Currency Reserves

China’s reserves fell by $69 billion in November. With the notable exception of Sid Verma and Luke Kawa at Bloomberg, Headlines generally have emphasized the size of the fall The Financial Times was pretty restrained compared to the norm, and the FT still highlighted that the November fall was “the largest drop since a 3 per cent fall in January.” But the fall was actually a bit smaller than what I was expecting. Valuation changes on their own knocked $30 billion or so off reserves (easy math—$1 trillion in euro, yen and similar assets, with an average fall of 3 percent in November). It isn’t quite clear how China books mark-to-market changes in the value of its bond (and equity portfolio). My rough estimate would suggest mark to market losses on China’s holdings of Treasuries and Agencies of about 1.5 percent, or $20 billion (Counting the agency portfolio and Belgian custodial book, per my usual adjustment). Bunds and OATs (French government bonds) also fell in value—but SAFE likely has a couple hundred billion in equities too, and their value rose. But it isn’t clear that all of China’s assets are marked to market monthly, so there is a bit of uncertainty here not just about the overall performance of the portfolio, but also how the portfolio’s value is reported. Sum it all up and it is possible valuation knocked somewhere between $30 and $50 billion off China’s headline reserves. Which implies that “true” sales were between $20 and $40 billion. And frankly that seems a bit low. The proxies (my term for the FX settlement data and the PBOC yuan balance sheet data that are proxies for actual intervention) haven’t been telling a consistent story recently. But the PBOC balance sheet data suggests monthly sales in the $30-40 billion range and there is good reason to think that the pace of sales picked up in November.* Depreciation (against the dollar) tends to spur expectations of more depreciation (against the dollar)—even if the depreciation against the dollar is fully explained by the mechanical operation of a basket peg. And, well, China presumably tightened its controls on capital outflows—notably by introducing much tighter controls on outward FDI—because it was either worried about the current pace of its reserve loss, or was worried that the pace might pick up in the future. Makes me all the more impatient to see the more reliable indicators for November. On the trade side, there was real news in the November data. Nominal exports (in yuan terms) jumped around 6 percent. If export prices stayed at their October level, real exports rose at a similar pace. That bit of good news was needed. Export prices rose by more than I projected in October, which means real exports in October were weaker than I initially thought: the Chinese data shows a 2 percent fall in goods export volumes for October. The strong November pulls my initial estimate of the year-over-year expansion in volumes over the last three months back into positive territory. Not great to be sure, but in line with the weak overall global trade numbers (U.S. imports, especially of consumer goods, have been weak; the commodity exporters are still adjusting to the 2014 commodity slump). Real imports for November look to be up about six percent as well (nominal imports are up more, so a lot depends on the evolution of import prices), China’s stimulus over the past year seems to have stabilized import demand. * Since the end of June, average monthly sales, using the change in foreign exchange reserves reported on the PBOC’s yuan balance sheet, have been $37 billion. I prefer the total for PBOC foreign assets for technical reasons, but that is harder to explain and the gap isn’t big—$33 billion versus $37 billion.

A couple of weeks ago, Daokai (David) Li argued that the “right” exchange rate for China isn’t clearly determined by China’s fundamentals. Or rather that two different exchange rates could prove to be consistent with China’s fundamentals. “Currently, the yuan exchange rate regime yields multiple equilibrium. When we expect the yuan to depreciate, investors will exchange large amounts of yuan into dollars, causing massive capital outflow and further depreciation. If we expect the yuan to remain stable, cross-border capital flow and the exchange rate will be relatively stable. The subtlety that causes the equilibrium is that liquidity in China is the highest in the world. If there is any sign of change in exchange rate expectations, the huge liquidity in the yuan translates into pressure on cross-border capital flows.” If China’s residents retain confidence in the currency and do not run into foreign assets, China’s ongoing trade surplus should support the currency at roughly its current level. Conversely, if Chinese residents lose confidence in the yuan, outflows will overwhelm China’s reserves—unless China’s financial version of the great firewall (i.e. capital controls) can hold back the tide. I took note of Dr. Li’s argument because it sounds similar to an argument that I have been making.* I would argue that there aren’t just multiple possible exchange rate equilibria for China, there are also at least two different possible macroeconomic equilibria. In the “strong” yuan equilibrium, outflows are kept at a level that China can support out of its current goods trade surplus (roughly 5 percent of GDP), which translates to a current account surplus of around 2.5 percent of GDP right now, though it seems likely to me that an inflated tourism deficit has artificially suppressed China’s current account surplus and the real surplus is a bit higher.** In this equilibrium, a larger “on-budget” central government fiscal deficit—together with an expansion of social insurance—keep demand up, even as investment falls. In the “weak” yuan equilibrium, China lets the market drive its currency lower—and a weaker currency increases the trade and current account surplus. Such surpluses would finance sustained capital outflows in excess of half a trillion dollars a year without the need to dip further into China’s reserves. The resulting surpluses would be shockingly large—especially for an era where popular support for trade is somewhat lacking. For example, a 15 to 20 percent depreciation in the yuan—on top of the 10 percent depreciation that has already occurred over the last year —would reasonably be expected to push China’s goods surplus from its current level of around $525 billion dollars (balance of payments basis) to say somewhere between $800 billion and a trillion dollars. The rule of thumb based on China’s own experience and the IMF’s cross country work is that a 10 percent move in the yuan raises/lowers the trade balance by between 1.5 and 2 percentage points of GDP —with a parallel shift up in China’s current account surplus. That large goods surplus would finance both tourism imports and capital outflows ... And, of course, a larger trade surplus would also provide support for the economy. As investment slows, China would in effect pivot back to exports – and it wouldn’t need to use the central government’s fiscal space to support demand. Both are plausible outcomes. The strong yuan equilibrium is obviously better for the world than the weak yuan equilibrium in the short-run. And, I suspect, in the long-run. In part because a weak currency today creates political pressures that tend to keep the currency weak tomorrow. That at least is my read of China’s experience with a “weak” currency in the mid 2000s. After 2000—and particularly after 2002— the yuan followed the dollar down, depreciating 13 percent in real terms from 2001 to 2005. That depreciation coincided with WTO entry, and gave rise to one of the most spectacular export booms ever. And the surge in exports created a set of interests that were vested in keeping the currency weak. The policy mandarins feel pressure from the export sector to avoid appreciation. And, so long as exports (and import substitution—which is likely to be nearly as significant in China’s case going forward) keep the economy humming, they do not feel pressure to take the politically difficult decisions needed to provide visible on-budget fiscal stimulus and to build a stronger social insurance system. Exporting savings through large current account surpluses substitutes for reforms that would lower China’s high levels of national savings. I think something like this also happened in Korea after the won depreciated in 2008 and 2009. Korea’s exports responded to the weaker won. Autos notably. Subsequently there was pressure to keep the won weak, by intervention if necessary (concerns about currency volatility tend to be more pronounced when the won is strengthening). The modern way to maintain an undervalued currency isn’t to intervene to weaken your currency. It is to step back and allow the market to drive your currency down– And then intervene to resist subsequent pressure to appreciate (and rebuild reserves) when the market turns. In countries that have a history of managing their currencies and strong export sectors, cyclical currency weakness can turn into permanent currency weakness. Call it the political economy of currency weakness. * I have not always agreed with Dr. Li on currency issues, hence my surprise. ** My guess is that some of the tourism deficit is really hidden financial outflows. If that is the case, China’s true current account surplus is above 2.5 percent of GDP. I would guess that it is now around 3.5 percent of GDP—a number that implies that there tourism deficit includes about a percentage point of GDP in hidden financial outflows.

