The market (or at least that part of the market that obsesses over balance of payment flows) has been swept with rumors today that foreign exchange reserves were down in January by $30 billion. My experience with these sorts of rumors is that they tend to be fairly accurate, and I suspect they will soon be confirmed.
If true, what does this imply about hot money flows? The PBoC’s accounts have been more opaque than ever and it is extremely difficult to figure out what is really happening, but let me give try at least to bracket the range of outcomes.
China’s trade surplus in January was $39.1 billion. It probably earned another $6-7 billion in interest income plus the reported $7.5 billion in FDI. This means that absent other effects reserves should have risen in January by $52 to $54 billion.
But there were other effects. China holds part of its reserves in currencies other than the dollar, and these declined in dollar terms January (the dollar appreciated). The total loss here may be around $30-40 billion. That means that absent other effects reserves should have risen by at least $15-20 billion. If reserves in fact declined by $30 billion, it would indicate at least $40-50 billion in unexplained outflows. Is this all hot money?
Brad Setser recently wrote a widely-read entry in his blog in reference to an article by Jamil Anderlini of the Financial Times about SAFE investments in equity markets that may have lost them $80 billion or more. If this is true, and it seems plausible, some of those losses may have occurred recently, although since the most vicious equity markets were last year, very little of that loss should have occurred in January – and it is anyway an open question whether the PBoC would value these investments at book or at market. Perhaps a small part of the unexplained $40-50 billion represents equity losses, but this cannot explain much of it.
We also know that China has stepped up its purchase of foreign commodities, either directly (which would have shown up already in the trade numbers) or indirectly via investments in commodity producers. The latter would have caused “unexplained” dollar outflows from the PBoC. It is not clear that much, if any, of this happened in January, but perhaps some of the outflow represents new outward investment of this sort. We don’t know.
Against that there is the question of whether December’s 150 basis point reduction in minimum reserves represents a reversal of dollar assets held at the central bank by commercial banks (remember that earlier increases in minimum reserves in 2007 and 2008 had been redenominated into dollars, and so their reduction should have reversed that process). If it did, and this would consist of about $30-40 billion, it would actually increase the unexplained amount. For the sake of conservatism, let’s assume that this hasn’t happened. We should know when the PBoC release its balance sheet numbers if the “Other dollar assets” account changed significantly.
Where does that leave us? There are about $40-50 billion in unexplained outflows and however you look at it there it is hard to believe that we haven’t seen at least $20-30 billion of hot money outflows in January. From my many years experience in developing markets I should say that the informational content of hot money flows is often wider than many people at first think. Much of the discussion about whether Chinese businessmen are bringing in or taking out money hinges on their perception of whether or not the currency will appreciate or depreciate (and in spite of the popular view of evil foreign speculators masterminding the flows, the truth is that the vast majority of this money is likely to be controlled by local businessmen).
But I would argue that usually a much bigger driver of hot money flows is the local perception of risk in the country experiencing the flows. If hot money is flowing out of China, it could be because local business owners believe the currency will depreciate, but I think it is more likely that the flows represent their concern that local investment opportunities – for example their businesses – have become increasingly risky and uncertain. Hot money flows tell us at least as much about risk perceptions as they do about profit opportunities, especially when the world is in trouble.
By the way, this exercise should indicate yet again why all the discussions and debate in China and the US – about whether or not China should continue financing the US fiscal deficit – are wholly beside the point, as I have been arguing almost monomaniacally for years. China cannot finance the US fiscal deficit, nor can any other country. China can only finance the US trade deficit, and it must do so by recycling its current account surplus, either via Chinese investors, or via central bank purchases of US dollar assets.
If there are hot money outflows from China large enough to cause the central bank to lose reserves, the central bank will not only stop buying US Treasury bonds and/or other dollar assets, it will have to sell something, which is most likely to be US dollar bonds. It has no choice.
Chinese investors who have taken money out of the country, on the other hand, will now effectively be responsible for recycling the Chinese current account surplus. They might decide to buy US Treasury bonds (and I suspect indirectly and directly many will), but they could also buy gold, Venezuelan bolivares, Moroccan real estate, or in fact anything else they choose, and it is their buying that will determine how the Chinese trade surplus gets allocated among China’s trading partners.
