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Chines Exchange Rates and Reserves from a Basic Monetary Approach Perspective

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By, Bludord H. Putnam, Stephen Jay Silver, D. Sykes Wilford …

By, Bludord H. Putnam, Stephen Jay Silver, D. Sykes Wilford

Presented at the Cass-Capco Institute Conference

April 14, 2011

Published in: Business, Economy & Finance

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  • 1. 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 2011D. Sykes Wilford: The Citadel wsykes@laudisi.com 1
  • 2. 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 processD. Sykes Wilford: The Citadel wsykes@laudisi.com 2
  • 3. 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.D. Sykes Wilford: The Citadel wsykes@laudisi.com 3
  • 4. Basic MBOP ModelD. Sykes Wilford: The Citadel wsykes@laudisi.com 4
  • 5. 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.D. Sykes Wilford: The Citadel wsykes@laudisi.com 5
  • 6. 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 DataD. Sykes Wilford: The Citadel wsykes@laudisi.com 6
  • 7. 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 D. Sykes Wilford: The Citadel wsykes@laudisi.com 7
  • 8. Basic MBOP Estimation Model• (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 DataD. Sykes Wilford: The Citadel wsykes@laudisi.com 8
  • 9. 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 D. Sykes Wilford: The Citadel wsykes@laudisi.com 9
  • 10. Basic MBOP Estimation Model• 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. D. Sykes Wilford: The Citadel wsykes@laudisi.com 10
  • 11. 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
  • 12. Before Asian Contagion: 1990-1997Dependent Variable: Foreign Reserve Growth (R/H)gRStart Period: January-1990End Period: December-1997R-Square Statistic 58.19% Estimated BetaIndependent Variable Coefficient Standard Error T-Statisticintercept Term 0.36 0.06 6.13Nominal Income (g(PY)) 0.71 0.23 3.08Domestic Credit Growth (D/H)g(D) -4.85 0.59 -8.17Exchange Rate g(FX) -1.46 0.24 -6.16US Rate Changes g(I) -4.20 2.15 -1.95 D. Sykes Wilford: The Citadel wsykes@laudisi.com 12
  • 13. Whole Period: 1990-2009 Monthly MBOP Estimation ResultsDependent Variable: Foreign Reserve Growth (R/H)gRStart Period: January-1990End Period: December-2009R-Square Statistic 22.37% Estimated BetaIndependent Variable Coefficient Standard Error T-Statisticintercept Term 0.14 0.03 4.77Nominal Income (g(PY)) 0.94 0.16 6.02Domestic Credit Growth (D/H)g(D) -0.26 0.19 -1.38Exchange Rate g(FX) -0.55 0.15 -3.70US Rate Changes g(I) 3.98 0.84 4.72 D. Sykes Wilford: The Citadel wsykes@laudisi.com 13
  • 14. Whole Period: 1990-2009 Monthly MBOP Estimation ResultsDependent Variable: Foreign Reserve Growth (R/H)gRStart Period: January-1990End Period: December-2009R-Square Statistic 22.37% Estimated BetaIndependent Variable Coefficient Standard Error T-Statisticintercept Term 0.14 0.03 4.77Nominal Income (g(PY)) 0.94 0.16 6.02Domestic Credit Growth (D/H)g(D) -0.26 0.19 -1.38Exchange Rate g(FX) -0.55 0.15 -3.70US Rate Changes g(I) 3.98 0.84 4.72 D. Sykes Wilford: The Citadel wsykes@laudisi.com 14
  • 15. Note the Sign Changes and R2 Recent Growth Period: 2002-2009Dependent Variable: Foreign Reserve Growth (R/H)gRStart Period: January-2002End Period: December-2009R-Square Statistic 77.53% Estimated BetaIndependent Variable Coefficient Standard Error T-Statisticintercept Term 0.12 0.04 3.15Nominal Income (g(PY)) 1.14 0.23 4.94Domestic Credit Growth (D/H)g(D) 0.12 0.10 1.19Exchange Rate g(FX) 0.59 0.22 2.64D. Sykes Wilford: The Citadel wsykes@laudisi.com 15US Rate Changes g(I) 2.52 0.47 5.32
  • 16. 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 iD. Sykes Wilford: The Citadel (4.72) wsykes@laudisi.com (5.32) (-1.95) 16
  • 17. 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 forthD. Sykes Wilford: The Citadel wsykes@laudisi.com 17
  • 18. Estimated Beta Coefficient 0.5 1.5 2.5 3.5 1 2 3 0 Dec-97 Jul-98 Feb-99D. Sykes Wilford: The Citadel Sep-99 Apr-00 Nov-00 Jun-01 Jan-02 Aug-02 Mar-03 Oct-03wsykes@laudisi.com May-04 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Growth in Nominal Income (Smoothed) Jun-08 Jan-0918 Aug-09
  • 19. Government Debt Owned By Central Bank 1 0Beta 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 D. Sykes Wilford: The Citadel wsykes@laudisi.com 19
  • 20. Betas suggest government debt changes are not driving the process by the late 90s 1 0Beta 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 D. Sykes Wilford: The Citadel wsykes@laudisi.com 20
  • 21. Estimated Beta Coefficient 0 -10 10 20 30 40 50 60 70 80 Dec-97 Jul-98 Feb-99D. Sykes Wilford: The Citadel Sep-99 Apr-00 Nov-00 Jun-01 Jan-02 Aug-02 Mar-03 Oct-03wsykes@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-0921 Aug-09
  • 22. 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 disruptionsD. Sykes Wilford: The Citadel wsykes@laudisi.com 22
  • 23. Smoothed Changes in Reserve and Domestic Credit 1200 (d(H-R) and d(H-D)) 1000 800 600Smoothed Series 400 200 0 -200 -400 -600 Date D. Sykes Wilford: The Citadel wsykes@laudisi.com 23
  • 24. 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 changesD. Sykes Wilford: The Citadel wsykes@laudisi.com 24
  • 25. 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 paperD. Sykes Wilford: The Citadel wsykes@laudisi.com 25
  • 26. 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!D. Sykes Wilford: The Citadel wsykes@laudisi.com 26
  • 27. TOURISTSD. Sykes Wilford: The Citadel wsykes@laudisi.com 27
  • 28. 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 LandD. Sykes Wilford: The Citadel wsykes@laudisi.com 28
  • 29. China Demographics 2005D. Sykes Wilford: The Citadel wsykes@laudisi.com 29
  • 30. India Demographics: 2005 For ComparisonD. Sykes Wilford: The Citadel wsykes@laudisi.com 30
  • 31. Chinese Demographics 2025D. Sykes Wilford: The Citadel wsykes@laudisi.com 31