My preferred indicators of Chinese intervention are now available for October, and they send conflicting messages. The changes in the balance sheet of the People’s Bank of China (PBOC) point to significant reserve sales (the data is reported in yuan, the key is the monthly change). PBOC balance sheet foreign reserves fell by around $40 billion, the broader category of foreign assets, which includes the PBOC’s "other foreign assets"—a category that includes the foreign exchange the banks are required to hold as part of their regulatory requirement to hold reserves at the central bank—fell by only a bit less. $40 billion a month is around $500 billion a year. China uniquely can afford to keep up that pace of sales for some time, but the draw on reserves would still be noticeable. The foreign exchange settlement data for the banking system—a data series that includes the state banks, but historically has been dominated by the PBOC—shows only $10 billion in sales, excluding the banks sales for their own account, $11 billion if you adjust for forwards (Reuters reported the total including the banks activities for their own account, which raises sales to $15 billion). China can afford to sell $10 billion a month ($120 billion a year) for a really long time. The solid green line in the graph below is foreign exchange settlement for clients, dashed green line includes an adjustment for the forward data, and the yellow line is the change in PBOC balance sheet reserves.* As the chart illustrates, the PBOC balance sheet number points to a sustained increase in pressure over the last few months after a relatively calm second quarter. The PBOC balance sheet reserves data also corresponds the best with the balance of payments data, which showed large ($136 billion) reserve sales in the third quarter. Conversely, the settlement data suggests nothing much has changed, and the PBOC remains in full control even as the pace of yuan depreciation against the dollar has picked up recently and the yuan is now hitting eight year lows versus the dollar (to be clear, the recent depreciation corresponds to the moves needed to keep the yuan stable against the basket at this summer’s level; the yuan is down roughly 10 percent against the basket and against the dollar since last August). The balance sheet data suggests pressures are building, the settlement data suggests tighter capital controls are working. The Wall Street Journal reports that the state banks are suspected of intervening to limit yuan depreciation on behalf of the central bank on Wednesday, so this isn’t entirely an academic debate. At this stage, the gap between changes in reserves and the settlement data is getting to be significant. Over the last four months of data (July through October), PBOC balance sheet reserves are down $148 billion while the FX settlement data shows only $60 billion of sales. if you include "other foreign assets" together with PBOC reserves, the gap only shrinks a bit -- the PBOC’s foreign assets are down $130 billion over four months, still way more than $60 billion. The recent monthly gaps, in annualized, would imply a $200 to $300 billion gap between the PBOC balance sheet data and the settlement data. That is big money, even for a country as large as China. And to be honest I cannot currently explain the gap. I generally trust the settlement data more, in large part because it historically has shown more volatility, and with hindsight the signal sent by settlement was the right signal. Back in early 2013—when China was struggling with inflows—the settlement data suggested much faster reserve growth than the PBOC reserves data. And last August and September, the changes in settlement were larger than the changes in balance sheet reserves. In January 2013 and in August 2015 cases, changes in the amount of foreign exchange that the banks held as part of their regulatory reserve requirement turned out to be part of the explanation for the gap between the settlement data and the reserves data (in extremely technical terms, there wasn’t much of a gap between the monthly change in the PBOC’s total foreign assets and the settlement data). The state banks helped the PBOC out, so to speak, and adjusted their foreign exchange holdings so the PBOC didn’t have to buy or sell quite as much. The most logical explanation of the current gap is that the state banks are buying foreign exchange, so some of the apparent fall in reserves is a shift within Chinese state institutions. But changes in the reserve requirement do not appear to explain the move. For now, it is a real mystery, at least to me. Help is always appreciated! A key part of reserve tracking is keeping track of the things that you do not quite understand. * PBOC balance sheet reserves are reported at historical cost in yuan; the PBOC series is thus different from the "headline" foreign reserves that SAFE reports monthly in dollars.

The most valuable indicators of China’s intervention in the foreign exchange (FX) market are now out, and both point to a pick-up in sales in September, and more generally in Q3. The data on FX settlement shows $27b in sales in September, and around $50b in sales for Q3. Add in changes in the forwards (new forwards net of executed forwards) reported in the FX settlement data, and the total for September rises to $33 billion, and the total for Q3 gets to around $60 billion. FX settlement is my preferred indicator, though it is always important to see how it lines up with other indicators. The data on the PBOC’s balance sheet shows a $51 billion fall in reserves in September, and a fall of over $100 billion in Q3. I like to look at the PBOC’s foreign assets as well as reserves, this shows a slightly more modest fall ($47 billion in September), as the PBOC’s other foreign assets continued to rise. But total foreign assets on the PBOC’s balance sheet are still down around $95 billion in q3 (with a bigger draw on reserves than implied by the settlement data, which includes the banking system; chalk the gap between settlement and the PBOC’s balance sheet up as something to watch). $100 billion in a quarter isn’t $100 billion a month—but it is noticeably higher than in Q2. All in all, the pressure on China’s “basket peg” or “basket peg with a depreciating bias” exchange rate regime (take your pick on what managing with reference to a basket means, it certainly has meant different things at different points in time this past year) is now large enough to be significant yet not so large as it appears to be unmanageable. China still has plenty of reserves; I wouldn’t even begin to think that China is close to being short of reserves until it gets to $2.5 trillion given China’s limited external debt, tiny domestic liability dollarization, and ongoing external surpluses. $2.5 trillion would still be the world’s biggest reserve portfolio by a factor of two, it also would be roughly 20 percent of China’s GDP, which would be in line with what many emerging markets hold. The depreciation in October has been consistent with maintaining stability against the CFETS basket, though stability at a level against the basket that reflects the depreciation that took place from last August to roughly July. The dollar has appreciated against the other major tradeable currencies in October this period, and maintaining stability against the CFETS basket meant depreciating somewhat against the dollar. But the pace of reserve loss has picked up, and, if past patterns hold, it could well have picked up more in October. Some believe that the depreciation against the dollar this October indicates that China has pulled back from intervention. I am not convinced. Maintaining a controlled pace of depreciation is one of the hardest technical tasks for a central bank to pull off. A bit of depreciation leads to expectations of more depreciation, and larger outflows. Historically, at least, depreciation against the dollar is associated with bigger reserves sales, not fewer. As Robin Brooks of Goldman emphasizes, Chinese households and firms still pay far more attention to the yuan/dollar than the CFETS basket. Dollar appreciation -- against the majors, which implies the yuan needs to depreciate against the dollar in order to remain stable against a basket -- tests the PBOC far more than dollar depreciation. As a result, I would not be surprised if outflow pressures have picked up as the yuan depreciated against the dollar. Big picture, I think China still has the tools available to manage its currency if it wants to use them. China has a large underlying goods trade surplus. It still has plenty of reserves, and plenty of liquid reserves. Its controls have been tightened, and could be tightened more. But the evidence from Q2 -- and Q3 -- suggests the controls work best when they are reinforcing expectations of currency stability, not fighting expectations of depreciation. The controls get tested when Chinese firms in particular start to position for further depreciation (firms have much more ability than households to move funds across the border through trade flows and the like). Especially if Chinese residents—and the offshore foreign exchange market— may not be satisfied with the 10 percent move against the basket since last August. Here is one big picture thought. China may need to tolerate a bit of appreciation against the basket to break any cycle of reinforcing expectations. Just as it allowed the currency to depreciate against the basket when the dollar was depreciating from February to May, it could allow a bit of appreciation against the basket. It has the flexibility within its new regime not to manage strictly for stability against the basket. Either that or China may need to show that it really is managing symmetrically against the basket, so if the dollar depreciates, there is a real risk the yuan could appreciate back to say 6.5 against the dollar—and thus the yuan/dollar isn’t a one way bet. If China lets its currency depreciate along with the dollar when the dollar is going down, and then manages against a basket during periods of dollar appreciation, the yuan/dollar effectively becomes a one way bet. Obviously all this is informed by my belief that the trade data shows the yuan is now fairly valued, or even a bit undervalued.* At the yuan’s current value against the basket, I would expect net exports to start contributing modestly to growth over the next year, especially if U.S. import demand picks up from its cyclical slowdown. Of course, China’s policy makers may well be quite happy with a bit of support from exports—and a currency’s value is set by more than trade. Financial flows can overwhelm any peg if expectations of a depreciation (or for that matter appreciation) are allowed to build. *Weak September export volumes should be balanced against strong August volume growth; average growth across the two months is around 3 percent—in line with q2, and likely a a bit faster than the overall expansion in global trade. A weak October would change my views here a bit. The comparison between this October and last October is a true one (same number of working days)—though it will be important to adjust for export price changes (a 5 percent fall in headline yuan exports would be consistent with stable export volumes, very roughly). Note: edited to correct an obvious error (appreciation was used twice in a sentence, in context one clearly was intended to be depreciation)

