Of course Chinese dollar holdings rose, but something changed drastically

There is an interesting, if perhaps predictable, June 17 Bloomberg article by Patricia Lui that discusses China’s holding of US dollar reserves. According to the article:

China is adding to its holdings of U.S. assets, data from the U.S. government showed yesterday, easing concern the Asian nation will sell dollar investments. Total holdings of U.S. equities, notes and bonds among foreign investors rose by a net $115.1 billion in April from $79.6 billion the previous month, the Treasury Department said yesterday in Washington. China’s holdings of Treasuries gained $11.4 billion to $502 billion, holdings of U.S. agency debt rose $11.9 billion and U.S. corporate bond investments increased $6.9 billion, data showed.

The discussion about whether or not China will continue funding the US deficit by buying dollar assets has been going on for a long time, and has caused an unnecessary amount of alarm among analysts worried about the consequences of a possible Chinese decision to stop buying dollar assets – without Chinese purchases of US securities, they worry, how can the US possibly finance its ballooning trade deficit? Yet time after time the data show that China continues to add to its dollar hoard – sometimes in amounts close to or even greater that the US deficit, as Brad Setser recently implied – and so for a little longer those concerns “ease”.

If you believe that the explosive growth in the US trade deficit since the late 1990s was caused primarily by a sudden massive increase in the desire of US consumers to consume, then it may make sense to worry about how the deficit must be financed. After all according to this view, the cost of out-of-control consumption by Americans exceeds American income, and so this requires some foreign saver to finance the consumption. At the individual level it was the wealth effect of rising stock markets and real estate prices that allowed Americans to increase their consumption, but in the aggregate a country running a current account deficit by definition needs external financing. Should this financing stop, US consumption would have to drop drastically in order to eliminate the current account deficit, and with it the US (and world) economy would slow sharply.

But if you believe, as I do, that the global balance of payments disequilibrium is driven primarily by the increase in external savings of a number of developing countries – mostly East Asian and OPEC, with China being by far the largest player – then worrying about how the deficit will be financed shouldn’t take up a lot of anyone’s time. The deficit exists primarily because of the need for China and other countries to invest the current account surpluses their monetary and fiscal policies were designed to create (or the windfall current account surpluses from high commodity prices, if they are commodity exporters).

I have explained why I think the latter is a better description of the global balance of payments disequilibrium several times in my blog, the last time in a June 4 entry (“Chinese savings and US deficits”) and in two longer entries on September 15 (“China and the savings glut” Parts One and Two). As I pointed out in those entries, I think a very plausible argument can be made that the 1997 Asian financial crisis created such a strong impression on Asian policy makers that their decision to protect themselves from a reoccurrence prompted them to put into place very strong mercantilist policies guaranteed to save them from a future external debt crisis. This implied substantial trade surpluses and rising reserves. It also required that some other country or countries be willing and able to run corresponding current account deficits.

The data show that after 1997-1998 Asian current account surpluses grew so quickly, and central bank reserve accumulation along with it, that for the first time developing countries as a group became net exporters of capital when reserve accumulation exceeded net private capital inflows (you can find the actual numbers in Jorg Bibow’s “The International Monetary (Non-)Order and the Global Capital Flows Paradox”). China was by far the biggest factor in this process, and of course as long as China was running such a policy, it needed to invest those surpluses. They were invested in the US.

The point is that China had no choice but to finance the US current account deficit. As long as it ran mercantilist policies aimed at generating trade surpluses only four things could happen:

  1. China finances the US current account surplus directly by buying US dollars assets.
  2. China finances the US current account surplus indirectly by buying euros and yen, and Japanese and European investors (most probably their central banks), buy US dollar assets.
  3. China buys euros and yen and Europeans don’t compensate by buying dollars, in which case China’s current account surpluses shift to Europe and Japan, who end up running current account deficits to replace the rapidly declining US current account deficit.
  4. China stops buying foreign assets, in which case its current account surplus disappears.

Since the whole point of the exercise was to generate current account surpluses and foreign currency reserves, China could not choose Option 4. In addition, as its currency regime locked it into a self-reinforcing system in which rising trade surpluses forced more surpluses (I explain why in “The value of the RMB does matter to the trade balance” Parts One and Two) there was no way for China to choose Option 4 without a serious adjustment to the currency regime and the possibility of a sharp and difficult collapse in exports.

Either China had to finance the US trade deficit, or it had to find someone else willing to accommodate its trade surpluses. The only important question, then, was whether Europe could absorb the necessary current account deficits or not. If so, China could begin to shift its reserve holdings into euros and so cause enough strength in the euro relative to the dollar that the US trade deficit would shift to Europe. To a certain extent this has been happening, but I am not sure it can continue for too much longer.

