Scary Bad Increase in Chinese Foreign Currency Reserves

In general, I’m not terribly fond of imprecise and emotion-laden terms such as “scary bad”. However, in this case, the more accurate description might be “mind-numbingly awful, pointing to increased financial instability.”

Michael Pettis gives us a very thorough report on the stunning and mystifying report from China that its FX reserves increased by $75.4 billion in the month of April alone. To put this in context, China already has the world’s largest foreign exchange reserves, and unbelievably, the pace of its growth in FX reserves is accelerating. FX reserves grew $247 billion in 2006, and then the addition almost doubled in 2007 to $462 billion. And now the growth in April is nearly half the growth of the first three months of the year.

Pettis is quietly horrified. The increase is well out of proportion to changes in China’s trade surplus. It appears to be in large part due to hot money inflows (from where, one might ask. The Middle East? Japan? Those seem to be the only places with large enough surpluses of their own to throw around). Dani Rodrik, Ken Rogoff, and Carmen Reinhart have all argued that high levels of international funds flows are correlated with financial instability. This announcement does not bode well for markets getting back on an even keel.

From Pettis:

An article just came out on Reuters claiming that inside sources have revealed that China’s foreign currency reserves at the end of April were $1.7567 trillion. If this is true that means that reserves grew in the month of April by $74.5 billion, the biggest one-month reserve jump in China’s history (and probably in the history of the world).

These Reuters reports have been correct in the past, but I am reluctant to believe the article because this number blows out anything I was expecting…

First quarter reserve growth of $154 billion was unbelievable. China has a number of regulations that limit money inflow, and these are usually set according to quotas for the calendar year, and so I had assumed that this would have boosted first quarter results relative to the rest of the year as investors filled their annual quotas immediately. But I would have been wrong…..

It is really hard to know what more to say about all of this. Last week Brad Setser was marveling at the Chinese balance of payments and wondering if there was any definition of “sustainable” that could possibly accommodate this level of reserve growth – almost certainly not, he concluded, and it is hard to disagree.

What makes the process so worrying is that after we have backed out all the things we can easily explain, there is still $230 billion of inflows of which we cannot easily account. Stephen Green of Standard Chartered Bank argues that foreign currency lending and PBoC swaps may account for a portion of first quarter reserve growth, but even if we accept all his numbers, they still only account for a small share of this massive unexplained amount. What else can it be?

Clearly at least part of it must be hot money inflows. For most of the past few years it was China’s trade surplus that drove the astonishing growth in reserves. As I argued way back in 2004 and 2005, China had locked itself into a trap in which rising trade surpluses, the consequence of an undervalued and pegged currency, were causing too-rapid monetary expansion as the PBoC was forced to buy the foreign exchange inflows.

This monetary expansion was channeled by the banking system into higher and higher levels of fixed asset investment, and all this investment resulted in soaring industrial production which, since consumption could not keep up, resulted in ever growing trade surpluses (the trade surplus is the gap between production and consumption). It was hard to know how China could exit the trap without a much more rapid appreciation of the currency.

We have reached what I believe is the end stage of this trap in which the monetary system is forced to adjust through appreciation and inflation. The problem is that in such a case there is a huge risk that hot money inflows destabilize the adjustment process, and this seems to be exactly what is happening. Instead of reducing foreign exchange inflows, the appreciation of the RMB is causing massive hot money inflows (which is not at all surprising, but it has been made much worse by China’s bad luck of having to adjust in the middle of the sub-prime crisis) and so the adjustment must be much more dramatic and much more painful. No matter how quickly China tries to reduce monetary expansion by appreciating the currency, in other words, monetary expansion grows even faster.

Right now much of the attention in China is still focused on the results of the devastating May 12 earthquake. Two unfortunate consequences of the earthquake are likely to be reluctance from the authorities to deal aggressively with these out-of-control money inflows, and the granting of indulgences to the banks that will allow them to ignore lending quotas and to forgive debt a little too easily. An article from today’s China Economic Review explains:

China’s banking regulator ordered banks to write off bad loans caused by the May 12 earthquake in order to reduce the debt burden on survivors and help overall reconstruction, state media reported. “If borrowers suffered huge losses that can’t be covered by insurance … the loans should be regarded as bad loans and written off in a timely manner,” the China Banking Regulatory Commission (CBRC) said. The CBRC and the People’s Bank of China previously urged banks to extend loan maturities and not to push for loan repayment if debtors in quake-hit regions fall behind in payments. Zhang Yun, vice president of Agricultural Bank of China, said the preliminary estimate for the bank’s bad loans from the earthquake was US$863 million. Banks have agreed to lend US$11.9 billion to Sichuan province for relief and reconstruction.

There is quite a bit of detail in the post, for those of you who have appetite for that sort of thing.

And I hate to say it, if I had any easy way to trade the RMB, I’d have bought it a long time ago. Any pegged currency right now looks like the safest financial bet in town. So this is yet another case of seemingly rational investor actions leading to undesirable outcomes.