My Blog

May 26, 2008

MON 26 MAY

What? $74.5 billion? Is this a mistake? By Michael Pettis

Note:  I have made a change in this piece from yesterday.  I forgot that there was an increase in the minimum reserve requirement in April, which means that foreign exchange inflows were actually around $22 billion higher than the ridiculously high number I discussed.

 

An article just came out on Reuters claiming that inside sources have revealed that China’s foreign currency reserves at the end of April were $1.7567 trillion.  If this is true that means that reserves grew in the month of April by $74.5 billion, the biggest one-month reserve jump in China’s history (and probably in the history of the world).

 

These Reuters reports have been correct in the past, but I am reluctant to believe the article because this number blows out anything I was expecting (although in retrospect China’s attempt to slow RMB appreciation in April may have had the effect of forcing even greater intervention).  Had you asked me yesterday, I would have told you with some confidence that April’s reserve growth would have been alarmingly high, but that the rate of growth would – simply had to – be lower than the average monthly pace for the first quarter. 

 

First quarter reserve growth of $154 billion was unbelievable.  China has a number of regulations that limit money inflow, and these are usually set according to quotas for the calendar year, and so I had assumed that this would have boosted first quarter results relative to the rest of the year as investors filled their annual quotas immediately.  But I would have been wrong.

 

To get a sense of scale, in 2006 reserves were up $247 billion for the whole year.  This, at the time, was a number guaranteed to shock.  No central bank in history has seen reserve growth at anywhere near this scale.  Nonetheless in 2007, the growth in reported reserves nearly doubled over the previous year -- $462 billion – and more than doubled if we backed out a series of transactions that reduced headline reserve growth but had no net impact on the monetization of currency inflows.  

 

But that wasn’t the end of record-busting reserves growth.  In the first quarter of 2008 headline reserves grew by $154 billion, nearly one-third of last year’s total growth, and if you back out all the non-relevant transactions that reduced headline growth, it represented a significantly larger share of last year’s reserve growth.

 

But $74.5 billion in April is equal to 48% of the total reserve growth for the first three months of the year. 

 

What is going on?  I am reproducing a table I made in my April 12 entry (“So many questions about PBoC reserve growth”) in which I try to put these numbers in some sort of context so as to understand the true monetary impact on China’s domestic money supply, and more importantly to get some sense of the hot money problem.  I have made one change to the table – Stone & McCarthy’s Logan Wright told me two weeks ago that around $20 billion of the PBoC transfer to the CIC may have been in the form of ownership of shares in Chinese securities companies, so I have removed $20 billion from the March “Transfer to CIC” column.

 

We can make some pretty good estimates of several components of this reserve growth.  Logan Wright does a lot of the work already and I quote the following from his May 26 report:

 

The trade surplus in April was $16.7 billion, and foreign direct investment totaled $7.6 billion, so we can only account for $24.3 billion of this increase through these channels. Add in an estimated $6.6 billion in interest income, and that leaves a residual of $44.2 billion.

 

Even more surprisingly, under our working assumption that SAFE foreign exchange reserve figures are adjusted for currency movements, the dollar rebounded in April, meaning that the foreign exchange reserve figures were likely adjusted down, as the PBOC's non-dollar assets depreciated in dollar terms during the month. Assuming a portfolio of around 20% in euros and 7.5% in yen, this would mean that China's reserve totals should have been $11.6 billion higher during the month, leaving an astonishing residual of $55.2 billion in unexplained capital flows.

