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Thursday, 29 March 2012

All those reserves....

Flow on effects
A recent comment from one reader questioned the likely effects of a China slowdown on some of its key trading partners.  As has been discussed previously there is concern amongst exporting economies of the effect of a China slowdown.  The previous week saw negative reaction to BHP executive Ian Ashby's comments of flat predicted Chinese steel demand, while recently the currency and stock markets in Canada, Australia and New Zealand have all declined on expectations of lower Chinese growth.  The FT Alphaville blog had some interesting figures out from researchers showing the growth of imports into China as exports have stagnated and which also singled out Australia and Brazil as having a particularly high share of their exports to China thereby making them vulnerable to a slowdown.

For Canada, which has a US focus but is vulnerable through commodity prices and by the fact that many Chinese companies and companies with China exposure are listed on its sharemarkets, this piece from Reuters had a couple of soundbites from researcher Murray Leith at Odlum Brown in Vancouver:
...The Canadian stock market is very geared to economic growth in China. If China slows, commodity prices moderate and because resource stocks constitute close to half the index that has negative implications....
It will be interesting to see how this develops.

Keeping a big rock in place
To a more long term issue, a fairly common point reached in China discussions in the size of the country's foreign reserves. They're huge, over $3 trillion and are considered by most to provide a sufficient firewall for any potential crisis the country faces.  A lighthearted survey by the Economist of just how many enormously sized things such an amount could buy is here.

Substantial foreign reserves have been de rigeur for emerging market economies for over a decade - in order to protect against fluctuations and rapid devaluations which can follow foreign investors quickly withdrawing direct investments (including speculative capital flows or "hot money") compounded by short sellers wading in to make quick profits betting on further declines in the midst of a crisis.  The lesson many Asian and emerging market countries drew from the Asian Crisis in 1997 was to build up an arsenal of foreign reserves to out-buy any speculators and compensate for any rapid capital flow shortfalls in future.

This need for security against financial contagion seemingly dovetailed nicely with China's longstanding trade policy, which is to achieve large trade surpluses by relying on an undervaluation of its currency, the Yuan or Renminbi (RMB) in particular with its largest trading partner the US (and its currency, the dollar).  As Krugman explained early on in the crisis, this policy wasn't necessarily anticipated or deliberate, but certainly China was locked into accumulating foreign reserves early on - with one problem being that China's reserves were concentrated in US dollars (through China's holdings of US Treasury Notes or debt) which made them vulnerable to falls in the dollar.

At the time there were calls to expand the use of Special Drawing Rights as an alternative to US dollars, although these fell silent and China's planners instead launched the internationalisation of the RMB, which is now used in trade settlements, some instruments and limited capital flows.


China's FX agency...has a few spare yuan down the back of the desk...
However steps to liberalise the capital regime have been gradual and even with some diversification by China into currencies such as the Euro and some overseas M&A, China's gargantuan foreign reserves still have weaknesses.  They do still hold a large position in US Treasuries which would be hard to liquidate (lest their remaining US dollar reserves would fall in value).  The amount of dollars they have to buy makes maintaining the currency peg - buying up all the excess dollars, expensive, while the Central Bank also has to  drain the resulting excess resulting RMB liquidity from the financial system by "sterilising" (requiring banks to buy debt or increase the amount that they must hold in reserve), an imprecise procedure when the Central Bank uses the same tool to conduct domestic interest rate policy.

In general there is no transparency about the precise nature of the reserves and the extent to which the reserves are in fact reinvested into domestic entities (and therefore less valuable) is not known (though Victor Shih has speculated).

The Rising Sun in the Currency Wars
A quite disturbing risk is that China might be unwittingly drawn into the ongoing "currency wars" and in particular a devaluation of the Japanese Yen.  The term "currency wars" came into frequent use in 2010 (Guido Mantega, the Brazilian finance minister used the term often) to describe the series of quantitative easing by developed country central banks (especially the UK and US) to lower their exchange rates and restore competitiveness relative to emerging markets.  Developing countries and especially emerging markets responded by introducing capital controls and restrictions, seeking to fight the tide of liquidity as investors moved money from developed to developing economies to seek returns.

Japan (like Switzerland) was seen as a safe haven, having a sound economy and currency which was seen as still a good store of value.  With increasing flows the value of the Yen has risen to very high levels, eating into the already declining competitiveness of Japan's export industries.  Coupling with a now crippling level of debt and effects from the earthquake, the Bank of Japan has also been involved in easing although it may not be done yet.  A few are now speculating that i) Japan has further easing to do and ii) China may feel the need to respond with its own devaluation to ensure its currency remains cheaper than Japan.  As Mike Dolan points out for Reuters, devaluing the RMB will bring China into conflict with the US, while Andy Xie argues that a big Yen devaluation could cause China's banking system to sink.  It is not clear how Andy imagines the collapse - whether by loss of confidence or speculation however there seems to be enough to at least mount a rebuttal to Michael Pettis who last year in a podcast stated that there was no doubt China's foreign reserves would be sufficient to repel any currency contagion.

And right now?
Of course a country's capital account is in flux and it is worth taking into account money flowing out from a country as well as in.

This year has seen a reversal in that China's foreign reserves shrank for the first time since 1998, while the slowing rate of RMB appreciation has seen China's central bank struggling to find a balance between trying to dampen the impact of investors withdrawing from bets on appreciation and inadvertently causing uncertainty which could encourage substantial capital outflows:

The central bank wants to widen that band to allow greater two-way flexibility, discouraging investors from taking one-way bets on yuan appreciation by bringing speculative capital into the country....But China's central bank still lives in the long shadow of the Asian financial crisis, when sudden outflows of capital brought neighbouring countries to their knees.

Further complicating the picture is the very hard to estimate extent of capital flight which anecdotal evidence suggests is high - "The errors and omissions in China’s balance of payments ($60bn in 2010) suggest tens of billions might be involved in such capital flight though it is difficult to distinguish between hot money outflows and capital flight".  A thorough analysis presented in an interview by Victor Shih, is here.



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