I had an opinion piece on China’s FX reserves in the WSJ China on Monday.  Chinese readers can see the original here.  For everyone else, the English version is below: 

The Real Drivers of Diversification in China’s FX Reserves

Where is China hiding its USD2.5trln in foreign exchange reserves?  The answer to that question is one of the best kept secrets in the world of finance.  The State Administration of Foreign Exchange (SAFE) - the organisation charged with the management of the USD2.5trln - certainly isn’t telling anyone, and for good reason.  When you are moving around the kind of money that SAFE is moving around,  telegraphing intentions to the market can make everything you want to buy terribly expensive and everything you want to sell awfully cheap.

But in the absence of real information, rumours proliferate, and sometimes fire the imagination of the markets.  This is one of those times.  First, at the end of May, came reports that SAFE was growing tired of the ups and downs of the euro, and reconsidering its holdings of European debt.  Those rumours were enough to send the euro plunging 1.5% against the dollar over the course of a single day’s trading.  A denial from SAFE calmed the markets.  But a few weeks later, rumours from Tokyo suggested that, despite its protestations to the contrary, SAFE was indeed growing weary of the euro, and was switching to Japanese government debt, with purchases of USD6.3bln over the first four months of the year.  The next week, another rumour, this time suggesting that SAFE was back in the euro game, with a purchase of E400mln (USD516mln) in 10-year Spanish bonds. 

Japanese bonds one week, Spanish bonds the next, if the press is to be believed, China is buying anything but US Treasury debt.  But what have we really learned from the  claims and counterclaims of the last few weeks?  Not a lot that we did not know already.  If China’s FX reserves are allocated in roughly the same proportions as global FX reserves as a whole - a reasonable assumption - then around 61% should be parked in dollar debt, with 27% in euro debt, 3% in yen, and the rest invested in other currencies.  That means that SAFE has something like USD675bln in euros, and a smaller but still sizeable USD75bln in yen.  In this context, the purchase of a few million in Spanish bonds and a few billion in Japanese government debt can hardly be regarded as anything other than business as usual.

A continued focus on dollar debt by China’s FX managers should come as no surprise.  Advocates of greater diversification point to risks to the value of China’s FX reserves from an excessive concentration in US Treasury debt.  Fair enough.  Inflation in the US, or a depreciation of the greenback, would both impact the purchasing power of China’s dollars.   But value is only one consideration, and not the main consideration, in the allocation of China’s FX reserves.  The fundamental reason for the allocation of China’s FX reserves to dollar debt is Beijing’s decision to manage the exchange rate against the dollar.  As long as China wishes to continue running a massive trade surplus with the US, whilst holding the yuan stable against the dollar, the brutal logic of supply and demand in foreign exchange markets dictates that every cent of that trade surplus be recycled into dollars. 

But the management of the exchange rate and the decision on where to invest FX reserves is a two step process.  SAFE might have to buy dollars in the first step - to manage the exchange rate, but once it has those dollars could SAFE not declare ‘mission accomplished’ and use them to buy European or Japanese government debt?  Not really.  Let’s take diversification into European debt as an example.  Use of dollars purchased in the FX market to purchase euro debt would weaken the dollar against the euro.  As the yuan is managed with reference to the dollar, that also means that the yuan would weaken against the euro.  That implies a reallocation of some of China’s trade surplus from the fast growing and dynamic US to a sclerotic EU.  As the current European sovereign debt crisis makes clear, the old world’s capacity to live beyond its means is substantially less than that of the new. 

The choice on the allocation of China’s FX reserves is not simply dictated by SAFE’s much repeated commitment to the principles of safety, liquidity, and returns.  It is also dictated by China’s choice of exchange rate regime.  It is not the micro-level investment plays but the macro-level economic policies that determine the allocation of China’s FX reserves.  Chasing after rumours from London bankers or Japanese bureaucrats - sources that have their own self interested axes to grind - will not bring us any closer to the truth.  But careful attention to shifts in China’s exchange rate policy just might. 

