More on the Jump in China’s Reserves

We commented the other day on the surprisingly large jump in China’s foreign currency reserves, noting that the monthly gain wa the biggest on record, when an appreciating yuan ought to put the growth in reverse (although one must note that the yuan hasn’t gained much if any ground relative to non-dollar currencies).

I’m following up because my instinct is that this development will prove to be important, even if the causal chain isn’t yet clear.

Brad Setser (who follows this beat more closely than I do) was kind enough to weigh in in comments:

The pick up in US export growth from 2003 on is clearly tied to the fall in the dollar, so I am a bit more optimstic than you are. Moreover, without a fall in the dollar, there is little incentive to reindustrialize the US. German auto makers are investing in the US now; they weren’t in 2001 and 2002. The rise in the RMB also seems to have slowed the increase in Chinese exports to the US (compare uS imports from China to Europe’s imports from China), so I am more optimistic there as well. I would tho caution that the us slump explains most of the slowdown in us imports from china.

The deindustrialization reflected at least in part the strong $ of the 90s and the artifically weak RMB of this decade; reversing course requires painful adjustments — and a weak dollar is part of the pain.

The problem is that reindustrialization is not a fast process. and the pain is likely to be attenuated, The US isn’t particularly good at taking setbacks.

Michael Pettis addressed the question short-form in his blog today (promising to do more digging):

As I noted in yesterday’s entry, the trade surplus accounted for $41.6 billion of that total while FDI accounted for another $27.4 billion. That sums to $69 billion. Roughly 30% of PBoC reserves are presumed to be held in currencies other than the US dollar, so the weakness in the dollar added to headline reserve growth – I am only guessing but my quick-and-dirty calculation suggests perhaps $30 billion or so. Add another $15 billion to account for interest received on the securities held. That takes us all the way up to $115 billion. There is still nearly $40 billion that needs to be accounted for. I am sure it is not all hot money, but it seems pretty obvious that the FDI numbers, and perhaps even part of the trade numbers, include speculative inflows. There is a lot of money coming into China and even a global slowdown is not going to make the country’s monetary policy easier to manage.

…..Needless to say this is a huge number, but I guess I am becoming a little numb to big numbers. Of course this makes me all the more convinced that inflation is not going to peak as soon as most people in the market seem to believe – everyone I have been reading recently is arguing that inflation will peak in the next three months, and then drop in the second half of the year. I not very confident that will happen.

Setser combed through the data today, stressing that the yuan has not risen against most currencies ex the dollar, and in agreement with Pettis on the amount of surplus increases that it unexplained and therefore could be hot money inflows (not a good thing):

Neither the fact that China added $154b to its reserves in the first quarter ($153.9b) nor the fact that the RMB (briefly) broke through 7 was exactly a surprise. China’s reserves were heading up quite nicely in January and February, and the RMB was steadily marching up (at least against the dollar) as well….

The US treasury has gone out of its way to praise the increase in China’s pace of appreciation against the dollar. I think that is a mistake. The G-7 recently has called for broad-based RMB appreciation not just appreciation v the dollar. That broad-based appreciation has yet to happen….

The $154b in reserve growth in q1 is both a little less and a little more than meets the eye….

However, there is also good reason to think that China’s reported reserve growth understates the overall increase in China’s foreign assets. After adjusting for valuation, China added $53.9b to its reserves in January (when the trade surplus was large), $47.7b in February (when the trade surplus was small) and $15.8b in March (when the trade surplus was moderate). The $15.8b increase in March (a level that implies large hot money outflows) is suspiciously small.

The increase in January if not all that large relative to the underlying flows (FDI of $11b, a trade surplus of close to $20b and $5-6b of interest income), while the increase in February is quite substantial.

The key question is what might be left out of the reserve data, or more precisely who else inside China might be adding to their foreign portfolio to take pressure off the central bank….

My personal view is that hot money inflows were at least as strong in the first quarter of 2008 as in the first quarter of 2007 — and that the overall increase in China’s foreign assets in q1 was over $150b, and perhaps substantially more than $150b…

I find it hard to believe that China’s export sector has really been squeezed by the RMB’s appreciation. The RMB hasn’t appreciated against China’s largest trade partner. And the increase in China’s exports – measured in dollar billion – remains very very strong.