China’s headline reserves dipped by about $19 billion in September, dropping below $3.2 trillion. Adjust for foreign exchange changes, and the underlying fall is widely estimated to be a bit more—around $25 billion. Press coverage emphasized that the fall “exceeded expectations.” To me that suggests “expectations” on China’s reserves aren’t formed in all that sophisticated a way. $20-30 billion in sales is in line with the change in the PBOC’s balance sheet in July and August (the FX settlement data, the other key proxy for intervention, suggests more modest sales in August). Throw in the September spike in the Hong Kong Inter-bank Offered Rate (HIBOR) —which suggested a rise in depreciation pressure on the CNY and CNH —and $25 billion in sales is if anything a bit smaller than I personally expected.* Of course, some of the sales could be coming through the state banks; time will tell. Even if the pace of sales did not pick up in September, there is is an interesting story in the Chinese data. The $75 billion a quarter and $300 billion a year pace of sales implied by the July-September monthly data aren’t anything like the pace of sales at the peak of pressure on China’s currency. But $75 billion a quarter is a still bit higher than the underlying pace of sales in Q2. The balance of payments data show Q2 reserve sales of about $35 billion (the change in the PBOC’s balance sheet reserves was $31 billion). But other parts of China’s state added to their foreign assets in Q2. In fact, counting shadow intervention (foreign exchange purchases by state banks and other state actors), I actually think the government of China’s total foreign assets may have increased a bit in the second quarter. There are a couple of line items in the balance of payments that seem to me to be under the control of the state and state actors. Most obviously, the line item that corresponds with the PBOC’s other foreign assets ("other, other, assets" in balance of payments speak: up $12 billion in q2, after a bigger rise in q1). But most portfolio outflows are likely from state-controlled institutions (portfolio debt historically has been the state banks, portfolio equity historically has been the China Investment Corporation and the state retirement funds in large part). If these flows are netted against reserve sales, there wasn’t much of a change in q2. In my view, shifts in assets within the state should be viewed differently than the sale of state assets to truly private actors. To get a positive number in q2, though, you need to add in the buildup of foreign assets associated with the increased foreign lending of the state banks (this adjustment is the most debatable). I suspect that the bulk of the China Development Bank’s outward loans are in the banking data, and thus the loan outflow should be viewed as a policy variable (China for example looks to have shut down this channel in q4 2015). Offshore loans were up about $25 billion in q2—a bit over the five year (2011 on) average of around $15 billion a quarter. That pushes my estimate for the total accumulation of foreign assets by China’s state, counting policy lending, into positive territory. Q2’s balance of payments data paints a picture of relative stability. I suspect that my broader metric for Q3 will show a fall in q3. And if that fall is eventually confirmed,** there is a question of why pressure picked up. China’s trade accounts show a substantial surplus (a very substantial surplus on the goods side, and a decent surplus on goods plus travel and tourism—the non-tourism service account is close to balanced). In volume terms, Chinese export growth has picked up—with y/y growth since April on average of 5 percent.*** That is better than the overall expansion of global trade. The pressure is all from the financial account. Interest rate differentials have shrunk, but are still in China’s favor. But the interest rate differential now can easily be dwarfed by exchange rate expectations. Over the past 14 months, the yuan has fallen by 8 percent against the dollar. My guess is that expectations for further depreciation picked up over the course of q3. The yuan appreciated a bit against the dollar from February through May (while depreciating against the basket). But the yuan depreciated against the dollar after the Brexit vote —and ticked down again a bit in late August. That, in my view, contributed to the expectations that China’s authorities are looking to continue the yuan’s depreciation—at least against a basket—after a temporary pause around the G-20 Hangzhou summit and the final SDR decision. Moves against the dollar still seem to have a disproportionate impact on expectations. Note: This chart has been updated to reflect data through 10/13/2016 It is not unreasonable for the market to think that the yuan’s future moves against the dollar will be asymmetric. If the dollar weakens against the major floating currencies, China may want to follow the dollar down. And if the dollar strengthens, maintaining stability against the basket—let alone maintaining a depreciating trend against the basket—implies a further depreciation in the yuan against the dollar. The implication of this view is that the market is (still) betting on where it thinks Chinese policy makers want the currency to go. As long as the market thinks China wants to depreciate one way or another against a basket after Hangzhou and the SDR decision, outflow pressure will continue. The alternative view is that Chinese residents want to get out of Chinese assets independently of the expected path of the yuan, and that the controls put in place in the spring are starting to show a few more leaks. The weaker fix on Monday doesn’t really settle this debate; the fix was below the symbolically important 6.7 level against the dollar, but was also broadly consistent with maintaining stability against the CFETS basket. There isn’t yet enough information to determine if China’s current policy goal is stability, or a stable pace of depreciation. * We don’t know the currency composition of China’s reserves, or the precise way changes in the value of China’s bond portfolio enter into headline reserves. The noise in headline reserves goes up when the expected change is small v the size of the stock, given all the other moves that can impact the stock. Plus or minus $10 billion in headline to me is noise. I prefer the proxies for intervention, which are less influenced by valuation. ** I am waiting for broader measures of sales for September; all analysis for now is contingent on confirmation by subsequent data releases. *** The simple average of monthly y/y changes in export volumes for 2016 is just below 4 percent; a bit higher than than the simple average of monthly changes in import volumes. Data is for goods only, and the y/y changes are distorted in q1 by the lunar new year. Export volumes are up even with softness in U.S. imports from China (setting finished autos aside)

The proxies that provide the best estimates of China’s actual intervention in the foreign currency market in August are out, and they in no way hint at the stress that emerged in Hong Kong’s interbank market in September. The PBOC’s balance sheet shows foreign currency sales of between $25 and $30 billion (depending on whether you use the number for foreign currency reserves or for foreign assets). A decent sum, but also a sum that is consistent with the pace of sales in July. SAFE’s data on foreign exchange settlement, which in my view is the single best indicator of true intervention even though (or in part because) it aggregates the activities of the PBOC and the state banks, actually indicates a fall-off in pressure in August. The FX settlement suggests sales of around $5 billion in August. Even after adjusting for reported changes in forwards (the dashed line above). All this said, there is no doubt something changed in September. The cost of borrowing yuan offshore spiked even though the exchange rate has been quite stable against the dollar and generally stable against the CFETS basket. Two theories. One is that China that the market thinks China will find a way to resume the yuan’s slow slide against a basket of currencies of its major trading partners after the G20 summit, even if that means additional weakness against the dollar. There was a widespread belief in the market—and among analysts who watch such things—that China would not allow a significant move in the market before the G20 summit. Now all bets are off, or will come off after the yuan is formally included in the SDR in early October.* The spike in offshore yuan interest rates thus reflects a true rise in speculative pressure against the yuan, one that the PBOC is resisting. Saumya Vaishampayan and Lingling Wei of the Wall Street Journal: "Suspected intervention by Chinese banks in what’s known as Hong Kong’s “offshore” market has led to a surge in the cost for banks in the territory to borrow yuan from each other. Investors and analysts believe the intervention—which they say has likely come at the behest of China’s central bank—is aimed at thwarting bets against the Chinese currency, also known as the renminbi. The suspected heavy buying by Chinese banks has helped squeeze a market China had tried to foster just a few years ago as it looked to promote the yuan as a major international trading currency." The other is that the PBOC has tightened offshore yuan liquidity for reasons of its own (not necessarily in response to a rise in speculative pressure), in part by putting pressure on the state banks not to roll over maturing forward contracts.* Only the PBOC, and perhaps the the Bank of China, knows for sure. I do though suspect that China is likely to have to show a bit more of its hand in the foreign currency market relatively soon. Does China manage for stability against a basket, or manage for a depreciation against the basket? Has the CNY depreciated by enough, or do the Chinese authorities want a larger move? How much weight does it put on the dollar versus the basket when push comes to shove? As many have noted, the broad effective value of China’s currency has slid pretty steadily this year—though there was a bit of a pause in August. Until recently, that slide was consistent with a yuan that was only a bit weaker against the dollar than in January (the move from 6.6 to 6.7 came in the face of the Brexit shock; it didn’t appear to be a unilateral Chinese move). Call it the Chinese currency version of Goldilocks Now, well, a further depreciation of the yuan against the basket might mean testing the post-Brexit lows against the dollar. And the yuan is getting to be within shouting distance to its level against the dollar during the 2008-2009 repeg. It doesn’t take all that much imagination to realize that reversing 8 years of appreciation against the dollar could matter politically as well as economically. The trade "fundamentals" to my mind do not provide a strong case for further weakness in the yuan against a basket of currencies. Even with weak Chinese exports to the United States, the Chinese data on export volumes shows modest year-over-year growth. August export volumes appear to be in line with recent trends; a reasonable estimate suggests Chinese exports continue to grow a bit faster than would be implied if China’s exports were growing with global trade.** I personally do not think China can expect to go back to the days when Chinese export growth significantly exceeded global trade growth (see Box 2 of this ECB paper). Of course, the trade data also isn’t the only factor that drives currency markets. * A small technical point. The Mexican peso plays a much bigger role in the U.S. dollar’s broad exchange rate than it plays in China’s basket. And the peso is weak right now. That is one reason why the CFETS index might diverge from the dollar index. The dollar/euro and dollar/yen rates have been relatively stable in September, though of course that could change. ** I am focusing on the data on volumes, not the nominal number. If export prices did not change in August, August export volumes increased year-over-year. The official Chinese data will be out in a few more days.

