Play With ≈$4 Trillion: Reading China's Falling Reserves

PBoC guv'nor Zhou Xiaochuan, second most powerful person in the world?

 If you were to be reborn as a global power broker, chances are you'd choose being Zhou Xiaochuan going by the numbers alone. Yet it is a lot less glamorous than it sounds waking up each morning with $3.89 trillion to play with. You'd think the world's your oyster as you make Norway's sovereign wealth fund look like a pipsqueak, but no, it's not that simple. The People's Bank of China (PBoC) is not an independent central bank after all. Nor does it have enough human capital in comparison to commercial fund management concerns in the West:

But there are limits as well. A government-affiliated institution is not a real company. It can never establish an efficient corporate governance structure as a real company, and its incentive mechanism will never be as effective. There are not enough people managing the forex reserve. Foreign experience shows that every employee in big, global investment institutions manage on average $500 million to $800 million worth of assets. There are slightly more than 500 people on SAFE’s forex reserve management team. That means every one of them oversees about $8 billion worth of assets.

Nevertheless, a particularly interesting phenomenon is that of Chinese forex reserves falling $100 billion in the most recent reporting period. It is being characterized as a "record drop" in PRC reserves unseen since 1986. While this amount represents more than the reserves of most developing nations, it's not all that much in the grander PRC scheme of things when they still have an astronomical $3.89 trillion. Before modern China came around, Japan was the previous record holder with a then-unimaginable sum around the one trillion mark. Still, watchers of the tea leaves of PRC monetary policy have made much of a fuss. There are three versions of similar events here:

1. The speculative version, capital flight edition: China's export performance and hence its forex reserves are falling argument. Gordon Chang cites foreign concerns losing interest in investing in China together with money that's already there heading for the exit:

First, multinationals and others have become much less interested in China as China has become much less interested in them. Direct foreign investment for the first nine months of the year was down 1.4%. Moreover, the prospect for future months is not bright. Beijing’s broad-based and prolonged attack on foreign companies has taken its toll on sentiment...

And that brings us to the second reason for the unexpected Q3 outflow. Hot money looks like a, if not the, main cause. Nathan Chow of DBS Group, in comments to Bloomberg, attributed the drop to concern about “the not-so-great data for August.” Moreover, during September the economy seemed to continue its downward trend, and some of the statistics released in the last few days, especially price data showing China to be in a deflationary environment, confirm that suspicion. Tim Condon of ING Groep called the rush out of China “a flight-to-safety for investors in September.”

2. The speculative version, deflationary pressures edition. Money supply growth is slowing as a result of fewer unsterilized capital inflows leaking into the mainland economy:

Now, as reserve accumulation goes into reverse, so too does the money supply. M2 — which includes currency, checking deposits and some time deposits — grew at just at 12.9% year-on-year for September, versus 14.7% year-on-year for June.

SocGen’s Edwards warns that China faces a looming credit crunch and is already on a deflationary precipice. China’s consumer inflation rate slowed to 1.6% in September, down from 2% previously. The property sector looks to have already begun the trip down: September marked China’s first year-on-year fall in new-home prices, which declined 1.3% according to China’s National Bureau of Statistics.

3. The official version, China's drop in foreign reserves is deliberate edition.

As a result of currency diversification, monetary authorities claim that mark-to-market losses on euros and other non-USD holdings are causing the drop in the recorded amount:

Guan Tao, the top official of the department of international payments at China's State Administration of Foreign Exchanges (SAFE), said that the recent drop in the nation's foreign-exchange reserves was not a sign of capital flight; rather, it was basically because of the devaluation of non-US assets. 

Speaking of these movements being deliberate, PBoC officialdom also suggests lessened intervention to keep the yuan weak as another reason.

China's foreign currency regulator is not concerned by signs of forex outflows, the country's State Administration of Foreign Exchange (SAFE) said on Thursday, saying a recent decline in forex reserves is in line with China's policy goals...[Guan] also said that the central bank was gradually ceasing intervention in the forex market.  

Obviously, these reasons are not mutually exclusive and can all be at play to some degree. Reserve accumulation on this level being unprecedented globally, China has also shown reluctance to cross thresholds, the current one being the $4 trillion mark. Reading too much into this drop in reserves is folly IMHO. Sometimes the official version of events is actually true (really). Unless these reserves drop precipitously in the months ahead, which I do not really expect, there are far more interesting things to talk about.