Neely (2017) Chinese Foreign Exchange Reserves, Policy Choices and the U.S. Economy

Risk of exchange rate fluctuation: Insulated by futures and options contracts

• available for businesses in developed economies
• other: government need to manage exchange rate

Central bank:

• buy its own currency in forex market = support exchange rate, side effect: reducing money supply
• buying domestic bonds = increase money supply
  • purchase in forex + buying domestic bonds = sterilize its action on money supply

Capital control: Taxes or restrictions on international transactions in assets like stocks or bonds

Exchange control: capital controls applied specifically to foreign exchange

• The conventional wisdom of the economics profession has been that capital controls are ineffective and impose substantial costs.
• China government: willing and able to rigorously enforce capital controls on both inflows and outflows; and which maintains substantial control over the domestic financial system, capital controls are more likely to be effective
• Regulate outflow: domestic purchase of foreign assets
• Regulate inflow: foreign purchases of domestic assets (reduces the amount of hot money, which likely to move out in a crisis, and thereby facilitates the controls on outflows)

Price of a stable exchange rate: unstable short-term interest rates

Balance of payments of a country ^{1 2}:

• BOP = Current account + Broadly defined capital account
• IMF definition: BOP = current account + capital account + financial account
• current account: country’s trade balance (include income from loans and investments or transfer payments)
  • current account balance = national saving – national investment
• capital account: transactions of capital assets, no impact on country’s production, rate of savings, or income
  • domestic ownership of foreign assets and foreign ownership of domestic assets
  • broadly definied: include central bank reserves; otherwise exclude
• credit in current account = debit in capital account, vice versa
• Balancing BOP:
  • raise exchange rate, hurt export & make import cheaper, also make domestic investment assets less attractive
  • inflation, make export less competitive

Foreign Investment ³:

• Direct investment: Establishing a direct business interest
• Portfolio investment: Investing in financial assets such as stocks or bonds

Businesses and currency exchange rate

• Chinese goods cheaper compared to their U.S. counterparts, making it more difficult for the U.S. firms to compete in common markets
• Chinese export (peaked in 2008) → Growth
• Growth + high domestic savings rate → current account surpluses + capital account deficit
  • high saving, high export = low import, thus current account surplus
  • capital account deficit = accumulation of foreign exchange reserve
• Chinese capital control + capital account deficit = internationally denominated bonds held by authorities (became foreign exchange reserves)
  • low rate of return asset, but very liquid
  • forex reserve help defend domestic currency against speculative attack or to recapitalize the domestic banking system in case of a financial crisis

China export declined in 2009–2015

• forecasted real growth decline → forecasted interest rate & demand of CNY decline
• current account surplus at 2–4% GDP (still healthy)
• capital account declined: balances on direct/portfolio/other investment become more negative
• result: decline in forex reserve (selling USD to maintain CNY value) since June 2014
  • Chinese firms repaying fireign debt
  • Chinese resident seeking to hold foreign assets
  • switch of ownership of foreign assets from official to private Chinese portfolios

Chen and Orlik (2016)⁴ calculate the adequacy of Chinese foreign exchange reserves under alternative assumptions about the effectiveness of Chinese capital controls.

• IMF recommendation: depends on exchange rate is floating or fixed and whether has effective capital control
• IMF methodology: weighted average of exports, short-term foreign debt, other foreign libabilities, and money supply
• China: fixed exchange rate regime
  • if capital control effective: reserve should equal to 10% annual export + 30% short-term debt + 20% other foreign liabilities + 5% of M2 (USD $1.8 Tn)
  • if capital control ineffective: need $2.9 trillion
  • PBOC held $3.3 trillion as of December 2015

Maintain exchange rate target and economic conditions created a demand for foreign assets and drained reserves

• Problem can be solved by positive shocks, e.g., an increase in expected growth that raises demand for domestic assets, without the need for a major policy change

Four policy choices to stem reserve losses:

• tighten capital controls: reduce demand for foreign assets
• tighter monetary policy (higher interest rates): reduce demand for foreign assets
• devalue the CNY substantially
• continuing to sell off reserves gradually and hoping that conditions improve

Tighten capital control:

• people are ingenious at moving money around
• imperfect capital controls tend to become “leakier ” over time.
• Tightening capital controls would counter to the longer-run goal to reduce financial regulation and increase the international use of CNY
• interfere with the efficient allocation of resources, at the cost of Chinese residents; no measurable effect on U.S. economy

Monetary or fiscal policy:

• Tighter monetary policy and expansive fiscal policy have opposite effects on GDP but both tend to raise domestic interest rates and thereby strengthen the CNY
  • both: expand money supply to encourage economic growth
  • fiscal policy (government): tax cut, rebates, govenment spending
  • monetary policy (PBOC): open market operations, reserve requirements, interest rates
• significant fiscal expansion = expensive and increase the debt-to-GDP ratio
  • fiscal policy takes time to formulate and implement and is difficult to adjust rapidly
• monetary tightening would have the very undesirable side effect of slowing domestic growth
  • Growth remains a major priority for the Chinese authorities
  • PBOC maintain liquidity and steady credit growth
• have effects on GDP, impacts U.S. exports, but U.S. exports to China account for only a very small proportion

Devalue the CNY:

• Asset shift to non-CNY assets
  • tighter capital controls would seek to prevent markets from making this asset shift
  • monetary or fiscal policy would change the fundamentals to make asset demand consistent with the desired exchange rate
  • devalue CNY substantially to reduce domestic purchases of foreign assets by making them more expensive and presumably reducing expectations of future returns
• if such a devaluation is to reduce fear of future devaluation, it must be substantial
  • small devaluation that simply increases expectations of future devaluations
• often find that such devaluations provoke inflation
• let CNY float freely: Chinese business have to cope with the uncertainty about the future exchange rate

Defer a decision and continue to sell off reserves

• sell off their foreign exchange reserves to domestic residents
• entire forex reserve portfolio: $3 trillion
  • USD 1.8 trillion in U.S. securities (USD 1.25 trillion treasuries, USD 500 billion agency and corporate debt)
  • sale of the whole $3 trillion forex reserve might raise U.S. yields by 20–30 b.p. along the yield curve
  • if sales is merely a transfer of assets from Chinese authorities to Chinese residents, they might not have any effect at all
• effect of a sale probably much smaller than QE: Chinese sale of U.S. assets cannot signal market participants about future Federal Reserve policy

Diagram summarizing dynamics between different components (roughly):

Bibliographic data

@techreport{
   title = "Chinese Foreign Exchange Reserves, Policy Choices and the U.S. Economy",
   author = "Christopher J. Neely",
   number = "Working paper 2017-001A",
   institution = "Federal Reserve Bank of St. Louis Research Division",
   year = "2017",
   month = "January",
   doi = "10.20955/wp.2017.001",
}