Currency Reserves

It should go almost without saying that China’s ability to maintain its current exchange rate regime matters. The yuan has been more less stable against the CFETS basket since last July. If the current peg breaks, China will struggle to avoid a major overshoot of its exchange rate. Christopher Balding recently has argued that the fall in the dollar (on say the Fed’s dollar index) in 2017 is more or less the same as the yuan’s depreciation against the basket—which would make China’s exchange rate regime now more a pure peg against the dollar rather than a true basket peg. Hence the lack of movement against the dollar in past few weeks. Maybe. I though am inclined to think that the yuan’s depreciation against the basket this year just undid the upward drift against the basket that came when the dollar appreciated last year, and China is still aiming to keep the currency more or less stable against the basket, not stable against the dollar. Time will tell. Right now, the exact nature of China’s peg now matters less than China’s ability to maintain some kind of peg, and thus to avoid a sharp depreciation. If there is a depreciation, either the world will absorb a new wave of Chinese exports—a 10 percent real effective exchange rate depreciation should raise China’s real trade balance by about 1.5 percent of China’s GDP, or by roughly $180 billion (using this IMF study as a baseline for the estimate, it is summarized here)—or a wave of protectionist action will limit China’s export response, and in the process threaten the global trading rules.* Neither is a good outcome. The data for the next few months will be critical. China does seem to have tightened its outflow controls—despite the official denials. FDI outflows certainly have slowed. Hopefully the screws will be placed on a few other categories of outflows—there are plenty of categories in the balance of payments that show a buildup of foreign assets that, in my view, should be controllable. The rise in Chinese bank loans to the world, for example. I also still think the yuan’s movement against the dollar is an important driver of outflows, so a sustained period of stability in the yuan’s exchange rate versus dollar—whether because the broad dollar is falling and that means the yuan needs to rise to maintain a basket peg, or simply because China starts to prioritize stability versus the dollar—should lead to a reduction in pressure.** Finally China does seem to be tightening its domestic policy, at least a bit. Higher money market rates should also help support the yuan. The proxies for intervention for January do suggest some reduction in pressure in January—though pressure by no means entirely went away. The FX settlement data, adjusted for reported forwards, shows net sales by the banking system of just under $20 billion. That is down from $36 billion in November, and $54 billion in December. The PBOC’s balance sheet data shows a $30 billion fall in foreign reserves, and a $60 billion fall in foreign assets. That can be compared to an average monthly fall—on both measures—of around $45 billion in the fourth quarter of 2016. I typically prefer foreign assets to foreign reserves, because foreign assets captures the foreign exchange the banks hold at the PBOC as part of their regulatory reserve requirement—and in the past, changes in the banks required reserves have been a tool that the central bank has used for shadow intervention. However, the January fall looks to be something else. In the past, changes in the PBOC’s foreign assets—at least those that mapped to backdoor intervention—generally have been correlated with changes in the settlement data (this makes sense, the PBoC’s other foreign assets are in part the banks required reserves, and the settlement data aggregates the central bank and the state banks). One story is that the PBOC has changed how it accounts for its contribution to the IMF. But until that story is confirmed, the fall in other foreign assets has to be part of the calculus. While the gap between the settlement number and the change in the PBOC’s balance sheet is particularly large in January, a smaller gap has been present for a while. The PBOC’s balance sheet data thus implies slightly larger outflows than the settlement data. Bottom line: The balance of evidence suggests a moderation in pressure on China’s exchange rate regime in January—but a moderation in pressure isn’t the same as an end to the pressure. Unlike some, I do not think China’s fundamentals require a depreciation. The current account remains in surplus, China’s export market share has held up well—and China is (once again) growing faster than most of the world. But sustaining the current basket peg will be hard if outflows do not moderate. * I recognize that a rise in protectionism is a possible outcome even if China doesn’t move ** If stability or appreciation against the dollar doesn’t materially reduce reserve loss over a several month period, I would need to reevaluate my priors

The pace of decline in China’s foreign reserves matters. Not because China is about to run out. But rather because China will at some point decide that it doesn’t want to continue to prioritize “stability” (against a basket) and will instead prioritize the preservation of its reserves, and let the yuan adjust down. Significant voices inside China are already making that argument. And I fear that if the yuan floats down, it will stay down. China will want to rebuild reserves, and—if exports respond to the weak yuan—(re)discover the joys of export-led growth. Relying on exports is easier than fighting the finance ministry’s opposition to a more expansive (on-budget) fiscal policy, or seriously expanding the provision of social insurance to bring down China’s savings. I thus disagree with those who argue that the “China” shock is over. It depends a bit on the exchange rate. China’s exports of apparel and shoes have probably peaked. But China’s exports of a range of machinery and capital goods continue to remain strong—and at a weaker exchange rate, China could supply more of the components that go into our electronic devices, and export far more auto parts, construction equipment parts, engines, generators, and even finished autos than it does now. “Mechanical” engineering writ large continues to be a significant part of the U.S. economy, and even more so the European economy. One of the main indicators—PBOC balance sheet reserves—that I follow for tracking China’s reserve sales is now out for December, and it points to around $45 billion in sales. I prefer to look at all the foreign assets the PBOC reports on its balance sheet rather than just its reported foreign exchange reserves. That variable was down $43 billion in December, and $133 billion for q4. Actual foreign exchange reserves fell by a bit more—$46 billion in December and $141 billion in q4. The difference between foreign exchange reserves and all of the PBOC’s foreign assets is primarily the foreign exchange the banks hold at the PBOC as a result of their reserve requirement. The loss of reserves in December was a bit smaller than in November. But only just. The average monthly fall in q4 was over $40 billion. That is a pace that is ultimately unsustainable. I think China would be fine with $2 trillion in reserves, given how little foreign debt it holds. Others say $2.5 trillion. If reserves are falling by a steady $40 billion a month/$500 billion year, it is only a matter of time before China hits its limit. With China, it may be a long time though… However, there are two reasons why I am not yet convinced that it is only a matter of time before outflows overwhelm the PBOC’s reserves and other exchange rate defenses. First, reserve loss and thus the scale of outflows remains correlated with movements in the yuan against the dollar. In quarters with significant yuan depreciation against the dollar, reserve loss—using the PBOC’s foreign assets as the measure—has varied between $100 billion and $225 billion (q3). In the two quarters during the past year when the yuan was stable or appreciating against the dollar (q2 of 2015 and q2 of 2016) the quarterly reserve loss was very modest—under $20 billion. So if the PBOC was serious—and that might mean losing a bit of face by moving away from the basket peg—and let the yuan strengthen against the dollar, my guess is that outflow pressures would fall significantly. It would help if the PBOC allowed a bit (more) upward drift against the basket—and thus reinforced expectations of two-way risk against the dollar. Remember that the PBOC took advantage of dollar weakness in the first half of 2016 to reset the yuan’s level against the basket. I understand why, but that reset had a price—it reinforced expectations that the yuan only will move one way against the dollar. The second is that a lot of the outflows so far in 2016 have come through channels that I think the State Administration for Foreign Exchange (SAFE) can effectively control, if it was determined to do so. A surprisingly large share of the outflows last year come from balance of payments categories that I think the authorities can control, and can control without too much administrative difficulty, as they ultimately require supervising a relatively small number of accounts at a manageable number of large state institutions (of course there are political difficulties here, but the administrative complexity should be lower). A bit of balance of payments math: China runs a goods surplus of around $500 billion (in BoP terms) annually. And—even with the fall off in FDI inflows—should get another $100-$150 billion in FDI ($250 billion would have been more typical a few years back). So China has over $600 billion/6 percent of GDP in inflows from FDI inflows and the goods trade to finance its services imports (which likely include a lot of hidden outflows through the tourism side), its FDI outflows, and non-FDI outflows, without having to dip into its reserves. Of course, China has dipped into its reserves in 2016. Based on the PBOC balance sheet data, reserve outflows in the balance of payments for 2016 should be about $450 billion (I am assuming a $150 billion fall in reserves in the q4 balance of payments). But I can count outflows of roughly equal size that seem to me relatively easy for the PBOC—really SAFE—to control if they really want to. In 2016, the banks have been adding to their foreign exchange reserves (other foreign assets) at the PBOC at a roughly $25 billion a quarter pace. That slowed in q4, so let’s call it about $75 billion a year in outflows. That easily could be put to an end; the share of the banks regulatory reserves held in foreign exchange is totally determined by the PBOC. In 2016, the build-up of portfolio debt and equity assets abroad—almost certainly by a few state institutions or major financial institutions that the state regulates—has been a bit under $25 billion a quarter. Call it $100 billion a year. China knows how to put a stop to these flows; outflows in these line items were essentially zero from 2010 to 2014. In 2016, overseas lending—long-term loans made by the Chinese state banks to the rest of the world—have averaged a bit over $25 billion a quarter, or $100 billion annualized. These all come from the big state commercial and policy banks. They could be slowed with a bit of regulatory supervision. And FDI outflows have averaged about $60 billion a quarter in the first three quarters (roughly $250 billion annualized). A more normal number—judging from the numbers seen before the devaluation—would be maybe $25 billion a quarter ($100 billion a year). Reducing outflows there back to the norm—as seems likely to happen—might reduce total outflows by $150 billion. Sum up these line items, and that takes away $425 billion in outflows—a sum almost equal to the projected fall in reserves in the balance of payments. And I suspect that if China’s reserves fell by $25 billion a year, no one would care that much (even if such a number implies an ongoing outflow of between $400 and $500 billion, depending on your view of how much of the services deficit is “real”).

