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.
Although China’s growth has been pretty spectacular during the past few decades, I have often heard it argued that a significant source of growth has simply been the unwinding of many decades of economic mismanagement.In order to test this I went onto Angus Maddison’s magnificent website where he tries to calculate real GDP (on a PPP basis), population and per capita GDP for every country over the past 2000 years until the year 2003.Obviously this is an immensely difficult thing to do, and there are large gaps in his data, but his is the most complete data set I know.
The graph below lists China’s per capita GDP as a share of that of what I think to be the four most culturally comparable countries or provinces – Japan, South Korea, Taiwan and Hong Kong.As the graph seems to indicate, during the first three decades after 1949 China’s economy slid very rapidly relative to its neighbors, and in the subsequent three decades it began to long process of narrowing the gap.
In 1929, China’s per capita income, for example, was roughly 30% of that of Japan.By 1949 it had declined to 23% of Japan’s as China suffered the depredations first of war with Japan and then civil war between the Nationalists and the Communists.
After the war years things got relatively worse as China’s neighbors enjoyed growth rates far in excess of anything China could muster.Of course per capita incomes in China did slowly increase during most of those years, but not nearly as fast as Japan’s or most of China’s other non-socialist neighbors. As a consequence Chinese incomes began a rapid relative decline, so that by the mid-1970s Chinese earned about 9% of what their Japanese counterparts earned. Since then China has experienced an equally rapid climb back to 23% of Japanese per capital income by 2003, although much of that relative growth occurred during the stagnant Japanese decade of the 1990s. Maddison does not have figures for Hong Kong before 1949, but after that year Hong Kong incomes track Japanese incomes fairly closely.
The relative numbers are more dramatic, not surprisingly, for the two poorer comparable counties.For much of the first half of the 20th century Taiwanese and South Koreans earned roughly twice what their Chinese counterparts earned.Beginning in the early 1950s as Korea and Taiwan took off and as China stagnated, the income of the average Chinese sank to 25% of the average Korean and 18% of the average Taiwanese, before Chinese incomes began recovering slowly in relative terms in the late 1970s.As of Maddison’s latest numbers (the year 2003), Chinese earn a little less than a third of what their counterparts in Taiwan and Korea do. China still has a long way to go before returning to its average relative position in the first half of the 20th Century, but it has clearly turned the corner.
The conclusion from the first graph is that in spite of the tremendous catching-up that has taken place in the past three decades, China has still lost ground. It is still far behind its position relative to its neighbors at the beginning of the six decades since 1949.That might suggest that indeed much of China’s recent growth boom may simply be the consequence of unwinding two decades of severe economic mismanagement
But that conclusion is not necessarily fair.Japan, South Korea, Taiwan and Hong Kong are among the best performers among China’s neighbors. For some reason I can't put more than one graph on this site, so I cannot show it graphically but on my worksheet I charted China’s change in per capita income relative to that of four other large and less successful Asian neighbors -- Malaysia, Thailand, Indonesia and the Philippines.
The story here is much more mixed.Their own political and social problems after the Second World War meant that economic stagnation in those countries matched that of China, until the 1960s when all four countries began widening their gap with China. By the early 1980s however, China had recovered much of the lost ground with Thailand and Malaysia so that the average Chinese was once again earning around 60% of what his counterpart in those two countries earned -- China's per capita income was broadly 60% of theirs both before 1949 and after 2003.
Although China has just caught up with those two (in relative terms), it has more than done so with Indonesia and the Philippines. From roughly 20% below in the late 1940s and early 1950s, Chinese per capita income lost ground in relative terms until the late 1970s and early 1980s, but thereafter grew so rapidly in relative terms that in recent years Chinese per capita income has significantly surpassed that of Indonesia and the Philippines (140% and 190%, respectively).
The experience of China relative to these two countries makes it harder to argue that China is simply recovering some of the ground it lost during the disastrous first two decades after 1949, although of course both of these countries have had very difficult economic histories themselves, and tracking the performance of China against these two does not lead to any obvious conclusions about the reasons for Chinese outperformance.
