Wednesday, April 14, 2010

China: signs of speculative pressure despite slower reserve accumulation

• China’s FX reserve accumulation slowed substantially in Q1 and if needed this could be additional ammunition for the Chinese leadership’s defence of the “USD peg.” However, some of the slower reserve accumulation is due to the valuation impact from stronger USD and we expect reserve accumulation to increase again in Q2.
• Despite the slower growth in reserves for Q1 as a whole, “hot money” inflows appear to have accelerated sharply in late Q1. This underlines that the expected gradual appreciation of CNY could prove extremely difficult to manage without tighter capital controls.

Hot money inflows puts pressure on China

China’s accumulation of FX reserves slowed substantially in Q1, where FX reserves only increased USD48bn to USD2,447bn following USD126bn and USD141bn increases in Q4 and Q3 2009 respectively. However, part of the explanation for the slower growth in China’s FX reserves is probably the valuation impact from the stronger USD that will reduce the value of EUR and JPY holdings in the FX reserve. Adjusting for this valuation impact (assuming 80% USD, 15% EUR and 5% JPY) we estimate FX reserves increased USD84bn, which is a substantial increase but nonetheless a slow down compared to the previous two quarters (see second chart).

Why did China’s accumulation of FX reserves slow in Q1? In the third chart at the bottom we have broken down the change in the FX reserves into the contribution from the trade balance, foreign direct investments into China and the rest which we regard as an estimate for speculative “hot money inflows.” As seen in the chart, the main explanation for the slower reserve accumulation in Q1 is a sharp reduction in the trade balance surplus to just USD15bn from USD61bn in the previous quarter. Part of this is seasonality (surplus is usually low in Q1) and a particularly low trade surplus this year due to a late Chinese New Year holiday.

Speculative capital for Q1 as a whole according to our calculations eased slightly to USD39bn from USD50bn in the previous quarter. On the surface this suggests that speculative capital inflows are not increasing. However, if we look at the development in speculative capital inflows, within close to 70% (USD26bn) was in March, while there were only “hot money” inflows in January and February (see chart on next page). Hence, there are signs that speculative inflows are increasing despite the overall slower growth in China’s reserves.
The increasing speculative pressure is supported by other indicators. The share of USD deposits in China continues to decline and in Hong Kong the share of yuan deposits is again increasing (see chart on next page).

Implications & Outlook

China’s accumulation of reserves slowed substantially in Q1 and this might be additional ammunition for China’s argument that there really is no need to adjusts its exchange rate policy. However, we expect reserve accumulation to pick up significantly in the current quarter. First, the trade surplus should improve substantially in Q2 and second the sharp pickup in hot money inflow in late Q1 suggests this will boost China’s FX reserves substantially in the current quarter..

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