Just before the global financial crisis, I wrote a paper on the geostrategic implications of the United States’ growing external debt—and specifically about the fact that the U.S.’s main external creditors were increasingly the reserve managers of other states, not private investors. Yes, there were large two-way gross private flows in the run up to the crisis; think U.S. money market funds lending to the offshore arms of European banks who in turn bought longer-term U.S. securities. But, on net, the inflows needed to sustain the United States’ external deficit from 2003 on mostly came from the world’s big holders of reserves and oil exporters who stashed funds away in sovereign wealth funds. With hindsight, I, and the others who speculated about how China’s Treasury holdings might be used for political leverage over-egged the pudding, as Dan Drezner, among others, has pointed out. Greece’s indebtedness to private bond holders and banks proved a bigger constraint on its economic sovereignty than the debt the United States owes to the PBOC and other official investors. Germany was the creditor country that ended up with the leverage, not China. And thinking back even further, Britain’s geostrategic vulnerability to the withdrawal of U.S. financing in the Suez crisis derived from its commitment to maintaining the pound’s external value. Letting the pound float was inconceivable at the time. That as much as anything gave the U.S. leverage over Britain. Worth remembering. I could argue that the global crisis reduced the United States’ need for all kinds of external financing significantly, which is true—and that the leverage that comes from the perception that China could rattle markets in times of stress has not entirely gone away. But it is also true that before the crisis I underestimated the Fed’s ability to influence term premia and the path of long-term U.S. interest rates independently of inflows from foreign creditors.* Call it the geostrategic impact of QE. Yet some of the more subtle aspects of my argument about the strategic consequences of the rise of new large state creditors have, I think, stood up to the test of time. One argument was that a major creditor could have an impact on the U.S. without actually selling dollars, just by moving their dollar portfolio around. And it is quite clear from former Treasury Secretary Hank Paulson’s memoir that the risk of a Chinese/ Russian funding strike of the Agencies in the summer of 2008 was something that worried U.S. policy-makers.** Robert Preston reported back in 2014: "I [Paulson] was talking to them [Chinese ministers and officials] regularly because I didn’t want them to dump the securities on the market and precipitate a bigger crisis ... I was meeting with someone … This person told me that the Chinese had received a message from the Russians which was, ’Hey let’s join together and sell Fannie and Freddie securities on the market.’ The Chinese weren’t going to do that but again, it just, it just drove home to me how vulnerable I felt until we had put Fannie and Freddie into conservatorship ..."** Another argument was that rising reserves would give the world’s new group of creditors “soft” financial power. I wrote: “Today, emerging economies ... not only do not need the IMF; they increasingly are in a position to compete with it. .... Chinese development financing provides an alternative to World Bank lending. Asia is exploring the creation of a reserve pool that could serve as a precursor to a regional monetary fund. If a small emerging economy got into trouble now, it undoubtedly would seek regional financing on more generous terms than those offered by the IMF." That doesn’t quite describe the Asian Infrastructure and Investment Bank. But it isn’t that far off either. Substitute "development finance" for regional financing and "World Bank" for the IMF. The reality is that the world can form financial coalitions of the willing without the participation of the U.S.. Even with the fall in China’s reserves and the strain that low commodity prices have placed on many commodity exporters. Scott Morris of the Center for Global Development has written a new CFR discussion paper on how the U.S. should respond to China’s success in setting up the Asian Infrastructure and Investment Bank. One of his conclusions is straight-forward. If the U.S won’t support an expansion of the balance sheet of the institutions where it has the most influence and weight—institutions like the World Bank—then the world will likely proceed without the United States. And the current “core” development institutions will over time be surpassed by new institutions where the U.S. has less influence. * I imagined a more convoluted path to stability, drawing a bit on Dooley, Garber and Folkerts-Landau. The direct path would be for the Fed to buy what others were selling. I though focused on an indirect path: European central banks, concerned about a rise in their currencies, would intervene and recycle funds back into the U.S. bond market. ** Technically, the Fed could—and in the end did—offset the loss of Chinese demand for the bonds of the Agencies. The Treasury though needed to step in to provide the Agencies with the capital needed to absorb losses on their mortgage portfolio. Dan Drezner argues China’s influence on the Agencies wasn’t decisive—which is fair. The Agencies had sold a lot of bonds to domestic investors as well. But it is also quite clear that China’s holdings weighed heavily on the minds of the relevant decision makers.

