PBOC (People's Bank of China)

With the Osaka Xi-Trump summit producing an indefinite "truce" that halts further escalation (at least for now), there is every reason to expect the yuan to remain stable. The intervention proxies (surprisingly) didn't show much activity in May, at the peak of the recent trade tension.

   

   

   

   

   

A primer on China reserve watching.

Analysis of the September intervention proxies for China and q2 Chinese balance of payments data.

For the past fifteen or more years, if not longer, the flow of foreign exchange in and out of China has never quite seemed to balance. Either the yuan was a one way bet up, and the PBOC had to buy foreign exchange to keep the currency from appreciating, or the yuan was (thought) to be a one way bet down, and the PBOC had to sell a lot of foreign currency to keep the yuan from depreciating. Neither was an especially comfortable position for the central bank. In August, though—and frankly through most of the summer—the available evidence suggests that inflows and outflows almost perfectly matched.* The stock of foreign exchange reserves reported on the PBOC’s yuan balance sheet—which shows its stock of foreign exchange reserves at its historical purchase price—didn’t move. And the numbers on foreign exchange settlement, which technically shows the flow of foreign exchange through the banking system but in practice tends to be dominated by the PBOC, show very modest net sales if you don’t adjust for reported forwards, and small net purchases if you do. It is pretty amazing if you think about it. The PBOC supposedly thought flows were close to balance when it reformed its foreign exchange regime way back in August of 2015, but quickly discovered that the apparent balance hinged on expectations that the PBOC would keep the exchange rate constant. Those expectations, obviously, were disrupted by the August 2015 depreciation. Two years and a trillion or so in reserves later,** and calm has been restored. To the chagrin of those who bet that the August 2015 depreciation augured a big future move down: some thought the depreciation signaled that China’s leaders wanted a much weaker currency (and I suspect China’s leaders did want a somewhat weaker currency; the yuan did depreciate against the CFETS basket from mid 2015 to mid-2016), others thought that the depreciation signaled that the PBOC was about to lose control over the exchange rate (not a view I shared). Yet it seems that the August equilibrium was itself somewhat fragile. The yuan shot up in the first week of September. I suspect—without having hard evidence—that the PBOC had to intervene to keep it from rising more. And then the PBOC loosened some of the controls that it had put in place to limit depreciation pressures. That was—rightly I think—interpreted as sign that China’s government didn’t want the currency to appreciate too much. The investment banks all seem to think that China’s exporters started to think the yuan was a one way bet up and started to unload the dollars they had accumulated back in 2016. Three more comments: 1) The PBOC could have used the reemergence of appreciation pressure to rebuild reserves, rather than to loosen controls. The fact that it didn’t suggests something about the PBOC’s policy goals. Among other things, it suggest the PBOC doesn’t think it needs more than $3 trillion in reserves. I agree. The three trillion number came from the heavy weight the IMF’s new reserve metric placed on local currency deposits if a country has a fixed exchange rate and an open capital account. The IMF’s China team, incidentally, also now recognizes—see paragraph 44 of its latest staff report—that the reserve metric doesn’t really fit China.*** 2) John Authers of the Financial Times noted last Friday that in China “the market and the economy are state-controlled.”