PBOC (People's Bank of China)

I want to step back a bit from the rather extraordinary moves in the offshore yuan market over the past few days. It seems quite clear that China’s authorities felt the need to signal that the yuan isn’t currently a one way bet against the dollar. And stepping back in this case means taking a deep dive into the details of the balance of payments data -- details that come out with a quarter lag, and thus provide information that is stale from the point of view of a forward-looking market. A lot, and I mean a lot, changed in the fourth quarter. I generally like it when China’s data series line up. Line up with each other. And, when possible, when China’s data also lines up with data reported by China’s trading partners. So I have been bothered for some time by the large discrepancy between the fall in China’s foreign exchange reserves (as reported on the PBOC’s balance sheet, $108 billion in the third quarter) and the much smaller net sales of foreign exchange by China’s banks (as reported in the FX settlement data, $50 billion in the third quarter without adjusting for the forwards reported in the settlement data, $63 billion with the forward adjustment). Fx settlement includes all the banks, not just the central bank. Historically, though, it has been very correlated with overall reserves. The initial balance of payments (BoP) data for the third quarter showed large reserves sales ($136 billion), sales on a scale that was consistent with the PBOC balance sheet numbers. The BoP reserves sales thus seemed to suggest a big pickup in capital outflows in the third quarter. However, the detailed balance of payments data suggests that the signal from the FX settlement data may be more accurate. Much of the q3 fall in China’s reserves seems tobe explained by the buildup of foreign assets by other state controlled financial institutions, not “private” capital outflows. I see a likely increase of around $85 billion in the foreign assets of state institutions other than the PBOC in q3. Which implies that the actual fall in “official” assets might be as low as $50 billion in the third quarter, and estimated private outflows (estimated as the difference between net inflows from the current account and net FDI flows and the buildup/sale of official assets) might have been about $100 billion. The ongoing build-up of foreign assets by the state banks and other state institutions also implies that the net sale of foreign assets by China’s state might have been as low as $200 billion in the four quarters from q4 2015 to q3 2016, with $400 billion in reserve sales offset in part by a rise of around $200 billion in the foreign assets of China’s other state financial institutions. Two hundred billion dollars is a large sum -- but one that also suggests that depreciation pressures earlier this year were significantly smaller (when official sales are scaled relative to China’s GDP) than the appreciation pressure back in 2006, 2007 and 2008 (and, for that matter, 2010). (In the chart above estimated reserves is a bit mislabeled; it should be either "augmented reserves" or "estimated official outflows") To be clear, my adjustments change the timing of the sales (and thus the timing of the peak outflow pressure) more than the cumulative magnitude of sales. They imply that state financial institutions sold a lot of foreign assets in the third quarter of 2015 to help the PBOC support the currency, and then rebuilt their foreign asset position over the next few quarters -- most obviously through a fall and then a rise in the state banks holdings of foreign exchange as part of their required reserves (reported as "other foreign assets" on the PBOC’s balance sheet).   And I also have little doubt that outflow pressure increased in the fourth quarter of 2016. The modest sum in the trailing four quarter sum through q3 is thus in part a function of the fact that two quarters with large sales are just outside the covered time period. Several other caveats are also needed. First, I am trying to understand the outflows in the third quarter (July through September). The third quarter is now ancient history. The yuan was relatively stable against the dollar in most of the third quarter. The yuan decidedly was not stable against the dollar in q4 and outflow pressures seem to have increased. The PBOC tightened its controls in the fourth quarter for a reason. Second, even if I am right and "true" private outflows are smaller than implied by reserve sales in the balance of payments in the third quarter —the obvious measure of “hot” outflows from China is either the difference between reserves (sales/purchases) and the current account, or the difference between reserve sales and the combined surplus from the current account and net FDI flows—there is no question that outflows were larger in the third quarter of 2016 than in the second quarter of 2016. The question is one of magnitude, not of direction. Third, to keep it simple, my estimate of "private" financial outflows in the first chart doesn’t include outflows that are disguised in the current account. It thus likely under-states actual capital outflows, as I clearly think there are financial outflows embedded in the current account. I tried to keep the chart relatively simple, and the adjustments relatively transparent -- so I didn’t adjust for hidden outflows.