Market Volatility and China's Hot Potato

money.jpgThe alsways excellent Mark Thoma had a post up a few days ago about a Kenneth Rogoff commentary in the Guardian and also an FT article musing about China's hot potato.

First off Rogoff takes on the question I have also grabbled with lately, most recently just below this one.  Rogoff sets out by concluding that market volaility is in the low end and that investors are laying the blame for this at the door of Asian Central Banks.

(Bold parts are my emphasis)  

'The favored bogeymen of the day are giant government investors, particularly Asian central banks, with their trillions of dollars in assets. These superfunds, whose managers do not necessarily share the same passion for profit as private investors, are said to be squeezing the life out of interest rates and exchange rates. "The big Asian central banks are oppressing us," one young trader recently complained to me.'

However, Rogoff is not sure here ... 

'In fact, the explanation for market calm probably lies elsewhere. So, if a conspiracy of Asian central banks is not to blame for the volatility drought that is parching traders' earnings, what is?

Surely, today's low volatility is partly cyclical. Stock market volatility was also very low during the early 1990s, before reaching new peaks later in the decade. Moreover, financial innovation and globalisation allow markets to spread risk more effectively than ever before, placing it in the hands of those who can best manage it. Improved central bank policy is another huge factor. In the early 1990's, the average level of world inflation exceeded 30%; now it is less than 4%.'

Ending off with a warning ...

So will today's relative market calm continue? Unfortunately, no. Today's brave new world of financial globalisation will almost surely face severe new stress tests, reminding us that recessions still happen.

In the spirit of Rogoff's initial point and also Thoma's narrative why don't we look at those huge Asian dollar assets from a while and from an Asian perspective too (as I always say when I go into this dollar/rmb muddle go see Brad Setser on this since he provides excellent coverage of this.)  So what is China's hot potato then?

(From the FT linked in the beginning - bold parts are my emphasis) 

'(...) the Beijing-based State Administration of Foreign Exchange has a serious, real-world job - to manage China's towering stack of foreign currency holdings.

Once, this would not have mattered much outside China's borders, but the country's swelling trade surpluses and large capital inflows have given Safe an investment pot to rival global fund management giants. Within the next few weeks, China's reserves are due to top $1,000bn - a record for any country, let alone a developing nation like China.

But it is not a moment everyone in China will be celebrating, especially the officials at Safe and their masters at the People's Bank of China, the central bank. "One trillion is a big amount, but it is also a hot potato," says Ha Jiming, chief economist at China International Capital Corp, the country's largest investment bank. "If it is not well managed, any erosion of value will be a source of shame for whoever is responsible for it."'

'The mountain of foreign currency has been generated by years of inward foreign investment, then speculative capital inflows and, more recently, a swelling trade surplus that has deluged the country with dollars. Normally this dollar excess would bid up the renminbi but, to keep the value of China's currency stable, the central bank has bought virtually all the incoming foreign currency and managed the money on its own balance sheet.


The huge value of the reserves has bought to the surface an intense debate within China itself about how the country should manage, and even spend, the funds. Two top leaders, Wen Jiabao, the prime minister, and Zeng Qinghong, a vice-president, both discussed the reserves for the first time in public comments this month.

Mr Wen said the increase had "improved China's overall national strength and international payment capability", though he also acknowledged the downside: the way in which the reserves flow back into the local financial system and feed the distorted structure of the economy.

Mr Zeng said China "would take comprehensive measures to avoid further significant growth" in the reserves. Zhou Xiaochuan, governor of the central bank, was even blunter in impromptu comments to reporters. Asked about the reserves, he replied: "We have enough."


Managing the huge growth in reserves is proving to be high-wire act for Safe and the People's Bank. In buying such a huge stock of dollars, the central bank has had to pay in renminbi and to "sterilise", or offset, the inflationary impact of this money in China's domestic economy, by taking it out of circulation.

To soak it up, the central bank has has to issue short-term securities, most of which have a maturity of one year and some even less. That means the authorities are under ever increasing pressure to turn over their holdings, which were worth Rmb2,903bn ($367bn, £193bn, €286bn), by the end of August.

The securities are bought by state banks, which have excess cash and few other places to park it. "The cost of sterilisation is being shouldered more and more by Chinese banks," says Zhong Wei, chief editor of the official China Foreign Exchange Magazine.

Oh and on a finishing note, there are plenty more in the FT article than I have reported on above.