**** That’s still largely the case for the onshore foreign exchange market, even if there are some channels that are difficult for China to completely control. China has lots of tools—especially now that it reversed the August 2015 reforms and effectively reintroduced the “fix” as a market signal back in June. It can dial capital controls up or down. And I think it can also dial the amount of state bank lending—and borrowing—from the rest of the world up and down. One reason why flows stabilized after the first quarter is that Chinese banks seem to have slowed their breakneck foreign loan growth (they also started borrowing more from the world, so their net foreign asset position stopped growing and actually looks to have shrunk a bit—but that’s a very technical topic for another time). In other words, balance in the market has come in part through managing the flows allowed to enter the foreign exchange market. I don’t really expect that to change—any coming liberalization is likely to be done in ways that are reversible.***** 3/ Exchange rate moves impact trade flows with a lag. The August appreciation of the yuan almost certainly had no impact on China’s August trade data (year-over-year volume growth was down a bit in August relative to July, but that is likely a result of standard volatility in the trade data—and the fact that the base from August 2016 was quite strong). A good rule of thumb is to look back a year to get a sense of the impulse the exchange rate is giving to current trade flows. And by that measure, China is still getting a boost from the exchange rate. Plus, well, the yuan—against the dollar—really isn’t that far from where it was eight or nine years ago and ongoing productivity gains should be leading the yuan to appreciate over time. And even with the yuan’s appreciation in August and September, the broad yuan is down close to 10 percent from its peak (against the CFETS basket)—though to be fair, that depreciation came after a significant appreciation in late 2014. I am not particularly impressed by the recent whinging of Chinese exporters (who probably should have hedged their future export orders earlier in the year but, well, probably didn’t when they expected the yuan to continue to depreciate). Chinese export growth in the first half of 2017 exceeded global trade growth, and exports to the U.S. have been doing just fine this year.     * There was a brief period in the summer and fall of 2012 when the PBOC doesn’t seem to have intervened much, as the euro crisis spilled over and triggered an emerging market sell-off. The foreign exchange reserves reported on the PBOC's balance sheet (in yuan terms) were also relatively flat for a period in late 2014 (when the dollar was appreciating), though the settlement data suggests sales in September and q4. ** About half of the fall in reserves is balanced by a fall in short-term debt. And a significant fraction of the remaining half a trillion is explained, in a mechanical sense, by the ongoing rise in the foreign assets of the state banks. *** I think it also doesn’t work that well for a lot of under-reserved emerging economies—largely because it gives equal weight to domestic and foreign currency deposits. **** “The market and economy are state-controlled (even if the profit motive is put to much more use than it was in previous communist experiments)”; I enjoyed the entire column, though I also tend to think that the eventual credit “reckoning” could still play out with some very Chinese characteristics (e.g. through a rather opaque recapitalization similar to what happened after 2003, though made more difficult by a slower underlying pace of growth). ***** I am not sure that is a bad thing by the way. I agree with Martin Wolf’s argument that it safer for everyone if China’s domestic financial system is kept one step removed from global markets so long as the domestic financial system has so many undercapitalized institutions (backed by an implicit or explicit state guarantee).

