems to me to be a paper loss?

Posted by: Kwaku at November 29, 2004 01:09 PM

The only get out that I can see would be for China would be to inflate the trouble away. If it stokes up inflation in the US, so it is greater than it is in China, it can engineer a real exchange rate appreciation of the Yuan without taking nominal losses on it dollar holdings. This is of course provided that the reserves are no long held as bonds – in other words China should buy up assets with its stash of dollars. Of course ideally those assets should not be dollar denominated but their purchase should increase the rate of inflation in the US. Buying Oil would be one option – it’s a real fungible assets and its appreciation will increases inflation in the US? The only question is then whether its more inflationary for the US than China its self – which is possible given Chinas lower car utilitsation. Food for thought.

Posted by: Giles at November 29, 2004 01:12 PM

"...we are putting out of mind the fact that dollars can be used for American purchases..."

No we're not. The Chinese and Japanese just don't have that much to buy in the U.S. There are only so many planes that they need. And if they wanted to invest their money, by buying real estate say, they would find that expensive - and make them liable not only for a loss on the exchange rate, but also a loss on the dollar value of the product.

Posted by: Andrew Boucher at November 29, 2004 01:16 PM

August 8, 2004

China in Africa: All Trade, With No Political Baggage
By HOWARD W. FRENCH

BEIJING, China - A look of satisfaction played on the trade official's face as he reeled off statistics recently from a ministry report about China's booming commerce with Africa.

''Forty African countries have trade agreements with China now,'' said the official, Li Xiaobing, deputy director of the West Asian and African Affairs division of the Trade Ministry. ''We are doing a railway project in Nigeria, a Sheraton hotel in Algeria and a mobile telephone network in Tunisia. We are all over Africa now.''

For any doubters, a glance at the statistics indicates that the official's exultation is, if anything, understated. Though starting from a modest base, China's trade with the African continent reached $18.5 billion in 2003, an increase of 50 percent since 2000, and it is on track for another big increase this year.

China's push into Africa is all the more remarkable because it comes when that continent has become the virtual stepchild of the international trade system, a mere footnote -- or worse, simply unmentioned in discussions of global commerce.

Beijing's fast-rising involvement with Africa grows out of China's immense and growing need for natural resources, in particular for imported oil, of which 25 percent now comes from Africa.

Lacking the economic and political ties that Western Europe has with Africa as a legacy of colonialism, and the economic power that the United States wields because of its wealth and influence in international financial institutions, China's new leadership under President Hu Jintao has pushed to forge stronger ties. Mr. Hu himself traveled to Africa in January and February, visiting Egypt, Gabon and Algeria.

China's diplomatic machine has spared no effort, making sure that African leaders do not view its interest as a passing fancy. The prime minister and vice president have also visited Africa in the last year.

Posted by: anne at November 29, 2004 01:17 PM

http://www.nytimes.com/2004/11/20/international/asia/20china.html?

China Widens Economic Role in Latin America
By LARRY ROHTER

SANTIAGO, Chile - The expected arrival here on Friday of President Bush, who personifies for Latin Americans the economic and political power of Washington, is being greeted with an uneasy mix of protests and hopes for greater growth.

But while the United States may still regard the region as its backyard, its dominance is no longer unquestioned. Suddenly, the presence of China can be felt everywhere, from the backwaters of the Amazon to mining camps in the Andes.

Driven by one the largest and most sustained economic expansions in history, and facing bottlenecks and shortages in Asia, China is increasingly turning to South America as a supplier. It is busy buying huge quantities of iron ore, bauxite, soybeans, timber, zinc and manganese in Brazil. It is vying for tin in Bolivia, oil in Venezuela and copper here in Chile, where last month it displaced the United States as the leading market for Chilean exports.

While President Bush is spending the weekend here for the Asian-Pacific Economic Cooperation forum, President Hu Jintao of China is here in the midst of a two-week visit to Argentina, Brazil, Chile and Cuba. In the course of it, he has announced more than $30 billion in new investments and signed long-term contracts that will guarantee China supplies of the vital materials it needs for its factories.

The United States, preoccupied with the worsening situation in Iraq, seems to have attached little importance to China's rising profile in the region. If anything, increased trade between Latin America and China has been welcomed as a means to reduce pressure on the United States to underwrite economic reforms, with geopolitical considerations pushed to the background.

"On the diplomatic side, the Chinese are quietly but persistently and effectively operating just under the U.S. radar screen," said Richard Feinberg, who was the chief Latin America adviser at the National Security Council during the Clinton administration. "South America is obviously drifting, and diplomatic flirtations with China would tend to underscore the potential for divergences with Washington."