The other point to consider in all this is the impact on Chinese monetary conditions. A net outflow from the central bank has to be financed by retiring central bank bills or “destroying” RMB. This implies monetary contraction, and it is still difficult for me to see how this would not have a contractionary effect on underlying money.
Note 1: Wednesday’s edition of the New York Times has an interesting article on Pingyao, a stunningly beautiful town about an hour from Taiyuan, in Shanxi province which, if it weren’t for the coal-dust-infested air, would remind me of San Miguel de Allende or some of the other old and protected silver-mining towns north of Mexico City. I visited three years ago and plan to go back because of my interest in Chinese financial history. Pingyao was probably China’s first financial center (although temples already operated as early banks thousands of years ago) and headquartered the largest and most famous piaohao – 19th Century merchant trading companies whose businesses had expanded to taking silver deposits in one city and making them available in other cities (travelling was dangerous), collecting the emperor’s taxes and transferring revenues, and ultimately to making loans. This is only marginally related to my blog, but for those readers interested in this kind of stuff, I encourage you to read about Pingyao and the piaohao. It is a fascinating story.
Note 2: Once again my site is blocked in China. I don’t know why– I hope it only has something to do with last week’s NPC meeting and will be fixed soon – but until it is resolved my formatting will be screwed up and I won’t be able to respond to comments. For China-based readers, I think you can access this site easily on SeekingAlpha.com
Just found your blog is blocked again. So gladly i am here to leave a comment!!!
You know your blog is like, no one else, right?
Hi Michael, you mentioned that: “China has stepped up its purchase of foreign commodities, either directly (which would have shown up already in the trade numbers) or indirectly via investments in commodity producers. The latter would have caused “unexplained” dollar outflows from the PBoC. ”
I suppose if private parties in China invested in foreign commodity producers, it would result in an outflow from the PBOC. However, if the SAFE or CIC invested in foreign commodity producers, directly or indirectly, then, the purchases would remain on the PBOC balance sheet, no?
Dear Michael,
There was a lot of buzz recently regarding Chinese IP recovery in Feb 09.
But can it be that all this production is just for the sake of production, all going into inventory – and the massive pick up in Chinese loans is just financing this working capital/inventory accumulation?
Maybe they decided – what the hell, we will produce in order to keep employment numbers from complete collpase, we will store all these finished goods somewhere for the time being and hopefully will sell later? That would be a disastrous scenario. Is there any way to confirm or disconfirm this hypothesis- in the balance of payments data maybe? Would be very intresting to hear your views and what you hear from your ex-students.
Thank you!
Drivers of Hot Money Flows? (Out Flows)….”but I think it is more likely that the flows represent their concern that local investment opportunities – for example their businesses – have become increasingly risky and uncertain.”
Exactly, EXACTLY!
The basic consideration is whether one can grow a sweet smelling rose in a cesspool which no one has the will to clean up. And just how long people will keep bidding up tulips, also. The answer is NO. And it is exasperating to realize that most people think this is possible, that there will be some sort of Chinese magic that that will change the basic physics of the market, when people finally become much more aware of what is really transpiring.
By the way, several days ago, the Baron of Brentford, has vamped up his estimate of the damage of climate impacts after recently publishing his 700 page Stern report, just over two years ago. Of course, he can not be faulted for his faulty report in 2006. Because the science has changed much, and has been more refined, during the past 3 years. Still, one can accuse the Baron of continually being far too optimistic. And not putting out the real report which he should have made originally. In the end, it just might be the optimists that finally are largely responsible for destroying the world. So, sorry to say, maybe we should damn the optimists in most cases, these days.
China’s electric power generation is tightly tied to coal use, maybe 80 percent? And China’s electric power generation is a proxy for judging GDP growth, just as the use of oil in the United States closely tracks GDP growth there. Is there anyone who is logical and reasonable who does not doubt that, at least during the next 20 years, it will be TRULY impossible for China to switch from continuing to rely on its cheap coal reserves, and its cheaply built coal fired power plants, each of which is designed to last over 40 years, to push its need for at least an annual 8 percent growth rate in GDP? To think otherwise, is magical.
This is why it might seem so strange to some. The obvious evidence of the immutable fact of China’s need to rely on burning up its coal reserves. And the very obvious fact that doing so might cause irreparable harm to the same country which is burning it..
