China’s reserves. Why did reserve increase by less than China’s trade surplus in November?

Suppose that you had $800 billion at the end of September. OK, not $800 billion exactly. Let's say $560 billion in dollars, $160 billion in euros (euro 132.7 billion), and $80 billion in yen (yen 9063.2 billion). By the end of November, that portfolio would have shrunk to $792.2 billion. The euro fell by 2.22% against the dollar (mostly in November); the yen fell by 5.32% against the dollar.

China, of course, didn't quite have $800 billion in reserves. Try $769 billion. Though I would argue that the real number is $829 billion, counting the $60 billion that have been transferred, at least nominally, to three state banks. And I certainly don't know the currency composition of China's reserves. 70% dollars, 20% euros and 10% yen is just a guess - though it is one of the guesses made by the IMF's former mission chief to China and his current colleague in the IMF's research department.

But it does suggest one reason why the pace of increase in China's dollar reserves slowed significantly in October, and then slowed even more in November. China is sailing into a significant headwind, as valuation losses could easily have reduced the dollar value of its foreign exchange reserves by $7.8 billion, if not more, over the last two months.

China has leaked that its reserves totaled $784.9 billion at the end of October, and $794.2 billion at the end of November. That implies that China's reserves increased by $15.9 billion in October on the back of a $12.0 billion trade surplus, and then increased by another $9.3 billion in November. The $9.3 billion increase in November is quite low - it is smaller than China's $10.5 billion November trade surplus.

I think it is safe to assume that the dollar value of China's existing reserve portfolio fell substantially in November, generating valuation losses that slowed the increase in China's reserves.

Of course, China reserves generally have increased by more than the country's trade surplus - big net capital inflows have contributed significantly to China's growing reserves. In the third quarter, those capital inflows were in the range of $10 billion a month. Roughly $5 billion in FDI and $5 billion in hot money inflows. Add together a $10 billion monthly trade surplus and $10 billion in monthly inflows generates reserves growth of around $20 billion a month.

Had China's reserve growth continued at that pace in October and November - setting valuation gains/ losses aside - China's reserves would now be $809 billion, rather than $794.2 billion. Even if you add in $7.8 billion in valuation gains, that only brings the (adjusted) total up to 802 billion.

Or, on a flow basis, if China had a 70/20/10 dollar/euro/yen reserve portfolio, China's reserves increased by $33 billion over the last two months -- think $33 billion, a $7.8 billion valuation loss, and a reported reserve increase of $25.2 billion.

That $33 billion underlying increase in reserves can be decomposed into a $22.5 billion trade surplus, which works out to a current account surplus of maybe $24 billion, and only $9 billion in (net) capital inflows. $9 billion over two months is $4.5 billion a month - a big fall off from the roughly $10 billion a month average in the third quarter.

So what happened? Five possibilities.

1. China holds more than 30% of its reserves in currencies other than the dollar. That would have generated larger valuation losses - and thus implies a stronger underlying pace of increase in China's reserves.
2. Chinese outward FDI picked up substantially in October and November, so say Chinese investment in oil fields abroad offset some of the money coming into China to build manufacturing facilities.
3. Inward FDI into China slowed substantially.
4. Hot money inflows into China slowed substantially. That is what the central bank has claimed. And with US short-term rates now above 4% and Chinese deposit rates only 2.25%, holding RMB is not as attractive as it used to be. If you don't think the Chinese government will allow the RMB to rise against the dollar - or that it will rise against the dollar at a glacial pace - holding RMB has a cost. To use market jargon, the carry is negative.
5. Chinese capital outflows picked up. China's government certainly has been trying to encourage capital outflows recently. The central bank would rather see private Chinese citizens (and Chinese firms) hold dollars than see the central bank's reserves rise.

My bet - a bit of all five. And since I have a suspicious mind, I would not be completely surprised if China's government did more than just loosen laws that were designed to discourage capital outflows. I would not be completely surprised to learn that say China's government put a bit of pressure on state firms not to repatriate their dollar profits, or to increase their offshore dollar holdings. After all, China's state oil firms probably intend to keep on buying oil producing assets abroad in 2006 ... and they might well be happy to build up their external dollar holdings.

If China released detailed data on its balance of payments, it would not be hard to figure out what happened - and, by inference, to figure out a bit more about the currency composition of China's reserves. But China lags the global trend towards better balance of payments statistics in a big way. Compare the data China releases on its balance of payments with the data Turkey releases, and you will see what I mean. That means more guess work for us all.

One last set of points. A couple of days ago, it looked like China might experience some valuation gains in December, but after a recent rally, the dollar looks set to end December at the same level it ended November. Today, the dollar is at 1.1842 v the euro and 117.81 against the yen, v 1.179 and 119.66 yen at the end of november. No big valuation gains, but no big valuation losses either.

Do look though for the pace of China's reserve growth to pick up in December. And if the dollar starts to fall during the course of 2006, don't be surprised if China's reserves really start to soar - at least in dollar terms.

Of course, China should really care about the RMB value of its reserves, not the dollar value of its reserves. And if the RMB rises against the dollar (and the euro), the RMB value of China's external assets will fall, while the value of its domestic liabilities (a mix of currency in circulation, bank deposits in the central bank and sterilization bills) will stay the same.   That is what Yu Yongding and others in the People's Bank of China worry about ...