I want to step back a bit from the rather extraordinary moves in the offshore yuan market over the past few days. It seems quite clear that China’s authorities felt the need to signal that the yuan isn’t currently a one way bet against the dollar. And stepping back in this case means taking a deep dive into the details of the balance of payments data -- details that come out with a quarter lag, and thus provide information that is stale from the point of view of a forward-looking market. A lot, and I mean a lot, changed in the fourth quarter. I generally like it when China’s data series line up. Line up with each other. And, when possible, when China’s data also lines up with data reported by China’s trading partners. So I have been bothered for some time by the large discrepancy between the fall in China’s foreign exchange reserves (as reported on the PBOC’s balance sheet, $108 billion in the third quarter) and the much smaller net sales of foreign exchange by China’s banks (as reported in the FX settlement data, $50 billion in the third quarter without adjusting for the forwards reported in the settlement data, $63 billion with the forward adjustment). Fx settlement includes all the banks, not just the central bank. Historically, though, it has been very correlated with overall reserves. The initial balance of payments (BoP) data for the third quarter showed large reserves sales ($136 billion), sales on a scale that was consistent with the PBOC balance sheet numbers. The BoP reserves sales thus seemed to suggest a big pickup in capital outflows in the third quarter. However, the detailed balance of payments data suggests that the signal from the FX settlement data may be more accurate. Much of the q3 fall in China’s reserves seems tobe explained by the buildup of foreign assets by other state controlled financial institutions, not “private” capital outflows. I see a likely increase of around $85 billion in the foreign assets of state institutions other than the PBOC in q3. Which implies that the actual fall in “official” assets might be as low as $50 billion in the third quarter, and estimated private outflows (estimated as the difference between net inflows from the current account and net FDI flows and the buildup/sale of official assets) might have been about $100 billion. The ongoing build-up of foreign assets by the state banks and other state institutions also implies that the net sale of foreign assets by China’s state might have been as low as $200 billion in the four quarters from q4 2015 to q3 2016, with $400 billion in reserve sales offset in part by a rise of around $200 billion in the foreign assets of China’s other state financial institutions. Two hundred billion dollars is a large sum -- but one that also suggests that depreciation pressures earlier this year were significantly smaller (when official sales are scaled relative to China’s GDP) than the appreciation pressure back in 2006, 2007 and 2008 (and, for that matter, 2010). (In the chart above estimated reserves is a bit mislabeled; it should be either "augmented reserves" or "estimated official outflows") To be clear, my adjustments change the timing of the sales (and thus the timing of the peak outflow pressure) more than the cumulative magnitude of sales. They imply that state financial institutions sold a lot of foreign assets in the third quarter of 2015 to help the PBOC support the currency, and then rebuilt their foreign asset position over the next few quarters -- most obviously through a fall and then a rise in the state banks holdings of foreign exchange as part of their required reserves (reported as "other foreign assets" on the PBOC’s balance sheet).   And I also have little doubt that outflow pressure increased in the fourth quarter of 2016. The modest sum in the trailing four quarter sum through q3 is thus in part a function of the fact that two quarters with large sales are just outside the covered time period. Several other caveats are also needed. First, I am trying to understand the outflows in the third quarter (July through September). The third quarter is now ancient history. The yuan was relatively stable against the dollar in most of the third quarter. The yuan decidedly was not stable against the dollar in q4 and outflow pressures seem to have increased. The PBOC tightened its controls in the fourth quarter for a reason. Second, even if I am right and "true" private outflows are smaller than implied by reserve sales in the balance of payments in the third quarter —the obvious measure of “hot” outflows from China is either the difference between reserves (sales/purchases) and the current account, or the difference between reserve sales and the combined surplus from the current account and net FDI flows—there is no question that outflows were larger in the third quarter of 2016 than in the second quarter of 2016. The question is one of magnitude, not of direction. Third, to keep it simple, my estimate of "private" financial outflows in the first chart doesn’t include outflows that are disguised in the current account. It thus likely under-states actual capital outflows, as I clearly think there are financial outflows embedded in the current account. I tried to keep the chart relatively simple, and the adjustments relatively transparent -- so I didn’t adjust for hidden outflows.** Fourth, these estimates hinge on a set of educated guesses about who appears where in the balance of payments data, as China doesn’t release the kind of details that would allow outside observers to know for sure which set of institutions inside China’s financial system built up their foreign assets. I want to emphasize that these estimates are subject to change as my understanding of what drives different categories in the balance of payments changes. So why precisely do I suspect official (or quasi-official) asset growth provided a significant offset to reserve sales in the third quarter? A) The balance of payments data shows a $16 billion increase in the line item that corresponds to the rise in the PBOC’s other foreign assets -- the technical term for the foreign exchange the banks are required to hold as part of the regulatory reserve requirement. B) There was a big rise in lending by the state banks to the rest of the world ("loans" by the banks to the world rose by $37 billion in q3). I have always assumed that the term “state commercial bank” has real meaning in China, and that such lending could be stopped if the government really wanted it to stop. It was more or less non-existent before 2011, and much of the rise since then clearly comes from the China Development Bank. C) The balance of payments data shows large purchases of foreign portfolio debt and foreign portfolio equity (just over $30 billion in q3). This is a bit puzzling because there was no reported change in the Qualified Domestic Institutional Investor (QDII) quotas. So it wasn’t, I assume, from small private investors. And it wasn’t totally hidden either. After all, it shows up in the official data as an outflow, and also as a rise in foreign assets in the international investment position data. My best guess is that this is coming from some kind of state institutions —be it the social security fund, the China Investment Corporation (CIC), the state banks or even perhaps the life insurers. As a result, my estimate of the total stock of foreign assets under China’s state control fell by significantly less than the PBOC’s reserves in the third quarter.** All this implies that one arm of the state is betting against another, with state financial institutions building up assets abroad even as the PBOC runs down its reserves. And it thus raises a simple question: why would the government want to draw down its central bank reserves to allow the state commercial banks and other state financial institutions to raise their foreign assets? My gut is that some folks at the PBOC started asking similar questions over the last year, which could in part explain the tightening of controls toward the end of this year—cracking down on FDI outflows sent a signal that the "go out" policy no longer dominates all other considerations. Chinese policy coordination isn’t always perfect. Finally, my gut also says that while the pressure in q3 wasn’t as severe as the fall in reserves suggests, the fourth quarter is different. The squeeze now underway in the offshore yuan market suggests that the PBOC is working hard to discourage further outflows and to fight expectations of further depreciation. * Technically, I am assuming that "other, other, assets", "other, loans, assets", "portfolio debt, assets", "portfolio equity, assets" are all driven by state controlled institutions, and not making further adjustments The portfolio flows data could be adjusted for QDII, but I think it is clear that "portfolio debt" historically has been driven by the state banks (05 to 06 purchases, then sales) and portfolio equity has been in part driven by the CIC given the timing, and the recent run-up isn’t a function of QDII. "Other, other" is the foreign exchange the banks hold at the PBOC as part of their required reserves, other, loans seems historically to have been driven by the CDB. Of course the recent rise could come from different channels, but it almost certainly comes from the large state banks. ** This is all based on "on balance sheet assets," it doesn’t attempt to adjust for China’s rumored forward book. See this post for more on the forwards (with apologies for the level of technical detail).