The announcement by the People’s Bank of China (PBOC) of a shift to a more flexible exchange rate, set with reference to a basket of currencies, has far reaching implications for the growth and allocation of China’s FX reserves.  First, on the growth of reserves, appreciation of just 0.7% against the dollar in the month since reforms were announced is unimpressive.  But over time, a stronger yuan will be one of the factors changing the balance between China’s imports and exports, and reducing the size of the trade surplus.  At the same time, two way movement in the yuan dollar exchange rate will reduce the incentive for currency speculators to dodge China’s capital controls, and hot money inflows should also be reduced.  This does not necessarily have any implications for the way reserves are allocated.  But a smaller trade surplus and reduced capital inflows will slow down the growth of China’s FX reserves and reduce SAFE’s budget for Treasury purchases.  The US Treasury got a taste of what that might look like in May this year, when capital outflows contributed to a substantial fall in the value of China’s FX reserves, and China’s holdings of US Treasuries fell by USD32.5bln. 

On the allocation of reserves, a more flexible exchange rate will also break the mechanical link which requires SAFE to recycle the trade surplus into dollars, and constrains their choice of where to park those dollars once they have bought them.  That means Beijing can push forward with another innovation: the privatisation of China’s FX reserves.  The first move in this direction, a shift in policy to allow Chinese firms to retain a portion of their overseas earnings, was announced quietly and without fanfare in 2009.  This might seem like a minor technical change, but it signals something rather significant: the end of SAFE’s monopoly control of China’s FX reserves.  The intention is to shift toward something like the Japanese system - where only a fraction of FX reserves are held by the government and the majority are in private hands.  This is a transition that will happen over time, but the bottom line is less cash for SAFE to buy Treasuries and more funds for Chinese companies to make foreign acquisitions.  The Chinese government might end up with a smaller share of the US public debt, but Chinese companies will end up with a bigger share of the Fortune 500.  Diversification of China’s FX reserves is happening, but it is these structural shifts, not this or that investment decision by SAFE’s money managers, that are the real drivers.

Exchange rate, Monetary Policy, Trade, US-China Relations

Second quarter growth in China’s FX reserves was a tiny USD7bln, despite more than a USD40bln addition from the trade surplus.  Slight growth in reserves despite the robust trade surplus suggests hot money was flowing out of China in the last two months of the quarter.

Two years of stability in the exchange rate knocked hot money off the policy agenda for the government: with little chance of yuan appreciation there was less reason for speculators to bring capital into the country.  But the recent announcement of the next stage in exchange rate reform will bring hot money back into vogue. 

Either appreciation against the dollar will be rapid and one way and the result will be increased incentives to bring hot money into the country - providing the real estate and equity markets pull themselves together.  Or appreciation will be faltering with the possibility of two way volatility - in which case speculators will probably find somewhere else to park their cash.

The interest in hot money in China’s policy circles is partly a relic of the Asian financial crisis, and, to a lesser extent, the speculative attack which forced the British pound to crash out of the European Rate Mechanism in the early 1990s. 

Chinese policy markers were horrified by the ability of foreign speculators to bring the governments of Asian neighbours to their knees, and by the humiliation at the hands of the IMF and its austerity programmes that followed. 

China has a closed capital account, so the chances of a similar attack are slight.  But that does not stop the Chinese media worrying about attacks by ‘big financial crocodiles’ (金融大锷 jinrong da e) - as George Soros style currency speculators are referred to.

This is my translation of a short section from a recent SAFE Q&A on the subject:

‘Our investigations in the first half of the year reveal that the vast majority of capital flows were legal and legitimate.  We have not discovered any large organised attempts to circumvent capital controls.  Most hot money is brought into the country through small transactions. 

As for so called ‘big financial crocodiles’, as we still have controls on capital account transations,  any speculative attack would be illegal - and this means that hedge funds and other financial institutions would think twice before trying their luck.

Hot money mainly enters the country disguised as legitimate trade and investment flows.  There are many and various routes.  But typically speculators are not particularly skilled at disguising hot money flows, so it is not that hard to pick up the signs of irregular transactions: 

-Companies in the processing trade will often under price inputs and over price outputs - with the collusion of their customers - to bring hot money into the country. 

-Shipping companies will take payments early and make payments late to increase their holdings of foreign capital. 

-Service companies can charge foreign customers for transport or consultancy services that are never provided, in order to have an excuse to bring hot money into the country. 

-Foreign investment is often disguised hot money, with investment advisory companies playing the role of broker for foreigners who want to make investments in the real estate or equity markets.’

You can see SAFE’s statement here.