Chinese investment and purchases are seen as vital for economies short on capital and struggling to emerge from a long slump. In Argentina earlier this week, for example, Mr. Hu announced nearly $20 billion in new investment in railways, oil and gas exploration, construction and communications satellites, a huge boost for a country whose economic vitality has been sapped since a financial collapse in December 2001.

China is also increasingly willing to venture outside the economic realm. In March, for example, after Dominica, in the Caribbean, severed diplomatic relations with Taiwan, Beijing responded with a $112 million aid package, which includes $6 million in budget support this year and $1 million annually for six years. In Antigua, it has pledged $23 million toward the construction of a new soccer stadium.

Political relations seem to be advancing most rapidly with Brazil, Latin America's most populous nation, where the left-leaning government has repeatedly floated the idea of a "strategic alliance" with Beijing.

Posted by: anne at November 29, 2004 01:20 PM

I find Anne's argument most useful here. And the "...we are putting out of mind the fact that dollars can be used for American purchases..." could even be enforced by substituting "American purchases" for "purchases of goods trading at stable prices in USD".

I certainly don't assume the central bank reserves are for buying domestic Chinese goods and services. However, with hindsight, they'd been better off holding Euros instead.

Posted by: Mats Lind at November 29, 2004 01:53 PM

Yes, Mats Lind, what you said = They would have been better off with Euros. They will also be better off in the future with euros. So will I. So will you. It is only a matter of time before they act on this obvious fact.

Will they double their bet in four years? Maybe, but I doubt it. But the thing is, they will then have to double it again. And then again. There WILL come a point when they say enough. And at that point you will want to be short dollars and long on whatever they switch to (euros). Of course, you could also buy some yuan, but then you are counting on them remaining stable, strong, etc. through the coming storm. I dont know if that is a good idea or not, but I would bet you a euro that the volatility of the yuan is way bigger than that of the euro over the next 5 years.

Posted by: steve kyle at November 29, 2004 02:22 PM

Mats :)

The only problem the Chinese might have with holding Euros, is that Europeans are still more reluctant to buy from China.

Posted by: anne at November 29, 2004 02:30 PM

Jim M -- Sterilization implies that China offsets the increase in the money supply associated with higher dollar reserves by issuing renminbi sterilization bonds (selling reminbi bonds for reminbi cash) at current exchange rates. The PBoC ends up with a renminbi liability (the sterilization bond), and a dollar asset -- its fx reserves. But that does not help here: if the renminbi eventually rises v. the dollar (dollars falls v. renminbi), the value of the central banks' assets (dollars) fall, creating a paper loss. There is a good higgins paper on this on the NY fed's webpage.

What does the paper loss imply? I do not know as much as I would like about the recapitalization of a central bank, but I suspect this would be handled like most bank recapitalizations (including the evential recapilization of Chinese state banks for their NPLs): by issuing a treasury bond sufficient to cover the losses incurred by the central bank (if someone knows more, do tell). The interest cost of servicing this bond over time becomes the utlimate cost born by the people of china.

Jim H -- I did the calculation v. GDP b/c I suspect the loss ultimately will be fiscalized. Reserves v. imports is more traditional, but in this case, the more relevant measure seemed to be GDP.

Posted by: brad setser at November 29, 2004 02:46 PM

Exactly this same situation is faced by Tokio (sic) Fire and Marine, the insurance company which is one of Japan's largest holders of Treasuries. In Tokio's case the exposure of letting the yen drift up to, say, 80 per US$ amounts to only a percent or so of GDP -- but for a single company that's a fairly hairy thing to think about.

Posted by: David Lloyd-Jones at November 29, 2004 03:31 PM

http://www.institutional-economics.com/

Celebrating Two Centuries of Current Account Deficits. The further deterioration in Australia’s current account deficit in Q3 to test previous cyclical highs as a share of GDP has seen the usual doom-mongering, with predictions of a currency ‘crisis’ (the Australian dollar is in fact at historical highs on a trade-weighted basis) and claims foreigners will stop funding our supposedly excessive consumption. The fact that foreigners have been funding Australia’s economic growth in this way more or less continuously for 200 years perhaps makes predictions of this kind the single worst cumulative forecasting failure of any economic point of view, yet people never seem to tire of these predictions.