The real question of course is whether China can keep up these growth rates and eventually make up for all of the ground it lost relative to a wider group of its neighbors. I have not had the time or resources to check the dependency ratios in these eight countries and provinces, so a straight comparison of per capital growth rates between them may conceal a lot. Remember, as I discussed two weeks ago (“Demographic projections and trade implications”), China switched from having a rapidly deteriorating dependency ratio during the first two-and-a-half decades after 1949 to a rapidly improving dependency ration since then. After 2010-2015 conditions will change again, and China’s dependency ratio begins to deteriorate quite dramatically. All of this necessarily affects per capita income growth.
According to today’s China Daily Morgan Stanley is predicting that year on year inflation for May is likely to decline dramatically from 8.5% in April to 7-6-8.0% in May.I haven’t seen the Morgan Stanley report but the article says “vegetable prices in the third week of May dropped 5.6 percent week-on-week, meat was down 0.3 percent, and eggs were up 1.7 percent.”
Morgan Stanley said inflation in China should gradually ease over the rest of this year as domestic supply improves and international prices stabilize. But it warned that the devastating earthquake in Sichuan province earlier this month could fuel more upward pressure on prices in the short-term.
"In the absence of any further major natural disasters, China inflation should ease gradually over the course of the year," it said.
If they are right it would imply that CPI declined by 0.2-0.5% month on month.
This would be a very welcome event if true, but even if it is true (and I am not so sure it will be) I am afraid that it would only be a temporary respite that would give the financial authorities, especially those in the Ministry of Commerce and the State Council who oppose further tightening, more ammunition for their arguments.And if prices do rise again in June and July, it would almost certainly be attributed, again, to a temporary and one-off factor – in this case the effect of the earthquake – and so a number of government officials would argue that there is little information about monetary conditions implied in the CPI price increases.
Two days ago, Ma Hongman, in a piece in the China Daily, argued yet again that any serious monetary tightening is the wrong response to current conditions because of the adverse impact it might have on economic growth.For him, and many like him, the only proper and effective tools are those likely to increase food production:
As a matter of fact, the traditional monetary policy tool, the interest rate or the deposit reserve requirement, could hardly work exactly upon the price-driving elements mentioned above.
Both measures could reduce the money supply in the economy, but they could do nothing in the short term to boost the supply of meat, eggs, poultry products or any other plants grown in the farm. The supply of agricultural produce cannot get free from the time span of their unique production cycle.In this cycle, raising the interest rate would only make the agricultural production more expensive, which, in turn, would push up the price of these produces, worsening the inflation pressure.
According to this argument policy-makers should ignore inflation and focus instead of measures to boost the economy.He goes on to say:
At a recent financial forum in Shanghai, Zhou Xiaochuan, governor of the People's Bank of China, described the dilemma of the decision-makers: to boost the economic growth, consumption should be nurtured or stimulated, while consumption needs to be curbed to ease the inflation.
He has really got the crux of the problem. The contradictory targets to maintain the economic soundness are really challenging the wisdom of the policymakers.Therefore, they should drop the customary practice of tightening the monetary policy once the inflation indicator is lifted, but fix more flexible countermeasures according to real-time changes.
I agree and disagree.I disagree of course with the argument that inflation is not a monetary problem, but I also don’t think most of the current monetary measures will make much difference. The problem in China is the growth in the money supply caused by the PBoC’s forced purchases of currency inflows, and as I wrote two days ago, foreign currency inflows have grown from astounding to even-more-astounding.The only way to address the problem is to reduce currency inflows.
On a related note it is worth noting that demand for PBoC's paper has softened over the past month. My student Shang Ning has been keeping track of interest rates and auctions of PBoC bills, and he says recent auctions have been small and heavily weighted to the short end.I think that is why we have seen so many increases in minimum reserve requirements, and will see still more. The PBoC is having trouble selling paper, and so raising minimum reserve requirements is one of the only ways it can affect the domestic money supply by reining in the banks. Whether this will work is an open question.
By the way I am hearing more and more that one of the main reasons for the irregular appreciation in the currency has been as an attempt to stop hot money inflows. In today’s report, for example, the G7 Group says “It is likely that the PBoC will continue to induce artificial volatility in the pace of RMB appreciation to reduce speculative capital inflows.”