The dollar’s rise doesn’t just have an impact on the United States. It has an impact on all those around the world who borrow in dollars. And it can have an enormous impact on those countries that peg to the dollar (Saudi Arabia is the most significant) or that manage their currency with reference to the dollar. China used to manage against the dollar, and now seems to be managing against a basket. But managing a basket peg when the dollar is going up means a controlled depreciation against the dollar—and historically that hasn’t been the easiest thing for any emerging economy to pull off. And China’s ability to sustain its current system of currency management—which has looked similar to a pretty pure basket peg for the last 5 months or so—matters for the world economy. If the basket peg breaks and the yuan floats down, many other currencies will follow—and the dollar will rise to truly nose-bleed levels. Levels that would be expected to lead to large and noticeable job losses in manufacturing sectors in the U.S. and perhaps in Europe. Hence there is good reason to keep close track of the key indicators of China’s foreign currency intervention. The two main indicators I track are now both available for November: The PBOC’s yuan balance sheet shows a $56 billion fall in foreign exchange reserves, and a $52-53 billion fall in all foreign assets (other foreign assets rose slightly). I prefer the broader measure, which captures regulatory reserves that the big banks hold in foreign currency at the PBOC. The FX settlement data—which includes all the state banks but historically has been dominated by the PBOC—shows a smaller $36 billion fall counting the change in the forward position (there is a forward component of FX settlement, but it doesn’t capture offshore yuan—e.g. CNH—forwards). Without the forwards the fall is $27 billion. Both measures show larger sales in November than October, though the settlement data suggests a smaller net outflow from the banking system than the PBOC balance sheet reserves data. Both thus highlight why PBOC was worried enough to tighten its controls at the end of November and start to review outward foreign direct investment a bit more tightly (a step that it arguably should have taken earlier). (Goldman’s numbers are similar). The settlement data shows about $300 billion in total sales by the PBOC and the state banks over the first 11 months of 2016; the PBOC foreign reserves data point to $315 billion of sales over 11 months. Very roughly, that suggests annual sales in the $325 to $375 billion range. With a current account surplus that should be around $275 billion, total private outflows will be at least $600 billion (or roughly $50 billion a month, on average). I say very roughly because I would get a higher number if I adjusted for outflows embedded in the current account—notably the possibility that some of China’s $300 billion plus in tourism "imports" are really disguised capital outflows. China in my view could sustain $350 billion in reserve sales for a couple of years. $350 billion is 3 percent of GDP, and China still has a bit over $3 trillion in official reserves and I suspect a bit more counting its hidden reserves. But it is also clear that the pace of outflow has not been constant in 2016. Outflows were higher in the first part of the year, then slowed significantly in the second quarter (when the yuan appreciated against the dollar), and then rose over the last five months. They still seem correlated with moves in the yuan against the dollar, though the magnitude of the reserve drain in November—when the yuan depreciated significantly against the dollar—was smaller than in January. Possibly that is because China’s controls have had an impact, thought is also could just reflect the fact that there is now less foreign currency debt to pay off. If the current pace of reserve sales is really the $50 billion a month implied by the PBOC’s balance sheet and its stays there, reserves would fall by $600 billion next year. That is uncomfortable even for China. China’s exchange rate management problem is that stability against a basket—during periods when the dollar is rising, and thus periods when stability against a basket implies further depreciation against the dollar—doesn’t seem to be enough to limit outflows. What works is stability or appreciation against the dollar. Any depreciation against the dollar still seems to lead to expectations of a further move. As the following chart makes clear, China has unquestionably managed its currency over the past few months to maintain stability against the basket. It is also clear that China’s hasn’t managed for stability against the basket consistently over the past year. The dollar now is a bit stronger than it was in late December and early January (back when the yen was over 120). Yet the yuan is weaker against the dollar now than it was then. At some point over the summer China seems to have shifted from managing for a depreciation against the basket to managing for stability against the basket. I see two possible paths from here. In one, the Chinese authorities continue to be able to manage the yuan so it remains stable against the basket—whether because the dollar stops rising and that takes some of the pressure off, or because China maintains sufficient control that it can limit the pace of the yuan’s depreciation to what is needed to maintain stability against the basket. A key part of this scenario is that the tighter financial controls prove effective, and outflow pressures abate once Chinese firms have more or less finished paying down their existing stock of external foreign currency debt. It would help if China used fiscal policy to support consumption and maintain demand growth, and thus depends less on monetary policy and cheap credit to support the economy. It would help if Chinese export growth strengthened on the back of the yuan depreciation since mid 2015, providing a more positive narrative around China’s currency. And of course it would help if the dollar didn’t rise too much more. The recent sell-off in China’s bond market has generally been presented as further evidence of China’s financial weakness. But it can be viewed as positive signal for the longer-run ability of China to maintain its current system of currency management, even if has disturbed the market: Chinese policy makers are now looking to raise rates and tighten credit for domestic reasons, as inflation has picked up and they are worried about froth in the housing market. It will be easier for China to maintain its current de facto basket peg if the PBOC wants to raise rates alongside the Fed next year.* In the other outcome, Chinese authorities either loose interest in resisting depreciation—perhaps in response to U.S. tariffs or other policy shifts, perhaps in response to a renewed slowdown in domestic growth—or loose control over financial flows and expectations. And, well, that would mean a much weaker yuan, much more pressure on other emerging currencies, a further leg up in the dollar, further falls in U.S. exports, more trade tension, and likely a rise in balance of payments imbalances globally. * I agree with Gabriel Wildau’s FT article, which emphasizes how the PBOC has chosen not to offset the impact of foreign currency outflows on money market rates because it wants to tighten money market conditions, not because it is incapable of doing so. " Market participants say the PBoC is taking advantage of capital outflows to squeeze leverage out of the bond market. By calibrating the volume of its reverse repos, the PBoC can passively guide short rates upwards. Higher interest rates have the added benefit of discouraging capital outflows by increasing the returns available on renminbi assets."

China’s reserves fell by $69 billion in November. With the notable exception of Sid Verma and Luke Kawa at Bloomberg, Headlines generally have emphasized the size of the fall The Financial Times was pretty restrained compared to the norm, and the FT still highlighted that the November fall was “the largest drop since a 3 per cent fall in January.” But the fall was actually a bit smaller than what I was expecting. Valuation changes on their own knocked $30 billion or so off reserves (easy math—$1 trillion in euro, yen and similar assets, with an average fall of 3 percent in November). It isn’t quite clear how China books mark-to-market changes in the value of its bond (and equity portfolio). My rough estimate would suggest mark to market losses on China’s holdings of Treasuries and Agencies of about 1.5 percent, or $20 billion (Counting the agency portfolio and Belgian custodial book, per my usual adjustment). Bunds and OATs (French government bonds) also fell in value—but SAFE likely has a couple hundred billion in equities too, and their value rose. But it isn’t clear that all of China’s assets are marked to market monthly, so there is a bit of uncertainty here not just about the overall performance of the portfolio, but also how the portfolio’s value is reported. Sum it all up and it is possible valuation knocked somewhere between $30 and $50 billion off China’s headline reserves. Which implies that “true” sales were between $20 and $40 billion. And frankly that seems a bit low. The proxies (my term for the FX settlement data and the PBOC yuan balance sheet data that are proxies for actual intervention) haven’t been telling a consistent story recently. But the PBOC balance sheet data suggests monthly sales in the $30-40 billion range and there is good reason to think that the pace of sales picked up in November.* Depreciation (against the dollar) tends to spur expectations of more depreciation (against the dollar)—even if the depreciation against the dollar is fully explained by the mechanical operation of a basket peg. And, well, China presumably tightened its controls on capital outflows—notably by introducing much tighter controls on outward FDI—because it was either worried about the current pace of its reserve loss, or was worried that the pace might pick up in the future. Makes me all the more impatient to see the more reliable indicators for November. On the trade side, there was real news in the November data. Nominal exports (in yuan terms) jumped around 6 percent. If export prices stayed at their October level, real exports rose at a similar pace. That bit of good news was needed. Export prices rose by more than I projected in October, which means real exports in October were weaker than I initially thought: the Chinese data shows a 2 percent fall in goods export volumes for October. The strong November pulls my initial estimate of the year-over-year expansion in volumes over the last three months back into positive territory. Not great to be sure, but in line with the weak overall global trade numbers (U.S. imports, especially of consumer goods, have been weak; the commodity exporters are still adjusting to the 2014 commodity slump). Real imports for November look to be up about six percent as well (nominal imports are up more, so a lot depends on the evolution of import prices), China’s stimulus over the past year seems to have stabilized import demand. * Since the end of June, average monthly sales, using the change in foreign exchange reserves reported on the PBOC’s yuan balance sheet, have been $37 billion. I prefer the total for PBOC foreign assets for technical reasons, but that is harder to explain and the gap isn’t big—$33 billion versus $37 billion.

