Economists don’t like to admit to being stunned by anything, even in unpredictable Asia. Last week, UBS AG’s Jonathan Anderson couldn’t seem to help himself.
The cause of the Hong Kong-based economist’s dismay: China’s currency reserves rose $1 million a minute in the first quarter.
“This is more than just a jump,” Anderson said in his report. “The magnitude and the abruptness of this acceleration are simply stunning.”
After average reserve growth of about $20 billion a month in 2006, February and March this year had increases of almost $50 billion—and $136 billion for the quarter. The total is now $1.2 trillion. “Just when we had convinced ourselves that China’s 2007 releases had nothing left to shock us, the first quarter FX reserve numbers came in,” Anderson said.
While all this raises many questions, three are probably foremost on investors’ minds. One, why are reserves increasing so fast? Two, what in the world will China do with that money? Three, can China continue avoiding big gains in the yuan?
The answer that Wang Qing, an economist at Bank of America Corp. in Hong Kong, offers for the first question is capital inflows averaging $25 billion per month during the first quarter. They may have been related to the so-called forward currency swaps that were carried out last year. Also, he wonders if there was some easing in controls allowing Chinese banks to repatriate offshore assets in order to extend credit domestically.
The second question—what to do with the money—is a more important one and impossible to answer. The 37% surge in reserves over the last year coincides with China’s move last month to set up a fund that may invest in companies in a similar manner to Singapore’s Temasek Holdings Pte. It’s part of efforts to better manage its rapidly growing reserves.
The trend also means the People’s Bank of China will have to work harder.
“This set of numbers will continue to put pressure on the central bank to tighten monetary policies further,” says Ma Jun, an economist at Deutsche Bank AG in Hong Kong.
Ma says China needs to “come up with more rate hikes, more reserve-requirement increases, more foreign-exchange swaps, more central-bank bills and more window guidance to mop up liquidity.” In other words, whatever officials have done to date to slow the growth of China’s money supply, it’s not working.
The third question—what this means for the yuan—is the touchiest of all. The kinds of inflows China is experiencing are curious. They suggest that much of the so-called hot money that exited China in 2006 suddenly rushed back in record amounts in the first three months of 2007.
“There’s no precedent for this in China’s own history,” Anderson said. “And the only time we saw anything remotely close to this in Asian practice was during the 1997 crisis, one of the biggest financial cataclysms we had ever seen in this region.”
The most obvious remedy, of course, is a big yuan revaluation. So far, there haven’t even been hints that it’s possible. Gains in China’s currency will be a political decision, one made not on the economics, but in spite of them. For China’s leaders, job creation is still the most important goal and that means a competitive exchange rate to support exporters. Yet, negative side effects from that strategy keep popping up. In March, China’s money supply grew by more than the central bank’s target for a second month. M2, which includes cash and all deposits, increased 17.3% from a year earlier, above the central bank’s target of 16%.
It’s not that the central bank has lost control; it has done a yeoman’s job keeping inflation under control even as booming exports flood the economy with cash. Yet, policymakers’ past performance offers few clues about whether they can continue to keep China from going off the rails.
A clear signal that could happen is the stock market. China’s benchmark CSI 300 Index of yuan-denominated A-shares has gained more than 55% this year and almost tripled over the last 12 months. It would appear China’s stock investors have found a way to defeat the laws of gravity for now. As stock prices soar, China’s currency is defying global conventional wisdom that it’s undervalued. So far, China has been able to avoid big gains in the yuan by amassing more and more currency reserves. One wonders how much longer that approach will work.
“If those reserve numbers continue to grow at $50 billion per month for the rest of the year, then it becomes much more likely that we have a very significant inflows problem on our hands,” Anderson said. “As always, stay tuned.”