T C A Srinivasa-Raghavan: China and its forex reserves

OKONOMOS

Mercantilist theories about China's reserves policy are wrong.

So you thought the reason why China has dollars coming out of its ears "" $17.2 billion a month during 2004 compared to $13.5 billion a month during 2003 "" is FDI inflows, right? Or is it portfolio investment? Or both?

Well, you couldn't be more wrong. A recent paper Eswar Prasad and Shang-Jin Wei shows, as only an IMF paper on such matters can, that the reason is" inward loans".

What are these loans, then? They are offshore borrowings by Chinese households and firms mainly, but other things as well.

"The two biggest increases, adding up to about $60 billion, are in the categories of inward loans ""representing offshore borrowing by Chinese households and firms "" and other assets.

This includes significant withdrawals of overseas lending by Chinese banks in order to meet rising domestic demand for foreign currency-denominated loans."

And why is this happening? Because everyone is now convinced that the yuan is going to appreciate vis-a-vis the dollar. "The general direction of all of these flows is consistent with expectations during this period of an appreciation of the renminbi."

The Chinese are on a huge betting spree "" on what they think is a one way bet. "Speculative pressures may have been exacerbated by the positive interest differential between China and the US, which implies that investors may have seen a move into renminbi-denominated instruments as essentially a one-way bet, and one without even an associated carrying cost."

There are, it seems, very significant amounts of unrecorded flows as well trying to get around China's capital controls. Where are they coming from?

"Anecdotal evidence suggests that the money flowing in is primarily accounted for by a reversal of outflows from Chinese households and corporates that took place during the 1990s to evade taxes or to avoid losses associated with a possible depreciation of the renminbi."

Is this build-up of reserves, whatever the origins of the inflows, desirable from the economy's point of view? Since some angst-ridden Indians have been pegging away at this length, let's see what the authors have to say about the issue.

"The literature on the optimal level of reserves (see Aizenman and Marion, 2004, and references therein) does not provide a clear-cut way of answering this question."

It is true that the rate of return on US T-bills is lower than what could be earned on capital investment in the country.

Capital inflows also increase liquidity in the banking system, creating potential problems in a weakly supervised banking system as banks have an incentive to relax their prudential standards in order to increase lending.

Sterilisation also entails fiscal costs as the rate of return on domestic sterilisation instruments is typically higher than that earned on reserve holdings.

But, say the authors, "China however, appears to be a special case in some respects. Its low and controlled interest rates imply that, since its reserve holding are believed to be held primarily in medium- and long-term industrial country treasury instruments and government agency bonds, there are in fact net marginal benefits to sterilisation...there is no clear evidence that the buildup of reserves in China has significant direct sterilisation costs, although it could have some efficiency costs."

From this point on, the paper quickly degenerates from what is happening to what could happen. Basically, say the authors, a lot of things could go wrong such that the benefits mentioned above turn into costs.

"Thus, traditional sterilisation costs may also soon start coming into play."

Now compare this to what India has been doing, which is pretty much the same thing, albeit on a much smaller scale. The question is: if the policy works for China, why should it not work for India?

The answer, some would say, lies in the way the exchange rate is managed. Perhaps, perhaps not.

But one thing is for sure: someone in the reserve Bank of India (RBI) needs to read this paper in full and write a similar paper for India. We need such an analysis, if only to deter scatter-brained schemes about how to use our reserves. The template is there, so it should not be a problem.

The Chinese Approach to Capital Inflows: Patterns and Possible Explanations, IMF Working Paper WP/05/79, April 2005