** Fourth, these estimates hinge on a set of educated guesses about who appears where in the balance of payments data, as China doesn’t release the kind of details that would allow outside observers to know for sure which set of institutions inside China’s financial system built up their foreign assets. I want to emphasize that these estimates are subject to change as my understanding of what drives different categories in the balance of payments changes. So why precisely do I suspect official (or quasi-official) asset growth provided a significant offset to reserve sales in the third quarter? A) The balance of payments data shows a $16 billion increase in the line item that corresponds to the rise in the PBOC’s other foreign assets -- the technical term for the foreign exchange the banks are required to hold as part of the regulatory reserve requirement. B) There was a big rise in lending by the state banks to the rest of the world ("loans" by the banks to the world rose by $37 billion in q3). I have always assumed that the term “state commercial bank” has real meaning in China, and that such lending could be stopped if the government really wanted it to stop. It was more or less non-existent before 2011, and much of the rise since then clearly comes from the China Development Bank. C) The balance of payments data shows large purchases of foreign portfolio debt and foreign portfolio equity (just over $30 billion in q3). This is a bit puzzling because there was no reported change in the Qualified Domestic Institutional Investor (QDII) quotas. So it wasn’t, I assume, from small private investors. And it wasn’t totally hidden either. After all, it shows up in the official data as an outflow, and also as a rise in foreign assets in the international investment position data. My best guess is that this is coming from some kind of state institutions —be it the social security fund, the China Investment Corporation (CIC), the state banks or even perhaps the life insurers. As a result, my estimate of the total stock of foreign assets under China’s state control fell by significantly less than the PBOC’s reserves in the third quarter.** All this implies that one arm of the state is betting against another, with state financial institutions building up assets abroad even as the PBOC runs down its reserves. And it thus raises a simple question: why would the government want to draw down its central bank reserves to allow the state commercial banks and other state financial institutions to raise their foreign assets? My gut is that some folks at the PBOC started asking similar questions over the last year, which could in part explain the tightening of controls toward the end of this year—cracking down on FDI outflows sent a signal that the "go out" policy no longer dominates all other considerations. Chinese policy coordination isn’t always perfect. Finally, my gut also says that while the pressure in q3 wasn’t as severe as the fall in reserves suggests, the fourth quarter is different. The squeeze now underway in the offshore yuan market suggests that the PBOC is working hard to discourage further outflows and to fight expectations of further depreciation. * Technically, I am assuming that "other, other, assets", "other, loans, assets", "portfolio debt, assets", "portfolio equity, assets" are all driven by state controlled institutions, and not making further adjustments The portfolio flows data could be adjusted for QDII, but I think it is clear that "portfolio debt" historically has been driven by the state banks (05 to 06 purchases, then sales) and portfolio equity has been in part driven by the CIC given the timing, and the recent run-up isn’t a function of QDII. "Other, other" is the foreign exchange the banks hold at the PBOC as part of their required reserves, other, loans seems historically to have been driven by the CDB. Of course the recent rise could come from different channels, but it almost certainly comes from the large state banks. ** This is all based on "on balance sheet assets," it doesn’t attempt to adjust for China’s rumored forward book. See this post for more on the forwards (with apologies for the level of technical detail).