A couple of weeks ago, Daokai (David) Li argued that the “right” exchange rate for China isn’t clearly determined by China’s fundamentals. Or rather that two different exchange rates could prove to be consistent with China’s fundamentals. “Currently, the yuan exchange rate regime yields multiple equilibrium. When we expect the yuan to depreciate, investors will exchange large amounts of yuan into dollars, causing massive capital outflow and further depreciation. If we expect the yuan to remain stable, cross-border capital flow and the exchange rate will be relatively stable. The subtlety that causes the equilibrium is that liquidity in China is the highest in the world. If there is any sign of change in exchange rate expectations, the huge liquidity in the yuan translates into pressure on cross-border capital flows.” If China’s residents retain confidence in the currency and do not run into foreign assets, China’s ongoing trade surplus should support the currency at roughly its current level. Conversely, if Chinese residents lose confidence in the yuan, outflows will overwhelm China’s reserves—unless China’s financial version of the great firewall (i.e. capital controls) can hold back the tide. I took note of Dr. Li’s argument because it sounds similar to an argument that I have been making.* I would argue that there aren’t just multiple possible exchange rate equilibria for China, there are also at least two different possible macroeconomic equilibria. In the “strong” yuan equilibrium, outflows are kept at a level that China can support out of its current goods trade surplus (roughly 5 percent of GDP), which translates to a current account surplus of around 2.5 percent of GDP right now, though it seems likely to me that an inflated tourism deficit has artificially suppressed China’s current account surplus and the real surplus is a bit higher.** In this equilibrium, a larger “on-budget” central government fiscal deficit—together with an expansion of social insurance—keep demand up, even as investment falls. In the “weak” yuan equilibrium, China lets the market drive its currency lower—and a weaker currency increases the trade and current account surplus. Such surpluses would finance sustained capital outflows in excess of half a trillion dollars a year without the need to dip further into China’s reserves. The resulting surpluses would be shockingly large—especially for an era where popular support for trade is somewhat lacking. For example, a 15 to 20 percent depreciation in the yuan—on top of the 10 percent depreciation that has already occurred over the last year —would reasonably be expected to push China’s goods surplus from its current level of around $525 billion dollars (balance of payments basis) to say somewhere between $800 billion and a trillion dollars. The rule of thumb based on China’s own experience and the IMF’s cross country work is that a 10 percent move in the yuan raises/lowers the trade balance by between 1.5 and 2 percentage points of GDP —with a parallel shift up in China’s current account surplus. That large goods surplus would finance both tourism imports and capital outflows ... And, of course, a larger trade surplus would also provide support for the economy. As investment slows, China would in effect pivot back to exports – and it wouldn’t need to use the central government’s fiscal space to support demand. Both are plausible outcomes. The strong yuan equilibrium is obviously better for the world than the weak yuan equilibrium in the short-run. And, I suspect, in the long-run. In part because a weak currency today creates political pressures that tend to keep the currency weak tomorrow. That at least is my read of China’s experience with a “weak” currency in the mid 2000s. After 2000—and particularly after 2002— the yuan followed the dollar down, depreciating 13 percent in real terms from 2001 to 2005. That depreciation coincided with WTO entry, and gave rise to one of the most spectacular export booms ever. And the surge in exports created a set of interests that were vested in keeping the currency weak. The policy mandarins feel pressure from the export sector to avoid appreciation. And, so long as exports (and import substitution—which is likely to be nearly as significant in China’s case going forward) keep the economy humming, they do not feel pressure to take the politically difficult decisions needed to provide visible on-budget fiscal stimulus and to build a stronger social insurance system. Exporting savings through large current account surpluses substitutes for reforms that would lower China’s high levels of national savings. I think something like this also happened in Korea after the won depreciated in 2008 and 2009. Korea’s exports responded to the weaker won. Autos notably. Subsequently there was pressure to keep the won weak, by intervention if necessary (concerns about currency volatility tend to be more pronounced when the won is strengthening). The modern way to maintain an undervalued currency isn’t to intervene to weaken your currency. It is to step back and allow the market to drive your currency down– And then intervene to resist subsequent pressure to appreciate (and rebuild reserves) when the market turns. In countries that have a history of managing their currencies and strong export sectors, cyclical currency weakness can turn into permanent currency weakness. Call it the political economy of currency weakness. * I have not always agreed with Dr. Li on currency issues, hence my surprise. ** My guess is that some of the tourism deficit is really hidden financial outflows. If that is the case, China’s true current account surplus is above 2.5 percent of GDP. I would guess that it is now around 3.5 percent of GDP—a number that implies that there tourism deficit includes about a percentage point of GDP in hidden financial outflows.

My preferred indicators of Chinese intervention are now available for October, and they send conflicting messages. The changes in the balance sheet of the People’s Bank of China (PBOC) point to significant reserve sales (the data is reported in yuan, the key is the monthly change). PBOC balance sheet foreign reserves fell by around $40 billion, the broader category of foreign assets, which includes the PBOC’s "other foreign assets"—a category that includes the foreign exchange the banks are required to hold as part of their regulatory requirement to hold reserves at the central bank—fell by only a bit less. $40 billion a month is around $500 billion a year. China uniquely can afford to keep up that pace of sales for some time, but the draw on reserves would still be noticeable. The foreign exchange settlement data for the banking system—a data series that includes the state banks, but historically has been dominated by the PBOC—shows only $10 billion in sales, excluding the banks sales for their own account, $11 billion if you adjust for forwards (Reuters reported the total including the banks activities for their own account, which raises sales to $15 billion). China can afford to sell $10 billion a month ($120 billion a year) for a really long time. The solid green line in the graph below is foreign exchange settlement for clients, dashed green line includes an adjustment for the forward data, and the yellow line is the change in PBOC balance sheet reserves.* As the chart illustrates, the PBOC balance sheet number points to a sustained increase in pressure over the last few months after a relatively calm second quarter. The PBOC balance sheet reserves data also corresponds the best with the balance of payments data, which showed large ($136 billion) reserve sales in the third quarter. Conversely, the settlement data suggests nothing much has changed, and the PBOC remains in full control even as the pace of yuan depreciation against the dollar has picked up recently and the yuan is now hitting eight year lows versus the dollar (to be clear, the recent depreciation corresponds to the moves needed to keep the yuan stable against the basket at this summer’s level; the yuan is down roughly 10 percent against the basket and against the dollar since last August). The balance sheet data suggests pressures are building, the settlement data suggests tighter capital controls are working. The Wall Street Journal reports that the state banks are suspected of intervening to limit yuan depreciation on behalf of the central bank on Wednesday, so this isn’t entirely an academic debate. At this stage, the gap between changes in reserves and the settlement data is getting to be significant. Over the last four months of data (July through October), PBOC balance sheet reserves are down $148 billion while the FX settlement data shows only $60 billion of sales. if you include "other foreign assets" together with PBOC reserves, the gap only shrinks a bit -- the PBOC’s foreign assets are down $130 billion over four months, still way more than $60 billion. The recent monthly gaps, in annualized, would imply a $200 to $300 billion gap between the PBOC balance sheet data and the settlement data. That is big money, even for a country as large as China. And to be honest I cannot currently explain the gap. I generally trust the settlement data more, in large part because it historically has shown more volatility, and with hindsight the signal sent by settlement was the right signal. Back in early 2013—when China was struggling with inflows—the settlement data suggested much faster reserve growth than the PBOC reserves data. And last August and September, the changes in settlement were larger than the changes in balance sheet reserves. In January 2013 and in August 2015 cases, changes in the amount of foreign exchange that the banks held as part of their regulatory reserve requirement turned out to be part of the explanation for the gap between the settlement data and the reserves data (in extremely technical terms, there wasn’t much of a gap between the monthly change in the PBOC’s total foreign assets and the settlement data). The state banks helped the PBOC out, so to speak, and adjusted their foreign exchange holdings so the PBOC didn’t have to buy or sell quite as much. The most logical explanation of the current gap is that the state banks are buying foreign exchange, so some of the apparent fall in reserves is a shift within Chinese state institutions. But changes in the reserve requirement do not appear to explain the move. For now, it is a real mystery, at least to me. Help is always appreciated! A key part of reserve tracking is keeping track of the things that you do not quite understand. * PBOC balance sheet reserves are reported at historical cost in yuan; the PBOC series is thus different from the "headline" foreign reserves that SAFE reports monthly in dollars.

