Chines Exchange Rates and Reserves from a Basic Monetary Approach Perspective

Chinese Exchange Rates and
Reserves from a Basic Monetary
Approach Perspective
• By
• Bluford H. Putnam
• Stephen Jay Silver
• D. Sykes Wilford

• Cass-Capco Institute Conference
• April 14th 2011

D. Sykes Wilford: The Citadel wsykes@laudisi.com 1

Discussion Points
• We believe the Monetary Approach to the Balance of
Payments (MBOP) offers an interesting, yet simple, way of
considering Yuan valuation and Central Bank Policy
• By looking at the accumulation in Reserves from a MBOP
perspective many of the political issues surrounding the
build-up can be avoided and trade disputes put aside to
focus on general policy.
• Two very different periods of policy have been identified
for the Central Bank
• Monetary Policy post the Asian Contagion is similar to
other countries in the Region
• Data are not reliable, but our research supports the
reported growth rates which we believe drive the process


Discussion Points -- Continued
• Strong growth – putting capital to underutilized labor
and urbanization -- has driven the demand for money
• That demand during the recent period has not been
satisfied through domestic expansion of debt
(Domestic Credit) as the Government has attempted to
control Inflationary trends
• Foreign Reserves have filled the vacuum and driven
High Powered Money.
• Revaluation will not change this process and we
believe that the reserve buildup is a desired outcome
of policy.


Basic MBOP Model


Basic MBOP Model
• Ms = a(R + D), where R = stock of international
reserves held by the bank, and D = domestic
credit

• Combining the basic equations noted above and
moving to percentage change terms (d log terms)
we can write the reserve flow equation as

• (R/H)gR = gY + gP –di – ga – (D/H)gD , where gX
refers to the rate of growth in X.


Basic MBOP Estimation Model
• The basic equation in a simple OLS estimation
form with an intercept term yields:

• (R/H)gR =  0 +  1gY +  2gP – 3di –  4ga–  5(D/H)gD + 

• Focusing on
– Nominal Permanent Income Growth
• (R/H)gR =  0 +  1gY*– 3di –  4ga–  5(D/H)gD + 

– We can use Monthly Data

Growth in Nominal Income Proxy,
Smoothed, Using Industrial Production
and CPI data
50.00%
Year over Year Percentage Change, 12-

45.00%

40.00%
month Moving Average

35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
Jul-93

Jul-00

Jul-07
Mar-91

Mar-98

Mar-05
Nov-95

May-99

Nov-02

May-06

Nov-09
May-92
Jan-90

Jan-04
Jan-97

Sep-01

Sep-08
Sep-94



• (R/H)gR =  0 +  1gY* – 3di –  4ga–  5(D/H)gD + 

• Focusing on
– Domestic Credit Creation
• (R/H)gR =  0 +  1gY*– 3di –  4ga–  5(D/H)gD + 

– Monthly Data


Domestic Government Debt Owned by the
Central Bank (D/H)gD
40.00%
Year over Year Percentage Change

35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%

-5.00%
May-94
Jan-90

Oct-99
Aug-97
Jun-95
Jul-96
Apr-93
Mar-92
Feb-91

Nov-00
Nov-01

Nov-03
Nov-04
Nov-05

Nov-07
Nov-08
Nov-02

Nov-06
Sep-98


• Rewriting the basic equation in a simple OLS
estimation form with an intercept term yields focus
on permanent nominal income, the domestic credit
factor and the fact the exchange rate did change
somewhat during the period:

(R/H)gR =  0 +  1gY* –  2di –  3(D/H)gD –  4g(FX) + 

Where, FX = the value of the yuan per dollar
exchange rate.


Value of the Yuan per US Dollar Year over
Year Percent Change
15.00%
Year over Year Percent Change

10.00%

5.00%

0.00%

-5.00%

-10.00%

-15.00%

-20.00%

-25.00%

-30.00%

-35.00%

-40.00%
May-96

May-07
Oct-94

Jun-99

Oct-05
Nov-97

Nov-08
Jan-90

Jan-01
Aug-91

Aug-02
Mar-93

D. Sykes Wilford: The Citadel wsykes@laudisi.com
Mar-04 11

Before Asian Contagion: 1990-1997

Dependent Variable: Foreign Reserve Growth (R/H)gR
Start Period: January-1990
End Period: December-1997
R-Square Statistic 58.19%

Estimated Beta
Independent Variable Coefficient Standard Error T-Statistic
intercept Term 0.36 0.06 6.13

Nominal Income (g(PY)) 0.71 0.23 3.08

Domestic Credit Growth (D/H)g(D) -4.85 0.59 -8.17
Exchange Rate g(FX) -1.46 0.24 -6.16
US Rate Changes g(I) -4.20 2.15 -1.95


Whole Period: 1990-2009 Monthly MBOP Estimation Results

Estimated Beta

US Rate Changes g(I) 3.98 0.84 4.72


Whole Period: 1990-2009 Monthly MBOP Estimation Results

Estimated Beta



Note the Sign Changes and R2
Recent Growth Period: 2002-2009

Estimated Beta

Domestic Credit Growth (D/H)g(D) 0.12 0.10 1.19
Exchange Rate g(FX) 0.59 0.22 2.64

Side By Side Comparisons Imply
Significant Policy Changes
Dependent Variable: Foreign Reserve Growth (R/H)r
Start Period: Jan-90 Jan-02 Jan-90
End Period: Dec-09 Dec-09 Dec-97
R-Square Statistic 0.2237 0.7753 0.5819

Coefficient Coefficient Coefficient
Independent Variable (t-statistic) (t-statistic) (t-statistic)

intercept Term 0.14 (4.77) 0.12 (3.15) 0.36 (6.13)