The dollar’s rise doesn’t just have an impact on the United States. It has an impact on all those around the world who borrow in dollars. And it can have an enormous impact on those countries that peg to the dollar (Saudi Arabia is the most significant) or that manage their currency with reference to the dollar. China used to manage against the dollar, and now seems to be managing against a basket. But managing a basket peg when the dollar is going up means a controlled depreciation against the dollar—and historically that hasn’t been the easiest thing for any emerging economy to pull off. And China’s ability to sustain its current system of currency management—which has looked similar to a pretty pure basket peg for the last 5 months or so—matters for the world economy. If the basket peg breaks and the yuan floats down, many other currencies will follow—and the dollar will rise to truly nose-bleed levels. Levels that would be expected to lead to large and noticeable job losses in manufacturing sectors in the U.S. and perhaps in Europe. Hence there is good reason to keep close track of the key indicators of China’s foreign currency intervention. The two main indicators I track are now both available for November: The PBOC’s yuan balance sheet shows a $56 billion fall in foreign exchange reserves, and a $52-53 billion fall in all foreign assets (other foreign assets rose slightly). I prefer the broader measure, which captures regulatory reserves that the big banks hold in foreign currency at the PBOC. The FX settlement data—which includes all the state banks but historically has been dominated by the PBOC—shows a smaller $36 billion fall counting the change in the forward position (there is a forward component of FX settlement, but it doesn’t capture offshore yuan—e.g. CNH—forwards). Without the forwards the fall is $27 billion. Both measures show larger sales in November than October, though the settlement data suggests a smaller net outflow from the banking system than the PBOC balance sheet reserves data. Both thus highlight why PBOC was worried enough to tighten its controls at the end of November and start to review outward foreign direct investment a bit more tightly (a step that it arguably should have taken earlier). (Goldman’s numbers are similar). The settlement data shows about $300 billion in total sales by the PBOC and the state banks over the first 11 months of 2016; the PBOC foreign reserves data point to $315 billion of sales over 11 months. Very roughly, that suggests annual sales in the $325 to $375 billion range. With a current account surplus that should be around $275 billion, total private outflows will be at least $600 billion (or roughly $50 billion a month, on average). I say very roughly because I would get a higher number if I adjusted for outflows embedded in the current account—notably the possibility that some of China’s $300 billion plus in tourism "imports" are really disguised capital outflows. China in my view could sustain $350 billion in reserve sales for a couple of years. $350 billion is 3 percent of GDP, and China still has a bit over $3 trillion in official reserves and I suspect a bit more counting its hidden reserves. But it is also clear that the pace of outflow has not been constant in 2016. Outflows were higher in the first part of the year, then slowed significantly in the second quarter (when the yuan appreciated against the dollar), and then rose over the last five months. They still seem correlated with moves in the yuan against the dollar, though the magnitude of the reserve drain in November—when the yuan depreciated significantly against the dollar—was smaller than in January. Possibly that is because China’s controls have had an impact, thought is also could just reflect the fact that there is now less foreign currency debt to pay off. If the current pace of reserve sales is really the $50 billion a month implied by the PBOC’s balance sheet and its stays there, reserves would fall by $600 billion next year. That is uncomfortable even for China. China’s exchange rate management problem is that stability against a basket—during periods when the dollar is rising, and thus periods when stability against a basket implies further depreciation against the dollar—doesn’t seem to be enough to limit outflows. What works is stability or appreciation against the dollar. Any depreciation against the dollar still seems to lead to expectations of a further move. As the following chart makes clear, China has unquestionably managed its currency over the past few months to maintain stability against the basket. It is also clear that China’s hasn’t managed for stability against the basket consistently over the past year. The dollar now is a bit stronger than it was in late December and early January (back when the yen was over 120). Yet the yuan is weaker against the dollar now than it was then. At some point over the summer China seems to have shifted from managing for a depreciation against the basket to managing for stability against the basket. I see two possible paths from here. In one, the Chinese authorities continue to be able to manage the yuan so it remains stable against the basket—whether because the dollar stops rising and that takes some of the pressure off, or because China maintains sufficient control that it can limit the pace of the yuan’s depreciation to what is needed to maintain stability against the basket. A key part of this scenario is that the tighter financial controls prove effective, and outflow pressures abate once Chinese firms have more or less finished paying down their existing stock of external foreign currency debt. It would help if China used fiscal policy to support consumption and maintain demand growth, and thus depends less on monetary policy and cheap credit to support the economy. It would help if Chinese export growth strengthened on the back of the yuan depreciation since mid 2015, providing a more positive narrative around China’s currency. And of course it would help if the dollar didn’t rise too much more. The recent sell-off in China’s bond market has generally been presented as further evidence of China’s financial weakness. But it can be viewed as positive signal for the longer-run ability of China to maintain its current system of currency management, even if has disturbed the market: Chinese policy makers are now looking to raise rates and tighten credit for domestic reasons, as inflation has picked up and they are worried about froth in the housing market. It will be easier for China to maintain its current de facto basket peg if the PBOC wants to raise rates alongside the Fed next year.* In the other outcome, Chinese authorities either loose interest in resisting depreciation—perhaps in response to U.S. tariffs or other policy shifts, perhaps in response to a renewed slowdown in domestic growth—or loose control over financial flows and expectations. And, well, that would mean a much weaker yuan, much more pressure on other emerging currencies, a further leg up in the dollar, further falls in U.S. exports, more trade tension, and likely a rise in balance of payments imbalances globally. * I agree with Gabriel Wildau’s FT article, which emphasizes how the PBOC has chosen not to offset the impact of foreign currency outflows on money market rates because it wants to tighten money market conditions, not because it is incapable of doing so. " Market participants say the PBoC is taking advantage of capital outflows to squeeze leverage out of the bond market. By calibrating the volume of its reverse repos, the PBoC can passively guide short rates upwards. Higher interest rates have the added benefit of discouraging capital outflows by increasing the returns available on renminbi assets."