The most valuable indicators of China’s intervention in the foreign exchange (FX) market are now out, and both point to a pick-up in sales in September, and more generally in Q3. The data on FX settlement shows $27b in sales in September, and around $50b in sales for Q3. Add in changes in the forwards (new forwards net of executed forwards) reported in the FX settlement data, and the total for September rises to $33 billion, and the total for Q3 gets to around $60 billion. FX settlement is my preferred indicator, though it is always important to see how it lines up with other indicators. The data on the PBOC’s balance sheet shows a $51 billion fall in reserves in September, and a fall of over $100 billion in Q3. I like to look at the PBOC’s foreign assets as well as reserves, this shows a slightly more modest fall ($47 billion in September), as the PBOC’s other foreign assets continued to rise. But total foreign assets on the PBOC’s balance sheet are still down around $95 billion in q3 (with a bigger draw on reserves than implied by the settlement data, which includes the banking system; chalk the gap between settlement and the PBOC’s balance sheet up as something to watch). $100 billion in a quarter isn’t $100 billion a month—but it is noticeably higher than in Q2. All in all, the pressure on China’s “basket peg” or “basket peg with a depreciating bias” exchange rate regime (take your pick on what managing with reference to a basket means, it certainly has meant different things at different points in time this past year) is now large enough to be significant yet not so large as it appears to be unmanageable. China still has plenty of reserves; I wouldn’t even begin to think that China is close to being short of reserves until it gets to $2.5 trillion given China’s limited external debt, tiny domestic liability dollarization, and ongoing external surpluses. $2.5 trillion would still be the world’s biggest reserve portfolio by a factor of two, it also would be roughly 20 percent of China’s GDP, which would be in line with what many emerging markets hold. The depreciation in October has been consistent with maintaining stability against the CFETS basket, though stability at a level against the basket that reflects the depreciation that took place from last August to roughly July. The dollar has appreciated against the other major tradeable currencies in October this period, and maintaining stability against the CFETS basket meant depreciating somewhat against the dollar. But the pace of reserve loss has picked up, and, if past patterns hold, it could well have picked up more in October. Some believe that the depreciation against the dollar this October indicates that China has pulled back from intervention. I am not convinced. Maintaining a controlled pace of depreciation is one of the hardest technical tasks for a central bank to pull off. A bit of depreciation leads to expectations of more depreciation, and larger outflows. Historically, at least, depreciation against the dollar is associated with bigger reserves sales, not fewer. As Robin Brooks of Goldman emphasizes, Chinese households and firms still pay far more attention to the yuan/dollar than the CFETS basket. Dollar appreciation -- against the majors, which implies the yuan needs to depreciate against the dollar in order to remain stable against a basket -- tests the PBOC far more than dollar depreciation. As a result, I would not be surprised if outflow pressures have picked up as the yuan depreciated against the dollar. Big picture, I think China still has the tools available to manage its currency if it wants to use them. China has a large underlying goods trade surplus. It still has plenty of reserves, and plenty of liquid reserves. Its controls have been tightened, and could be tightened more. But the evidence from Q2 -- and Q3 -- suggests the controls work best when they are reinforcing expectations of currency stability, not fighting expectations of depreciation. The controls get tested when Chinese firms in particular start to position for further depreciation (firms have much more ability than households to move funds across the border through trade flows and the like). Especially if Chinese residents—and the offshore foreign exchange market— may not be satisfied with the 10 percent move against the basket since last August. Here is one big picture thought. China may need to tolerate a bit of appreciation against the basket to break any cycle of reinforcing expectations. Just as it allowed the currency to depreciate against the basket when the dollar was depreciating from February to May, it could allow a bit of appreciation against the basket. It has the flexibility within its new regime not to manage strictly for stability against the basket. Either that or China may need to show that it really is managing symmetrically against the basket, so if the dollar depreciates, there is a real risk the yuan could appreciate back to say 6.5 against the dollar—and thus the yuan/dollar isn’t a one way bet. If China lets its currency depreciate along with the dollar when the dollar is going down, and then manages against a basket during periods of dollar appreciation, the yuan/dollar effectively becomes a one way bet. Obviously all this is informed by my belief that the trade data shows the yuan is now fairly valued, or even a bit undervalued.* At the yuan’s current value against the basket, I would expect net exports to start contributing modestly to growth over the next year, especially if U.S. import demand picks up from its cyclical slowdown. Of course, China’s policy makers may well be quite happy with a bit of support from exports—and a currency’s value is set by more than trade. Financial flows can overwhelm any peg if expectations of a depreciation (or for that matter appreciation) are allowed to build. *Weak September export volumes should be balanced against strong August volume growth; average growth across the two months is around 3 percent—in line with q2, and likely a a bit faster than the overall expansion in global trade. A weak October would change my views here a bit. The comparison between this October and last October is a true one (same number of working days)—though it will be important to adjust for export price changes (a 5 percent fall in headline yuan exports would be consistent with stable export volumes, very roughly). Note: edited to correct an obvious error (appreciation was used twice in a sentence, in context one clearly was intended to be depreciation)

China’s headline reserves dipped by about $19 billion in September, dropping below $3.2 trillion. Adjust for foreign exchange changes, and the underlying fall is widely estimated to be a bit more—around $25 billion. Press coverage emphasized that the fall “exceeded expectations.” To me that suggests “expectations” on China’s reserves aren’t formed in all that sophisticated a way. $20-30 billion in sales is in line with the change in the PBOC’s balance sheet in July and August (the FX settlement data, the other key proxy for intervention, suggests more modest sales in August). Throw in the September spike in the Hong Kong Inter-bank Offered Rate (HIBOR) —which suggested a rise in depreciation pressure on the CNY and CNH —and $25 billion in sales is if anything a bit smaller than I personally expected.* Of course, some of the sales could be coming through the state banks; time will tell. Even if the pace of sales did not pick up in September, there is is an interesting story in the Chinese data. The $75 billion a quarter and $300 billion a year pace of sales implied by the July-September monthly data aren’t anything like the pace of sales at the peak of pressure on China’s currency. But $75 billion a quarter is a still bit higher than the underlying pace of sales in Q2. The balance of payments data show Q2 reserve sales of about $35 billion (the change in the PBOC’s balance sheet reserves was $31 billion). But other parts of China’s state added to their foreign assets in Q2. In fact, counting shadow intervention (foreign exchange purchases by state banks and other state actors), I actually think the government of China’s total foreign assets may have increased a bit in the second quarter. There are a couple of line items in the balance of payments that seem to me to be under the control of the state and state actors. Most obviously, the line item that corresponds with the PBOC’s other foreign assets ("other, other, assets" in balance of payments speak: up $12 billion in q2, after a bigger rise in q1). But most portfolio outflows are likely from state-controlled institutions (portfolio debt historically has been the state banks, portfolio equity historically has been the China Investment Corporation and the state retirement funds in large part). If these flows are netted against reserve sales, there wasn’t much of a change in q2. In my view, shifts in assets within the state should be viewed differently than the sale of state assets to truly private actors. To get a positive number in q2, though, you need to add in the buildup of foreign assets associated with the increased foreign lending of the state banks (this adjustment is the most debatable). I suspect that the bulk of the China Development Bank’s outward loans are in the banking data, and thus the loan outflow should be viewed as a policy variable (China for example looks to have shut down this channel in q4 2015). Offshore loans were up about $25 billion in q2—a bit over the five year (2011 on) average of around $15 billion a quarter. That pushes my estimate for the total accumulation of foreign assets by China’s state, counting policy lending, into positive territory. Q2’s balance of payments data paints a picture of relative stability. I suspect that my broader metric for Q3 will show a fall in q3. And if that fall is eventually confirmed,** there is a question of why pressure picked up. China’s trade accounts show a substantial surplus (a very substantial surplus on the goods side, and a decent surplus on goods plus travel and tourism—the non-tourism service account is close to balanced). In volume terms, Chinese export growth has picked up—with y/y growth since April on average of 5 percent.*** That is better than the overall expansion of global trade. The pressure is all from the financial account. Interest rate differentials have shrunk, but are still in China’s favor. But the interest rate differential now can easily be dwarfed by exchange rate expectations. Over the past 14 months, the yuan has fallen by 8 percent against the dollar. My guess is that expectations for further depreciation picked up over the course of q3. The yuan appreciated a bit against the dollar from February through May (while depreciating against the basket). But the yuan depreciated against the dollar after the Brexit vote —and ticked down again a bit in late August. That, in my view, contributed to the expectations that China’s authorities are looking to continue the yuan’s depreciation—at least against a basket—after a temporary pause around the G-20 Hangzhou summit and the final SDR decision. Moves against the dollar still seem to have a disproportionate impact on expectations. Note: This chart has been updated to reflect data through 10/13/2016 It is not unreasonable for the market to think that the yuan’s future moves against the dollar will be asymmetric. If the dollar weakens against the major floating currencies, China may want to follow the dollar down. And if the dollar strengthens, maintaining stability against the basket—let alone maintaining a depreciating trend against the basket—implies a further depreciation in the yuan against the dollar. The implication of this view is that the market is (still) betting on where it thinks Chinese policy makers want the currency to go. As long as the market thinks China wants to depreciate one way or another against a basket after Hangzhou and the SDR decision, outflow pressure will continue. The alternative view is that Chinese residents want to get out of Chinese assets independently of the expected path of the yuan, and that the controls put in place in the spring are starting to show a few more leaks. The weaker fix on Monday doesn’t really settle this debate; the fix was below the symbolically important 6.7 level against the dollar, but was also broadly consistent with maintaining stability against the CFETS basket. There isn’t yet enough information to determine if China’s current policy goal is stability, or a stable pace of depreciation. * We don’t know the currency composition of China’s reserves, or the precise way changes in the value of China’s bond portfolio enter into headline reserves. The noise in headline reserves goes up when the expected change is small v the size of the stock, given all the other moves that can impact the stock. Plus or minus $10 billion in headline to me is noise. I prefer the proxies for intervention, which are less influenced by valuation. ** I am waiting for broader measures of sales for September; all analysis for now is contingent on confirmation by subsequent data releases. *** The simple average of monthly y/y changes in export volumes for 2016 is just below 4 percent; a bit higher than than the simple average of monthly changes in import volumes. Data is for goods only, and the y/y changes are distorted in q1 by the lunar new year. Export volumes are up even with softness in U.S. imports from China (setting finished autos aside)