I got my start, so to speak, tracking global reserve growth and then trying to map global reserve flows to the TIC data. So I have long thought that large scale central bank purchases of U.S. Treasuries and Agencies, and German bunds, and JGBs didn’t start with large scale asset purchase programs (the academic name for “QE”) by the Fed, the ECB and the BoJ. Before the crisis, back in the days when China’s true intervention (counting the growth in its shadow reserves) topped $500 billion a year, many in the market (and Ben Bernanke, judging from this paper) believed that Chinese purchases were holding down U.S. yields, even if not all academics agreed. The argument was that Chinese purchases of Treasuries and Agencies reduced the supply of these assets in private hands, and in the process reduced the term/risk premia on these bonds. Bernanke, Bertaut, Pounder DeMarco, and Kamin wrote: "...observers have come to attribute at least part of the weakness of long-term bond yields to heavy purchases of securities by emerging market economies running current account surpluses, particularly emerging Asia and the oil exporters .... acquisitions of U.S. Treasuries and Agencies took these assets off the market, creating a notional scarcity that boosted their price and reduced their yield. Because [such] investments were for purposes of reserve accumulation and guided by considerations of safety and liquidity, those countries continued to concentrate their holdings in Treasuries and Agencies even as the yields on those securities declined. However, other investors were now induced to demand more of assets considered substitutable with Treasuries and Agencies, putting downward pressure on interest rates on these private assets as well." I always thought the mechanics for how the Fed’s QE impacts the U.S. economy—setting aside the signaling aspect*—should be fairly similar. Both reserve purchases and QE salt “safe assets" away on central banks’ balance sheets.** There are now a number of charts illustrating how the ECB and BoJ have kept central bank bond purchases high globally even after the Fed finished tapering. Emma Smith of the Council’s Geoeconomics Center and I thought it would be interesting to add reserve purchases to these charts and to look at total purchases of U.S., European, Japanese and British assets by the world’s central banks over the last fifteen years—adding the emerging market (and Japanese and Swiss) purchases of G-4 bonds for their reserves to the bonds that the Fed, the ECB, the Bank of Japan and the Bank of England bought. Obviously there are important differences between balance sheet expansion done through the purchase of foreign assets (reserve buildup) and balance sheet expansion done though the purchase of domestic assets (quantitative easing).  One is aimed at the exchange rate, the other at the domestic economy. But if portfolio balance theories are right, the direct impact on bond prices from foreign central bank purchases of bonds and from domestic central bank purchases of bonds should I think be at least somewhat similar. As the chart above makes clear, large-scale central bank asset purchases in some sense preceded the global crisis.  Pre-crisis, the purchases came from emerging market central banks. China, counting its shadow intervention, bought about 15% of its GDP in reserve assets from mid 2007 to mid 2008; as a share of GDP, that is a pace of asset purchases equal to the BoJ’s current pace. More recently, reserve managers have quite obviously been selling. The reserves the PBOC bought from 2012 to 2014 were sold in 2015 and 2016. Yet with three trillion plus in reserves, and more in its shadow reserves, the PBOC hasn’t yet sold anything it bought prior to the global crisis. And more importantly, recent reserve sales have come at a time when the BoJ and ECB have been ramping up their purchases. Aggregate central bank demand for safe assets has remained elevated. There has been a significant shift in the currency composition of large scale central bank assets purchases in the past couple of years. In fact, adding reserve purchases to QE purchases magnifies the recent global shift in central bank demand away from dollars. EM reserves managers have been selling dollar assets. At the same time the Fed isn’t buying assets anymore. And the G-7 currency agreement has limited the ECB and (especially) the BoJ to the purchase of their own assets, so there has been a surge in central bank purchases of euro and yen denominated bonds. Prior to the crisis, I was never completely convinced by arguments that the currency composition of the reserves held by central banks didn’t matter. Partially that was self-interest of course; I had spent a lot of time developing my reserve tracking technology. But I also didn’t think private investors were completely indifferent to the currency composition of their portfolio of safe assets. If the central banks accumulating reserves wanted euros rather than dollars, the euro would need to rise relative to the dollar to make "safe" dollar assets cheaper and thus more appealing to private investors. Treasuries and German bunds were not perfect substitutes. Nor for that matter are Agencies and French government bonds. I still think that is the case. It matters that the ECB conducts its asset purchases by buying euro assets, not by buying Treasuries. At the same time, with ECB purchases exceeding euro area government net issuance and with BoJ purchases far exceeding net new issuance of JGBs, it is hard to argue that some investors in European and Japanese debt haven’t been pushed into U.S. Treasuries and Agencies. (This Banque de France working paper found that foreign holders of euro-denominated bonds were the most likely to sell to the ECB.) And thus there should be some impact on the U.S. yield curve from the actions of other central banks even when those central banks aren’t buying dollars. All this said, the indirect impact on Treasuries from the purchase of JGBs and Bunds is likely to be smaller than the direct impact of central bank purchases of Treasuries.** Krishnamurthy and Vissing-Jorgensen’s 2013 Jackson Hole paper argued that Treasuries and Agencies weren’t perfect substitutes, which is why the Fed’s purchases of Agency MBS had an impact.  I have long thought the QE-Agency MBS-lower mortgage payments channel provided an important offset to the fiscal tightening the U.S. did in 2013, as mortgage refinancing put cash directly in the pockets of many households. And the current, relatively low level of direct central bank demand for U.S. Treasuries reinforces Larry Summers’ argument that low Treasury rates now aren’t just a reflections of central banks purchases... In subsequent posts, Emma and I plan to look into these points in a bit more detail, by disaggregating central bank flows by currency and comparing central bank demand (the sum of "foreign” reserve demand and “home” monetary policy demand) to government issuance. A note on methodology. Asset purchases by the Fed, ECB, BoJ and BoE are easy to track directly. Reserve purchases come from summing the foreign exchange reserves of around 60 countries—a broad sample that replicates the IMF COFER data. China’s other foreign assets are added to the total (it doesn’t matter much, but it is a point of pride for me—these are assets on the PBOC’s balance sheet that walk, talk and quack like reserves). The dollar share of reporting economies is assumed to be replicated across the full sample (broadly speaking this produces the same result as assuming a constant 60 or 65% dollar share over time). * Signalling here means signalling a credible commitment to hold policy rates low for a long time, i.e. enhancing the credibility of forward guidance. Michael Woodford, for example argued back in 2013 that this was the transmission channel that mattered. ** Technically, a central bank buying bonds creates bank reserves when it credits the account of the seller of the bonds with cash. QE reduces the supply of safe longer-dated bonds in the market (raising their price, and reducing their yield in theory) while adding to the supply of safe short-term assets (claims on the central bank).

China is running a persistent current account surplus, one that could be larger than officially reported (the huge tourism deficit looks a bit suspicious). If China paid off all its external debt, it would still have around $2 trillion in reserves.* If it paid off all its short-term debt, it would have $2.5 trillion in reserves. And China has a very low level of domestic liability dollarization (3 percent of total deposits are in foreign currency) True, $3.2 trillion ($3.3 trillion if you include the PBOC’s other foreign assets, as you should, and as much as $3.5 trillion if you include the China Investment Corporation’s foreign portfolio, which is more debatable) isn’t $4 trillion.** But much of the fall in reserves over the last 18 months has stemmed from the use of reserves to repay China’s short-term external debt. The IMF projects that China’s short-term external debt will have fallen from $1.3 trillion in 2014 to just over $700 billion by the end of this year. Reserves are down, but—from an external standpoint—China’s need for reserves is also down. The two year fall in short-term debt is actually about equal to projected drop in reserves. The Fund though sees things a bit differently. Buffers, according to the Fund’s staff report, are now low, and need to be rebuilt. Some in the market agree. And that gets at a critical issue for China, and a critical issue for assessing reserve adequacy more generally. Just how many reserves do countries like China, need? For China, two “traditional” indicators of reserve adequacy—reserves to short-term debt and reserves to broad money—point in completely different directions. Reserves are over 400 percent of short-term debt (way more than enough). *** Reserves are now “only” 15 percent of broad money (not enough; 20 percent of M2 is the traditional norm). You cannot really fudge the difference; you have to tilt one way or the other. (Hat tip to Emma Smith of the Council on Foreign Relations’ Greenberg Center for Geoeconomics, who prepared the charts). I personally put more stock on balance sheet indicators, and reserves to short-term external debt is the most important. From a balance sheet point of view, there is also a strong case for paying attention to reserves relative to domestic sight deposits (a measure of liability dollarization). The Fund though sees things differently; in the design of the new reserve metric the Fund leaned strongly against balance sheet indicators of reserve need (see the discussion of liabliity dollarization here), and instead went with a composite of the three traditional indicators (short-term debt, m2, and imports—though the Fund prefers using exports), with an additional factor for longer-term external liabilities. The Fund’s reserve metric effectively says China needs to hold more reserves, relative to its GDP, than a typical emerging economy. Especially if China opens its financial account before its currency floats freely. And that is the case even though China has much less external debt than a typical emerging economy, and also has less liability dollarization of its financial system. Personally, I think foreign currency deposits pose more risks than domestic currency deposits, and, to the extent a country should hold reserves against the risk of domestic capital flight, those countries with more domestic foreign currency deposits should hold proportionately more reserves. The Fund’s metric, though, explicitly doesn’t adjust for liability dollarization. As a result, the Fund believes China needs to hold far more reserves against the risk of domestic capital flight than other emerging economies, including emerging economies with a lot more domestic FX deposits. The gap between the reserves China needs to hold on the Fund’s metric and the reserves other emerging economies need to hold is even more extreme in dollar terms; as the Fund’s metric requires the biggest emerging economy to hold more reserves than other emerging economies—remember that 20 percent of M2 for China is 40 percent of China’s GDP, or well over $4 trillion.**** One hundred percent of short-term debt by contrast requires reserves of $750 to $900 billion now. I will though give the Fund credit for now recognizing one obvious implication of its analysis of reserve adequacy: China needs to proceed cautiously on financial account liberalization, and the pace of financial account liberalization needs to be in synch with the process of domestic balance sheet repayment and bank/shadow bank recapitalization. *$3.5 trillion in reserves at the end of 2015, v $1.5 trillion in external debt, see table 2 of the IMF’s staff report. ** I will have more to say on this in an another post. There is a debate about the liquidity of China’s $3.2 trillion in reserves ($3.3 trillion counting other foreign assets). The key issue here is how China accounts for the foreign assets of China Ex-Im and China Development Bank (CDB). They shouldn’t technically be counted in reserves, but China’s hasn’t been completely clear on this point. The bulk of the evidence though suggests that China Ex-Im and CDB loans show up in the net international investment position in “loans” not as reserves, and that, to the extent these loans have been financed by entrusted reserves, those entrusted reserves are counted as “other foreign assets” in China’s SDDS disclosure of its foreign exchange reserves. In other words, the illiquid loans are not currently counted as part of China’s “foreign exchange reserves,” but rather appear elsewhere. China really should clarify this though. The IMF Article IV unfortunately did not shed new light on this issue. *** Data is from tables 2 and 3 of the IMF’s staff report, pp 40 and 41. http://www.imf.org/external/pubs/ft/scr/2016/cr16270.pdf China holds roughly three times more reserves than any other country. **** The IMF generally requires 5 percent of M2 in its composite metric, or 25 percent of the standard M2 to GDP norm. That rises to 10 percent of M2 for countries with fixed exchange rates, so long as the financial account is open. With M2 to GDP running around 200 percent thanks to China’s high savings rate, and with China’s GDP projected to rise above $15 trillion over the next few years, this soon won’t be an academic debate.