Unlike in the US, the Australia government currently makes a positive contribution to national saving, so the current account deficit is entirely the work of consenting adults. Unless one can make a persuasive case for systemic failure in capital markets, then Australia’s current account deficit is an unambiguous sign of economic strength, not weakness. The sad thing is that much of the doom-mongering comes from economists who should know better.

Posted by: anne at November 29, 2004 03:37 PM

The Coming of the Xianbei and Other Nomads

http://www.metmuseum.org/special/China/s2_obj_5.L.asp

http://www.metmuseum.org/special/China/section_02_intro.asp

Posted by: anne at November 29, 2004 03:55 PM

The wording of the article implies that somehow China's losses are going to take place in the future. But because the dollars already in hand were clearly overvalued when they were bought, the losses on them have in fact already been incurred; all that remains is for them to be officially recognized. As the Japanese have shown, official recognition of losses can be postponed almost indefinitely.

Posted by: jm at November 29, 2004 04:10 PM

Is the currency Yuan or Renminbi? I'm so confused.

Posted by: Emma Anne at November 29, 2004 04:11 PM

Emma Anne:

The currency is the Renminbi, which loosely translates as "The People's Currency". "Yuan" is a unit. It's as if we referred to our currency as "US Currency", and "dollar" was used only as a unit name.

Posted by: jm at November 29, 2004 04:20 PM

Some intersting reports:


http://www.fxstreet.com/nou/noticies/noticiaespecialgran.asp

http://www.fxstreet.com/nou/noticies/editorselection.asp?publicitat1=forexgrandlogo&publicitat2=fxplogo&publicitat3=brokers&publicitat4=newsnow

Posted by: jm at November 29, 2004 04:22 PM

Well, Donald Luskin says you're all full of it. He also says Warren Buffet and Alan Greenspan are full of it. True, Buffet has made some money playing US currency short, but, hey, even a broken clock is right twice a day (sez Luskin).

Nope. Everything is just fine. Oddly Luskin never mentions US budget Deficits in any of his recent cheerleading pieces, but then he writes for "Smart Money" so he must be smart and correct.

The point being that with this kind of perspective pervasive in the markets, effects of trade imbalances/budgetary deficits might be delayed might be delayed, though rougher when they finally hit.

Posted by: avedis at November 29, 2004 04:22 PM

In line with Anne's thinking about purchasing U.S. assets other than Treasuries, what prevents foreign governments from purchasing shares in U.S. corporations? Is there a gentleman's agreement not to interfere in the stock markets of other nations, international treaties to that effect or just concerns about risk that prevent the Bank of China from holding, let us say, 2% of General Electric and other blue chip U.S. multinationals?

Posted by: MTC at November 29, 2004 04:53 PM

Sorry. In line with the current dollar reserve amounts, it should be "Bank of Japan" and not "Bank of China" in the above post.

Posted by: MTC at November 29, 2004 05:00 PM

There are international public holders of stocks in many American corporations.

Posted by: anne at November 29, 2004 05:06 PM

I am aware that on a political level, my inquiry is idiotic: the central bank's investing in the shares of an American company would of course be perceived as a subsidy to the competitors of one's own national champions.

Posted by: MTC at November 29, 2004 05:30 PM

"I am aware that on a political level, my inquiry is idiotic: the central bank's investing in the shares of an American company would of course be perceived as a subsidy to the competitors of one's own national champions."

Just thinking out loud... China could invest in Walmart, and other of their customers. Wouldn't that be smart for them?

Posted by: Pizza Face at November 29, 2004 06:43 PM

David Lloyd-Jones writes:
>
> Exactly this same situation is faced by Tokio (sic) Fire and
> Marine, the insurance company which is one of Japan's largest
> holders of Treasuries. In Tokio's case the exposure of letting
> the yen drift up to, say, 80 per US$ amounts to only a percent
> or so of GDP -- but for a single company that's a fairly hairy
> thing to think about.

Yes, and this is the kind of problem I think will be more important (and potentially more destabilizing) problem in the short-run. It would be one thing if all the dollars were owned by central banks, but it's another thing when the dollars are the losing investments of private entities that can be forced to do screwy things. For me, a very large worry is that even the dollar's very graceful decline causes some big problems because some nutty hedgefund out there blows up when the Canadian dollar hits US$.87. (Or something like that; my point is that there are some incredibly leveraged and complicated positions out there we aren't even aware of until they unwind way too suddenly.) Here in the US, we have a housing bubble in several markets (heck, even Minneapolis is up like 50% over the last 5 years), some very, very over-valued stocks (Apple Computer, however much I like their products, is not worth $68.44 per share, or even half of that) and a bond market which is in some sense the worry this whole thread started over. I can see the point of the textbook explanation for how this could all unwind with little violence, but I see way too many springs wound up so tight you don't really want to touch them at all because you don't know what they'll do if they snap.

