Monetary Policy

Christopher Balding (Balding’s World) highlights the risks from the interaction between PBOC tightening—whether because China’s own economy has picked up or a need to mimic the Fed’s tightening cycle —and rising levels of debt (mostly corporate debt, counting the debts of state enterprise as corporate) in a carefully argued Bloomberg view column. Adair Turner’s column “A Socialist Market Economy with Chinese Characteristics” emphasizes how surprised many were by China’s 2016 rebound: “Almost all non-Chinese economists anticipated a significant slowdown, which would intensify deflationary pressures worldwide. In fact, the opposite has happened. Central and local government borrowing in China has soared: bank and shadow-bank credit has grown rapidly: and the People’s Bank of China (PBOC) has increasingly issued direct loans to state-owned banks in a maneuver closely resembling monetary finance of government spending." Turner highlights the risks of large losses from the bad lending that has come with rapid credit growth, while—correctly in my view—noting that financial crises ultimately come from a run on the liability side of the balance sheet. Turner also notes that even if a quarter of China’s investment is unproductive, the three-quarters that is invested productively still equals about a third of China’s GDP. That alone would drive a strong expansion in China’s stock of useful capital. I like to be reminded just how unique China is. I have my own take out as part of the Council on Foreign Relations’ look at global economic issues at the start of the new year. I was less surprised than many by China’s 2016 rebound, though there isn’t much of an electronic record to document my views. I thought that China’s 2014-2015 slowdown was in no small part a consequence of a poorly timed policy decision to tighten “off balance sheet” fiscal policy (by limiting local government financing and infrastructure investment) when real estate investment was in the doldrums. Since I viewed the 2014-2015 slowdown more as a function of policy tightening than as a direct consequences of the underlying weaknesses in China’s growth model, I also believed that policy easing was likely to support growth—even if I would have preferred more of the easing to come through a larger rise in the central government’s headline fiscal deficit and less through the usual off-balance sheet funding channels. While both Balding and Turner emphasize the risks created by China’s rapid credit growth, I put more emphasis on what I view as the more fundamental problem: China’s exceptionally high level of savings. Such high savings -- now that productive investment opportunities have shrunk a bit as the easy catch-up gains fade -- generates an underlying, structural weakness in demand growth. And until the savings rate falls, making up for the weakness in household demand requires getting demand from exports, from credit fueled investment, or from fiscal deficits. I still like a line from my paper on Asia’s savings glut: “A national savings rate that still approaches 50 percent of output increasingly implies either bubbles in credit domestically or large capital surpluses that have to be exported.” In my view, durably ending China’s reliance on credit for growth without giving rise to massive trade surpluses that create (additional) global problems requires the kind of reforms that bring savings down and consumption up—not just policy tightening.

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.

Taiwan has an extremely large current account surplus. Over 14 percent of GDP in 2015, and over 10 percent of GDP since 2012. (See the WEO data or this chart). Relative to its GDP, Taiwan’s current account surplus is far bigger than China’s current account surplus is relative to its GDP. Taiwan’s central bank clearly has been buying foreign currency in the foreign exchange market. The balance of payments data shows between $10 and $15 billion of purchases a year in recent years, and roughly $3 billion of purchases a quarter this year (data here). And Taiwan’s government clearly has been encouraging private capital outflows—notably from the the life insurance industry—largely by loosening prudential regulation, and allowing the insurers to take more foreign currency risk. Private outflows help limit the need for central bank intervention to keep the currency down, but also require private institutional investors to take on ever more foreign currency risk. China by contrast has been selling foreign exchange reserves in the market to prop its currency up. Right now, the case that China is managing its currency in ways that are adverse to U.S. trade interests is not strong. Plus, Taiwan’s real effective exchange rate—using the BIS data—has depreciated significantly over the past ten-plus years, unlike China’s real effective exchange rate. The fact that a weaker real exchange rate has gone hand in hand with the rise in Taiwan’s surplus shouldn’t be a surprise, but there are still a surprising number of folks who believe that real exchange rates don’t matter for trade in an era of global supply chains. In Taiwan’s case, the correlation between a weaker currency and a bigger current account surplus is clear. “Taiwan is actually intervening in the market to hold its currency down” is the kind of wonky technocratic detail that seems somewhat out of favor right now.* But it is also factually true that Taiwan has a bigger current account surplus and a more consistent pattern of intervention to resist appreciation over past few years than China does. Korea too, though Korea is a more complex story.** Which adds to the awkwardness of singling China out…if that is in fact what President-Elect Trump plans to do. And, of course, this is all second order compared to the broader foreign policy issues involved in the "One China" policy. * Taiwan’s bilateral surplus with the U.S. is modest. But it no doubt would be much bigger if calculated on a value-added basis. Depending on where the quantitative thresholds are set you could make a case that Taiwan would meet the 2015 Bennet amendment’s three criteria. Directionally at least. ** To be clear, Korea intervened heavily to block won appreciation in the third quarter, when the won was around 1100—but it hasn’t been buying recently. No need. The won has sold off with the dollar’s appreciation, with an assist from Korea’s own political uncertainty. It is no longer at levels where the Korean authorities typically intervene to limit appreciation. In fact, the won has depreciated to levels where the Koreans occasionally sell. The detailed data for October indicates very modest sales, after taking into account the fall in Korea’s forward book. November is likely to be similar.