The proxies that provide the best estimates of China’s actual intervention in the foreign currency market in August are out, and they in no way hint at the stress that emerged in Hong Kong’s interbank market in September. The PBOC’s balance sheet shows foreign currency sales of between $25 and $30 billion (depending on whether you use the number for foreign currency reserves or for foreign assets). A decent sum, but also a sum that is consistent with the pace of sales in July. SAFE’s data on foreign exchange settlement, which in my view is the single best indicator of true intervention even though (or in part because) it aggregates the activities of the PBOC and the state banks, actually indicates a fall-off in pressure in August. The FX settlement suggests sales of around $5 billion in August. Even after adjusting for reported changes in forwards (the dashed line above). All this said, there is no doubt something changed in September. The cost of borrowing yuan offshore spiked even though the exchange rate has been quite stable against the dollar and generally stable against the CFETS basket. Two theories. One is that China that the market thinks China will find a way to resume the yuan’s slow slide against a basket of currencies of its major trading partners after the G20 summit, even if that means additional weakness against the dollar. There was a widespread belief in the market—and among analysts who watch such things—that China would not allow a significant move in the market before the G20 summit. Now all bets are off, or will come off after the yuan is formally included in the SDR in early October.* The spike in offshore yuan interest rates thus reflects a true rise in speculative pressure against the yuan, one that the PBOC is resisting. Saumya Vaishampayan and Lingling Wei of the Wall Street Journal: "Suspected intervention by Chinese banks in what’s known as Hong Kong’s “offshore” market has led to a surge in the cost for banks in the territory to borrow yuan from each other. Investors and analysts believe the intervention—which they say has likely come at the behest of China’s central bank—is aimed at thwarting bets against the Chinese currency, also known as the renminbi. The suspected heavy buying by Chinese banks has helped squeeze a market China had tried to foster just a few years ago as it looked to promote the yuan as a major international trading currency." The other is that the PBOC has tightened offshore yuan liquidity for reasons of its own (not necessarily in response to a rise in speculative pressure), in part by putting pressure on the state banks not to roll over maturing forward contracts.* Only the PBOC, and perhaps the the Bank of China, knows for sure. I do though suspect that China is likely to have to show a bit more of its hand in the foreign currency market relatively soon. Does China manage for stability against a basket, or manage for a depreciation against the basket? Has the CNY depreciated by enough, or do the Chinese authorities want a larger move? How much weight does it put on the dollar versus the basket when push comes to shove? As many have noted, the broad effective value of China’s currency has slid pretty steadily this year—though there was a bit of a pause in August. Until recently, that slide was consistent with a yuan that was only a bit weaker against the dollar than in January (the move from 6.6 to 6.7 came in the face of the Brexit shock; it didn’t appear to be a unilateral Chinese move). Call it the Chinese currency version of Goldilocks Now, well, a further depreciation of the yuan against the basket might mean testing the post-Brexit lows against the dollar. And the yuan is getting to be within shouting distance to its level against the dollar during the 2008-2009 repeg. It doesn’t take all that much imagination to realize that reversing 8 years of appreciation against the dollar could matter politically as well as economically. The trade "fundamentals" to my mind do not provide a strong case for further weakness in the yuan against a basket of currencies. Even with weak Chinese exports to the United States, the Chinese data on export volumes shows modest year-over-year growth. August export volumes appear to be in line with recent trends; a reasonable estimate suggests Chinese exports continue to grow a bit faster than would be implied if China’s exports were growing with global trade.** I personally do not think China can expect to go back to the days when Chinese export growth significantly exceeded global trade growth (see Box 2 of this ECB paper). Of course, the trade data also isn’t the only factor that drives currency markets. * A small technical point. The Mexican peso plays a much bigger role in the U.S. dollar’s broad exchange rate than it plays in China’s basket. And the peso is weak right now. That is one reason why the CFETS index might diverge from the dollar index. The dollar/euro and dollar/yen rates have been relatively stable in September, though of course that could change. ** I am focusing on the data on volumes, not the nominal number. If export prices did not change in August, August export volumes increased year-over-year. The official Chinese data will be out in a few more days.

Just before the global financial crisis, I wrote a paper on the geostrategic implications of the United States’ growing external debt—and specifically about the fact that the U.S.’s main external creditors were increasingly the reserve managers of other states, not private investors. Yes, there were large two-way gross private flows in the run up to the crisis; think U.S. money market funds lending to the offshore arms of European banks who in turn bought longer-term U.S. securities. But, on net, the inflows needed to sustain the United States’ external deficit from 2003 on mostly came from the world’s big holders of reserves and oil exporters who stashed funds away in sovereign wealth funds. With hindsight, I, and the others who speculated about how China’s Treasury holdings might be used for political leverage over-egged the pudding, as Dan Drezner, among others, has pointed out. Greece’s indebtedness to private bond holders and banks proved a bigger constraint on its economic sovereignty than the debt the United States owes to the PBOC and other official investors. Germany was the creditor country that ended up with the leverage, not China. And thinking back even further, Britain’s geostrategic vulnerability to the withdrawal of U.S. financing in the Suez crisis derived from its commitment to maintaining the pound’s external value. Letting the pound float was inconceivable at the time. That as much as anything gave the U.S. leverage over Britain. Worth remembering. I could argue that the global crisis reduced the United States’ need for all kinds of external financing significantly, which is true—and that the leverage that comes from the perception that China could rattle markets in times of stress has not entirely gone away. But it is also true that before the crisis I underestimated the Fed’s ability to influence term premia and the path of long-term U.S. interest rates independently of inflows from foreign creditors.* Call it the geostrategic impact of QE. Yet some of the more subtle aspects of my argument about the strategic consequences of the rise of new large state creditors have, I think, stood up to the test of time. One argument was that a major creditor could have an impact on the U.S. without actually selling dollars, just by moving their dollar portfolio around. And it is quite clear from former Treasury Secretary Hank Paulson’s memoir that the risk of a Chinese/ Russian funding strike of the Agencies in the summer of 2008 was something that worried U.S. policy-makers.** Robert Preston reported back in 2014: "I [Paulson] was talking to them [Chinese ministers and officials] regularly because I didn’t want them to dump the securities on the market and precipitate a bigger crisis ... I was meeting with someone … This person told me that the Chinese had received a message from the Russians which was, ’Hey let’s join together and sell Fannie and Freddie securities on the market.’ The Chinese weren’t going to do that but again, it just, it just drove home to me how vulnerable I felt until we had put Fannie and Freddie into conservatorship ..."** Another argument was that rising reserves would give the world’s new group of creditors “soft” financial power. I wrote: “Today, emerging economies ... not only do not need the IMF; they increasingly are in a position to compete with it. .... Chinese development financing provides an alternative to World Bank lending. Asia is exploring the creation of a reserve pool that could serve as a precursor to a regional monetary fund. If a small emerging economy got into trouble now, it undoubtedly would seek regional financing on more generous terms than those offered by the IMF." That doesn’t quite describe the Asian Infrastructure and Investment Bank. But it isn’t that far off either. Substitute "development finance" for regional financing and "World Bank" for the IMF. The reality is that the world can form financial coalitions of the willing without the participation of the U.S.. Even with the fall in China’s reserves and the strain that low commodity prices have placed on many commodity exporters. Scott Morris of the Center for Global Development has written a new CFR discussion paper on how the U.S. should respond to China’s success in setting up the Asian Infrastructure and Investment Bank. One of his conclusions is straight-forward. If the U.S won’t support an expansion of the balance sheet of the institutions where it has the most influence and weight—institutions like the World Bank—then the world will likely proceed without the United States. And the current “core” development institutions will over time be surpassed by new institutions where the U.S. has less influence. * I imagined a more convoluted path to stability, drawing a bit on Dooley, Garber and Folkerts-Landau. The direct path would be for the Fed to buy what others were selling. I though focused on an indirect path: European central banks, concerned about a rise in their currencies, would intervene and recycle funds back into the U.S. bond market. ** Technically, the Fed could—and in the end did—offset the loss of Chinese demand for the bonds of the Agencies. The Treasury though needed to step in to provide the Agencies with the capital needed to absorb losses on their mortgage portfolio. Dan Drezner argues China’s influence on the Agencies wasn’t decisive—which is fair. The Agencies had sold a lot of bonds to domestic investors as well. But it is also quite clear that China’s holdings weighed heavily on the minds of the relevant decision makers.