The proxies for China’s foreign exchange intervention in July are now available, and they point to $20 to $30 billion of reserve sales. The PBOC’s foreign assets fell by about $23 billion (The PBOC’s foreign reserves, as reported on the PBOC’s renminbi balance sheet, fell by $29 billion; I prefer the change in the PBOC’s foreign assets though, as foreign assets catches the foreign exchange that banks hold at the PBOC as part of their reserve requirement). FX settlement with non-banks shows net sales of around $20 billion. Throw in the change in forwards in the settlement data, and total sales were maybe $25 billion. All the proxies show more variation than appeared in headline reserves, which only fell by $5 billion. I trust the proxies. The bigger story, I think, is two-fold. One is that there is still a correlation between FX sales and moves in the yuan against the dollar. In June and July the yuan slid against the dollar, and the magnitude of FX sales increased. That fits a long-standing pattern. The second, and far more important point, is that the magnitude of sales during periods when the yuan is depreciating against the dollar are significantly smaller than they were last August, or back in December and January. Why? Tighter controls? Or, more simply, has a lot of the foreign currency debt that was built up as part of the carry trade (borrow in dollars to buy yuan to pocket higher interest rates on the yuan) now been paid back, reducing corporate demand for foreign currency in periods of depreciation? Either way, if a bad month means $20-30 billion in sales, China isn’t going to run out of reserves anytime soon. For now, the desire (or desire, combined with ability to execute) of Chinese savers to hold foreign assets seems to be roughly equal to China’s underlying current account surplus. Hence the broad stability in reserves. August should be fairly calm on the reserve front. The yuan has appreciated a bit against the dollar recently. And if you squint, you can argue that it also has been stable (rather than slowly depreciating) against a basket, at least for a few weeks. There is no reason to expect large sales.

Both of the key proxies for China’s actual intervention in June are out. The PBOC’s balances sheet shows a $15 billion dollar fall in reserves. And the State Administration on Foreign Exchange (SAFE) data on foreign exchange settlement by the banking system (the PBOC is treated as part of the banks) shows $18 billion in sales from the banking system (using sales for clients, not net settlement). They paint a consistent picture. The gap between the modest sales reported in the data and the rise in headline reserves ($13.4 billlion) is almost certainly from the mark-to-market gains on a portion of SAFE’s book. The portfolio of high quality bonds should have increased in value in June. Friends who read Chinese say SAFE has admitted as much on its website. The more interesting thing to me is how modest the sales were, at least when compared to other periods of depreciation (against the dollar) in the last two years. Either the carry trade unwind is over or the controls work. Or somehow this most recent depreciation hasn’t produced expectations for further depreciation, even though the crawl down against the basket has been pretty stable. It is a puzzle, at least to me. For the conspiratorially minded, the banks do look to have sold foreign exchange from their own accounts in June, as they did last August and this January. But the sales from their own account were modest—$5 billion versus $85 billion last August and $15 billion in January. And the settlement data for forwards also shows a modest reduction in the net forward book of the banks in June. Net of the change in forwards, total sales in the settlement data look to be just under $15 billion. Not much, in other words. But there is at least a suggestion that expectations started to build over the course of July in a way that worried the PBOC. The need to break the cycle of expectations is one explanation for the decision to appreciate the yuan in the middle of the week back to about 6.7 to the dollar, even though such appreciation against the dollar meant appreciation against a basket. Bloomberg reported: "The yuan advanced the most in two weeks, with the central bank’s daily fixing adding to signs that China’s authorities are prepared to overrule the market to control the currency’s moves.The People’s Bank of China strengthened its reference rate, which restricts onshore yuan moves to 2 percent on either side, even as the dollar advanced the most since July 5. This spurred speculation that the central bank isn’t sticking to its stated policy of following the direction of the market, which would have resulted in a weaker fixing." The mystery of the PBOC’s actual exchange rate policy rule remains. Perhaps intentionally. All this matters, of course, because the exchange rate is the mechanism that most powerfully transmits any weakness in Chinese domestic demand to other manufacturing economies. Commodity exporters are, of course, impacted more directly by changes in commodity prices. The cumulative depreciation against the dollar over the last 12-plus months has reached 7-8 percent—enough that it would reasonably be expected to start having an impact on trade flows going forward.