Exchange rate, IFIs, Investment, Monetary Policy, Property, Stocks, Trade

I have an opinion piece in the South China Morning Post today on Beijing’s latest moves on the CNY and the implications for this weekend’s G20.

SCMP subscribers can read the piece here.

Everyone else can read it below:

US Might Miss an Open Goal on the Exchange Rate at G20 Summit

China’s hapless soccer team might not have qualified for the World Cup, but when it comes to playing the game of global politics, its leaders have shown considerably more finesse.  So whilst China’s soccer eleven are polishing their boots, China’s economics A-team is on the way to Toronto for the latest summit of the G20.  There has not been this many Chinese faces arriving in Canada since Hong Kong’s reunion with the mainland.

One week ago, it looked like the latest meeting of the world’s self appointed high council on all things financial crisis would be a festival of China bashing, with the exchange rate the main focus of attention. 

Back in April, when the US Treasury delayed publication of a critical report on China’s exchange rate regime, the unspoken trade off was that China would start the yuan appreciation ball rolling ahead of this week’s pow wow.  The attack dogs in the US Congress latched firmly onto that informal deadline, threatening that if there is no movement on the exchange rate by the G20, they will take matters into their own hands.  If China had not acted last weekend, the US would have been compelled to go on the offensive at Toronto. 

The European debt crisis has Brussels gazing at its own bureaucratic navel.  But with emerging markets like Brazil and India adding their voices to the paean of protest, and rumblings of discontent from East Asian neighbors, China looked set to find itself isolated at the international negotiating table.

By signaling the end of the yuan’s 22-month peg to the US dollar, China has done just enough to calm the storm.  In the few days that have followed the announcement, the yuan has been little moved.  A 0.2% appreciation against the dollar will hardly be enough to bring the competitive shine back to manufacturers in the US rust belt. 

But China has won itself the benefit of the doubt.  The same voices that were, last week, raised in protest, are now offering a cautious welcome for Beijing’s promise of increased flexibility.  The US Congress remains on the war path.  But China has given the Obama administration the fig leaf it needs to justify its softly softly approach to dealing with Beijing, and done just enough to ease tensions in relations with other emerging markets. 

Leaders in the US and elsewhere want China to translate its words into actions - they want real change not just a commitment to change.  But for now, Beijing has moved the exchange rate to where it wants to be - off the G20 negotiating table.

A careful examination of the fine print in Beijing’s announcement on exchange rate reform, however, suggests the US would be well advised not to allow the yuan to slide too far from view. 

China’s trade surplus might have come in at a tidy USD198bln in 2009, but that is still way down from almost USD300bln in the 2008.  Beijing has taken this as evidence that the trade account is coming close to balance of its own accord, and the need for further adjustment of the exchange rate is limited.  The announcement also makes clear that what adjustment there is will be gradual, to give the export factories of the Pearl and Yangtze river deltas time to adapt.  When it comes to exchange rate reform ‘limited’ and ‘gradual’ are not the words that Washington DC wants to hear. 

Even more alarming for the US, China has made it clear that in the future, the direction of travel for the yuan against any particular currency could be down as well as up.  The new plan for the yuan might mean continued stability, or even depreciation, against the dollar, at the same time as the currency appreciates against the euro, the Brazilian Real or the Indian Rupee. 

If Brussels, Brasilia, and New Delhi find the yuan’s new flexibility means appreciation against their own currencies, they will see little reason to support the US on the need for appreciation against the dollar.  By conceding to US demands for enhanced flexibility of the exchange rate, China might have succeeded in turning the international consensus on the need for yuan appreciation on its head.  If it is the US that finds itself isolated at the negotiating table at the next G20, scheduled for Korea in November, they might regret missing an open goal in Canada.

Exchange rate, Financial Crisis, International Relations, Trade, US-China Relations

It’s all change on the exchange rate, with the People’s Bank of China (PBOC) signaling the end of the CNY’s 20-month peg to the USD.  Quite what will replace the peg is not yet clear, with the PBOC suggesting that a move to a basket regime - with the value of the CNY determined in relation to a number of currencies of major trade partners - is a possibility.

In keeping with tradition, the PBOC made their policy announcement at the weekend - partly to give the markets time to assimilate the news before trading begins but mainly, I suspect, to deny us economists any leisure time.

