Latest PBoC Reserve Numbers Leave Many Unanswered Questions

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

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.

Comments

[J.D:]

You bet, hot money drawn on the expectation (firmly grounded) that gaming China's financial system is now the best investment in China. At this point who knows where this lead, but none of the paths are particularly positive.

2008 Apr 14 11:33 AM

[User 123309:]

this explains well why A share market and China property market might go down together - there is still hope in the local market that the money shifting out from the property market could be put into work in the stock market.

2008 Apr 14 07:34 PM

[chinesepetti:]

Mike, again I beg you to pay more attention to your own problem in the west(especially in USA). I appreciate your great effort whinning about the Chinese holding too much foreign Reserve; so what is your advice ? Giving Back some to save the hopeless American? The Chinese might consider your idea if Citi Bank could stop rewarding it's CEO $60m for losing $10billion; people like you have a very rigid mind regarding Chinese as you seemed to believe the Chinese even need your advice on how to use chopisticks !!!! Once again Chinese do not want and need your worthless money USD; they have enough money in investing its own future economic development; and if we have some leftover we might considering buying some distressed western assets.

2008 Apr 15 05:46 AM

[chinesepetti:]

Mike, Stop teaching Chinese how to use chopsticks; otherwise they will kick you out of the school and ask your salary back !!!!

2008 Apr 15 06:22 AM

[hattryx:]

wow. where would the usd be w/o the chinese bank? what would china look like if this cash was used instead for infrastructure. or defense. or space.

there has to be something i'm missing. why do they hold this junk? both japan and china.

2008 Apr 15 08:52 AM

[huangthomas:]

No one want usd. Our treasury force them to buy usd because of trade imbalance. Just look at Japan, Taiwan, Korea.......middle eastern oil producing countries...... Their central banks are stuck with usd, because if they sell, the value of usd goes down. They get hurt most and we have been playing the game for so long. Few pay much attention to it until China came along. We do not trust China as much as other allies and that's what get us nervous. If someday, China dump all usd on the market..........
Recent fall in usd may be attributed in part to the fact that China is switching some of her foreign reserve to Euro.
Don't try to prescribe for China regarding their foreign currency reserve. They know what they are doing. Her major concern now is INFLATION and income inequality.

2008 Apr 15 11:05 AM

[User 142738:]

"chinadonot want yourmoney", you fail to notice the section this article is filed under is labeled, in very large letters, "China." Leave it up to a PLA lackey to turn a balance sheet discrepancy into a political issue.

2008 Apr 15 11:21 AM

[Doug Roberts:]

Hi - I find your analyses to be very helpful as I put together my own very simple model of the Chinese economy. Thank you very much. - Doug Roberts

2008 Apr 15 12:00 PM

[chinesepetti:]

Is your Fed and iconic Citi Bank better than PLA; go Bashing your Prince Chuck Prince before making comments about Chinese Foreign Reserve. Is real money better than Your American Evil subprime Debt? [Comment edited for abusive language. Commenter put on notice]

2008 Apr 15 12:06 PM

[huangthomas:]

Hey! Follow the topics of discussion and don't shout like a RED GARD and don't throw that little red books at everybody!

2008 Apr 15 12:32 PM

[chinesepetti:]

Huang, R u Chinese? if you are then stand up liake a real Chinese.At least you need to stand up with something even with a red book when retarded American attacking China with distorted facts; otherwise what would you do ? Reason with them? I wish I could but you are in vain to reason with evils; attacking them in return so they feel the pain and back off! Good luck Huang!

2008 Apr 15 12:45 PM

[huangthomas:]

You are not used to deal with a great free country as USA. Here any one is free to express their own ideas, some of which you may not like. If you intend to convert USA into a land of Chairman Mao, my advice is don't do it. You cannot even do it in China, why adventure out to the USA? I know many of you are unhappy about what happened to Olympic torch parade in the West, but that is not a good reason for Chinese to become irrational!

2008 Apr 15 03:57 PM

[chinesepetti:]

Hunag for your information I do live in the west and I visit San francisco every 2 weeks; I do enjoy Polk street free wireless. What Can I say? also I do travel around the world and I would say Phillipine is a free democracy nation like USA but it is the most corrupted country I ever knew of. Meanwhile how is free expression going in the west? How come your most libral and free minded NYC Times backed the Iraq war in 2003? Free expression should make people more aware of things around instead of twisting facts and talking down other cultures, free expression should make people not afraid of listening to crirical voices(even feeling paiful). Look this site most blogs are all agreeing each other and worst twsiting facts in China; this is not a good sign for western democracy. Huang if you read Chinese there are hundreds of Chinese website; you could see there are always hundreds of different blogs for one topic. say eastmoney.com
I suppose you want to make some money Huang here; so instead of listening to your Mike petti who is trying to teach chopisticks in China which has 5000 year commerce and culture history , you better off start to listen what Chinese experts say about it's own economy. Do not get me wrong I am not asking you only to listen uncritial view about China though. Anyway Hunag stand up being a real independent Chinese! At last I am not FOX News converting people to right wings; it's a free world otherwise go worshing mike petti I am pretty sure he will make you lots of money. For your information the salary in Beijing Uni is not that high; is it beeter off for him to go back being A Lehman Banker again?

2008 Apr 15 10:31 PM

[johnthebear:]

Amazing how the discussion has deteriorated.

2008 Apr 16 03:45 PM

[Itsjustal:]

John, Chinesepetti is like an internet stalker. I found him bashing Michael Pettis in the comment section of a completely unrelated article by a different author on this website...so I just had to see what he had written under Pettis' latest article....

He's good for a laugh!!!! :)

I find it remarkable that he is incapable of tolerating a commentary on China's economic system. Perhaps when he next visits San Francisco he can partake of the use of a public library, or perhaps enjoy full and unfettered access to the internet to better educate himself....

For the record, this was another perceptive article by Mr. Pettis....

2008 Apr 17 12:08 AM

[hattryx:]

if you think the us is corrupt and all cronyist, visit asia, africa or even russia.

2008 May 14 03:00 PM

[website:]

Agreed!

Jan 01 01:07 PM