No sign of pressure on China's exchange rate regime in the June intervention proxies. Overall intervention in the second quarter is back at pre-August 2015 levels.

The proxies for Chinese intervention in May do not show any significant reserve drain

Chinese reserves appear to be stable over last three months.

Martin Wolf’s important column does a wonderful job of illustrating the basic risk China poses to the world: at some point China’s savers could lose confidence in China’s increasingly wild financial system. The resulting outflow of private funds would push China's exchange rate down, and rise to a big current account surplus—even if the vector moving China’s savings onto global markets wasn’t China’s state. History rhymes rather than repeating. And I agree with Martin Wolf’s argument that so long as China saves far too much to invest productively at home, it basically is always struggling with a trade-off between accepting high levels of credit and the resulting inefficiencies at home, or exporting its spare savings to the world. I never have thought that China naturally would rebalance away from both exports and investment. After 2008, it rebalanced away from exports—but toward investment. There always was a risk that could go in reverse too. In one small way, though, I am more optimistic than Martin Wolf. I suspect that China’s regime was under less outflow pressure in 2016 than implied by the (large) fall in reserves, and thus there is more scope for a combination of “credit and controls” (Wolf: "The Chinese authorities are in a trap: either halt credit growth, let investment shrink and generate a recession at home, a huge trade surplus (or both); or keep credit and investment growing, but tighten controls on capital outflows") to buy China a bit of time. Time it needs to use on reforms to bring down China’s high savings rate. All close observers of China know that China has been selling large quantities of reserves over the last 6 or so quarters. The balance of payments data shows a roughly $450 billion loss of reserves in 2016, with significant pressure in q1, q3, and q4. The annualized pace of reserve loss for those three quarters was over $600 billion (q2 was quite calm by contrast). But close examination of the balance of payments indicates that Chinese state actors and other heavily regulated institutions were building up assets abroad even as the PBOC was selling its reserves. In other words, a lot of foreign assets moved from one part of China’s state to another, without ever leaving the state sector. For a some time I have tracked the balance of payments categories dominated by China’s state—and, not coincidentally, categories that experienced rapid growth back in the days when China was trying to hide the true scale of its intervention. One category maps to the foreign assets the state banks hold as part of their regulatory reserve requirement on their deposit base. Another captures the build up of portfolio assets (foreign stocks and bonds) abroad, as most Chinese purchases of foreign debt and equity historically has stemmed from state institutions (the state banks, the CIC, the national pension fund). Even if that isn't totally true now, portfolio outflow continues to take place through pipes the government controls and regulates. These “shadow reserves” rose by over $170 billion in 2016, according to the balance of payments data. The state banks rebuild their foreign currency reserves after depleting them in 2015, and there were large Chinese purchases of both foreign equities and foreign debt. And the overseas loans of Chinese state banks—an outflow that I suspect China could control if it wanted to—rose by $110 billion. As a result much of the foreign exchange that the central bank sold ended up in the hands of other state actors. My broadest measure of true official outflows* shows only $150 billion in net official sales of foreign assets in 2016. Not a small sum to be sure. But not an unmanageable sum. That kind of outflow can easily be financed out of China’s large foreign exchange reserves for a time, or China could more or less bring the financial account into balance by limiting the buildup of foreign assets by the state banks and simultaneously cracking down on outward FDI (over $200 billion in outflows 2016, and largely from state and state-connected companies). In other words, much of the reserve draw was offset by the buildup of other state assets—especially counting the assets state banks and state firms acquired abroad.** That I suspect is why flows suddenly started to balance once China tightened its controls (and likely made it harder for one part of the state to bet against another part of the state). Of course, the renminbi’s relative stability against the dollar also helped—you do earn more on a bank deposit in renminbi than on a bank deposit in dollars. There are of course still private outflows. But the outflows aren’t that much bigger than what China could finance out of its export surplus. If you take the growth in the state banks' overseas assets ("other, other assets" and "other, loans, assets" for the BoP geeks) out of the data, it seems that the pace of outflows actually slowed a bit in 2016. Of course, I do not like simple stories. I think the outflow numbers on the financial account are a bit less scary after you adjust for the financial activity of China's state, but I also think the current account may disguise some real private outflows. Bottom line: the 2016 reserve drain was offset in part by the buildup of assets at the state banks and in other large regulated financial institutions, so it is a bit less scary than it seems—for now. Especially in a context where China’s growth is accelerating, China is on a tightening cycle and, for now, the dollar isn't appreciating in the way many expected. * This measure includes the foreign loans of China's banks (assuming, correctly, that all the major lenders are state-owned), the traces the PBOC's other foreign assets leave in the balance of payments data (other, other, asset -- which reflects the foreign assets the banks hold as part of their regulatory reserve requirement on domestic deposits) and portfolio equity and debt. Historically, the CIC has dominated portfolio equity outflows and the state banks accounted for most portfolio debt outflows. That is a bit less true now, so this arguably over-counts. If that is the case, I would welcome a revision to the Chinese balance-of-payments data that splits out China's holdings of portfolio assets abroad by sector -- consistent with the reporting provided by many other countries. One thing though is clear: portfolio outflows are governed by quotas and are executed through channels the state regulates. They cannot happen without state approval. ** This would explain in part why the data on fx settlement, which includes the state banks as well as the PBOC, shows fewer sales than implied by the change in the PBOC's foreign balance sheet.

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