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.

President-elect Trump has said that he plans to declare China a currency manipulator on day one. I am among those who think this is a bad idea. This isn’t the right time to signal that China’s long-standing exchange rate management has crossed over the line and become manipulation. If China responded by ending all exchange rate management—no daily fix, no band, no intervention, a true float—the renminbi would certainly fall, and potentially fall by a lot. Uncomfortable as it is to say, right now it is in the United States’ economic interest for China to continue to manage its exchange rate. Subsequent to the yuan’s August depreciation last summer, China has been selling large sums in the market—sums that increased in q3, after falling in q2—to control the yuan’s decline. A freely floating yuan makes long-term architectural sense: the other SDR currencies float against each other, and China’s monetary policy shouldn’t be linked to that of the United States. But for China to be in a position where it can transition to a free float in a way that stabilizes the world economy, it needs both to do a serious recapitalization of its banks and to introduce a set of policy reforms that would strengthen the domestic base of China’s economy. Such reforms should include policies aimed at lowering China’s still exceptionally high level of savings. That said, there currently seems to be a bit of confusion about what it takes for the Treasury to name China a manipulator, and what a designation of manipulation means. My read of the Treasury’s April foreign exchange report is that this semi-annual currency report now satisfies two distinct statutory requirements.* The 1988 Omnibus Trade and Competitiveness Act (section 3004), and the 2015 Trade Facilitation and Trade Enforcement Act (and specifically the Bennet Amendment; Section 701). The underlying requirements are similar, but not quite the same. The 1988 Act empowers the Treasury to name a country as a manipulator: “The Secretary of the Treasury shall analyze on an annual basis the exchange rate policies of foreign countries, in consultation with the International Monetary Fund, and consider whether countries manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.“ (emphasis added) However, the 1988 act doesn’t authorize any specific sanctions that follow from naming a country a manipulator, only the initiation of negotiations with the named country. Manipulation is a label, nothing more. See Alan Beattie. Of course, if there is a finding of manipulation and nothing changes after a year, Congress could pass a law authorizing some form of sanction, or one of the existing laws that the Peterson’s Gary Clyde Hufbauer has identified could be invoked, or link the finding to a new approach to safeguards, or (far less likely) the U.S. could file some kind of complaint at the WTO. The Bennet amendment is different. It avoids the “manipulation” label. Rather it forces the Treasury to lay out specific numerical criteria for the bilateral trade balance, the current account and foreign exchange market intervention, and if those criteria are violated, it requires that a country be designated for “enhanced bilateral engagement.” If no solution is found after year of dialogue and negotiation, it requires that the President do one (or more) of four things: deny financing/risk insurance on new investment to the country through the Overseas Private Investment Corporation (OPIC); deny the country’s firms access to the U.S. government procurement market; seek additional IMF surveillance; and take into account the country’s currency practices in the negotiation of new trade agreements. There is an escape clause as well. The Treasury’s April 2016 foreign exchange report used the Bennet amendment’s criteria as the basis for its evaluation of the 1988 trade act. I lack a law degree, but I would bet that is a choice, not a legal requirement. As I read it, a country that did not meet the criteria for enhanced bilateral engagement laid out in the Bennet amendment could still be named a manipulator under the 1988 trade law. The Bennet sanctions wouldn’t automatically come into play. But several of those sanctions either aren’t particularly relevant for China, or could be replicated through other forms of executive action. Set aside the specific thresholds the Treasury identified in April for the bilateral trade balance, the current account surplus, and intervention. No matter how the third criteria of the Bennet amendment is defined, China doesn’t meet it, at least not in any meaningful way. I guess you could argue that that China’s reserves sale have been persistent and one-sided, and thus fit the letter of law. But China has sold foreign exchange in the market to keep the yuan from depreciating. The monthly data suggest has China not bought foreign exchange in the market to keep the yuan from appreciating in the past 6 quarters or so, only sold.** Its intervention in the market has worked to prevent exchange rate moves that would have the effect of widening China’s current account surplus over time. Every indicator of intervention that I track is telling the same story. I can see how a case could be made that China’s broader exchange rate management—notably its use of the fix to guide the CNY—could meet the 1988 law’s definition of manipulation. The depreciation in the yuan’s daily fix (both against the dollar and the basket) has arguably impeded adjustment in the balance of payments and given China an advantage in trade, at least relative to a world where China had not changed its exchange rate regime last August. I have consistently argued that China’s currency is still tightly managed.