China’s US$3 Trillion problem: One Expensive Peg

China’s FX reserves passed the US$3 trillion mark in March, reaching a level of US$3.044 trillion at the end of the month. Given that China recorded a trade deficit for the quarter, this implies that China received a hefty amount of hot money in the quarter.

 

Adjusting for valuation, RGE estimates that China added about US$140 billion of FX reserves in Q1. With a US$7 billion trade deficit and modest FDI inflows, most of the inflows reflect short-term capital inflows. China is only partly sterilizing the inflationary effect of its reserve accumulation, meaning that its currency policy is undermining its attempts to tighten monetary policy and fight inflation. Based on the successive increases in required reserve ratios, the PBoC sterilized about half of the valuation-adjusted inflow in Q1 2011, about even with its long-run average. With RRR’s at a record high 20% for large banks, the PBoC returned to open-market operations to sterilize inflows in March 2011 by offering higher yields on its bill/repo sales.

Figure 1: Hot Money Returns in Q1

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China is closing in on another milestone – having US$2 trillion of US dollar assets. RGE’s assumption of a dollar share of just over 60% implies dollar holdings of about US$1.9 trillion. This is roughly in line with RGE’s adjustment of the U.S. Treasury International Capital (TIC) survey which suggests that China held US$1.8 trillion in US assets, US$1.2 trillion in US treasury bonds bills and notes at the end of 2010. As long as China avoids currency appreciation, it will have little choice but to buy US dollar assets. In fact, statements in support of USD alternatives like the SDR, alongside its BRICS counterparts, may actually increase pressure on the RMB further necessitating further purchase of USD assets.

Figure 2: A Load of Dollars

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