Whilst the PBOC was putting the world to rights, I was flying back from Xinjiang to Beijing, and took the opportunity to glance over a copy of everyone’s favourite nationalist rag, the Global Times - provided for free by the good people at China Air.  The front page splash, which was evidently written before the PBOC announcement, was devoted to the latest saber rattling by the US Congress on the exchange rate.  This is my translation of the opening paragraphs:

‘Howls from a multitude of Congressmen yesterday turned what was originally a quiet hearing into a ’struggle session’ direct at China’s exchange rate policy.  The message from Congress was that patience with China’s policy on the CNY is at an end, and that if action does not come from China by the G20 meeting this week, then Congress will take the matter into its own hands.

This kind of ‘final warning’ from the US Congress has been heard so often in the last 20-years that it has started to give many Chinese people callouses on their ears.  Their selfish and self interested, or blindly arrogant resolutions have contributed countless troubles to the US China relationship.

In fact, the Congress does not have the power to make China act.  But at the same time they are not just a paper tiger.  Experts on US China relations believe that finding a way to deal with the US Congress is a long term challenge for the Chinese government.  But the first objective is not to fear Congressional posturing, and to study ways to break up their power.

This kind of Congressional grandstanding will make international observers believe that US China relations have already passed from a balmy spring into a turbulent summer.’

I especially enjoyed the re-imagining of Congressional Ways and Means Committee as a Cultural Revolution style struggle session.

Exchange rate, US-China Relations

The US China Strategic and Economic Dialogue has come and gone with no change to the yuan dollar exchange rate.  The US side appear to believe that the G20 in late June will be the new focus for pressure on China.  But market expectations of a resumption of appreciation have collapsed.

This is the view on the pros and cons (mainly cons) of yuan appreciation from Central University of Finance and Economics Professor Guo Tianyong, which I have translated in summary fashion from a recent posting on his blog:

‘We are going through a period of radical transformation in the structure of the Chinese and the world economy.  China will no longer be able to rely on the luxurious consumption of consumers in the West to drive growth, but will have to look to internal drivers.  In this context, rapid appreciation of the yuan would not provide a stable basis for changing the economic structure.

Second, as everyone knows, Chinese industry benefits from controlled domestic prices for important inputs to production - energy and water prices for example.  These controlled prices have been beneficial but have also introduced distortions into the economy and high levels of pollution.  Removing controls and bringing prices up to market levels is now a priority, but this will mean higher costs which will damage the competitiveness of China’s exporters.  Rapid yuan appreciation on top of higher factor costs would place too great a strain on our businesses.

Third, though some people claim that appreciation of the exchange rate can be used to control inflation, and China is faced with inflationary pressure, in fact the relationship between the exchange rate and inflation is not straightforward.  During the period from 2005 to 2008 faster appreciation appears to have been linked to higher inflation - not the other way around.

Turning to the impact on business, the impact of appreciation would vary from industry to industry and from company to company.  For commodity importers, and companies that want to invest overseas, a stronger yuan would be a positive.  For exporters, it would weaken their competitiveness.

For the export sector, textiles, electronics, light industry, and machinery and power generation make up 70% of exports and employ more than 70m people.  These are low value added industries that compete on price and make profits from high volume.  Our research indicates that these firms use mainly domestic inputs, so they would not benefit from cheaper imported input costs if the yuan appreciates. 

Our research also indicates that the after tax profits of these firms is already very low - close to 5% in the second half of 2007.  An appreciation of the yuan would therefore have a serious impact on them, and so on the wider economy.

For importers, the benefits of yuan appreciation would be limited.  China is a major importer of raw materials and an appreciation of the yuan would certainly reduce the cost.  But as the recent debacle over the pricing of iron ore indicates,  control of the price of commodities lies outside of China’s hands, and this would be the case no matter what the value of the yuan.

Summing up, the evils and maladies of a large yuan appreciation outweigh the benefits, and gradual appreciation is still the best strategy.’

Professor Guo is not adverse to the use of loaded rhetoric (references to the ‘luxurious consumption’ of the USA) or examples (the iron ore price negotiation - which has little to do with the subject at hand but is an emotive point for Chinese nationalists). 

But he is an influential economist within China, and it is interesting to see how points which  in the US and elsewhere would help make the case for rapid appreciation are here used to make the case for a more gradual approach. 

Secretary Geithner might argue that appreciation of the yuan is part of the adjustment of the Chinese economy.  Prof Guo argues that because China is adjusting the structure of its economy it cannot be expected also to rapidly appreciate the value of the yuan.