I got my start, so to speak, tracking global reserve growth and then trying to map global reserve flows to the TIC data. So I have long thought that large scale central bank purchases of U.S. Treasuries and Agencies, and German bunds, and JGBs didn’t start with large scale asset purchase programs (the academic name for “QE”) by the Fed, the ECB and the BoJ. Before the crisis, back in the days when China’s true intervention (counting the growth in its shadow reserves) topped $500 billion a year, many in the market (and Ben Bernanke, judging from this paper) believed that Chinese purchases were holding down U.S. yields, even if not all academics agreed. The argument was that Chinese purchases of Treasuries and Agencies reduced the supply of these assets in private hands, and in the process reduced the term/risk premia on these bonds. Bernanke, Bertaut, Pounder DeMarco, and Kamin wrote: "...observers have come to attribute at least part of the weakness of long-term bond yields to heavy purchases of securities by emerging market economies running current account surpluses, particularly emerging Asia and the oil exporters .... acquisitions of U.S. Treasuries and Agencies took these assets off the market, creating a notional scarcity that boosted their price and reduced their yield. Because [such] investments were for purposes of reserve accumulation and guided by considerations of safety and liquidity, those countries continued to concentrate their holdings in Treasuries and Agencies even as the yields on those securities declined. However, other investors were now induced to demand more of assets considered substitutable with Treasuries and Agencies, putting downward pressure on interest rates on these private assets as well." I always thought the mechanics for how the Fed’s QE impacts the U.S. economy—setting aside the signaling aspect*—should be fairly similar. Both reserve purchases and QE salt “safe assets" away on central banks’ balance sheets.** There are now a number of charts illustrating how the ECB and BoJ have kept central bank bond purchases high globally even after the Fed finished tapering. Emma Smith of the Council’s Geoeconomics Center and I thought it would be interesting to add reserve purchases to these charts and to look at total purchases of U.S., European, Japanese and British assets by the world’s central banks over the last fifteen years—adding the emerging market (and Japanese and Swiss) purchases of G-4 bonds for their reserves to the bonds that the Fed, the ECB, the Bank of Japan and the Bank of England bought. Obviously there are important differences between balance sheet expansion done through the purchase of foreign assets (reserve buildup) and balance sheet expansion done though the purchase of domestic assets (quantitative easing).  One is aimed at the exchange rate, the other at the domestic economy. But if portfolio balance theories are right, the direct impact on bond prices from foreign central bank purchases of bonds and from domestic central bank purchases of bonds should I think be at least somewhat similar. As the chart above makes clear, large-scale central bank asset purchases in some sense preceded the global crisis.  Pre-crisis, the purchases came from emerging market central banks. China, counting its shadow intervention, bought about 15% of its GDP in reserve assets from mid 2007 to mid 2008; as a share of GDP, that is a pace of asset purchases equal to the BoJ’s current pace. More recently, reserve managers have quite obviously been selling. The reserves the PBOC bought from 2012 to 2014 were sold in 2015 and 2016. Yet with three trillion plus in reserves, and more in its shadow reserves, the PBOC hasn’t yet sold anything it bought prior to the global crisis. And more importantly, recent reserve sales have come at a time when the BoJ and ECB have been ramping up their purchases. Aggregate central bank demand for safe assets has remained elevated. There has been a significant shift in the currency composition of large scale central bank assets purchases in the past couple of years. In fact, adding reserve purchases to QE purchases magnifies the recent global shift in central bank demand away from dollars. EM reserves managers have been selling dollar assets. At the same time the Fed isn’t buying assets anymore. And the G-7 currency agreement has limited the ECB and (especially) the BoJ to the purchase of their own assets, so there has been a surge in central bank purchases of euro and yen denominated bonds. Prior to the crisis, I was never completely convinced by arguments that the currency composition of the reserves held by central banks didn’t matter. Partially that was self-interest of course; I had spent a lot of time developing my reserve tracking technology. But I also didn’t think private investors were completely indifferent to the currency composition of their portfolio of safe assets. If the central banks accumulating reserves wanted euros rather than dollars, the euro would need to rise relative to the dollar to make "safe" dollar assets cheaper and thus more appealing to private investors. Treasuries and German bunds were not perfect substitutes. Nor for that matter are Agencies and French government bonds. I still think that is the case. It matters that the ECB conducts its asset purchases by buying euro assets, not by buying Treasuries. At the same time, with ECB purchases exceeding euro area government net issuance and with BoJ purchases far exceeding net new issuance of JGBs, it is hard to argue that some investors in European and Japanese debt haven’t been pushed into U.S. Treasuries and Agencies. (This Banque de France working paper found that foreign holders of euro-denominated bonds were the most likely to sell to the ECB.) And thus there should be some impact on the U.S. yield curve from the actions of other central banks even when those central banks aren’t buying dollars. All this said, the indirect impact on Treasuries from the purchase of JGBs and Bunds is likely to be smaller than the direct impact of central bank purchases of Treasuries.** Krishnamurthy and Vissing-Jorgensen’s 2013 Jackson Hole paper argued that Treasuries and Agencies weren’t perfect substitutes, which is why the Fed’s purchases of Agency MBS had an impact.  I have long thought the QE-Agency MBS-lower mortgage payments channel provided an important offset to the fiscal tightening the U.S. did in 2013, as mortgage refinancing put cash directly in the pockets of many households. And the current, relatively low level of direct central bank demand for U.S. Treasuries reinforces Larry Summers’ argument that low Treasury rates now aren’t just a reflections of central banks purchases... In subsequent posts, Emma and I plan to look into these points in a bit more detail, by disaggregating central bank flows by currency and comparing central bank demand (the sum of "foreign” reserve demand and “home” monetary policy demand) to government issuance. A note on methodology. Asset purchases by the Fed, ECB, BoJ and BoE are easy to track directly. Reserve purchases come from summing the foreign exchange reserves of around 60 countries—a broad sample that replicates the IMF COFER data. China’s other foreign assets are added to the total (it doesn’t matter much, but it is a point of pride for me—these are assets on the PBOC’s balance sheet that walk, talk and quack like reserves). The dollar share of reporting economies is assumed to be replicated across the full sample (broadly speaking this produces the same result as assuming a constant 60 or 65% dollar share over time). * Signalling here means signalling a credible commitment to hold policy rates low for a long time, i.e. enhancing the credibility of forward guidance. Michael Woodford, for example argued back in 2013 that this was the transmission channel that mattered. ** Technically, a central bank buying bonds creates bank reserves when it credits the account of the seller of the bonds with cash. QE reduces the supply of safe longer-dated bonds in the market (raising their price, and reducing their yield in theory) while adding to the supply of safe short-term assets (claims on the central bank).