Turkey has long ranked at the top of most lists of financially vulnerable emerging economies, at least lists based on conventional vulnerability measures. Thanks to its combination of a large current account deficit and modest foreign exchange reserves, Turkey has many of the vulnerabilities that gave rise to 1990s-style emerging market crises. Turkey’s external funding need—counting external debts that need to be rolled over—is about 25 percent of GDP, largely because Turkey’s banks have a sizable stock of short-term external debt. At the same time, these vulnerabilities are not new. Turkey has long reminded us that underlying vulnerability doesn’t equal a crisis. For whatever reason, the short-term external debts of Turkey’s banks have tended to be rolled over during times of stress.* And, fortunately, those vulnerabilities have even come down just a bit over the last year or so. After the taper tantrum, Turkey’s banks even have been able to term out some of their external funding by issuing bonds to a yield-starved world in 2014, and by shifting toward slightly longer-term cross-border bank lending in 2015 and 2016 (See figure 4 on pg. 35 of the IMF’s April 2016 Article IV Consultation with Turkey) And while the recent fall in Turkey’s tourism revenue doesn’t look good, Turkey also is a large oil and gas importer. Its external deficit looks significantly better now than it did when oil was above a hundred and Russian gas was more expensive. Turkey doesn’t have many obvious fiscal vulnerabilities; public debt is only about 30 percent of GDP. Its vulnerabilities come from the foreign currency borrowing of its banks and firms. There is one more strange thing about Turkey. Its banks have increased their borrowing from abroad in foreign currency after the global financial crisis, but there hasn’t been comparable growth in domestic foreign currency lending. Rather, the rapid growth has come in lending in Turkish lira, especially to households. So the banks appear to have borrowed abroad and in foreign currency to fund domestic lending in Turkish lira. Bear with me a bit. Balance sheet analysis is interesting but not always straightforward. Turkish banks have significant domestic foreign currency deposits, and lots of domestic foreign currency loans.** The banks have added to their domestic foreign currency funding with a lot of short-term external debt (the data in the chart above sums cross border deposits and "short-term" loans by original maturity). And Turkey’s banks also have lots of liquid foreign currency assets on their balance sheet, some abroad but mostly in the form of deposits at the central bank. When you sum it up, domestic foreign currency deposits cover domestic foreign currency lending. The IMF staff report notes: “The sector’s loan-to-deposit (LtD) ratio stands at 119 percent, with the ratio at 89 and 142 percent for foreign (FX) and local currency respectively.”*** Why then do the Turkish banks borrow in foreign currency abroad, when, on net, they seem to just park the proceeds at the central bank? And how do they finance domestic currency lending with foreign currency borrowing without running an open foreign currency position? Turkey’s banks rely on two bits of financial alchemy. First, the central bank allows the domestic banks to meet much of their reserve requirement (including the reserve requirement on lira deposits) by posting gold and foreign currency at the central bank (this is the famous or infamous reserve option mechanism). That frees up lira to lend domestically.*** And second, the banks clearly rely on “off balance sheet” hedges (cross currency swaps) for a part of their funding. Look at the financial sector section of IMF’s staff report on pp. 23 to 26. The result is an interesting mix of risks. The banks ultimately need wholesale funding in lira, which Turkey’s central bank could supply in extremis—though with consequences for the exchange rate. The banks could also offset a loss of external foreign currency funding by drawing down on their liquid foreign currency assets. Monday’s Central Bank of Turkey (CBRT) press release notes that nearly $50 billion in liquidity sits at the central bank. But if the banks ever needed to draw on their foreign currency reserves, Turkey’s headline reserves would fall fast. A lot of Turkey’s foreign exchange reserves—which are not high to begin with—are effectively borrowed from Turkey’s banks. Makes for an interesting case. And it highlights a second debate of particular interest to me. What role should domestic balance sheet vulnerabilities play in determining the “right” level of foreign currency reserves for an emerging market economy? And what kind of domestic vulnerabilities matter the most, those from domestic currency deposits or those from foreign currency deposits? Specifically, should emerging economies with current account deficits and high levels of domestic liability dollarization (e.g. countries like Turkey) hold more reserves (relative to the size of their economies) than countries with current account surpluses and low levels of domestic liability dollarization (e.g. most East Asian economies, notably China)? This isn’t entirely an academic debate. The IMF’s new reserve metric—a composite indicator that is a weighted average of reserves to short-term external debt, reserves to all external liablities, reserves to exports, and reserves to domestic bank liabilities (M2)—effectively says that countries with large banking systems (like China) need to hold more reserves against the risk of capital flight than countries with heavily liability dollarized banks (like Turkey). And to get all wonky, this is because of the weight the IMF’s reserve index puts on the “M2” variable and the IMF’s decision to omit “foreign currency deposits” from its metric. There turns out to be large variance in the ratio of M2 to GDP across large emerging economies And for those countries, high levels of M2 to GDP are not, in general, correlated with high levels of liability dollarization, while a high level of M2 to GDP, it turns out, is correlated with a current account surplus. Let me be more concrete. M2 to GDP is about 200 percent of GDP in China. It is around 100 percent of GDP in Korea. And about 50 percent of GDP in Turkey. Five percent of M2 (the IMF’s norm for most emerging economies) works out to be roughly 10 percent of GDP in China, 5 percent of GDP in Korea, and 2.5 percent of GDP in Turkey. So there is a meaningful difference across countries. Ten percent of M2—the IMF’s norm for countries with fixed exchanges and open financial accounts—would work out to be about 20 percent of GDP in China. As a result, the M2 (broad money) variable drives much of the variation in the amount of reserves that large emerging economies need to hold to meet the IMF’s reserve norm. the following table, prepared by the CFR’s Emma Smith, decomposes reserve needs at the end of 2015. The IMF also has a somewhat cumbersome reserves data tool here. For countries with high levels of short-term debt and a low level of M2 to GDP, the IMF composite metric can have the effect of reducing the reserves that they need to hold relative to simple measures like reserves to short-term-debt. For example, in December 2015, when Turkey had a bit more short-term debt ($120 billion, by residual maturity) than it does now, the IMF’s metric would have been met with slightly fewer reserves ($115 billion) than Turkey’s short-term external debt. Conversely, for countries with low levels of short-term debt and a high levels of M2 to GDP, the IMF’s metric has the effect of raising needed reserves well above measures based on short-term external debt. China is the most obvious example, but not the only one. Turkey still needs to have a decent amount of reserves relative to the size of its economy to meet the IMF’s metric, especially after the lira’s 2015 depreciation. As it should given its large stock of external debt. I would argue it actually needs even more. $90 billion in foreign exchange reserves is low for a country with lots of foreign currency denominated internal debt (e.g. foreign currency deposits, which fund foreign currency loans) and lots of foreign currency denominated external debt. And I find it a bit strange that with the IMF’s metric China—even with a relatively closed financial account—needs substantially more reserves, relative to the size of its economy, than say Brazil or Russia. Brazil runs a current account deficit and Russia has significant domestic liability dollarization.**** The IMF argues—in its staff guidance note on the reserve metric—that there is no additional risk from high levels of liability dollarization. They didn’t find evidence of more or bigger runs in economies with dollarized liabilities. I am not sure I agree with their interpretation of the data on runs—I remember Uruguay’s crisis, and Ukraine lost substantially more reserves over the past few years than the IMF initially forecast in part because of a draw-down in its domestic foreign currency deposits.***** But more significantly, I would argue that the consequences of a run out of foreign currency deposits are much larger than the consequences of a run out of domestic currency deposits. There is a limit to the ability of most central banks to act as a lender of last resort in foreign currency.****** Technical stuff. But important. It has a big impact on who needs to hold what. * The standard explanation is that some of the funding comes from wealthy Turks with funds offshore. I though wonder if that is still the case given the magnitude of the banks’ external liabilities. ** Turkish firms have increased their foreign currency borrowing from the domestic banks from $50 billion in 2008 to around $180 billion now; the Turkish central bank helpfully provides all the data on this here. The resulting risks are well known. *** See table 6, on p. 44 of the IMF’s staff report for changes in the loan-to-deposit ratio over time. **** See the peer comparison on p 38 of the IMF’s staff report for Turkey, among other sources. ***** See Figure 9, p. 29 of the IMF’s April 2015 paper on reserve adequacy. ****** I tend to compare foreign currency debts to foreign exchange reserves—leaving out gold reserves. I followed that convention in the chart above. I am reconsidering a bit, given Venezuela’s apparent ability to borrow against its gold. But in Turkey’s case, I suspect most of its $20 billion or so in gold is likely borrowed from the banks (through the reserve option mechanism), and thus not really available to meet a foreign currency liquidity need.

There are plenty of possible explanations for the surprise jump in China’s headline reserves in June. A high allocation to yen (up around 6.5 percent), for example, or a low allocation to pounds (down nearly 8 percent). Headline reserves are reported in dollars, and thus change when dollar value of euros, pounds, yen, and other currencies held in a typical reserve portfolio change. But, absent a much bigger allocation to yen than to pounds, it is hard to see how currency moves in June can explain the $13.5 billion increase in headline reserves. My simple valuation adjustment actually churns out a tiny valuation loss from currency moves, so it implies a slightly higher underlying pace of reserve accumulation than the rise in headline reserves. However, some countries—following the IMF’s SDDS standard—also report the market value of their securities portfolio. And rises in the value of a portfolio that consists primarily of bonds could easily explain the rise in China’s June reserves. A two-year Treasury should have increased in value by about half a point, and a five-year Treasury rose by almost two points. I get bond valuation gains of very roughly $15 to $20 billion on a stylized version of China’s U.S. Treasury portfolio,* and there should also be gains on China’s euro portfolio and other fixed income assets. 5 year bunds were up a bit under a point. Extrapolating a bit, across all currencies bond market gains could have added something like $25 billion to the value of a bond portfolio that likely tops $2.5 trillion by a significant margin (not all of China’s reserves are in bonds). Of course, it is also possible China also might have started to buy dollars in the market. This though feels like a stretch — most observers suspect China’s central bank is still selling dollars through the state banks, at least in the offshore market in Hong Kong. China seems to have wanted to make sure the CNY’s depreciation against the dollar in June was orderly, and that the CNH moved in line with the CNY. This recent Reuters article, for example, hints that China still is selling foreign currency ("further weakness was capped as the central bank was suspected of intervention to offset massive dollar demand from banks’ clients, traders said"). The uncertainty about the sign of China’s activity in the market makes the foreign exchange settlement and the PBOC balance sheet data that will be released toward the end of the month all the more important. The settlement data and the PBOC’s balance sheet data often provide a cleaner read on China’s actual intervention than the change in headline reserves. [*] Ballpark math: if China held around $1.5 trillion in U.S. Treasuries (I added Agencies to my actual estimate and rounded a bit), with two-thirds at an average maturity of two years and one-third at an average maturity of 5 years (to fit with the data showing total returns on both maturity buckets) the mark to market gain on its Treasuries would be around $15 billion. If two-thirds were in five-year bonds and only a third in two-year bonds, that would be $20 billion. All this is very rough. Precise estimates here would stretch the technology a bit too far, given all the uncertainty about China’s reserve portfolio. Most Treasuries held in central bank reserves, according to the Treasury data, have a maturity of less than five years; see pp. 24-25 of this Treasury report.

