The document discusses the Chinese exchange rates and reserves from a monetary approach perspective, emphasizing the accumulation of reserves as a key policy outcome. It highlights the relationship between reserve growth, domestic credit, and nominal income, illustrating the shifts in central bank policy following the Asian financial crisis. Additionally, it addresses potential risks and implications associated with revaluation and the impact of Chinese demographic changes on future monetary policy.

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 2011
D. 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 process
D. 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 Model
D. 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 Data
D. 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 Data
D. 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: 1990-1997
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
D. Sykes Wilford: The Citadel wsykes@laudisi.com 12

13. Whole Period: 1990-2009 Monthly MBOP Estimation Results
Dependent Variable: Foreign Reserve Growth (R/H)gR
Start Period: January-1990
End Period: December-2009
R-Square Statistic 22.37%
Estimated Beta
Independent Variable Coefficient Standard Error T-Statistic
intercept Term 0.14 0.03 4.77
Nominal Income (g(PY)) 0.94 0.16 6.02
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
D. Sykes Wilford: The Citadel wsykes@laudisi.com 13

14. Whole Period: 1990-2009 Monthly MBOP Estimation Results
Dependent Variable: Foreign Reserve Growth (R/H)gR
Start Period: January-1990
End Period: December-2009
R-Square Statistic 22.37%
Estimated Beta
Independent Variable Coefficient Standard Error T-Statistic
intercept Term 0.14 0.03 4.77
Nominal Income (g(PY)) 0.94 0.16 6.02
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
D. Sykes Wilford: The Citadel wsykes@laudisi.com 14

15. Note the Sign Changes and R2
Recent Growth Period: 2002-2009
Dependent Variable: Foreign Reserve Growth (R/H)gR
Start Period: January-2002
End Period: December-2009
R-Square Statistic 77.53%
Estimated Beta
Independent Variable Coefficient Standard Error T-Statistic
intercept Term 0.12 0.04 3.15
Nominal Income (g(PY)) 1.14 0.23 4.94
Domestic Credit Growth (D/H)g(D) 0.12 0.10 1.19
Exchange Rate g(FX) 0.59 0.22 2.64
D. Sykes Wilford: The Citadel wsykes@laudisi.com 15
US 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 i
D. 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 forth
D. 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-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

19. 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
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
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
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-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

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 disruptions
D. 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
600
Smoothed 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 changes
D. 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 paper
D. 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. TOURISTS
D. 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 Land
D. Sykes Wilford: The Citadel wsykes@laudisi.com 28

29. China Demographics 2005
D. Sykes Wilford: The Citadel wsykes@laudisi.com 29

30. India Demographics: 2005
For Comparison
D. Sykes Wilford: The Citadel wsykes@laudisi.com 30

31. Chinese Demographics
2025
D. Sykes Wilford: The Citadel wsykes@laudisi.com 31