Nominal Income py 0.94 (6.02) 1.14 (4.94) 0.71 (3.08)
-0.26 0.12 -4.85 (-
Domestic Credit Growth (D/H)d (-1.38) (1.19) 8.17)
-0.55 0.59 -1.46 (-
Exchange Rate x (-3.70) (2.64) 6.16)
3.98 2.52 -4.2
US Rate Changes i
D. Sykes Wilford: The Citadel (4.72)
wsykes@laudisi.com (5.32) (-1.95) 16

Recursive Estimations
• Eight Year Window Estimations of Betas
– Charts below report the Betas for variables based
upon an 8 year moving window
– For example in the chart December 1998 refers to
the period 1990 through 1998, and so forth
– Movement in Betas are then graphed
– Again, data are smoothed and monthly estimates
of Nominal Permanent Income and so forth


Estimated Beta Coefficient

0.5
1.5
2.5
3.5

1
2
3

0
Dec-97
Jul-98
Feb-99

D. Sykes Wilford: The Citadel
Sep-99
Apr-00
Nov-00
Jun-01
Jan-02
Aug-02
Mar-03
Oct-03

wsykes@laudisi.com
May-04
Dec-04
Jul-05
Feb-06
Sep-06
Apr-07
Nov-07
Growth in Nominal Income (Smoothed)

Jun-08
Jan-09
18

Aug-09

Government Debt Owned By Central Bank
1

0
Beta Coefficient Estimate

-1

-2
Government Debt
-3
is a driver of policy
-4 until the late 90s
-5

-6

-7

-8 May-04
Jan-02

Jan-09
Oct-03
Aug-02

Aug-09
Jun-01

Jun-08
Jul-98

Jul-05
Apr-00

Apr-07
Mar-03
Dec-97

Dec-04
Feb-99

Feb-06
Nov-00

Nov-07
Sep-99

Sep-06

Betas suggest government debt changes
are not driving the process by the late 90s
1

0
Beta Coefficient Estimate

-1

-2

-3

-4
Reserve flows are driving
-5 High Powered Money, not
-6 Debt as was the case
-7 earlier
-8 May-04
Jan-02

Jan-09
Oct-03
Aug-02

Aug-09
Jun-01

Jun-08
Jul-98

Jul-05
Apr-00

Apr-07
Mar-03
Dec-97

Dec-04
Feb-99

Feb-06
Nov-00

Nov-07
Sep-99

Sep-06

Estimated Beta Coefficient

0
-10
10
20
30
40
50
60
70
80
Dec-97
Jul-98
Feb-99

D. Sykes Wilford: The Citadel
Sep-99
Apr-00
Nov-00
Jun-01
Jan-02
Aug-02
Mar-03
Oct-03

wsykes@laudisi.com
May-04
Percentage Change)

Dec-04
Jul-05
Feb-06
Sep-06
Apr-07
Nov-07
Exchange Rate (Yuan per US Dollar, Year over year

Jun-08
Jan-09
21

Aug-09

Alternative Estimate of Data
• We can observe the policy changes by the way
Reserves and Domestic credit changes over the period.
• Can we find Causality?
– Domestic Credit to Reserves?
– Reserves to Domestic Credit?
• No. We cannot prove causality
– Policy appears to change dramatically however
– Interruptions occur due to crisis management
– Reserve build up important after the Asian Contagion
• The following graphic uses IMF data in a more raw
form, although smoothed of seasonal disruptions


Smoothed Changes in Reserve and
Domestic Credit
1200
(d(H-R) and d(H-D))
1000

800

600
Smoothed Series

400

200

0

-200

-400

-600 Date


Issues to Consider
(Ceteris Paribus)
• Revaluation without floating will raise the relative cost of
labor to capital faster than if left to domestic inflation in
labor costs alone but ……
• Attempts to control domestic inflation through tighter
monetary policy seems simply to attract foreign reserves to
fulfill the need for a larger money supply to meet demand,
or The open economy overrules closed economy monetary
policy efforts.
• Today’s Chinese reserve policy is consistent with the needs
of an aging population. Build up the reserves now to use
later as the population ages.
– When will this change
– Who is the loser when it changes


Issues to Consider

• Politicians in The U. S. and Europe have benefited from the
Policy followed by China for the last decade:
– Lower inflation in the West
– Deficits are financed easily
• Spend baby Spend
• One could even argue poor banking system governance and
policy was covered up for some time by the demand for
foreign reserves in China
– Policies of not charging significantly capital for bank purchases
of government debt in Europe
– Low interest rates due to excess demand for government paper


Risks to Think About
Ceteris Paribus
• Sins in the West could be covered up by bubble
demand
– Fast growth in China led to demand for assets from abroad
– Poor domestic policy covered up
• Housing in the US
• Government debt in the hands of banks
• Spendthrift governments all over the West
• What happens to this demand with revaluation
– Nothing really; there is a one time effect on Reserves
– Everything is a one time event
– The average Chinese wealth will rise relative to the West
• However: TOURISTS with Cameras will arrive!


TOURISTS


When will China Float the Yuan?
• What happens with a float – Lots of Uncertainty
– Is the Chinese banking system ready for it?
– Are the Western governments ready for it?
– Will labor unrest with slower employment growth arise?

• Demographics may be key
– Can they create enough jobs to keep labour peace?
– Will the domestic banking system develop enough to allow this to
occur without causing disruptions?
– Will the Chinese savings rate drop as aging sets in
– Will the Chinese want to diversify?
• That is the effect may be for the Yuan to actually fall in Value as expectations
adjust.
• Reserve flows reverse and diversification may trump expected return on
capital as the Chinese investors discover Disney Land


China Demographics 2005


India Demographics: 2005
For Comparison


Chinese Demographics
2025


Chines Exchange Rates and Reserves from a Basic Monetary Approach Perspective

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