You can see the original blog posting here.

Exchange rate, Industry, Trade, US-China Relations, Uncategorized

China and US leaders are about to kick off this year’s meeting of the Strategic & Economic Dialogue with opening remarks.  I have an op ed on the talks in today’s South China Morning Post.

SCMP subscribers can read the article here, or I’ve pasted it below:

Don’t Mention the Currency

A sunk ship in South Korea and a sinking economy in Greece may be enough to scupper hopes of movement on the exchange rate at the US China Strategic & Economic Dialogue

China is a currency manipulator and unless they change their wicked ways we will take them to task: that was the message from Senator Barack Obama on the 2008 Presidential campaign trail.  Back then, the exchange rate was 6.83 yuan to the dollar.  Almost two years and one global financial crisis later, the exchange rate is still 6.83 yuan to the dollar, and President Barack Obama and his team have fallen strangely silent.

One reason for that silence might be that an informal understanding between Beijing and Washington has been reached.  Back in April, the US Treasury decided to delay publication of a report to Congress on international exchange rates - a report which might have officially designated China as a currency manipulator.  That decision came shortly after a visit to the US capital of one Zhong Shan, China’s vice Commerce Minister.  Whispers from Washington suggest that, though no concrete assurances were given, Zhong’s visit did at least result in a meeting of minds.  The US would dial down the rhetoric on the exchange rate and China would proceed with appreciation, at its own pace, but within a reasonable time frame.

For many in Washington, a reasonable time frame meant before the next meeting of the Strategic & Economic Dialogue - the annual US China talk fest which is set to take place in Beijing on the 24th and 25th May.  But with the talks about to commence, expectations of an early resumption of appreciation appear increasingly misplaced. 

Why the delay? Look no further than the European sovereign debt crisis.  The EU might have belatedly mounted its white horse to ride to the rescue of the Greek damsel in distress.  But the episode has rung alarm bells in Beijing, suggesting that the global financial crisis has yet to run its course and the time for the resumption of yuan appreciation is not yet right.

If a resumption of appreciation in advance of the meeting was too much to hope for, maybe a little table thumping in the meeting itself will do the trick? 

Probably not.  On the US side it is the State Department that’s calling the shots, and that means a focus on the strategic, not the economic, half of the Dialogue.  The sinking of a South Korean navy ship, with the deaths of 46 sailors on board, has raised the temperature on North Korea.  With an official investigation placing the blame squarely at the door of Pyongyang, shaping a response has risen to the top of the agenda for the Dialogue.  And with the focus of attention elsewhere, there is little hope of progress on the exchange rate.  Officials on both sides have already begun to talk the issue down.

A sinking economy in Greece and a sunk ship in South Korea might be enough to scupper hopes of a move on the exchange rate at this week’s Dialogue.  But excuses will do little to appease an increasingly vocal domestic lobby in the US.  Trade unions, industrial interests, and a Congress spoiling for a fight might have bought into the Treasury’s softly softly approach in the run up to the Dialogue.  But continued inaction may well use up scarce supplies of patience. 

The Treasury has signaled that it wants to see a multilateral solution to the problem - hinting at a resumption of appreciation ahead of the meeting of the G20 in Canada in June.  But if no action is forthcoming by then, domestic interest groups might start to ask what President Obama has done to make good on his campaign trail promises.

EU-China Relations, Exchange rate, Financial Crisis, International Relations, US-China Relations

I have an op ed in today’s South China Morning Post on the impact of the latest trade data and the European sovereign debt crisis on the outlook for China’s exchange rate.

SCMP readers can see the text here.  Or I’ve pasted it below:

Even the tea leaves some questions unanswered
 
 
When will Beijing loose its iron grip on the value of the yuan and allow its appreciation to resume? No one has a definitive answer to that question. But, until quite recently, the signs in the tea leaves suggested a resumption of appreciation was imminent and that a first move might even be on the agenda for this month or next.
Why so confident? Three factors seemed to suggest Beijing was gearing up for a policy shift. First, China’s exports are moving back onto an even keel. The factories of the Pearl and Yangtze river deltas are shifting up to full capacity, and exports for March and April have returned to pre-crisis levels.
 
