Latest PBoC Reserve Numbers Leave Many Unanswered Questions

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 |  Includes: FXI, PGJ
by: Michael Pettis

The closer you look at the latest PBoC reserves numbers the more surprising they seem. Headline reserve growth of $154 billion in the first quarter of 2008 is an astonishing number by any standard and suggests that the PBoC’s ability to manage monetary policy must be under ferocious strain, but it turns out that net foreign currency inflows purchased either by the PBoC or by its proxies may have been much, much higher. How can they manage?

Let’s go through these first-quarter reserve numbers again. Here is what I think we know with reasonable certainty:

1. For the first three months of 2008 reserve growth was $61.6 billion in January, $57.3 billion in February, and 35.0 billion in March. This adds up to $153.9 billion.

2. The trade surplus for the first three months of the year was $19.5 billion in January, $8.6 in February, and $13.6 billion in March, for a grand total of $41.6 billion.

3. FDI contributed $11.0 billion in January, $6.9 billion in February, and $9.5 billion in March. These add up to $27.4 billion.

There are other things that we know increased the value of PBoC reserves. We don’t have precise numbers but we can make reasonably accurate estimates.

1. It is pretty certain that at least part of the PBoC reserves are held in currencies other than US dollars – most experts estimate this portion to be about 30% of reserves, a number that jibes with estimates by CFR’s Brad Setser and Stone & McCarthy’s Logan Wright, two of my favorite experts on the topic. Logan went through the numbers and tells me that he believes that valuation gains, which occur as the dollar declines against other currencies in the PBoC portfolio, accounted for $10 billion in January, $10 billion in February, and $18 billion in March. This totals to $38 billion.

2. The PBoC also earns interest on its portfolio. We are given zero information on the composition of the PBoC portfolio, but let’s assume (a safe assumption) that most of it is in government bonds. That would add approximately 1% a quarter in interest income, or just under $16 billion for the first quarter of 2008.

Now for the part about which we are not sure but have some pretty good circumstantial evidence. Headline reserve growth may have underestimated the amount of dollars which the PBoC was forced to buy for several reasons.

In January, the PBoC hiked minimum required reserves by 0.5%, and they did so again in March. This necessarily resulted in an increase in the amount banks had to deposit at the PBoC, which we can reasonably reliably estimate to be the RMB equivalent of $22 billion and $24 billion respectively.

There is a strong circumstantial and market gossip that banks were “asked” to redenominate these deposits in dollars. They would do so by effecting a series of accounting transactions. As I understand it, the banks would sell RMB to the PBoC and purchase dollars, which would then be deposited as reserves, instead of RMB. This accounting transaction would cause a net reduction in RMB assets on the banks’ balance sheets of the RMB equivalent of about $45 billion, and a net increase in dollar assets of $45 billion. The banks now have more exposure to a declining dollar, unless they have a currency hedge with the PBoC.

The opposite occurs at the PBoC. Their dollar assets decline by $45 billion. Had this transaction not taken place, in other words, the PBoC’s headline reserve growth for the first quarter would have been $199 billion, not $154 billion. Because the banks were forced, in effect, to take on $45 billion of the PBoC’s role, they saved the PBoC from being forced to record $45 billion more reserves, but they did not prevent the PBoC from buying these in the market. In fact the act of redenominating had no impact on either the amount the PBoC needed to sterilize (although of course the reserve requirement hike did) or on the net amount of foreign currency inflow that had to be purchased by the PBoC.

Finally, and this all come from Logan Wright, there is very good reason to assume that the full transfer of $200 billion to the CIC was completed by March of this year, and he believes (for reasons which I prefer he explains, but which seem solid to me) that perhaps $95 billion of this transfer took place in 2008, probably in March. Let me dump the full amount into March.

That leaves us with the following table:

January

February

March

Total

Headline reserve growth

62

57

35

154

Trade surplus

20

9

14

42

FDI

11

7

9

27

Currency gains

10

10

18

38

Interest

5

5

5

16

Unexplained amount

16

27

(11)

31

Reserve hike

22

-

24

45

Adjusted reserve growth

83

57

59

199

Unexplained amount

38

27

12

76

Transfer to CIC

95

95

Adjusted reserve growth

83

57

154

294

Unexplained amount

38

27

107

171

Click to enlarge

To read this table, we start with official headline reserve growth at the top of the table. After adjusting the things we know or can estimate reasonably, we get to an “unexplained” amount for each month. This adds up to $31 billion for the quarter. Notice that the “unexplained” amount for February is a negative number, suggesting that net other flows, including hot money, left China in deficit. This is counterintuitive.

But not for long. We then add back the amount we believed was taken out by the minimum reserve redenomination. If we are right, the “unexplained” amount for every month is positive and the real growth in reserves was $199 billion for the first quarter. The total “unexplained” amount is $76 billion.

I am a little bit nervous about the timing of the last assumption, although I am very comfortable that this did happen (the transfer of money from the PBoC to the CIC), but had there not been the transfer to the CIC, headline reserves should have higher, whether in 2007 or 2008. Logan believes much of this occurred in 2008.

If he is right, actual net foreign currency inflows purchased by the PBoC during the first quarter of 2008 was not $154 billion, the headline number, nor even $199 billion, but perhaps as much as $294 billion. Consequently the unexplained amount ranges anywhere from $31 billion to as much as $171 billion. How much of this is hot money? Who knows? But it doesn’t need to be a very high fraction for it to be a very worrisome problem. In fact I would guess that by now speculative money inflows (included those incorrectly recorded in the trade and FDI accounts) are so high that the trade surplus is less and less the main pump driving out-of-control money growth in China. Speculative money is probably the main problem, and only a currency adjustment will be able to resolve this problem quickly enough.

By the way annual M2 growth in March declined to 16.3, from 18.9% in January and 17.1% in February. This is being heralded nearly everywhere as an indication that the PBoC has been successful in its fight against monetary expansion, but I look at things a little differently. To me this level of money growth is still much too high, especially given the volume issued of sterilization notes and the 1% reserve hike during the quarter. If this is all they can achieve with so much effort, it is going to be a long and difficult fight.