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 [email protected]

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 gXrefers 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


0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

Jan

-90

Mar

-91

May

-92

Jul-

93

Sep

-94

No

v-9

5

Jan

-97

Mar

-98

May

-99

Jul-

00

Sep

-01

No

v-0

2

Jan

-04

Mar

-05

May

-06

Jul-

07

Sep

-08

No

v-0

9

Year

ove

r Ye

ar P

erc

en

tage

Ch

ange

, 12

-m

on

th M

ovi

ng

Ave

rage

Growth in Nominal Income Proxy, Smoothed, Using Industrial Production

and CPI data



• (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


-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

Jan

-90

Feb

-91

Mar

-92

Ap

r-9

3

May

-94

Jun

-95

Jul-

96

Au

g-9

7

Sep

-98

Oct

-99

No

v-0

0

No

v-0

1

No

v-0

2

No

v-0

3

No

v-0

4

No

v-0

5

No

v-0

6

No

v-0

7

No

v-0

8

Year

ove

r Ye

ar P

erc

en

tage

Ch

ange

Domestic Government Debt Owned by the Central Bank (D/H)gD



• 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.


-40.00%

-35.00%

-30.00%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

Jan

-90

Au

g-9

1

Mar

-93

Oct

-94

May

-96

No

v-9

7

Jun

-99

Jan

-01

Au

g-0

2

Mar

-04

Oct

-05

May

-07

No

v-0

8

Year

ove

r Ye

ar P

erc

en

t Ch

ange

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


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%

Independent VariableEstimated Beta

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









Domestic Credit Growth (D/H)g(D) -0.26 0.19 -1.38

Exchange Rate g(FX) -0.55 0.15 -3.70

US Rate Changes g(I) 3.98 0.84 4.72


Recent Growth Period: 2002-2009









Domestic Credit Growth (D/H)g(D) 0.12 0.10 1.19

Exchange Rate g(FX) 0.59 0.22 2.64

US Rate Changes g(I) 2.52 0.47 5.32

Note the Sign Changes and R2


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

Independent Variable

Coefficient

(t-statistic)

Coefficient

(t-statistic)

Coefficient

(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)

Domestic Credit Growth (D/H)d

-0.26

(-1.38)

0.12

(1.19)

-4.85 (-

8.17)

Exchange Rate x

-0.55

(-3.70)

0.59

(2.64)

-1.46 (-

6.16)

US Rate Changes i

3.98

(4.72)

2.52

(5.32)

-4.2

(-1.95)D. Sykes Wilford: The Citadel [email protected]

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


0

0.5

1

1.5

2

2.5

3

3.5D

ec-9

7

Jul-

98

Feb

-99

Sep

-99

Ap

r-0

0

No

v-0

0

Jun

-01

Jan

-02

Au

g-0

2

Mar

-03

Oct

-03

May

-04

Dec

-04

Jul-

05

Feb

-06

Sep

-06

Ap

r-0

7

No

v-0

7

Jun

-08

Jan

-09

Au

g-0

9

Esti

mat

ed

Be

ta C

oe

ffic

ien

tGrowth in Nominal Income (Smoothed)


-8

-7

-6

-5

-4

-3

-2

-1

0

1D

ec-9

7

Jul-

98

Feb

-99

Sep

-99

Ap

r-0

0

No

v-0

0

Jun

-01

Jan

-02

Au

g-0

2

Mar

-03

Oct

-03

May

-04

Dec

-04

Jul-

05

Feb

-06

Sep

-06

Ap

r-0

7

No

v-0

7

Jun

-08

Jan

-09

Au

g-0

9

Be

ta C

oe

ffic

ien

t Est

imat

eGovernment Debt Owned By Central Bank

Government Debt is a driver of policy until the late 90s


-8

-7

-6

-5

-4

-3

-2

-1

0

1

Dec

-97

Jul-

98

Feb

-99

Sep

-99

Ap

r-0

0

No

v-0

0

Jun

-01

Jan

-02

Au

g-0

2

Mar

-03

Oct

-03

May

-04

Dec

-04

Jul-

05

Feb

-06

Sep

-06

Ap

r-0

7

No

v-0

7

Jun

-08

Jan

-09

Au

g-0

9

Be

ta C

oe

ffic

ien

t Est

imat

eBetas suggest government debt changes

are not driving the process by the late 90s

Reserve flows are driving High Powered Money, not Debt as was the case earlier


-10

0

10

20

30

40

50

60

70

80D

ec-9

7

Jul-

98

Feb

-99

Sep

-99

Ap

r-0

0

No

v-0

0

Jun

-01

Jan

-02

Au

g-0

2

Mar

-03

Oct

-03

May

-04

Dec

-04

Jul-

05

Feb

-06

Sep

-06

Ap

r-0

7

No

v-0

7

Jun

-08

Jan

-09

Au

g-0

9

Esti

mat

ed

Be

ta C

oe

ffic

ien

tExchange Rate (Yuan per US Dollar, Year over year

Percentage Change)


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


-600

-400

-200

0

200

400

600

800

1000

1200

Sm

oo

thed

Serie

s

Date

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


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 AboutCeteris 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


D. Sykes Wilford: The Citadel

India Demographics: 2005For Comparison

[email protected]

Chinese Demographics2025


Chines Exchange Rates and Reserves from a Basic Monetary Approach Perspective

Business

Transcript of Chines Exchange Rates and Reserves from a Basic Monetary Approach Perspective