Posted by: Jonathan King at November 29, 2004 09:21 PM

David Lloyd-Jones writes:
>
> Exactly this same situation is faced by Tokio (sic) Fire and
> Marine, the insurance company which is one of Japan's largest
> holders of Treasuries. In Tokio's case the exposure of letting
> the yen drift up to, say, 80 per US$ amounts to only a percent
> or so of GDP -- but for a single company that's a fairly hairy
> thing to think about.

Yes, and this is the kind of problem I think will be more important (and potentially more destabilizing) problem in the short-run. It would be one thing if all the dollars were owned by central banks, but it's another thing when the dollars are the losing investments of private entities that can be forced to do screwy things. For me, a very large worry is that even the dollar's very graceful decline causes some big problems because some nutty hedgefund out there blows up when the Canadian dollar hits US$.87. (Or something like that; my point is that there are some incredibly leveraged and complicated positions out there we aren't even aware of until they unwind way too suddenly.) Here in the US, we have a housing bubble in several markets (heck, even Minneapolis is up like 50% over the last 5 years), some very, very over-valued stocks (Apple Computer, however much I like their products, is not worth $68.44 per share, or even half of that) and a bond market which is in some sense the worry this whole thread started over. I can see the point of the textbook explanation for how this could all unwind with little violence, but I see way too many springs wound up so tight you don't really want to touch them at all because you don't know what they'll do if they snap.

Posted by: Jonathan King at November 29, 2004 09:26 PM

If I were the Chinese Central Bank, I'll buy a whole lot of gold or any other commodities to diversify the risk of holding dollar assets away rather than US assets -- due to the risk of a currency crisis impacting the real economy. In order for C/A rebalancing to occur, US consumption *has* to fall. Sure, the volatility is much greater and we're near the top of the market but if US dollar is going to fall another 30-40%, then there's a good chance that high commodity price is here to stay.

Which they might be already doing. The Chinese economic management team is always smarter than everyone thinks they are.

Posted by: Weco at November 30, 2004 01:53 AM

Thanks for your comment, Brad, although the first part of my question was referring to using a sterilization operation as if the capital losses were _outflows_ of dollars. The second part of your comment gets more to my question--which raises another. If they sell government bonds to recapitalize the Bank, don't they further shrink a money base already shrunk (in local currency terms) by the decline in the value of their dollar assets?

Posted by: Jim M at November 30, 2004 06:07 AM

My first response upon reading that some Asian Central Banks are already moving away from dollars and that currency markets are therefore punishing the hardy fools that remain loyal to USD, was some version of the "Greater Fool Theory." After all, perhaps the Chinese can simply sell their dollar assets to Don Luskin and his friends on Wall St. Maybe the worlds two biggest economies won't go down together...

But then I remembered the last time anyone used GFT as a good description (accurate, not benign) of market behavior. And I'm not sure that the 90's tech bubble is really what we want to be thinking about when it comes to currency devaluations.

Recall: NASDAQ and the S&P500 began their acceleration in spring 1995. Alan Greenspan warned of irrational exuberance in December 1996. The Economist called tech stocks a bubble on an August 1998 cover (and had made a similar case in more cautiously hand-wringing fashion earlier). But the market didn't top out until March 2000, almost three years later. Will it take four or five years from now before markets react to the dollar's weakness? It would be better to deal with it all now before the imbalances get far worse and the corrections far more costly.

There are a great many Greater Fools, but their supply is not infinite, only their foolishness.

Posted by: Silent E at November 30, 2004 07:35 AM

Jim -- the bonds used in bank recap are not really sold so much as given away. a bank loses $100 billion (hypothetically). The government gives the bank a bond worth $100 billion, and maybe takes some of the bank's equity. (obviously, a bit different with a central bank) in return. the bond -- particularly if held by a central bank -- would not trade. Indeed, most recap bonds held by private banks don't really trade, since favorable regulatory treatment makes them more valuable to the bank than on the market.

as for the shrinking money base point, i'll have to think harder -- presumably the central bank could sell cash for bonds to increase the currency in circulation to offset that tho.

Posted by: brad setser at November 30, 2004 09:58 AM

Interesting article on Wal-Mart and China:
http://www.chinadaily.com.cn/english/doc/2004-11/29/content_395728.htm

Posted by: jm at November 30, 2004 11:04 AM
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