My Blog

March 6, 2008

THU 6 MAR

What is going on with PBoC January reserve increases? By Michael Pettis

There is a fairly surprising report on Reuters tonight.  According to “unnamed sources”, central bank reserves at the end of January were $1,651.4 billion, which means that reserves were up by $61.6 billion during the month – nearly three times the average rate for the past few months.  I called up some friends, including Logan Wright, who knows more about the PBoC’s market operations than anyone I know, and it seems that these numbers might be credible.

 

If this is true, I am surpprised.  How is it possible that central bank reserves were up $61.6 billion?  Actually, according to Logan, they might have been up substantially more than that.  In January the PBoC raised minimum reserve requirements and it seems, according to traders, that the banks were required to redenominate the $22 billion of additional reserves into dollars.  I have written earlier about how this reduces the headline PBoC reserve number but has no appreciable monetary impact, so if this is true it means that PBoC reserves effectively may have risen in January by an additional $22 billion, for a total of $84 billion.  I am not sure about the latter because it may be that the “informed sources” were already including this $22 billion number in their calculations, but I guess we’ll know soon enough.

 

Whether it is $62 billion or $84 billion, how do we account for this huge increase?  I wrote two weeks ago that FDI inflows for January had surged to $11.2 billion – more than twice last January’s number – and I speculated that at least part of this surge might reflect RMB appreciation expectations – investors accelerating their disbursements in order to take advantage of expected appreciation.  Since then I have heard a number of other people argue that this is indeed what seems to have happened.

 

The trade surplus for January is expected to be just under $25 billion – itself a pretty hefty number that suggests that the trade surplus is not about to wither away, even with the faster RMB appreciation and the supposed US slowdown.  Finally, there should be coupons and valuation gains in the portfolio that explain part of the increase.  I estimate these to be around $15-20 billion.  Add these two numbers together and we explain $51-56 billion of PBoC reserve increases in January.

 

That still leaves us with between $5 billion and $33 billion of January reserve increases that need explaining.  This probably isn’t all hot money, but if any significant portion of it is hot money, then things may be much worse than even I expected.  The combination of high Chinese interest rates and a rapidly appreciating RMB has had the expected effect of causing an unsustainable rise in hot money inflows. 

 

I don’t want to draw any conclusions since these numbers haven’t been confirmed, but I think several of us are going to be waiting for the official release of PBoC January numbers with a great deal of nervousness.

 

And it’s not just the PBoC numbers that we will be waiting for.  CPI numbers will be coming out soon too, and the rumors aren’t good.  Another person whose work on China I value a lot is Xinxin Li, of the New-York-based Observatory Group, and in a note today he has this to say about inflation:

 

¨   The February CPI number is expected to be extremely strong due to the impact of the severe weather, and we estimate that it will jump to around 8% y-o-y, from 7.1% of January.  It is rumored to be 7.8%, although the market estimates are even higher.

 

¨   More importantly, the CPI report will be released…in the middle of the NPC session.  Inflation will certainly become a hot topic among lawmakers, as it is closely associated with social welfare and thus Hu’s political movement for a “Harmonious Society.”  In other words, it is not a pure economic debate, but a sensitive political topic at the NPC.

 

¨   Another important factor is the attitude of the new cabinet, which worries that inflation pressures may ultimately cause social instability particularly in the run-up to the Olympic Games in August.  Moreover, fighting inflation is the first tough assignment for Wang Qishan, the new Vice Premier in charge of monetary and financial policies.  Wang may have to “do something” to show his political correctness.

 

Meanwhile I read Premier Wen’s “Report on the Work of the Government” (all 45 pages) delivered today to the opening session of the 11th NPC.  As most commentators reported, he seems to have emphasized the threat of rising inflation (I can’t remember how many times the subject came up, but it came up a lot).  I want to stress this.  Some reports suggested that inflation was simply the primus entre pares of a variety of issues, and although I suspect unemployment is one of the things that most concerns the leadership, it seemed pretty clear to me that inflation is easily the number one concern in Wen’s and the leadership’s mind, at least as far as today’s speech goes. As the Financial Times put it today:

 

Wen’s report was a “warning” to local officials, many newly promoted and keen to stand out with big-spending projects, that fighting inflation should be their priority, said Mao Shoulong, a public policy expert at the People’s University of China.

 

I agree.  I think the anxiety level has moved up pretty continuously since October and I suspect that a lot of people in the leadership are terrified.  But what can they do?  If reports of January’s reserve increase are even vaguely credible, it will be very hard for them to use interest rates to slow the economy, and of course speeding up the RMB appreciation rate can’t work either. 

 

Either strategy will simply cause hot money inflows to soar.  Traditional measures, like selling PBoC bills and increasing minimum reserve requirements, haven’t seemed to have done much good either.  I expect that price controls and administrative measures will be left in place, and perhaps even strengthened, but I also expect that within a few months they will have proven how little value they have in addressing the root problem – excess money growth.  China Daily did report today that the authorities plan to combat food inflation by importing more food and by selling off domestic food reserves, but expectations of rising Chinese food imports have already sent global food prices soaring and of course selling off food reserves puts downward pressure on prices in the short term but upward pressure in the long term, when food reserves need to be replenished.  After this winter’s scare, I don’t suppose the authorities want to be caught without substantial reserves.

 

One last note – as if we didn’t need more bad news.  According to yesterday’s Bloomberg, “European finance ministers said they are ‘increasingly concerned’ that the euro’s advance to a record against the dollar risks deepening the economic slowdown in the region.”  Although they spent much of the EEC session sending stern glances towards the US Treasury, there was some debate about sovereign wealth funds, which is often code for China. Weakness in the dollar is going to make China’s adjustment much more difficult because it means that China’s trade surplus shifts from the US to Europe, and I don’t see much appetite in Europe for any of this.

 

THU 6 MAR

Hot money IS a concern

Governor Zhou Xiaochuan of the PBoC said in a speech today that there is still room to use interest rates increases in the fight against inflation.  This was interpreted by many as suggesting that the government does not plan to increase the appreciation rate of the currency.  But he also said that China should lower its savings ratio to encourage more domestic consumption.  I am not sure that increasing interest rates will lower the savings rate, unless he means he will increase the lending rate without increasing the deposit rate.  Good news for banks, I guess, but not for depositors struggling with inflation.

 

In today’s Bloomberg I saw an interesting related comment:

 

Li Deshui, China's former statistics chief, voiced concern over “excessive expectations” for yuan appreciation.  Premier Wen said China will strengthen monitoring of cross-border capital inflows as part of a move to curb money growth.  “Dollars outside of China tried all ways to come in, and hot money, via both legal and illegal channels, flew in to bet on the yuan's appreciation,” Li said in Beijing yesterday.

 

There is still a debate going on among banking analysts about the extent of hot money inflows into China.  My read is that however you choose to interpret the numbers, the financial authorities do not act like they think there is a vigorous and legitimate debate about whether hot money inflows are a problem.  They definitely seem to think the problem exists.

 

I have been asked to do an interview later this evening on Dialogue, on CCTV9, so my entry is very short today.  If you’re interested, I think the program airs at 8 p.m. and we are expected to discuss the 11^th NPC and economic policy-making.  I think it is my role to be the pessimist.