Now here is a huge classic example of the REAL definition of cognitive dissonance. China has made a decision to use its coal to further its growth. But this decision will lead to its own destruction, and maybe that of its vaunted 5000 year old civilization.
Obviously, very soon, China is going to need time on the couch for some very heavy psychoanalysis to relive its feelings of deep anxiety which result from this obvious cognitive dissonance..
As we will all need time on the couch, if the Baron of Brentford’s most recent pronouncements AGAIN prove to be minimizing the real extent of the problem, which is totally likely.
During this time of very slight economic downturn, most people do not realize that there will soon be a huge rebound in economic activity, three years from now. And this rebound will lead to the same profligate use of resources which were seen just before the economic dip. Which will cause over use of carbon based fuels. And which will, without doubt, lead to the many problems which everyone secretly acknowledges.
Of course, the Stern report is just another so called High School book. The strange thing in this case is that High Schoolers today, many of them, will be around in the 2090′s to pay witness to the very toned down version of the future that this weakling, over optimistic report tried to convey.
The problem is, with such a huge population, China can NOT afford to get the future wrong. But, the history of the CCP shows, it is always getting the future wrong, YEAR ON YEAR!
Michael: I maybe asking a stupid question. Tell me what is “hot money” and how do you define it?
Interestingly, the perception of China’s economic strength in the US is much greater than picture Michael presents (which is the one I find more credible). The NYT has another, “China is Kicking the World’s Ass” article on-line today. That, I think, creates a problem for China in that it likely will fuel expectations China is not able to meet in terms of demand creation and, in the end, fuel a protectionist backlash.
If Chinese business men are pulling money out of China, it’s probably a better indicator of economic conditions than any official pronouncement.
I think that the outflows are less the result of lack of confidence in the underlying economy than people covering bad currency bets. A year ago, people were making huge amounts of money betting that there is no way that the RMB would depreciate.
Lots of borrowing in dollars and lending in RMB, and much of that was likely short term borrowing with the expectation that things would be rolled over. Guess what?
Also, my observation is that it’s not so much underlying confidence in local business that drives currency flows. It’s usually the opposite, that in emerging markets, currency flows drives confidence in local business.
Could this have something to do with the outflows?
http://www.washingtonpost.com/wp-dyn/content/article/2009/03/16/AR2009031603293.html?wprss=rss_business
On Feb. 12, China’s state-owned metals giant Chinalco signed a $19.5 billion deal with Australia’s Rio Tinto that will eventually double its stake in the world’s second-largest mining company.
In three other cases, China has used loans as a way of securing energy supplies. On Feb. 17 and 18, China National Petroleum signed separate agreements with Russia and Venezuela under which China would provide $25 billion and $4 billion in loans, respectively, in exchange for long-term commitments to supply oil. And on Feb. 19, the China Development Bank struck a similar deal with Petrobras, the Brazilian oil company, agreeing to a loan of $10 billion in exchange for oil.
On Saturday, Iran announced that it had signed a $3.2 billion agreement with a Chinese consortium to develop an area beneath the Persian Gulf seabed that is believed to hold about 8 percent of the world’s reserves of natural gas.
“Once again my site is blocked in China. I don’t know why”.
OK, this seems a minor disturbance. But the question remains, what might the blogger feel if all of his speech were muzzled? This is just the reason why it is so very important for every, EVERY, blogger, citizen and organization to fight against the bastards who seek to quash freedom of speech. One can not emphasize this enough. There is NO middle ground.
Just as the vagaries of the CCP internet policy have seemed to block this sight for some unknown reason, still there are thousands, AND THOUSANDS of well meaning citizens in China who have no protection from the Chinese State, and who are actually locked up in state jails and black jails, just for doing nothing more than speaking their minds.
There is only one way to fight this so that everyone can be free to speak. Everyone must always be in the battle, and as aggressively as possible.
There is still room for hope. 1990, this blog would not be allowed. However, what is being said and what might be said if all controls were removed is the difference between an ant and an elephant.