*** But that doesn’t mean naming China is a good thing to do right now. Remember, if China stopped all management (“e.g. manipulation”) and let the yuan float against the dollar, China’s currency would drop. Possibly precipitously. China’s export machine would get a new boost. And rising exports would take pressure off China’s governments to make the difficult reforms needed to create a stronger domestic consumer base. The goal of the United States right now, in my view, should be to encourage China to manage its currency in a way that doesn’t give rise to strong expectations of further depreciation that could fuel potentially unmanageable outflows—while encouraging China to put in place the bank recapitalization and social safety net needed to more permanently wean China off external demand. Naming China as a manipulator doesn’t force a tit-for-tat escalation to a full trade war, at least not in the first instance.**** Subsequent actions of course could. But it also isn’t the most obvious way to convince China that it is in China’s interest to manage its currency—and more importantly its economy—in a way that reduces the risk of a large depreciation. * pp. 6-7 of the April 2015 foreign exchange report suggests that the two acts differ: “Based on the analysis in this Report, Treasury has also concluded that no major trading partner of the United States met the standard of manipulating the rate of exchange between its currency and the United States dollar.” (emphasis added) ** The PBOC’s reserves haven’t shown any consistent increase -- using the PBOC’s yuan balance sheet -- since Q1 of 2014 (and April 2014). The small rise in October 2015 should be discounted given the magnitude of the sales in August and September, and the evidence from other indicators. The FX settlement data -- which includes the banks -- suggests very small purchases in q2 2015. *** Technically, I think China could have reduced the scale of its reserve sales if it had managed the fix a bit differently; on occasion, it has had to intervene in the market to offset expectations of depreciation that the PBOC helped create through setting the fix at levels that suggested a desire for depreciation, whether against the dollar or against the basket. A small point. I have no doubt that the basic direction of pressure on the yuan/dollar changed after the dollar’s fall 2014 appreciation against a range of currencies. **** Keith Bradsher is right to point out that both the U.S. and China would find it difficult to take trade actions that didn’t also hurt their own economies in important ways in the event of a major escalation. A large share of U.S. imports from China are consumer electronics where there isn’t any real option in the short-term to shift to domestic production, and a significant share of U.S. exports to China are commodities (ores, wood pulp, gold -- counting Hong Kong, soybeans, cotton, etc) where China would hurt itself by shutting out foreign supply/ raising the price of foreign supply (and in some cases the global market might adjust in ways that didn’t hurt the U.S. that much -- in soybeans for example an increase in Chinese purchases from Brazil would create opportunities for U.S. exports to markets now served by Brazil, just as Brazil’s bad harvest created an export opportunity for the U.S. in q3). The pain would go in both ways.

  

China’s headline reserves fell by around $45 billion in October, dropping to $3.12 trillion. Many China reserve watchers expected a bigger fall. Moves in the foreign exchange (FX) market knocked around $30 billion off China’s roughly $1 trillion portfolio of euros, pounds, and yen assets in October. After adjusting for these valuation changes, China might only have sold a bit over $15 billion or so in October. That is less than my estimates of the true pace of sales in September. But it bears repeating that the changes in headline reserves often do not provide as good an estimate of China’s actual activities in the market as the PBOC’s balance sheet data and the FX settlement data. Neither is yet available for October. I at least do not yet have confidence that the pace of underlying sales really slowed.* China’s October reserves, though, aren’t the real subject of this post. Rather, I want to make two arguments about the non-reserve foreign assets held by Chinese state institutions. The second is a bit speculative. It is meant to encourage more work, not to provide a definitive answer. One, China’s state sector still has a lot of foreign assets, assets that are not formally counted as FX reserves. The state banks hold foreign exchange as part of their capital, thanks to past recapitalizations. The state banks hold foreign exchange as part of their regulatory reserve requirement (the banks have to set aside a large portion of every deposit at the PBOC). This pool of foreign exchange is not counted as part of China’s formal reserves. The China Investment Corporation (CIC—China’s sovereign wealth fund) holds some foreign assets in its portfolio, and financed the purchase of those assets with domestic borrowing. The China Development Bank (CDB) and the China Export-Import Bank have also made significant loans to the rest of the world. There is room to debate just how big the state’s non-reserve portfolio is, but the balance of payments indicates something like $200 billion in cumulative outflows through the banks and China Investment Corporation, and well over $300 billion or so in offshore loans—mostly, I assume, from the CDB. Two, those foreign assets have created a set of state actors that have an underlying currency mismatch on their balance sheet, and thus, a set of institutions that are naturally exposed to changes in the yuan’s value. There