Second, inflation has returned to the mainland’s economy. Increases in consumer prices might be contained but prices at the factory gate are way up, and one of the main reasons is higher costs for imported crude oil and iron ore. The appreciation of the yuan would help keep a lid on imported price rises.
Third, China’s trade partners are ratcheting up the pressure. A meeting of the US-China strategic and economic dialogue at the end of this month and a G20 summit at the end of next month will increase the volume of calls for appreciation. Beijing faces its own domestic pressures and nationalist sentiment might make it difficult to kowtow to the United States. But with the European Union and other emerging market economies like Brazil and India also calling for appreciation, China’s leaders might find themselves with few friends and many enemies round the G20 table.

The signs in the trade, inflation and political tea leaves seemed to point towards an imminent resumption of appreciation. But a vanishing trade surplus in March and April and the European sovereign debt crisis have thrown the tea leaves into a new configuration.
Central to the case for China’s trade partners is the idea that the appreciation of the yuan will help bring China’s trade account, and so also the world economy, back into balance. An undervalued yuan, the argument goes, gives China’s exporters an unfair advantage and cripples the competitiveness of exporters in the EU and US. The result is bumper trade surpluses in China and corresponding deficits elsewhere in the world.
But a deficit in China’s trade account in March and a tiny surplus in April have called this argument into question. If China’s trade account is moving back into balance at the current exchange rate, what is the urgency in resuming the yuan’s stalled appreciation?
The European sovereign debt crisis has also changed the calculation. For China’s leaders, the Greek drama signals that the international outlook remains uncertain. If the path to recovery is rockier than was previously thought or, even worse, might lead off another cliff, that is bad news for China’s exporters.
The EU seems to have moved decisively, if belatedly, to restore confidence and stability. But with the outlook uncertain, China’s leaders are hardly likely to kick away the main support for the most important sector of the economy.
The Greek crisis also affects the way the European side views the exchange rate. A silver lining to the Greek cloud has been a fall in the value of the euro against the yuan - strengthening the competitiveness of European exporters. With plenty to worry about at home and the exchange rate moving in their favour in any case, Brussels is likely to dial down the volume of complaints on China’s exchange rate regime.
All this changes the calculation on China’s exchange rate regime. The signs in the tea leaves are no longer as clear as they were. If the Greek drama develops into a European tragedy, or China’s trade account stays close to balance this month, it might even be time to brew a fresh pot.

EU-China Relations, Exchange rate, International Relations, Monetary Policy, Trade, US-China Relations

When will China raise interest rates?  That, alongside the question of the exchange rate, is the key focus for market attention.  In the view of Fudan University economics professor Sun Lijian, now is not the time.  This is my translation of the main points from his recent blog posting:

‘Today, China is faced with the problems of imported inflation from high commodity prices and a bubble in the property sector.  That is a similar situation to the one we faced in the second half of 2007 and first half of 2008.  Back then, academic and government economists were united in calling for higher interest rates.  What is the difference now?

First, the real economy is growing fast, but it’s a feverish, not a healthy growth.  With the real economy still in recovery phase, using the blunt instrument of interest rates to raise the cost of capital might actually have the impact of forcing capital out of the real economy and into the capital markets - making the property bubble worse.  Quantitative measures - like the reserve requirement ratio - are the best way to clamp down on asset price bubbles without impacting the recovery in the real economy.

Secondly, raising interest rates would not be interpreted by the markets simply as a tightening of monetary policy, but rather be seen as a withdrawal of the stimulus.  If panic gripped the markets, the good work of the twin fiscal and monetary stimulus might be undone.  At the same time, by increasing the interest rate differential with the USA, raising rates might attract hot money inflows, putting more pressure on the currency to appreciate.

Third, for Asian countries - Thailand, Korea, Indonesia - the problem is containing property bubbles caused by rapid inflows of capital.  Containing inflationary pressure and asset bubbles resulting from capital inflows is the most important economic problem facing Asian governments, including China.  Raising rates would attract more capital inflows and make that job more difficult.

Summing up, the risks to the real economy, worsening asset price bubbles, putting more pressure on the exchange rate, and attracting capital inflows suggest that the government should focus first on the use of quantitative tools (the reserve requirement ratio, lending guidance to banks), and that the time for raising interest rates is not yet right.’

You can see the original here.