The more the State tries to limit the free exchange of ideas, then the more it is the moral responsibility of everyone to fight back. Otherwise, living under a State without the freedom of expression, it is like being not human. It is just too objectionable and not acceptable. It is truly like being just half a person. Most people on this blog probably do not know what it feels like. But not having freedom of speech is just about the worst thing that could befall anyone. It is like being manacled from the heart instead of the hands. And it is terrible.
Out flow of hot money, or Chinese government secretly dumping USD? This is the way to do it without causing the collapse of USD.
You are indeed blocked in Shanghai. Funnily, acces works fine via China Mobile Blackberry, though…
I have a question for you Mr. Pettis.
It has been bandied about that China is in a position similar to the USA position in the Great Depression, because it is export platform to the world, and thus has more to lose from protectionism than current account deficit countries. You may also have said this.
I wonder about the relevance of the gold standard. Countries that could not depreciate their currency because they kept to the gold standard did far worse than others who were able to depreciate. See http://www.voxeu.org/index.php?q=node/3280.
I wonder whether the modern day Chinese currency peg functions, from the USA point of view, like the 30′s gold standard. In the 30′s
“countries abandoning the gold standard and allowing their currencies to depreciate saw their balances of payments strengthen”
But the USA can’t take actions that make its currency depreciate vis a vis China, that is because China is intervening for its own purposes to peg the currency. Therefore the flexibility that the USA needs to pull out of this slump is not going to be available, and USA may be more impacted by this slump more then some were anticipating. Because of the peg, USA may suffer inordinately, especially as compared to China. Your thoughts?
Prof Pettis,
Again,shouldn’t we be glad to see headline figures coming down a bit?
There are other factors affecting reserves other than hot money which you haven’t mentioned.For example,the US treasury bonds prices are declining which has a major negative impact on chinese reserves.
On the real economy side,there are news about foregin importers defaulting on their buying from chinese exporters.
Sergei, exactly right. If Chinalco purchased a foreign company, it would reduce PBoC reserves. If SAFE bought shares in a foreign company, there would initially be no change in the amount of foreign assets held. Depending on whether those shares were held in the trade or investment account, subsequent changes in share price might or might not affect the PBoC balance sheet.
Curious, we can get some sense of this by looking at inventory levels. If they are rising either one of two things must happen. Either they correctly anticipated future increases in demand, or, if not, they will have to be run down in subsequent months, thereby acting as a drag on production.
Dr. Loo, it is not a stupid question. There is no formal definition of hot money and each person’s definition depends on what he is interested in measuring. Very broadly the term is used to mean money that moves quickly in and out of a country to take advantage of short-term profit opportunities or to avoid risk, but there are lots of grey areas whose inclusion as hot money depends on what you are trying to measure. In my case I am interested in anything whose movement might have a monetary impact, via PBoC purchases and sales of RMB. By the way hot money outflow are often referred to as “flight capital.”
Twofish, I am pretty sure that this is not the case. The currency “bet” on the RMB was actually a good one since the RMB rose and Chinese interest rates were higher. At any rate there is a lot of anecdotal evidence to the contrary. For example check out this article that Keith Bradsher sent me today. As for your second point, the relationship between hot money flows and confidence is self-reinforcing, so there is some truth in what you say, but few people actively involved in developing countries would disagree with the statement that changes in confidence are a major driver of hot money flows, especially outflows.
Tyaresun, all these deals, if they take place, will eventually cause outflows from the PBoC’s balance sheet, but none of them has occurred yet and so probably cannot be included in the January numbers. Most analysts track those in trying to understand the components of capital flows.
Seatrus, the evidence is not that the PBoC is dumping USG bonds but rather is increasing their purchases. For example although total reserves were down in January, PBoC holdings of Treasury bonds was up – I believe by $12 billion but I am quoting from memory so don’t trust the actual number. At any rate if the PBoC were selling USG bonds they would have to use the cash to buy some other foreign asset and it would have no immediate net impact on their balance sheet.
Lark, yes the comparison with the 1930s is a point I have made several times. Competitive devaluations were a pretty important factor in distributing the impact of the crisis, and clearly they matter. I am not sure I would make to close a comparison between the Chinese currency peg and problems with the gold standard peg, but you are right to consider the monetary implications for all the countries involved of pegs and depreciation strategies. These are almost certainly going to figure largely in any future account of the current crisis.