are a lot of emerging economies where big firms raise funds by borrowing in foreign currency, and take on a "balance sheet" mismatch as a result. They lose out in a depreciation. A portion of China’s balance sheet risk though is the other way around. The state banks and the CIC have raised funds in yuan and are holding foreign currency-denominated assets. As a result of this mismatch the banks and the CIC appear to gain if the yuan depreciates against the dollar. But they also stand to lose if the yuan rises against the dollar. In the past, this was not just an academic risk. In fact, for many years, the state banks had trouble finding a market actor that would allow them to hedge (the banks would in effect enter into a trade where they would give up the gains from a fall in the yuan, in return for protection against the losses that would come with a rise in the yuan). It is possible that they hedged this risk in the past with the central bank (this would imply that in the past the PBOC had more foreign currency exposure than implied by its formal reserve holdings). So I wonder if some of the unusual activity that many have observed in the FX market over the past year comes as a result of the state banks and the CIC moving from hedging their unmatched foreign currency book with the central bank (or not hedging it at all) to hedging it with the market. By taking on the risk that the yuan would appreciate (which the state banks need to move off their books to be FX matched), the foreign exchange market would get the gains from yuan depreciation. I have a lot more confidence in the first argument than in the second argument, which is at this stage just a hunch. That is a critical caveat. Let me start with a bit of history. Back in 2003, the PBOC provided $45 billion in foreign exchange reserves to the Bank of China and China Construction Bank. China could have done the recapitalization in other ways—most bank recapitalizations are done by giving the banks domestic bonds (with the government getting bank equity in exchange). But it had plenty of foreign exchange reserves, and it did the recapitalization with its reserves. At 2003 exchange rates, these foreign assets had a value of 372 billion yuan ($45 billion times 8.28 yuan/dollar). Once the yuan started to appreciate in 2005, though, the bank capital was shrinking in yuan terms. By 2008, at 6.83 yuan to the dollar, the same foreign assets were worth just over 300 billion yuan. The banks’ capital from this part of the 2003 and 2005 recapitalization, in yuan terms, had shrunk by a bit more than 15 percent. Some people suspect—based in part on the data China used to release as part of its disclosure of the foreign exchange balance sheet of the state banks—that the banks could hedge this risk with China’s authorities in one way or another (see my 2009 working paper). The banks, after all, were doing the PBOC a favor by holding their capital foreign exchange, rather than selling the foreign exchange (back to the PBOC) and adding to China’s fast growing reserves. And over time the pool of foreign assets held by the state commercial banking system increased, and rose well beyond those that stemmed directly from the use of foreign exchange reserves in the recapitalization of the state banks. Specifically, starting in 2007, the PBOC forced the banks to meet a portion of their regulatory reserve requirement in foreign exchange. Back in 2011, Guonan Ma, Yan Xiandong, and Liu Xi wrote: "on several occasions, Chinese commercial banks reportedly were asked to deposit foreign currency with the PBOC to meet the reserve requirements on their local currency deposits." This was a way of keeping the foreign exchange off the PBOC’s balance sheet. China’s problem back then was that its reserves were growing too fast. Between mid-2007 and mid-2008, the banks were encouraged to hold $200 billion of foreign reserves to meet the reserve requirement on their domestic deposits (and likely were allowed to hedge the FX risk at the central bank, as foreign exchange was being held against domestic currency deposits). The PBOC didn’t want the world to know just how much it was in effect intervening in the market at the time; it also wanted to keep its reserves from rising through $2 trillion. The foreign exchange hidden in the state banks during this period explains most of what I labelled "shadow" reserves in the chart (needed data is only available through q2 2016). At various other points in time, other Chinese state institutions—the “national team” to use a term popularized during China’s stock market intervention—also issued bonds domestically to finance the purchase of foreign assets. The China Investment Corporation for example. And after the crisis, the nature of the buildup of non-reserve foreign assets in the Chinese state system changed. The China Development Bank emerged as a critical source of outflows when it went on a global lending spree. Such lending substituted for further reserve growth. State-backed institutions remained fairly active in the foreign exchange market, but China started to recycle more of the foreign exchange it was building up by making loans to a range of riskier borrowers—and put a bit less into U.S. bonds. The CDB finances itself primarily by selling domestic, yuan-denominated bonds. The CDB also now has, according to the balance sheet data in its 2015 annual report, $260 billion in foreign currency loans (and a total of around $295 billion in foreign currency denominated assets) on its balance sheet and only $135 billion in on-balance-sheet foreign currency liabilities. It thus has an explicit funding gap—more visible foreign currency assets than visible foreign currency liabilities, and it fills