Exchange rate, Financial Crisis, Monetary Policy, Property

China’s sudden rise invites comparisons with the equally abrupt arrival of its near neighbour Japan on the world scene a few decades ago.  China’s leaders also like to draw lessons from the economic mismanagement of Japan, which has resulted in a lost decade of torpid growth.  In particular, China’s leaders like to point at the problems caused by Japan’s revaluation of the yen, as part of their argument against revaluing the yuan.

But exchange rates are not the only point of comparison between China and Japan.  A cartoon doing the rounds on the Chinese internet invites comparison between the Japanese property sector of the 1980s and the Chinese property sector of today. 

The diagram gives a stylised history of the collapse of the Japanese property sector:

1985 - the Japanese yen appreciated

1986 - speculative capital started flowing into Japan

1987 - house prices had tripled in value (it doesn’t say from what level)

1988 - property prices collapsed but were supported by real estate moghuls

1991 - property prices fell again, there was no one to support them, and the real estate sector collapsed.

The author of the diagram suggests that the Chinese property sector is going through the same process: appreciation of the yuan in 2005, hot money inflows in 2006, sharp rises in property prices in 2007, a fall in prices halted by intervention by real estate developers in 2008, and set for a total collapse in 2011.

Property prices in China are certainly high, and much higher as a multiple of average income than in the US and EU, or even other emerging market economies.  With property prices out of line with fundamentals there’s a risk of a correction, and perhaps a sharp correction.  But I am not sure the comparison with Japan is necessarily the best one to make.  China today is still a developing country with a low level of urbanisation.  Rising incomes and a continual shift of the  from the countryside into the cities will underpin demand for property.  Japan in the 1980s was already a developed and urbanised country, so the property sector could rely on neither of these supports.

You can see the original cartoon here.

Exchange rate, Property

I have an article in today’s South China Morning Post on where China is investing its USD2.4trln in FX reserves.

SCMP subscribers can read the article here and I’ve also pasted it below.

The USD2.4trln mystery

Where exactly is China investing its US$2.4 trillion in foreign exchange reserves? Most economists agree that a substantial chunk, and perhaps the majority, of those reserves are invested in US Treasuries - debt issued by the US government to finance its spending.

Until quite recently, monthly data published by the US Treasury supported that thesis. The Treasury International Capital System (TIC) - a massive data collection effort by the bean counters in Washington - showed a steady increase in China’s holdings of US Treasuries. Holdings did not increase by as much as the increase in China’s foreign exchange reserves, but they did grow steadily enough to confirm that China’s State Administration of Foreign Exchange remained the US Treasury’s best customer.

But, in the second quarter of last year, that relationship started to break down. China’s foreign exchange reserves continued to grow at a rapid pace, but the Treasury data picked up little if any increase in China’s holdings of US Treasuries.

Data from the People’s Bank of China shows that between April and December last year, China added a whopping US$441 billion to its foreign exchange reserves. But according to purchases picked up by the monthly TIC data over the same period, China’s total holdings of US Treasuries fell by US$12 billion.

That discrepancy flies in the face of common sense. China has continued to run a substantial trade surplus with the US. If Beijing’s foreign exchange managers were not reinvesting that surplus in US dollars, the brutal logic of supply and demand in international currency markets would force the yuan to appreciate against the dollar. But it has not, suggesting that China continues to park its reserves in US dollar debt.

Enter the Treasury’s annual survey of foreign holdings of US securities, which pieces together who is really buying US Treasuries. The results of the latest survey show China’s purchases of US Treasuries continued unabated. The results propel China back into first place as the biggest holder of US Treasury debt, with US$894 billion.

What the annual survey captures, that the monthly data misses, is a bias in the monthly data that attributes Treasury purchases to the place they are purchased, not the country of ownership.

Beijing’s foreign exchange managers appear to be taking advantage of flaws in the system to hide their purchases - deliberately channelling purchases through London and other centres to hide the increase in their holdings.

The motivation is probably partly domestic public opinion, which is decidedly averse to financing the profligate US government. At the same time, signalling intentions to the markets makes little sense.

For Beijing, hiding its purchases of US Treasuries plays to the nationalist gallery by hiding the fact that China continues to fork out its cash to finance the US deficit. And it keeps the financial markets guessing on where China is investing its money. If that means the rest of us also stay in the dark, that’s just too bad.

Exchange rate, International Relations, Monetary Policy, US-China Relations