So as I see it, the question of whether the US trade deficit can be financed or whether China can suddenly “change its mind” about financing the deficit is not a very worrying one because the US trade deficit and, increasingly, the European trade deficit are consequences of foreign financing, not their cause. However something very important has changed recently, and I am not completely sure about its implications.

Specifically, for many years China’s burgeoning reserves were powered primarily by its burgeoning trade surplus (with net FDI playing a secondary role). In that case it was pretty easy to trace out the balance of payments flows and their consequences. I agree with most pessimists that the balance of payments numbers were becoming unsustainable, but not mainly because the US current account deficit was unsustainable. In fact I don’t think it is, for reasons I explain partly in “Demographic projections and trade implications”. For me the biggest problem with the existing balance of payments relationships was that China’s reserve accumulation was becoming unsustainable because of its domestic monetary impact.

Recently this has become an even bigger problem. In the past few quarters China’s reserve accumulation has mushroomed to levels that make the 2006 and 2007 numbers, as incredible as they seemed back then, almost laughably small today. And yet China’s trade surplus and net FDI have not grown to nearly the same extent – in fact the trade surplus, while still incredibly high, has actually shrunk, and FDI, which is much smaller but has grown sharply, probably includes a healthy dose of speculative inflows disguised as FDI (as does, many of us suspect, the trade surplus).

It now seems that China’s rate of reserve accumulation, seemingly unsustainable even two years ago, has reached even higher levels, but what is powering it now is not the (relatively) stable trade surplus and FDI accounts but rather highly unstable speculative inflows (for an explanation of how reserve accumulation has been generated see “What? $74.5 billion? Is this a mistake?”). If I am right, it seems to me that there has not just been a quantitative change in China’s and the world’s balance of payments accounts in recent months (i.e. even more rapid growth in an already unsustainable rate of Chinese foreign currency reserve growth), but also a qualitative change – the cause of China’s reserve growth has shifted significantly. The old mechanism, large trade deficits in some countries balanced by rapid reserve accumulation in others, has been converted into something much more complex and maybe even pro-cyclical (hence volatility enhancing): large trade deficits in some countries plus massive speculative inflows in others are being balanced by even more massive reserve accumulation in the latter countries.

I still need to work out in my mind what some possible implications are, but I would be lying if I said I didn’t find this change worrisome. My instinct is that because of the intensely pro-cyclical nature of speculative inflows, this new system is a lot less stable than the old one.

10 Responses to "Of course Chinese dollar holdings rose, but something changed drastically"

  1. bsetser   June 17, 2008 at 11:14 am

    Michael — I wouldn’t discount the disruption associated with a shift from world 1 to world 2 (or a mix of world 2 and 3). That in some sense was the worry.I share your concern though about a world where Chinese reserve growth is roughly 2 times the size of its current account surplus, a fact that implies that China is effectively a global financial intermediary. It is taking (likely) losses on both its actions as a domestic intermediary (raising RMB and investing them abroad as the counterpart to the current account surplus) and its actions as a global intermediary (absorbing capital inflows from investors seeking RMB and investing them abroad). and I cannot see why China wants to play the second role — it is a net loss to China. but it isn’t clear how China can maintain an undervalued exchange rate and its current account surplus without acting as a global intermediary as well.

  2. Gloomy   June 17, 2008 at 11:40 am

    Great column. Thanks for the insight.

  3. guest   June 17, 2008 at 4:04 pm

    It does all seem a lot less stable. What though are the policy responses?Can China reduce the speculative capital flows without taking policy action which are destabilizing?

  4. Guest   June 17, 2008 at 4:46 pm

    rnThink the US Manufacturing Industry was murdered by the Chinese. Wrong, think againrnhttp://www.prudentbear.com/index.php/BearsLairHomernrnThe sad story of GE Appliances is a paradigm of what has gone wrong in the US economy since 1980. No, manufacturing did not need to leave the United States; US manufacturing was killed by a multitude of foolish short-term-profit motivated decisions by inept and overpaid US management. It is thus clear that by starving GE Appliances of investment and, more important, of research dollars, and devoting the company’s efforts to financial services, “Neutron Jack” and his cohorts have deprived the United States of a major new business. rnrnThe other questions can also be answered. Manufacturing is not intrinsically a low-skill and uninteresting operation, it involves skills at the highest possible level and can readily employ high-wage workers – after all LG’s workforce in South Korea are these days very far from being subsistence-level Third World proletariat. Finally, the US cannot survive through financial services and tech startups alone; it needs to reinvest in manufacturing or it will find itself unable to support an advanced-economy living standard for the mass of its population.rnrnGeneral Electric, however from 1981 to 2001 run by ultra-fashionable “Neutron Jack” Welch, epitomized the failings of the era. It under-invested in many of its manufacturing businesses, entered into a blizzard of divestitures designed to boost its short term earnings, played games with its pension accruals and built a gigantic financial services empire of low quality businesses in which it could never be a leader. It also ruthlessly eliminated its middle management and overpaid its top management, winners in the corporate office political game. GE was a much admired operation in Welch’s later years; it is less so now, and if the bloated global financial services business returns to a historically normal size may finally be seen to have been a disaster. rn