the gap in part through around $80 billion in swaps (p. 196 of the 2015 annual report, thanks to a friend for pointing this out). (One small note: the CDB’s total overseas loans seem bigger than foreign currency loans). The buildup of these foreign assets can be tracked, indirectly and imperfectly, through China’s balance of payments data (with a bit of help from the PBOC’s balance sheet data). There is a line item in the balance of payments that maps relatively well to the portion of the banks reserve requirement that was held in foreign currency (also reported on the PBOC’s balance sheet, as "other foreign assets"). China reports its portfolio investment abroad—and while some of that is private, a lot clearly comes from the China Investment Corporation. And it reports the foreign loans of the banking system. It is reasonable to think that a lot of these loans are from the China Development Bank. Sum up the outflows through all these channels in the balance of payments over time, and you can estimate the total non-reserve holdings of China’s “official” sector—foreign assets that aren’t part of reserves. I get a total of almost $700 billion, roughly split between shadow reserves held in the banks and in the CIC, and the overseas lending of the state banks (mostly the CDB). My chart treated all the outflows in certain categories of the balance of payments as official, which is likely an overstatement—there are about $90 billion in outflows from the qualified domestic institutional investor program, and some of those are private. Yet even if not all of the accumulated assets offshore are from the state banks, the CIC, and the CDB, it is reasonable to think most are.** So how might this relate to China’s rumored forward book? For those who need background (beyond this primer on modern intervention techniques from the BIS), there is an argument in parts of the foreign exchange market that China doesn’t really have $3.12 trillion in foreign exchange reserves, because it has sold some of its reserves forward. Those rumored forward sales allowed some in the market to place bets that the yuan would depreciate, and depreciate by more than what was “priced” in the forward market. The PBOC now discloses a $45 billion short position (up from $29 billion earlier this year), but many in the market believe the real position is larger. It though seems to me possible that a number of big state institutions might be the ones who have sold dollars forward. We know that the state banks, the CIC and the CDB all have significant foreign currency assets—and since thy finance those foreign currency assets in part with yuan borrowing, their balance sheets have an underlying foreign currency mismatch. Specifically, they need to protect themselves against the risk the yuan rises (and they gain if the yuan falls). That makes them natural buyers of protection against yuan appreciation, and natural suppliers of protection against yuan (and offshore CNH) weakness. Take an overly simple example. Suppose the CDB has raised funds by selling a one year bond denominated in yuan. And it has made a one year dollar-denominated loan. It loses if the dollar depreciates relative to the yuan (the yuan appreciates) over the next year. And it can protect itself against the risk that the yuan will appreciate by selling the dollar it expects to get back from the loan forward for an agreed sum of yuan, effectively locking in the yuan’s future price today. (A swap does the same thing, while providing the bank with actual dollars to lend out) My guess is that the state banks hedged against the risks of yuan appreciation with the PBOC in one way or another, back during the period of yuan appreciation. Or got regulatory approval not to hedge. That would imply that the PBOC took on some of the foreign currency risk associated with what might be called China’s shadow reserves; the foreign currency risk wasn’t all being held on the books of the state banks and the CDB. And maybe now some state institutions that previously hedged against yuan appreciation with the PBOC hedge in the offshore market? Back when the yuan was rising, the private market wanted to bet on the yuan’s appreciation, which wasn’t much use to banks that themselves needed to hedge against appreciation—but the story changes if the market wants to bet on yuan depreciation. There is a tiny bit of hard data to support this theory, notably the indications in the CDB’s annual report that it has a large swaps book—that though doesn’t tell us who the CDB swaps with (and if the CDB does swaps with the State Commercial Banks, who the state banks then swap with). And I have long wondered how the state banks hedged the foreign currency risk associated with the requirement that they hold a portion of their regulatory reserve requirement in foreign currency, which added to the risks that they took on by holding foreign exchange as part of their regulatory capital.