 

Adding these to my table shows the following:

 

	January	February	March	April	Total
Headline reserve growth	62	57	35	75	229
Trade surplus	20	9	14	17	59
FDI	11	7	9	8	35
Currency gains	10	10	18	(12)	26
Interest	5	5	5	6	22
Unexplained amount	16	27	(11)	57	87
Reserve hike	22	-	24	22	68
Adjusted reserve growth	83	57	59	97	296
Unexplained amount	38	27	12	79	155
Transfer to CIC	-	-	75	-	75
Adjusted reserve growth	83	57	134	97	371
Unexplained amount	38	27	87	79	230

 

 

As the table indicates, headline reserve growth for the first four months of the year was $229 billion, or 49% of all of last year’s growth.  When we add back the reduction in headline reserves caused by the redenomination of minimum reserve requirements, this rises to $296 billion – which means we are already running at well over 50% of last year’s adjusted growth in reserves.  When we add back the transfer of PBoC reserves in 2007 and 2008 to China’s “other” central bank, the CIC, reserve growth for the year probably equals two-thirds or more of last year’s astonishing number (I am assuming that adjusting last year’s $464 billion to account for the redenomination of minimum reserves and the CIC transfer would have resulted in real reserve growth of around $550 billion).

 

It is really hard to know what more to say about all of this.   Last week Brad Setser was marveling at the Chinese balance of payments and wondering if there was any definition of “sustainable” that could possibly accommodate this level of reserve growth – almost certainly not, he concluded, and it is hard to disagree.

 

What makes the process so worrying is that after we have backed out all the things we can easily explain, there is still $230 billion of inflows of which we cannot easily account.  Stephen Green of Standard Chartered Bank argues that foreign currency lending and PBoC swaps may account for a portion of first quarter reserve growth, but even if we accept all his numbers, they still only account for a small share of this massive unexplained amount.  What else can it be? 

 

Clearly at least part of it must be hot money inflows.  For most of the past few years it was China’s trade surplus that drove the astonishing growth in reserves.  As I argued way back in 2004 and 2005, China had locked itself into a trap in which rising trade surpluses, the consequence of an undervalued and pegged currency, were causing too-rapid monetary expansion as the PBoC was forced to buy the foreign exchange inflows. 

 

This monetary expansion was channeled by the banking system into higher and higher levels of fixed asset investment, and all this investment resulted in soaring industrial production which, since consumption could not keep up, resulted in ever growing trade surpluses (the trade surplus is the gap between production and consumption).  It was hard to know how China could exit the trap without a much more rapid appreciation of the currency.

 

We have reached what I believe is the end stage of this trap in which the monetary system is forced to adjust through appreciation and inflation.  The problem is that in such a case there is a huge risk that hot money inflows destabilize the adjustment process, and this seems to be exactly what is happening.  Instead of reducing foreign exchange inflows, the appreciation of the RMB is causing massive hot money inflows (which is not at all surprising, but it has been made much worse by China’s bad luck of having to adjust in the middle of the sub-prime crisis) and so the adjustment must be much more dramatic and much more painful.  No matter how quickly China tries to reduce monetary expansion by appreciating the currency, in other words, monetary expansion grows even faster.

 

Right now much of the attention in China is still focused on the results of the devastating May 12 earthquake.  Two unfortunate consequences of the earthquake are likely to be reluctance from the authorities to deal aggressively with these out-of-control money inflows, and the granting of indulgences to the banks that will allow them to ignore lending quotas and to forgive debt a little too easily.  An article from today’s China Economic Review explains:  

 

China's banking regulator ordered banks to write off bad loans caused by the May 12 earthquake in order to reduce the debt burden on survivors and help overall reconstruction, state media reported. "If borrowers suffered huge losses that can't be covered by insurance ... the loans should be regarded as bad loans and written off in a timely manner," the China Banking Regulatory Commission (CBRC) said. The CBRC and the People's Bank of China previously urged banks to extend loan maturities and not to push for loan repayment if debtors in quake-hit regions fall behind in payments. Zhang Yun, vice president of Agricultural Bank of China, said the preliminary estimate for the bank's bad loans from the earthquake was US$863 million. Banks have agreed to lend US$11.9 billion to Sichuan province for relief and reconstruction.

 

This is not the right environment in which to deal with such worrying monetary numbers.  By the way the stock market was down 3.13% today.