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.

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.

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.

Quick answer. A lot. Between $1.3 trillion and $1.4 trillion, or about 40 percent of China’s reserves. The last year has made it abundantly clear that Belgium’s holdings of Treasuries aren’t from Belgian dentists. China’s reserves started to fall last summer. Yet China’s reported holdings of Treasuries in the custodial data barely budged. Belgium’s holdings, by contrast, fell by around $200 billion. It is now standard among those who care about this stuff to add Belgium’s holdings (between $80 and $90 billion in long-term Treasuries, and $154 billion if you count Treasury bills) to those of China ($1245 billion). A more interesting question, one that takes a bit more technical wizardry to report, is how many U.S. assets China holds. The right answer, I think, is at least $1.8 trillion and perhaps more. That is somewhat less than China used to hold—but still quite a lot. In addition to Treasuries, China has $200 billion or so in Agencies, and $200 billion or so in U.S. equities, and close to $100 billion on deposit in U.S. banks. That is more or less in line with expectations for a country with $3.2 trillion in reserves. I actually lied about the technical wizardry required. Now that the Treasury reports monthly custodial holdings of all kinds of debt along with custodial holdings of U.S. equities, the amount of skill required isn’t very high. You just need to know where to look. (Historical data is here) I do still have a few tricks up my sleeve. After all, the trick to Treasury International Capital (TIC) watching is looking at changes over time, and trying understanding the resulting patterns. The art comes in making the adjustments needed to make the custodial data better map to the transactional data. If you want a continuous time series that goes back to the start of China’s reserve accumulation, you need to extrapolate between the annual custodial surveys from 2002 to 2012. Using, in broad terms, the methodology outlined here, that can be done with a fair amount of sweat, toil, and tears. After 2012, the Treasury provides a continuous monthly data series. The resulting graph of China’s U.S. portfolio holdings (really a close up of the initial graph) relative to the amount of dollars China would need to hold to have a dollar share of reserves in line with the global average does tell a set of stories.** Over time, China has gone from holding Treasuries and Agencies to holding Treasuries, Agencies and equities.* Between 2005 and 2007 the dollar share likely fell from around 70 percent to around 60 percent. Almost all of that fall shows up in the U.S. custodial data. At the time, though, the custodial data was only published once a year. And since then there has been one other significant move. Starting in 2010, China’s visible U.S. holdings —counting wee little Belgium’s Treasury holdings—fell from around 60 percent of its portfolio to a low of around 50 percent. And if anything China’s visible holdings are now rising back toward 60 percent. But I also suspect that after the global crisis the change in China’s U.S. custodial holdings doesn’t fully capture the evolution in China’s holdings of dollar-denominated assets. What really happened in 2010? The TIC data is silent there. One possibility is that China could have made greater use of offshore custodians (like Belgium and Luxembourg) so that its true holdings stopped appearing cleanly in the data. China’s holdings of corporate bonds for example, are almost certainly higher than reported in the TIC data. China could have started buying more non-dollar assets—euros, Australian dollars and the like. I could be missing an important adjustment to the data. There is a bit of work required to find the best fit. I have erred on the side of minimizing the needed adjustments for the sake of transparency. Another possibility is China started lending a portion of its reserves (through complex mechanisms, like entrusted loans) to other emerging economies while still counting these less than liquid assets as reserves. We know from a Chinese data set that the foreign loans of the state banks started to increase around this time. I used to think this was a big part of the story. Back in 2013, Caixin reported that the China Development Bank (CDB) was tapping China’s reserves for financing: "The initiative is an