*** Fundamentally though this is a hypothesis to be tested with more financial sleuthing. It is not something the available data proves. And of course it is something that the Chinese could clarify with a bit more transparency about just how the foreign currency risk associated with China’s non-reserve official assets has been managed over time. Right now there are only hints. If this all is even roughly right, China’s central bank isn’t failing to report its forward book to the IMF. The PBOC isn’t the one that is selling its foreign exchange reserves forward. The state banks are. At the same time, one of China’s hidden buffers—the underlying foreign currency position of the large state institutions that had been building up what might be called China’s shadow reserve portfolio—is now being used in a new way to help stabilize the offshore market. To be technical, a hidden long—the FX risk that the state institutions either didn’t hedge or hedged with the PBOC—is being reduced. To be more colloquial, China has used up a lot of ammunition in the market over the last year, but it also likely started with a bigger stockpile than most realized. * The $135 billion reserve outflow in the q3 balance of payments has attracted a bit of attention. That suggests an underlying monthly pace of reserve sales in q3 of about $40 billion a month. Some bank analysts have noted that there is a big gap between the balance of payments data and the change in headline reserves. That is true. But it also isn’t significant. The PBOC’s own balance sheet data for q3 suggested close to $110 billion in reserve sales (see this), and that is a better indicator. Other "proxies" that include the state banks show somewhat smaller sales, suggesting that the banks bought some foreign exchange off the books of the PBOC. ** My estimate of the growth in China’s state portfolio tracks closely to the cumulative current account surplus—or actually the cumulative surplus in the current account and the FDI balance—until the recent period. The balance of payments data clearly implies that a lot of actors, not just the central bank, built up a reasonably sized foreign portfolio from 2005 to 2014, and that overtime the nature of this portfolio shifted, with the CDB assuming a bigger role. I count other foreign assets, all portfolio outflows, and all bank “loans” to the world in the balance of payments (other, loans, assets) in my measure. Some of the portfolio outflows in particularly clearly come from the qualified domestic institutional investor program; that would reduce the total by $90 billion or so. I avoided this adjustment because of the added complexity—and because many of the portfolio outflows really map to periods when either the banks or the CIC were known to be buying external assets. *** The PBOC’s data on the foreign currency balance sheet of the state banks used to report a line item, under funding sources, called “purchases and sales of foreign exchange.” Back in 2009, I thought this line item was explained by swaps the banks conducted with the PBOC, where they essentially swapped yuan for dollars. This was the funding source the banks used for the ill-fated foray in the global bond market in 2005 and 2006 for example. China stopped publishing this line item at the end of 2015. One way of understanding my thesis is more or less as follows: the state banks (and the CDB) previously were selling dollars forward to the central bank, and rolling that position—and the PBOC was in effect holding foreign currency risk off its balance sheet. That explains the growth over time in foreign currency funding from "purchases and sales" on the state banks balance sheet. And the PBOC no longer needs to take the other side of the trade, as the state banks can easily find other actors who want to take on the risk of yuan appreciation in return for the gains from yuan depreciation. (And the banks themselves do not want to make an outright bet on the yuan; they need to try to match their books). Incidentally, the China Development Bank appears to be part of the state commercial banks’ foreign currency balance sheet data set.The CDB has at times been viewed as a commercial bank and at times as a policy bank, but in the data, it is a commercial bank—hence the steady growth in overseas loans from 2010 on in the aggregate foreign currency balance sheet (link).

The global capital flows story these days is complex. I wanted to build on Landon Thomas’ article with a set of charts drawing out how I think large surpluses in Asia and Europe are now influencing the TIC data. Obviously, this is a more technical post. Asia’s surplus is big. In dollar terms, the combined current account surplus of China, Japan, and the NIEs (South Korea, Taiwan, Hong Kong, and Singapore) is back at its pre-crisis levels. China’s surplus is a bit smaller in 2007, but Korea and Taiwan are clearly running bigger surpluses. Yet unlike in the past, very little of Asia’s surplus is going into a reserve buildup. China is obviously selling, and its selling overwhelms intermittent purchases by Korea (Korea sold in q1 2016, but bought in q3) and Taiwan. The outflow of savings from Asia is currently overwhelmingly a private flow. That is a change. And frankly it makes the impact of Asia’s surplus on global markets harder to trace. The Bank for International Settlement (BIS) data shows that much (I would say most) of the "capital outflow" from China over the last four quarters has actually gone to paying down China’s external bank debt, not to build up assets. It thus just becomes a new source of liquidity for the global banking system (once a dollar loan is repaid, the bank is left with a dollar—which has to be parked somewhere else). And of course the eurozone and northern Europe also run substantial surpluses. Negative rates and ECB asset purchases in effect work to push investors out of super low-yielding assets in Europe, and into somewhat higher yielding assets outside the eurozone.