China is running a persistent current account surplus, one that could be larger than officially reported (the huge tourism deficit looks a bit suspicious). If China paid off all its external debt, it would still have around $2 trillion in reserves.* If it paid off all its short-term debt, it would have $2.5 trillion in reserves. And China has a very low level of domestic liability dollarization (3 percent of total deposits are in foreign currency) True, $3.2 trillion ($3.3 trillion if you include the PBOC’s other foreign assets, as you should, and as much as $3.5 trillion if you include the China Investment Corporation’s foreign portfolio, which is more debatable) isn’t $4 trillion.** But much of the fall in reserves over the last 18 months has stemmed from the use of reserves to repay China’s short-term external debt. The IMF projects that China’s short-term external debt will have fallen from $1.3 trillion in 2014 to just over $700 billion by the end of this year. Reserves are down, but—from an external standpoint—China’s need for reserves is also down. The two year fall in short-term debt is actually about equal to projected drop in reserves. The Fund though sees things a bit differently. Buffers, according to the Fund’s staff report, are now low, and need to be rebuilt. Some in the market agree. And that gets at a critical issue for China, and a critical issue for assessing reserve adequacy more generally. Just how many reserves do countries like China, need? For China, two “traditional” indicators of reserve adequacy—reserves to short-term debt and reserves to broad money—point in completely different directions. Reserves are over 400 percent of short-term debt (way more than enough). *** Reserves are now “only” 15 percent of broad money (not enough; 20 percent of M2 is the traditional norm). You cannot really fudge the difference; you have to tilt one way or the other. (Hat tip to Emma Smith of the Council on Foreign Relations’ Greenberg Center for Geoeconomics, who prepared the charts). I personally put more stock on balance sheet indicators, and reserves to short-term external debt is the most important. From a balance sheet point of view, there is also a strong case for paying attention to reserves relative to domestic sight deposits (a measure of liability dollarization). The Fund though sees things differently; in the design of the new reserve metric the Fund leaned strongly against balance sheet indicators of reserve need (see the discussion of liabliity dollarization here), and instead went with a composite of the three traditional indicators (short-term debt, m2, and imports—though the Fund prefers using exports), with an additional factor for longer-term external liabilities. The Fund’s reserve metric effectively says China needs to hold more reserves, relative to its GDP, than a typical emerging economy. Especially if China opens its financial account before its currency floats freely. And that is the case even though China has much less external debt than a typical emerging economy, and also has less liability dollarization of its financial system. Personally, I think foreign currency deposits pose more risks than domestic currency deposits, and, to the extent a country should hold reserves against the risk of domestic capital flight, those countries with more domestic foreign currency deposits should hold proportionately more reserves. The Fund’s metric, though, explicitly doesn’t adjust for liability dollarization. As a result, the Fund believes China needs to hold far more reserves against the risk of domestic capital flight than other emerging economies, including emerging economies with a lot more domestic FX deposits. The gap between the reserves China needs to hold on the Fund’s metric and the reserves other emerging economies need to hold is even more extreme in dollar terms; as the Fund’s metric requires the biggest emerging economy to hold more reserves than other emerging economies—remember that 20 percent of M2 for China is 40 percent of China’s GDP, or well over $4 trillion.**** One hundred percent of short-term debt by contrast requires reserves of $750 to $900 billion now. I will though give the Fund credit for now recognizing one obvious implication of its analysis of reserve adequacy: China needs to proceed cautiously on financial account liberalization, and the pace of financial account liberalization needs to be in synch with the process of domestic balance sheet repayment and bank/shadow bank recapitalization. *$3.5 trillion in reserves at the end of 2015, v $1.5 trillion in external debt, see table 2 of the IMF’s staff report. ** I will have more to say on this in an another post. There is a debate about the liquidity of China’s $3.2 trillion in reserves ($3.3 trillion counting other foreign assets). The key issue here is how China accounts for the foreign assets of China Ex-Im and China Development Bank (CDB). They shouldn’t technically be counted in reserves, but China’s hasn’t been completely clear on this point. The bulk of the evidence though suggests that China Ex-Im and CDB loans show up in the net international investment position in “loans” not as reserves, and that, to the extent these loans have been financed by entrusted reserves, those entrusted reserves are counted as “other foreign assets” in China’s SDDS disclosure of its foreign exchange reserves. In other words, the illiquid loans are not currently counted as part of China’s “foreign exchange reserves,” but rather appear elsewhere. China really should clarify this though. The IMF Article IV unfortunately did not shed new light on this issue. *** Data is from tables 2 and 3 of the IMF’s staff report, pp 40 and 41. http://www.imf.org/external/pubs/ft/scr/2016/cr16270.pdf China holds roughly three times more reserves than any other country. **** The IMF generally requires 5 percent of M2 in its composite metric, or 25 percent of the standard M2 to GDP norm. That rises to 10 percent of M2 for countries with fixed exchange rates, so long as the financial account is open. With M2 to GDP running around 200 percent thanks to China’s high savings rate, and with China’s GDP projected to rise above $15 trillion over the next few years, this soon won’t be an academic debate.

The proxies for China’s foreign exchange intervention in July are now available, and they point to $20 to $30 billion of reserve sales. The PBOC’s foreign assets fell by about $23 billion (The PBOC’s foreign reserves, as reported on the PBOC’s renminbi balance sheet, fell by $29 billion; I prefer the change in the PBOC’s foreign assets though, as foreign assets catches the foreign exchange that banks hold at the PBOC as part of their reserve requirement). FX settlement with non-banks shows net sales of around $20 billion. Throw in the change in forwards in the settlement data, and total sales were maybe $25 billion. All the proxies show more variation than appeared in headline reserves, which only fell by $5 billion. I trust the proxies. The bigger story, I think, is two-fold. One is that there is still a correlation between FX sales and moves in the yuan against the dollar. In June and July the yuan slid against the dollar, and the magnitude of FX sales increased. That fits a long-standing pattern. The second, and far more important point, is that the magnitude of sales during periods when the yuan is depreciating against the dollar are significantly smaller than they were last August, or back in December and January. Why? Tighter controls? Or, more simply, has a lot of the foreign currency debt that was built up as part of the carry trade (borrow in dollars to buy yuan to pocket higher interest rates on the yuan) now been paid back, reducing corporate demand for foreign currency in periods of depreciation? Either way, if a bad month means $20-30 billion in sales, China isn’t going to run out of reserves anytime soon. For now, the desire (or desire, combined with ability to execute) of Chinese savers to hold foreign assets seems to be roughly equal to China’s underlying current account surplus. Hence the broad stability in reserves. August should be fairly calm on the reserve front. The yuan has appreciated a bit against the dollar recently. And if you squint, you can argue that it also has been stable (rather than slowly depreciating) against a basket, at least for a few weeks. There is no reason to expect large sales.

Both of the key proxies for China’s actual intervention in June are out. The PBOC’s balances sheet shows a $15 billion dollar fall in reserves. And the State Administration on Foreign Exchange (SAFE) data on foreign exchange settlement by the banking system (the PBOC is treated as part of the banks) shows $18 billion in sales from the banking system (using sales for clients, not net settlement). They paint a consistent picture. The gap between the modest sales reported in the data and the rise in headline reserves ($13.4 billlion) is almost certainly from the mark-to-market gains on a portion of SAFE’s book. The portfolio of high quality bonds should have increased in value in June. Friends who read Chinese say SAFE has admitted as much on its website. The more interesting thing to me is how modest the sales were, at least when compared to other periods of depreciation (against the dollar) in the last two years. Either the carry trade unwind is over or the controls work. Or somehow this most recent depreciation hasn’t produced expectations for further depreciation, even though the crawl down against the basket has been pretty stable. It is a puzzle, at least to me. For the conspiratorially minded, the banks do look to have sold foreign exchange from their own accounts in June, as they did last August and this January. But the sales from their own account were modest—$5 billion versus $85 billion last August and $15 billion in January. And the settlement data for forwards also shows a modest reduction in the net forward book of the banks in June. Net of the change in forwards, total sales in the settlement data look to be just under $15 billion. Not much, in other words. But there is at least a suggestion that expectations started to build over the course of July in a way that worried the PBOC. The need to break the cycle of expectations is one explanation for the decision to appreciate the yuan in the middle of the week back to about 6.7 to the dollar, even though such appreciation against the dollar meant appreciation against a basket. Bloomberg reported: "The yuan advanced the most in two weeks, with the central bank’s daily fixing adding to signs that China’s authorities are prepared to overrule the market to control the currency’s moves.The People’s Bank of China strengthened its reference rate, which restricts onshore yuan moves to 2 percent on either side, even as the dollar advanced the most since July 5. This spurred speculation that the central bank isn’t sticking to its stated policy of following the direction of the market, which would have resulted in a weaker fixing." The mystery of the PBOC’s actual exchange rate policy rule remains. Perhaps intentionally. All this matters, of course, because the exchange rate is the mechanism that most powerfully transmits any weakness in Chinese domestic demand to other manufacturing economies. Commodity exporters are, of course, impacted more directly by changes in commodity prices. The cumulative depreciation against the dollar over the last 12-plus months has reached 7-8 percent—enough that it would reasonably be expected to start having an impact on trade flows going forward.