MoneyIllusionist, as with most broad economic indicators, a change can reflect either “good” reasons or “bad” reasons. If headline reserves were declining because of surge in consumption, that would be great. If they declined because of outward investment by Chinese corporations, that would also be good. If they decline however because Chinese businessmen are worried about rising risk, that is probably a bad thing. I don’t think the decline in reserves reflects declining US Treasury prices. I think they have actually been rising, but even if they have declined, it wouldn’t be by much. At any rate the PBoC probably carries the bopnds at book, not at market, so changes in their value don’t show up. Finally if foreign importers are defaulting on their purchases, it would already show up in the trade numbers.
I can’t be the only growing tired of NitWit’s propensity to speak on behalf of 1.3 billion Chinese “manacled from the heart”. The CPC might not do a very good job of representing me at all times, but that doesn’t mean you get appointed to the position.
Re: Brad Setser followed up the much-quoted article with another one, calling Jan’s TIC data “a disaster”. Are China and the United States both potentially facing the withdrawal of “hot money”…?
Sorry CCT but every blog seems to attract grandstanders. As long as comments are not totally irrelevant I try to approve them.
As for your second point, I think the problem for the US is not the withdrawl of hot money but rather the opposite. Too much money is pouring into the US as the “safe haven,” causing the dollar to rise against most other currencies. This is making the trade adjustment more difficult.
Sorry… forgot to say great post – can’t wait to read your next one!
CCT remarks that the population of China is 1.3 billion. But this is a misnomer. As everyone knows, there is a plus or minus discrepancy of at least 10 percent for most developing nations.
Add to this the factor that the Chinese can not track down their population with any true certitude, due to their one child policy, meaning that many families hide the second child, makes arriving at a true China population very difficult for anyone to figure.
Anyone who has read the many reports knows that this so called 1.3 billion figure is in great debate. Probably the true figure is much closer to 1.5 billion, these days.
But what is an extra 200 million, here or there, knowing that China is already overpopulated by about 5 times the reasonable carrying capacity for this area.
Sure, one can quibble about the actual numbers. But we will see, in the very near future, just how the overpopulation of China plays out during the next 20 years. Hopefully, CCT will be one of those who is paying attention.
Michael,
Understood… some people just like to travel with a soapbox.
I’m sure you saw Brad Setser’s newest entry? (Sorry.. I’m really not qualified to come up with original thoughts here. I just pass on the insights I glean from the two of you.) He says in part:
“It is also striking that — for all the talk of safe haven flows to the US — foreign demand for all long-term US bonds has effectively disappeared.”
Moving to the short-end of the yield curve… well, a cynical way of seeing it is cold-money becoming increasingly hot. A potentially scary trend, and today’s Fed action only makes me squirm a little more.
In the recent World Bank Report on China they write:
Moreover, reserves are so large that, even if, as is unlikely, a few hundred billion dollars of non-FDI capital were to leave China, that would not be a major concern. (p 24)
I realize that “a few hundred billion” is a small fraction of $2T, but this struck me as rather cavalier in a deflationary environment.
Pettis: The currency “bet” on the RMB was actually a good one since the RMB rose and Chinese interest rates were higher.
Things are great bets, until they aren’t. Once dollar credit dries up and all your short term credit gets cut and you can no longer roll over loans, then you are scrambling to convert RMB back to dollars to close your loans.
We basically saw this happening all over the world, so it’s likely that it also happened in China.
Pettis: Few people actively involved in developing countries would disagree with the statement that changes in confidence are a major driver of hot money flows, especially outflows.
On the other hand, what we had was a crisis of confidence in the US financial system, and things worked differently than in your average emerging market. What was striking and very different from your average emerging market is that as you had a collapse in confidence in the US financial system, everyone moved to short term treasuries which pushed the dollar up.
There really wasn’t a push model, but rather a pull model. It didn’t matter what the local business environment in Latvia or South Korea was, once you had a panic in the United States, it pulled cash from everywhere else.
Michael: Too much money is pouring into the US as the “safe haven,” causing the dollar to rise against most other currencies. This is making the trade adjustment more difficult.
In the case of China, dollar appreciation + pegged currency means smaller deficit. With everywhere else, the crashing demand is swamping any impact in currency. I suppose one hidden bit of good news is that when the US trade deficit plunging, there is no real pressure for any sort of protectionist measures.