* The combined surplus of China, Japan, the NIEs, the eurozone, Sweden, Denmark, and Switzerland was close to $1.2 trillion in 2015. That is a big sum; one that has to leave traces in the global flow data. The U.S. current account deficit isn’t as big as it was prior to the crisis (and it is smaller than the UK’s current account deficit), but it is still financed, in part, by inflows from abroad into the U.S. bond market. Total inflows from private purchases of U.S. bonds by foreign investors—together with the inflow from American investors selling their existing stock of bonds abroad and bringing the funds home—actually look to be at a record high in the TIC data (in dollar terms, not when scaled to U.S. GDP). $500 billion in inflows from foreign purchases of Treasuries, Agencies, and corporate bonds by private investors abroad, and $250 billion in financing from Americans bringing funds previously invested in foreign bonds home. The TIC data’s split between private and official investors is notoriously unreliable. Lots of private purchases in the past weren’t really private purchases. But with China and Saudi Arabia selling reserves, and with Japan reducing its reserve holding of long-term securities and building up its deposits, I strongly suspect most of the private inflow is now really private. Counting official sales, the net inflow from foreign investors—private plus official—are actually on the weak side even as private inflows are are on the strong side. The private inflow data is both important, and not the full story. I should note that official inflows into the U.S bond market before the crisis were clearly more than $200 billion a year. The "transactional" TIC data suffers from a lot of problems. It never really registered China, or Gulf, purchases cleanly. They showed up, but as private inflows from Europe (typically) not official inflows from West or East Asia. The custodial data did a better job of capturing the total inflow from China, and, well, it caught a bigger share—but not all—of the inflow from the Gulf. In years past, the best estimate of true official inflows was simply to add all private purchases of Treasuries and Agencies to the official flows in the data. That probably isn’t still the case, but it is still a useful check. (I plotted inflows into Treasuries and Agencies in the TIC data relative to my estimate of reserve growth/ sales here). There is one other important theme. Before the global crisis there were exceptional inflows from the rest of the world into Treasuries and Agencies. That was—as Ben Bernanke and others have emphasized—a central bank/ reserve accumulation driven flow. But there was also a large inflow from the rest of the world—and Europe—in particular into U.S. corporate bonds. The "corporate bond" category includes asset backed securities (private label asset backed securities, Agency guarantees are in the "Agency" category). We now know that European banks—and investment vehicles that were based offshore but backed by U.S. banks (SIVs)—accounted for much of this flow. The banks and investment vehicles buying U.S. asset-backed securities didn’t take on much direct currency risk though. The European banks, and various shadow banks, borrowed in dollars, whether from U.S. money market funds or from central bank reserve managers who put dollars on deposit rather than buying in securities, or swapped euros for dollars—to buy U.S. asset-backed securities. They took credit risk, and dollar funding risk. We actually should have been able to figure this out in real time; the BIS data showed the rapid growth of the dollar balance sheets of European banks pre-crisis, and the TIC data showed massive European purchases of corporate bonds. I, among others, didn’t quite put two and two together. In any case, the massive inflow into corporate bonds in the TIC data from 2005 to 2007 came to an abrupt end well before the global crisis. The flow stopped in the summer of 2007, about a year before "Lehman" and the height of the panic. And right now there isn’t a massive inflow into any particular segment of the market, at least not judging from the TIC data. Foreigner private investors are buying a mix of Treasuries, Agencies (private investors bought $200 billion in Agencies over the last 12 months, thanks I suspect to Japanese investors) and corporate bonds (real corporate bonds this time, not asset backed securities, data here). And a big source of net inflows isn’t coming from foreign investors buying U.S. paper, but rather from U.S. investors bringing their money back home. That provided $300 billion of (external) financing at its peak, and has provided about $250 billion in financing over the last 12 months. The mixed total inflow from private investors is a function of flows into all categories of bonds, not demand for one single type of security. Mapping the TIC data to underlying imbalances (current account surpluses, which in aggregate need to be offset by external deficits) isn’t straightforward, and it requires a degree of judgement. Chains of risk intermediation can obscure the flow (and yes, create gaps between gross flows and net flows, think of U.S. money market funds lending to European banks to buy U.S. asset-backed securities). But at the end of the day, there usually is something that can be teased out of the data. Right now, it is that a glut of savings in parts of Asia and most of Northern Europe is generating—both directly, and by yield-hungry American investors back home—significant inflows into the U.S. bond market even with relatively low U.S. bond yields. * Technically private bond inflows can finance equity capital outflows, official bond sales or the buildup of deposits abroad. Gross inflows are equal to gross outflows plus the current account. Saying the inflows finance the current account deficit is this an over-simplification. But it is a reasonable over-simplification in the following sense: the flow over time that has provided the most financing for the the U.S. current account over time has come from the buildup of foreign holdings of bonded debt (portfolio debt securities, in the net international investment position data) -- other flows tend to more or less net out over time. Putting all the needed caveats into a chart label is hard.