offshoot of a forex lending service started in May 2010, when a SAFE [State Administration of Foreign Exchange] affiliate called the Central Foreign Exchange Business Center signed the first loan agreement of its kind with the government’s policy lender China Development Bank (CDB)...CDB has tapped the reserves for more than two-thirds of the US$ 250 billion in foreign currency loans that it has issued to clients since May 2010." Now I am less sure, as China’s Special Data Dissemination Standard (SDDS) reserve disclosure shows that almost all of China’s reported reserves are in securities, and China also reports over $200 billion in non-reserve foreign assets. The non-reserve foreign assets could be things like PBOC’s deposits at the CDB that finance the CDB’s entrusted loans. And what has China sold over the last year as reserves fell? The answer seems to be both Treasuries and U.S. equities. The fall in Treasuries shows up in the change in Belgium’s holdings, not the change in China’s holdings. Between December 2014 and March 2016 the long-term Treasuries held by Belgian custodians fell from $321 billion to under $90 billion (data). And the U.S. data shows a fall of around $150 billion in China’s custodial holdings of U.S. equities since last March. $20 to $30 billion of the fall might be explained by valuation changes (the last data point for now is February). But it looks like China either sold a large sum of U.S. equities, or shifted those equities to a non-U.S. custodian. China held $323 billion in U.S. equities in December 2014, and $345 billion last March. In February it had $193 billion in U.S. equities in U.S. custodial accounts. The apparent sales in the U.S. custodial data seem commensurate with the fall in China’s reserves. With maybe two-thirds of China’s reserves in dollars, a fall in reserves implies that China’s government will be selling reserves. Of course, private Chinese residents are building up their foreign assets and paying down their foreign debt. But private Chinese holdings tend not to appear in the U.S. data in any easy to track way. The U.S. data can still be used as a proxy, in my view, for the U.S. assets held by the China’s central bank and its sovereign funds. The bigger story though is that there isn’t evidence to back up some of the scare stories circulating earlier this year. Unless China has pledged a big chunk of the Treasuries, Agencies and equities visible in the TIC data, China isn’t at all short on liquid reserves. China’s holdings of Treasuries—after factoring in Belgium’s holdings—and Agencies are still substantially bigger than Japan’s. Compared to its Special Drawing Rights (SDR) peers, China has no shortage of ammunition. And—as I will discuss in another post—China’s government still has somewhat more foreign assets than it reports as reserves, thanks to foreign assets the state banks hold at the PBOC as part of the reserve requirement and the Chinese Investment Corporation’s (CIC) international portfolio. Unless its forward sales are a lot bigger than the $30 billion China has disclosed, China’s “true” reserves are probably a bit bigger than its stated reserves. A lot though depends on how the CDB’s loans register in the data. And that is where I at least have the least certainty. (*) China’s reported holdings of equities in the U.S. data are higher than China’s total (private) holdings of foreign equities in China’s net international investment position data, which is only possible if a meaningful part of the foreign assets of China’s reserve manager—SAFE—are in equities. A technique I use a lot is comparing China’s data on its foreign assets with external data that should measure the same thing, and finding the differences. Google "SAFE investments"; SAFE’s equity holdings aren’t exactly a secret. (**) I have added the PBOC’s "other foreign assets" -- reported on the PBOC’s local currency balance sheet -- to China’s reported reserves. These are required reserves that the banks are hold in foreign currency rather than held in renminbi. This adjustment adds about $100 billion to China’s reserves right now. Confusingly, the "other foreign assets" reported by the PBOC and different than the "Other foreign currency assets" reported by SAFE in China’s SDDS disclosure. Similar name, but different things. And I have assumed that China’s dollar share is roughly equal to the global dollar share of reserves. A constant "65 percent in dollars" share would yield a similar estimate.