If this is true I think they have it completely wrong.Inducing volatility in the exchange rate really means nothing as far as speculative inflows go – although it may help exporters learn about hedging. Everyone pretty much knows that the RMB is a one-way bet, and even if it declines a little for one or two days that only means that it will have to run up even more in the future to make up for the decline. This is hardly likely to cause speculators to lose any sleep, especially since anyone who thinks Chinese hot money inflow is caused by George Soros and all the other assorted evil-doers out there has it very wrong.
In fact most of this massive inflow is likely to be the consequence of hundreds of thousands of much smaller transactions involving money brought in by small Chinese businesses with extended family networks abroad. A little bit of intra-week volatility is hardly going to scare them away, and since the slower appreciation and greater volatility of April coincided with the largest one-month inflow in the history of central banking, I hope and expect it shouldn’t take too long to jettison this particular strategy for reducing inflows. I worry that the authorities here are so determined to keep the mythical speculators from profiting (they all seem to have read Currency Wars, a very silly book about the financial cabal – mostly Jews, of course – who control the world and want in particular to profit by destroying China) that they are missing the point.
At any rate I am still marveling at the size of the reported April surge in reserves. I can’t wait to see what May brings.
The stock markets here are being buffeted around by rumors of futures trading on local stock indices. Yesterday Fan Fuchun, Vice President of the CSRC, gave a speech at a forum in Shanghai in which he seemed to imply that everything was ready for a launch of a futures market on the main Shanghai index. That set off rumors about an imminent approval.
Although previously there were fears that index futures would cause the market to crash, the rumors actually drove the market up 2.5% yesterday. Today, it seems that the rumors were quashed. According to an email from my student Shang Ning:
The speech by Fan Fuchun has been posted today on the official website.However some words have been changed. “The preparation has been completed” has been changed to “The preparation has made big progress.”
That is, clearly, a significant change in meaning. The market traded up early in the day after opening 0.7% down, mainly because of lower oil prices and strong markets elsewhere – the Chinese oil “brothers” performed very well – to a high of 3481 (up 0.6% from yesterday’s close), before dropping 2.3% from its high to close at 3401, down 1.66% from yesterday’s close.
The Economist has an interesting story this week in which it warns that “emerging economies risk repeating the same mistakes that the developed world made in the inflationary 1970s.” The main message is that stagflation is becoming a real threat to a number of emerging economies, including China, for reasons that are worryingly reminiscent of the US in the 1970s.Among other things they say:
Many policymakers in emerging economies argue that serious monetary tightening is not warranted: higher inflation, they say, is due solely to spikes in food and energy prices, caused by temporary supply shocks and speculation. Higher interest rates cannot call forth more pigs or grain. They expect inflation to ease later this year as higher prices prompt an increase in supply (food prices have started to edge down over the past month) and as sharp rises in commodity prices drop out of year-on-year comparisons.
Yes, food inflation is likely to slow later this year; but that does not mean rising headline inflation can be ignored. The synchronised jump in global food prices suggests that there is more to the story than disruptions to supply. Prices are also rising partly because loose monetary conditions in emerging economies have boosted domestic demand.
They go on to make an interesting point:
According to conventional wisdom, the monetary-policy mistakes that caused the Great Inflation are much less likely today because central banks are independent of politicians. But unlike the Federal Reserve and the European Central Bank (ECB), many central banks in emerging economies (notably China, India and Russia) are not fully independent. In another echo of the 1970s, they often face intense political pressure to hold rates low to boost growth and jobs.
It is easy to see a possible example of this in the debate in China between the monetary alarmists, who are worried about excessive expansion in the money supply and about rising inflation, and the pro-growth camp, who dismiss the recent high inflation numbers as arising from temporary and reversible shocks.They may be right (although I side with the monetary alarmists here) but unfortunately, as the US learned in the 1979s, by the time there is incontrovertible proof that inflation ids a problem it will be very difficult to drive it outrt of the economy without a sharp slowdown.
Meanwhile the South China Morning Post says in an article today by Adam Chen that “Currency regulators on the mainland have increased surveillance of the flow of so-called hot money into the country, asking banks in Shenzhen to report deposits of more than 50,000 yuan (HK$56,250) by non-mainland residents.” According to the article SAFE was behind the move to monitor and manage destabilizing money inflows.Shenzhen has become one of the biggest conduits for money inflows, which is not surprising given the amount of business-related traveling between Hong Kong and Shenzhen, but I would guess that it is going to be very hard to reduce this. There are too many ways money can enter the system.
