There has been a particular graph which originated from Russell Napier of CSLA circulating around the web that caught my attention this past week. It shows the year on year growth of foreign exchange reserves of china (Figure 1) and to accompany it, Figure 2 is the dollar amount in foreign exchange reserves. It was particularly noteworthy because as you can see from the big red downward looking arrows, whenever the growth in china’s foreign exchange reserves has slowed down significantly there seems to have been some correlation with crash in the US economy. The first arrow emerges just before the Tech Bubble in the 2000’s, the second occurs during the GFC, and the third is presently ongoing, which started just last year. These are all visible in Figure 2 from the relatively flat periods of China’s Foreign Exchange. But unlike the skyscraper index, the activity in the graph would be more likely to have a direct impact on the actual economies itself, as it affects things like exchange rates and the balance of payments that give rise to foreign exchange reserves.
Source: efinancial news
So we will begin by briefly looking at the basics of increasing or decreasing China’s foreign exchange reserves. Since China runs a trade surplus where money flowing into the economy is greater than outflows, in the exchange rate market there is more demand of the Yuan than the supply from free market operations, therefore leading to an appreciation of the Yuan. As the Chinese central bank does not want an appreciation of the Yuan they legally print money and purchase the leftover demand from foreign currencies in the market, causing the exchange rate to remain stable and leads to an accumulation of foreign currency reserves in the Chinese central bank. What they do with the foreign currency reserves is they purchase bonds and other foreign denominated securities like Australian Bonds and European bonds, but mostly US-treasuries due to its reputation of safety.
This process may have contributed to the asset bubbles in 2001 and 2008 and the subsequent crash (bear in mind the other factors that would have also contributed such as lax lending rules and irrational exuberance). However, it’s hard to see how the asset bubbles could have reached the heights they did without the extraordinary growth in Chinese forex reserves. This is because it would have kept US interest rates low leading to increased consumption, increasing debt accumulation due to easy money and thus leading to economic growth. China has also been a beneficiary of this process by increasing its own exports and economic growth as well during this period.
As of right now, the forex reserve growth is slowing down, the hot money inflows which previously came from foreign direct investments has pulled back significantly due to fears on China’s short term growth and its own bubble fears. Another contributing factor is that the wealthy, as well as the politicians, are also taking their money out of the country and putting it into safer foreign assets. Exports to China’s largest market Europe has also taken its toll on the current account, therefore the central bank doesn’t need to intervene as much in the currency market, reducing the growth in forex reserves.
If we start seeing back-to-back negative growth in China’s foreign exchange reserves it would mean China is becoming a Net seller of US treasuries, thus the bond yields will increase and the US will need to quickly find another way to fund its debt. However this is an unlikely scenario given the 3 trillion in foreign exchange reserves China’s central bank currently holds, it is more likely to stabilize this amount than cut it down.
Russell Napier also pointed out from figure 3 that China has accounted for 45% of the world’s money supply growth compared to the US’s 15% since 2007. This has changed in recent times where we have seen both US and Japan use QE to increase the monetary base, however these have been mostly failed experiments in inducing substantial actual changes in the money supply category of M2. Since Chinese banks are mostly under state control, the printed money should technically flow easier into the economy.
As China no longer needs to print money to stabilise the Yuan, who will contribute to money supply growth in the medium term? Europe is in austerity and using QE, US and Japan are wild cards as to whether or not their QE will eventually work. These procedures have a profound effect on the monetary base, but not the money supply most relevant to the economy. In any case we shouldn’t rule out the extremely unlikely event of a global deflationary shock in the not-too-distant future just like the one that has been hitting Japan for some time now.
So in the end, is figure 1 suggesting an upcoming crash in the US or a global economic shock? Perhaps but inconclusive, it really depends on one’s view on the valuations of US assets like stocks, bonds, houses. Also bear in mind that economic data is still weak in the US and that they are still recovering from their last crash. There has also been significant deleveraging occurring creating a reduced probability of a debt-fuelled bubble bursting which is central to how China’s foreign exchange reserves activities affected foreign economies in the past. Going forward what this graph does tell us is that the good days of easy money and stable year-on-year economic prosperity during the 2000’s – 2007 well might be over if China’s foreign exchange reserves continue its trend.