Qingdao, one of the legacies of 1997 is that too many people who should know better think that the only risk of capital outflows is that it could force a devaluation leading to an explosion in dollar-denominated debt. These people keep pointing to China’s $2 trillion and saying “no problem.” Aside from the fact that they should also be pointing to China’s low levels of external debt, they are missing the real risk in China, which is, as you point out, the monetary consequences of outflows.
Michael: I have been reading the debate here with interest. You said “the only risk of capital outflows is that it could force a devaluation..” Is this the only risk? When there are risks there are opportunities as well. What opportunities can you see under such circumstances?
Michael, I’m interested on your thoughts about the impact of the Fed’s ‘printing press’ approach on China, the current account deficit, & Chinese reserves. Many say this will drive down the dollar. Will that make it more difficult for China to maintain the peg? In general, how will it impact Chinese trade relationships? thanks.
Great Blog Mike. I think hot money outflow is very likely given as smart money anticipating years of sub par growth ahead and relative overvalue of CNY currency and assets compared to it’s Asian neighbor and competitors. Even if China can hold its ccy from deval, in the next round of global booming CNY assets should underperform other regions so at least for me it doesn’t make any sense to hold CNY denominated assets for now.
Regarding policy reaction to the outflow from Chinese authorities, I suspect they will try to maintain the peg to USD for now as there’s subtle clue that China has the political ambition to internationalize Yuan and make it a major settlement and reserve currency, (there’s some official talks about it if I didn’t remember wrong, and they are settling up swap agreement to various Emerging countries even those outside of Asian), and an unstable currency contradicts that ambition. However, as the whole world engage in Quantitative Easing one by one, all the deflation and depression pressure will be transferred to China if they still keep CNY appreciate on a Trade Weighted basis. So I expect CNY devalue at some stage, maybe not necessarily against USD, but definitely precious metal/commodities which can preserve real purchase power.
Also, as China’s trade balance shrink (good chance to slump into deficit next month), they will be forced to reduce US Treasury holdings no matter China/ US like to see it or not. So my macro trade idea right now is to pay USD rates (2.6% in 10y now, down side 260 bps, while upside could be 1500 bps or more in a black swan situation), long commodity, and hedge the risk of sharp risk reduction from wipe my portfolio by long equity puts.
Just sharing a bit of my view here to get more discuss/debates on your Blog ?
DJ Jiancong Duan: Very interesting post. What I fear is if the supply of US$ keeps exceeding the demand then a serious problem will arise. I will not be surprised to see a Big Mac at US$50.
Mr. Pettis!
How is the connection between the investment-consumption-export work?
I mean,if the export fall,the investment and the consumption have to fall,and the consumption fall have to mean an additional fall in the investment.
I assume that the initial fall in the export have to mean a fall in the investment by the percentage of the investment in the GDP (so,5 percent fall in GDP due to the smaller export have to mean a 2% additional drop in the investment)
What is your oppinion?
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Rock on mr. pettis aka banker man…
It seems clear that the Chinese want to diversify their holdings away from USTs and use the purchasing power that they still have to purchase assets abroad that they will need in the future. Eventually, the amount that they use to purchase Peruvian iron ore mines, Argentine plantations and Chilean copper plays will show up as a decline in their foreign exchange reserves.
Last spring I took the kids to Xi’an for their three week March break holiday. While I was there I had breakfast with a former official from AVIC, who seems very well connected and used to be a very important player when I worked in China in the 1990s. He pointed out that one way to hedge the risk of a USD collapse was to have the Chinese use their reserves to buy companies that hold a great deal of debt. Frankly, I am surprised that they have not made more attempts to purchase large natural resource companies that have a need to refinance.
> Note 2: Once again my site is blocked in
> China. I don’t know why– I
> hope it only has something to do with last
> week’s NPC meeting and will
> be fixed soon – but until it is resolved my
> formatting will be screwed
> up and I won’t be able to respond to comments.
I am sure you are aware you are no longer blocked in China. But if you want to be able to get around the local censorship, may I recommend you install Tor http://www.torproject.org/ and use it with the Firefox web browser and either the “torbutton” or “foxyproxy” Firefox plugins.