Thursday, April 12, 2007

What the hell is China playing at?

Yesterday, Macro Man wrote that he had a bigger beef with China’s FX reserve policies than he did with the level of the RMB per se. Now, the two issues are intimately related, of course, as a change in the prosecution of the former would indubitably result in a change in the value of the latter. Nevertheless, it is the distortions caused by reserve growth that pose the larger structural threat, in Macro Man’s view, because of the artificial compression of risk premia that result.

Well, China released Q1 FX reserve data last night...and it really makes Macro Man wonder what the hell they are playing at. The stock of reserves increased by a whopping $136 billion in the first quarter alone, a growth rate that is looking decidedly parabolic.
What makes the reserve growth particularly galling is that the have authorities dramatically slowed the pace of RMB appreciation since mid February. Now, maybe this has been in preparation for a large one-off step revaluation of the RMB....but probably not. And obviously, ex-post, it’s difficult to reconcile RMB stagnation with any myths about capital xportation when Q1 reserve growth exceeded the reported trade balance by almost $90 billion. The only reasonable explanation is that Q1 saw a deliberate attempt to slow the pace of RMB appreciation and/or accrue FX reserves. And while Macro Man is certainly no fan of protectionism, he does think that China (and indeed Russia) needs to be called onto the carpet. Perhaps the G7/IMF will do so this weekend. Failing that, maybe the US Treasury report on currencies will finally name and shame China for taking the piss.

In any event, the upshot is that China, Russia, India, and the rest of their brethren have a lot of wood to chop in terms of their reserve management. Macro Man estimates that those three plus Taiwan, just by themselves, needed to buy €35 billion in Q1 just to maintain portfolio benchmarks. While these guys have certainly been active so far this year, Macro Man does not have the sense that they have shifted this sort of size- otherwise, the euro would be even stronger. And the higher the euro goes, the larger the performance lag against benchmark will- and thus the greater the pressure to come to market. It is for this reason that Macro Man fears that USD/Europe could be perched on the edge of a precipice, near term.
Regardless, it seems we have entered a new chapter in the ongoing saga of Voldemort versus the currency market.



"Cassandra" said...

Let us be frank. There are no real victims here in the genocidal sense. The most egregious imbalances are as much the result of a "5-minute abs" mentality to all things that are the least bit politically strenuous (or should I say taxing) in Americaland. A comprehensive Euro-style energy policy of energy taxes, incentives and disincentives, combined with no-nonsense Canadian-style levels of like-structured %gdp fed revenue extraction and healthcare provision, and imbalances begin to dramatically melt away. Then, of course, the US should positively dance upon the heads of the other east asian ZIRPantilists to normalize rates insuring investment flows are NOT employed for parochial mercantile advantage. But these things are so obvious, one is obliged to search for the reasons why they HAVEN'T been pursued to-date, and why US authorities have played victim in the most Gulliver-like fashion when the means to disrupt what is in essence a cynical process are in their hands.

I am, pleased to see your outrage, which is the correct reaction for all but the most passive and cynically self-interested observers and participants alike. But it's focused direction at Voldemort ignores the wider culpability of co-conspiring and sadly not-so-pure-of-heart US & Japanese officials.

Macro Man said...

In fairness, the US fiscal balance has improved, and indeed is not worse than Europe's at the moment.

Moreover, I am not sure if a European style energy policy is credible without viable transport alternatives, which simply don't exist in many parts of the US. As such, a "stick" based energy policy of taxation would probably do relatively little to alter behaviour in the medium term. I'd concur though that more "carrots" should be offered towards alternative energy.

As for health care, it reminds me a bit of the public transport system in the UK- a hodge podge of "service" providers that costs an arm and a leg and doesn't seem to work terribly well. I'd concur that something needs to be done, but obviously that's easier to say than to do.

As for the my view, the US and Japan committed its errors in 2003-2004 by not tightening policy quickly enough (US) and intervening too heavily (Japan.) I know we see differently on the BOJ at the moment...I just don't see the rush to tighten with zero inflation and mixed activity data. So in my mind, the capital exodus from Japan, which is primarily a private sector phenomenon, is completely different from the China situation. I suppose one could argue that at some point (>125?) the MOF should take profits on some of its reserve holdings.

Contrast that to Voldemort, who's in the market every day buying dollars (and then buying euros) at the same time that the trade surplus has ramped up to levels that Japan's never been able to dream of.

So while the US and Japan are far from blameless (and indeed were highly culpable a few years ago), it's China, Russia, and the like that are causing most of the problems now.

But make no mistake- I am hardly a disinterested party- Voldemort and co. are a significant disruption in my markets and have made life much more difficult than it needs to be. That's why I take comfort from seeing non-market practioners like Brad Setser puzzling over the same issues that confound me.

Anonymous said...

MM. I am as stunned as you are. agree with the need to buy 35b euro to hold to their portfolio benchmarks, and am interested in your sentiment that the three you mentioned haven't bought that much. that would be consistent with CB activity in past periods of $ weakness -- they end up adding a lot of $ to their portfolio on a flow basis.

BRIC reserve growth in q1 topped $200b -- $800b annualized. that is faster than the 06 pace. i suspect when i sum everone up, q1 reserve growth will top $250b, or a trillion annual pace. tis a truly stunning number (tho q4 06 looks somewhat similar).

incidentally, have you laid out your estimates of the portfolio benchmarks for Russia, India, China and Taiwan publically? We should compare notes (Russia is easy -- they have pretty much said 50:40:10 I think, and hinted that 50 = too many $ ... they also have added some yen)

brad setser

Macro Man said...

The problems with estimating benchmark weights is that a) they move, b) they may be misleading due to the custodial effect (i.e. farming out dollar reserves to an external manager with a global unhedged benchmark), and c) a number of big players don't show up in the data. Of course, you know all this!

So my estimate is based on a KISS methodology of keeping it relatively simple and hoping the simplifications balance each other out.

I have assumed a bipolar world of just USD and EUR. I model the TRICs in aggregate, rather than a country by country basis, because it is easier.

I assumed that at the beginning of 1999, the $ comprised 85% of reserves and the euro 15%. I then assume that a process of gradual diversification has taken place. This reflects a) the euro 'making its bones' as a real currency, b) a legitimate effort by many CBs to diversify in the the early noughties when the euro was cheap as chips, and c) the fact that many players not caputed in the data buy relatively more euros than some of the CBs captured in the COFER- read here the sovereign wealth funds.

So I start at 15% euro at the beginning of 1999, and raise the benchmark weight by 15 bps a month...which takes the euro weight to 28 and a bit percent as of March 2007.

While this analysis may underestimate the amount of euro buying that occurred before, say, four years ago, I think it pretty accurately captures what's been going on since, at least in order of magnitude. All I am trying to figure out is, if my assumptions are broadly correct, what would need to be done to stay at benchmark.

I'd be happy to exchange data/spreadhseets offline.

Emmanuel said...

Macro Man--what is your data source for China's monthly reserve change? Is it the PBoC website?

Macro Man said...

Emmanuel- It is official PBOC data which I download through Bloomberg. I am not sure if the data is available on the PBOC/SAFE websites- I never have much like finding anything useful there.