The implications of Brexit understandably have dominated the global economic policy debate. But there are issues other than Brexit that could also have a large global impact: most obviously China and its currency. The yuan rather quietly hit multi-year lows against the dollar last week. And today the yuan-to-dollar exchange rate (as well as the offshore CNH rate) came close to 6.7, and is not too far away from the 6.8 level that was bandied about last week as the PBOC’s possible target for 2016.* The dollar is—broadly speaking—close to unchanged from the time China announced that it would manage its currency with reference to a basket in the middle of December.* So the yuan might be expected to be, very roughly, where it was last December 11. December 11 of course is the day that China released the China Foreign Exchange Trade System (CFETS) basket. Yet since December 11, the yuan is down around 1.5% against the dollar, down about 5 percent against the euro and down nearly 19 percent against the yen. The reason why the renminbi is down against all the major currencies, obviously, is that managing the renminbi "with reference to a basket" hasn’t meant targeting stability against a basket. As the chart above illustrates, over the last seven months the renminbi has slowly depreciated against the CFETS basket. The renminbi has now depreciated by about 5 percent against the CFETS basket since last December, and by about 10 percent since last summer. How? No doubt there are many tricks up the PBOC’s sleeve. But one is straightforward. When the dollar goes down, China hasn’t appreciated its currency by all that much against the dollar. And when the dollar goes up, China has depreciated against the dollar in a way that is consistent with management “with reference to a basket.” That takes advantage of the fact that the yuan’s value against the dollar is what matters inside China, while the broader basket matters more for trade. And it takes advantage of the fact that politically the yuan-to-dollar exchange rate matters more than the yuan-to-euro exchange rate. So even if the yuan was a bit overvalued last summer, it isn’t obviously overvalued now. China’s manufacturing export surplus remains quite large. And export volume growth—which was falling last summer—has now turned around. It is not realistic for Chinese export volumes to outperform global trade by all that much any more; China is simply too big a player in global trade. China will have to adjust to a new normal here. My hope is that China will pocket the depreciation achieved over the last several months, and will now start managing its currency more symmetrically or even be somewhat more willing to allow a stronger dollar to flow through to a stronger yuan. Since January, the expectation of stability (more or less) against the dollar together with the repayment of (unhedged) external debt, a tightening of controls and the threat of intervention in the offshore market seem to have reduced outflow pressures. The fairly steady depreciation against the basket has coincided with smaller reserve sales.*** But there is a risk that speculative pressure could return if the market concludes that China thinks it can now depreciate against a basket thanks to tighter controls and less external debt. And, obviously, if depreciation against the basket can only be achieved through depreciation against the dollar, it is hard to see how the yuan doesn’t become even more of a domestic political issue in the United States. 6.8 against the dollar brings the renminbi back to its level of eight years ago, more or less. * Reuters: "China’s central bank would tolerate a fall in the yuan to as low as 6.8 per dollar in 2016 to support the economy, which would mean the currency matching last year’s record decline of 4.5 percent, policy sources said." The PBOC indirectly pushed back against the story, and has reiterated that it is committed to a "basically stable" renminbi. The Reuters story can also be read two ways: as a signal that China wants a steady depreciation against the dollar, or a signal that there is a limit on how far China is willing to allow the yuan to depreciate against the dollar even if the dollar starts to appreciate against the majors. ** China’s basket doesn’t mirror the U.S. basket. Japan for example, has a 15 percent weight in China’s basket versus a 6-7 percent weight in the Federal Reserve’s broad index, and Canada and Mexico figure more prominently in the U.S. index. The pound, incidentally, has a 4 percent weight in the CFETS basket. Still, the dollar index provides a rough guide to how China would move if it pegged to the dollar. *** Goldman’s Asia team has suggested that Chinese firms have been settling imports with renminbi in 2016, and this flow likely reflects an orchestrated attempt to limit pressure on the currency that should be counted as a form of hidden intervention. I will take that argument up at a later time. But even with the Goldman adjustment, the pace of reserve sales (using the settlement data) has fallen from $100-150 billion a month in January to $25 billion or so in April and May.

The best available indicators of China’s activity in the foreign exchange market—the People’s Bank of China’s (PBOC) balance sheet data, and the State Administration of Foreign Exchange’s (SAFE) foreign exchange settlement data—are out. They have confirmed that China did not sell much foreign currency in May. The PBOC’s balance sheet data shows a fall of between zero and $8 billion (I prefer the broadest measure—foreign assets, to foreign reserves, and the broader measure is flat). And SAFE’s data on foreign exchange (FX) settlement shows only $10 billion in sales by banks on behalf of clients, and $12.5 billion in total sales—both numbers are the smallest since last June. The settlement data that includes forwards even fewer sales, as the spot data included a lot of settled forwards. A couple of weeks ago I noted that May would be an interesting month for the evolution of China’s reserves. May is a month where the yuan depreciated against the dollar. The depreciation was broadly consistent with the basket peg. The dollar appreciated, so a true basket peg would imply that the yuan should depreciate against the dollar. And in the past any depreciation against the dollar tended to produce expectations of a bigger move against the dollar, and led to intensified pressure and strong reserve sales. That though doesn’t seem to have happened in May. All things China have stabilized. So what has changed? Four theories, building on ideas that I have laid out previously: a) The tightening of controls has had an impact b) The pay-down of external debt since last August has had an impact. China had increased its short-term cross border bank borrowing by about $500 billion from late 2012 to late 2014, creating the potential for a sharp swing if cross border flows reversed. We should have data through quarter one of 2016 soon. Paying down or hedging is a one time demand for foreign currency, so outflows naturally should slow after China’s external debt has been sorted. c) The PBOC has been able to signal that it isn’t looking for a big depreciation against the dollar (even if it is willing to allow a weaker dollar to drag the yuan’s value down against a basket of currencies). d) The data masks hidden sales by various state actors that are not captured in the reserves; "true" sales are higher than the visible sales. Personally, I put some weight on all of the first three. And fairly little weight on the last argument, for now. I take the notion that China, and other Asian countries, often intervene through the backdoor very seriously. Last August, for example, a lot of China’s foreign exchange sales came from accounts in the state banks. But the available data for May—which is more limited than it should be—suggests the state banks added to their foreign exchange holdings, and rebuilt some of the buffer that they spent last August. The PBOC’s "Other foreign assets" (which corresponds to the required bank reserves that the banks hold in foreign currency) rose in May. The state banks’ forward book (net sales), based on the fx settlement data, also fell. There could be more going on, but I have not discovered it. And of course there is another factor. China’s ongoing monthly trade surplus is around $50 billion, and the ongoing monthly surplus in the broader current account should be at least $25 billion. China can finance a decent amount of capital flight (or portfolio diversification) without having to dip into its reserves.