According to today’s Credit Suisse Emerging Markets Economics Daily, a government official for the first time suggested that we are not going to see inflation peak this year.Earlier this year most commentators and nearly all government officials suggested that inflation would peak in the second quarter before coming down over the rest of 2008. More recently, as my student Shang Ning pointed out to me last week, the same commentators have shifted their forecast and have suggested that inflation would peak around August or September before starting to decline.
Now it seems that at least one official is suggesting that the peak might not come until some time next year.According to Dong Tao, of credit Suisse:
Xu Xianchun, deputy director of the National Bureau of Statistics, has suggested that inflation might not peak until 2009.Xu made this comment on 28 May at an investment forum in Shanghai. He said that historically the peak of inflation lags two years behind the peak of growth.With GDP growth peaking outin 2007, Xu argued that the worst in the inflation cycle has yet to arrive. This is the first public comment coming from the government that suggests inflation may rise further. It is in contrast to the government'starget of a meaningful moderation in CPI inflation to 4.8% as food prices start to decline.
Dong Tao argues that there is a lot of evidence that inflation is spilling over into wages, which should result in another round of rising inflation towards the end of this year or the beginning of next. He argues that the recent decline in certain food prices might result in an inflation “valley”, but that lower inflation in the next few months will not mean that the inflation problem is over.
I agree.When you look at the trajectory of US inflation in the early 1970s, which in some ways resembles China today, the monetary looseness of the 1960s fed first into the “gogo” period of low inflation, low unemployment, rapid productivity growth and booming asset markets, before slowly showing up as persistent inflation in the early 1970s. At the time, as in China today, there were strong arguments made that US inflation was not monetary but rather was caused by a series of supply shocks (the first and second big oil shocks, for example), and the US even imposed price controls in the hopes of breaking inflationary expectations.
These didn’t work, and US inflation rose inexorably, not in a straight line (it almost never does), but with periodic declines until by the mid-1970s it became clear that the US was experiencing a monetary inflation.Needless to say it took pretty brutal steps in the late 1970s before US inflation was finally broken.
History doesn’t repeat itself with great precision, of course, and there is no reason to assume that China today is necessarily like the US in the early 1970s, but it is worth remembering the mistaken analysis back then and consequent policy mistakes.I am afraid that if we do see Dong Tao’s inflation “valley,” it will seriously discredit the monetary alarmists in the short run and result in yet another excuse to ignore the consequences of China’s massive monetary inflows.One positive impact of a decline in the next month or two, if indeed this happens, is that it might make the authorities a little more willing to relax some of the price subsidies, especially on refined oil products.Of course this would immediately feed into headline CPI inflation, but price freezes are very costly and are simply forcing inflation to spread in other ways.
The PBoC, however, continues to insist on fighting inflation. On a report released on their website today, they warned that local governments needed to keep the fight against inflation as a priority. If you believe, as I do, that inflation is caused not so much by nasty local hoarders and price gougers, but rather by excess monetary growth, it is hard to see what local governments can do to keep inflation down, but clearly the PBoC is still very concerned.
On a completely different topic, I saw a report on Bloomberg today about engineering studies in the US and China. There is a lot of rather excited talk about the astonishing development of science and engineering in China, and as someone who has taught in the top two schools in the country, I am always a little bemused by the fascination the West has of the Chinese “threat” in science.
My students at Peking University are easily some of the most brilliant students I have ever taught, but they and their professors don't seem terribly impressed by the threat they pose. Although scientific and engineering education in China is improving, it still has a long way to go even to catch up with certain other developing countries, let alone with scientific and technological powerhouses.
The most excited talk nonetheless revolves around the enormous hordes of science and engineering students being produced in China, and no matter how many times it is pointed out that the quality of teaching is relatively low and the educational system one that systematically discourages innovative thinking, the counterargument is always the one of sheer numbers. On that note:
Harvard and Yale…following the lead of Princeton University and Columbia University, added to the status, staffing and visibility of the engineering schools in the past year.
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. 