  5. Michael Pettis   June 17, 2008 at 9:34 pm

    Brad, I agree the shifts you cite can be destabilizing, and certainly they are things policy makers need to think about. In fact I suspect at least part of the recent dollar weakness is the consequence of this shift. Nonetheless I don’t think worrying too much about whether the US deficit can be financed is necessary, and I think you agree. I think we should worry more about whether the financing can find a home – or rather what kinds of disruptions are likely to occur as this investment need works its way out.rnrnFor several years China’s low currency provided a very large subsidy to foreign consumers. As you point out it is now providing a very large subsidy to Chinese and foreign “speculators”, and this can’t make a lot of sense (although since many if not most of these are either Chinese or resident in China, I suspect this is more of a distribution issue than an economic loss). The numbers aren’t small – assuming that China is subsidizing investors to the tune of 6-8%, every $100 billion of investment inflows represents a wealth transfer of $6-8 billion a year, and of course however much it is the stock of speculative inflows is much, much greater than $100 billion. rnrnThe key point I want to make is that these balance of payment flows are bigger than ever and their composition has shifted dramatically. Predicting trade and FDI flows is not easy, but it is a cinch compared to predicting speculative flows. What is more, trade and FDI flows can be pro-cyclical, but they also tend to be less liquid and so change more slowly. The new forms of inflows are likely to be much more pro-cyclical and of course much more liquid. I think China’s balance of payments has become far more potentially destabilizing than it used to be.rn

  6. Michael Pettis   June 17, 2008 at 9:51 pm

    Guest, as I and a few others have been arguing for a while, probably the only real way China can reduce the speculative inflows is by engineering a maxi-revaluation sufficiently large so as sharply to reduce the incentive for speculative inflows. This is not going to be easy. It takes a higher expected return to create channels for hot money than to retain it. Countries with large current account surpluses and appreciating currencies have historically seen an awful lot of appreciation before the process ends.rnrnA maxi-revaluation comes with a lot of problems, but the alternatives seem, to me anyway, even worse, so I am pretty convinced that eventually they will do it. Unfortunately one impediment is that whoever takes responsibility for such a move is almost inevitably going to be blamed for the accompanying problems. The defense that “it would have been worse if we didn’t” is not one likely to impress too many people, so it would be politically “courageous”, as they used to say in the brilliant English comedy Yes, Minister (and reportedly one of Deng Xiaopings’s favorites, by the way) for anyone to propose it until a consensus is reached.rnrnOne thing I think most of us agree, if there is indeed a problem, the longer they take to address it the worse the consequences are likely to be. At least one reason for this is that as money continues to pour in, the bank system is likely to be increasingly vulnerable to an adverse shock.

  7. Anonymous   June 19, 2008 at 8:35 am

    Massive speculative inflows and then outflows are what make and break developing economies, for example, Thailand in 1997, Vietnam now. The difference is that the Chinese control the outflows so they are less likely to quicken beyond control, Chinese control that is. Want your money out of China? Not until they are ready to allow you to take it. If they ever do.

  8. RG   June 21, 2008 at 11:48 am

    Anonymous, China doesn’t want the money to come into China, but money is pouring in at a rate never before seen in a country with a closed capital account. Why assume that they can keep money from leaving when their desperate attempts to keep it from coming in have failed ?

  9. CapM   June 21, 2008 at 11:50 am

    This is one of the most original and troubling descritions I have read of current monetary conditions. I think you are the first to point out its dimensions. Thanks.

  10. blindoptimist   July 13, 2008 at 6:46 am

    Maybe the pronounced and rapid inflow of speculative capital into China, allied to the booming prices for metals and energy and the very rapid expansion of manufacturing capacity in that country are signs of another bubble. The asset bubbles in the Atlantic economies are now well understood, but China is still a statistical and institutional mystery. I have heard anecdotal accounts of recent collapses in the residential property markets in East & South East China and can’t help thinking that things are ot what they seem. I wonder if there is anyone with insight into this situation.