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)

In earlier posts, Emma Smith and I added up central bank purchases of G-4 government bonds. This includes emerging market, Japanese and Swiss purchases for reserve accumulation and purchases by the Fed, Bank of Japan, European Central Bank and Bank of England during periods of quantitative easing (QE). In this post we compare our estimates of official demand for U.S., Japanese and European bonds with changes in the supply of safe assets—that is, purchases by central banks relative to net new issuance of government bonds. If central bank demand for a particular asset is lower than net new issuance, then private sector holdings of government bonds continue to grow but at a slower pace than would otherwise be the case. And if central bank demand for a particular asset exceeds net supply, then private sector investors—such as banks and pension funds—have to reduce their holdings of safe assets, and move into alternative assets. This is how the portfolio re-balancing transmission channel of asset purchases works: private investors sell to the central bank and are forced to find new places to park their money. Conceptually, it should not matter much if the central bank buying say U.S. assets is the People’s Bank of China or the Fed, at least so long as both are expected to hold on to their purchases for a long-time. When either buys, it reduces the stock of assets in private hands and forces investors to shift into other assets. Central bank asset purchases aren’t limited to government bonds of course, but, to simplify things, we limited our analysis to new issuance of government bonds. We know this over-simplifies. For example, a lot of “official” demand has gone into Agencies. Before the global crisis Agencies were a favorite of reserve managers globally. But adding in the Agencies to net supply takes a bit (ok, a lot) more work. The Fed also bought Agencies, but Fed holdings of Agencies and Treasuries are reported separately on their balance sheet. The numbers below only count the Fed’s Treasury portfolio. In the U.S., the supply of Treasuries has exceeded central bank demand since 2010. This is largely because the U.S. Treasury ramped up issuance of Treasury securities after the crisis (offsetting, it should be noted, a big fall in private bond issuance). Even as annual net issuance of Treasuries slowed from its peak of around $1.7 trillion to a little over $600 billion, it has remained above official purchases. Right now there isn’t any official bid for U.S. bonds. Reserve managers on net have been selling and the Fed hasn’t been buying. In contrast, official purchases in Europe and Japan during the period of "QE" well exceed net issuance. Annual net issuance of eurozone government bonds peaked in the second half of 2009 at around $900 billion. It has since fallen by nearly 90 percent, to around $120 billion today. Much of this can be explained by the pursuit of austerity—in aggregate, the eurozone’s government budget deficit has fallen from a peak of 6½ percent of GDP to 2 percent. When only reserve managers were buying eurozone government bonds, the increase in supply exceeded official demand. But that obviously changed with the ECB’s QE program. While there has been renewed talk of fiscal easing in Europe—which would bring with it higher government bond issuance—current plans for 2017 don’t suggest any significant expansion. A modest structural easing in Italy likely will be offset by tightening in Spain and Portugal; Germany’s tiny 2017 easing will likely be offset by tightening in the Netherlands, and France’s fiscal stance is roughly neutral. Official demand for Japanese bonds overtook supply at the beginning of 2013—just before the BoJ launched its most recent large-scale asset purchase program (“Quantitative and Qualitative Monetary Easing”). And since Japan tightened fiscal policy after QQE ramped up, the gap between the increase in supply and official demand has increased. With purchases of around 15 percent of Japan’s GDP and net issuance down to around 5 percent of GDP, the stock of bonds held in the market is falling fast. The current pace of official asset purchases implies that private investors need to reduce their holdings of eurozone bonds by about $450 billion a year, and Japanese bonds by about $370 billion a year. Hence concerns that the ECB and BoJ may run out of government bonds to buy. That is part of the reason why the BoJ and the ECB have expanded the universe of assets they can buy—to include corporate bonds, and ETFs in Japan. And the BoJ has begun to move away from a set quantity of asset purchases to targeting the level of bond yields. And presumably the absence of more issuance—relative to official purchases—in Europe and Japan has something to do with the dollar’s current relative strength. In a standard macroeconomic model, fiscal expansion helps strengthen the currency—offsetting the impact of monetary easing. And in a flow sense, the investors displaced by the ECB and BoJ have to go somewhere. The yield on U.S. Treasuries is looking relatively attractive at the moment. We know these estimates are a bit rough. We didn’t include Agencies, or the European analogues to the Agencies (EIB, ESM and the like) in our calculation of net supply of safe assets. We assumed that all reserve demand for foreign assets goes into bonds, when in practice some important reserve managers have a small portion of their portfolio in equities. Our goal was simply to provide a rough cut of how official demand has compared to the straight supply of government bonds once you factor in foreign exchange reserve demand; our suspicion is that the "hydraulics"—the raw sums that the market is either absorbing or coughing up— matter.