Growth in reserves continues to astonish. Allegra effects side: yesterday the NDRC announced that reserves had hit $1.455 trillion by the end of October. This means they were up $21 billion for the month of October, after rising by $136 billion in the first quarter, $130 billion in the second quarter, and $101 billion in the third quarter, for a total of $388 billion year to date. This compares with a huge $247 billion for all of 2006, and an already very high $209 billion for 2005 and $207 billion for 2004 (the $117 billion increase in reserves in 2003, a big number then, now seems almost insignificant).
We know that the trade surplus for the month was a record $27.1 billion, and FDI inflows were $6.8 billion, which implies that net other flows were a negative $13 billion, but it is hard to figure out how to think about that number. There may have been an additional transfer to the CIC, and it seems that banks and SOEs (and even retail investors) are being encouraged to hold dollars offshore themselves. The total amount of money that came into China in October through the current and capital accounts, in other words, is a lot higher than $21 billion and is probably even a lot higher than $34 billion (because of hot money inflows), but its impact on the PBoC’s balance sheet has been reduced by PBoC transfers to the CIC and by other capital account outflows.
The CIC can be though of as a sort of “second” central bank although dollars held by the CIC are not, strictly speaking, monetized in the same ways that dollars held by the PBoC are. Because it was (or will be) fully funded by an RMB-denominated bond issue, the money creation associated with CIC holdings are fully “sterilized”, and they are sterilized by the issuance of long term MoF bonds, not central bank bills. These MoF bonds still have an expansionary monetary impact, but clearly they are much less money-like than central bank bills, and the effective substitution in the market of these MoF bonds for PBoC bills (the PBoC has indirectly purchased the bonds but plans to use them as part of its open market operations) will reduce money creation somewhat.
If other entities are holding more dollars, this is also good for China because the domestic monetary impact of the foreign currency inflows into China is limited, but we should be careful not to assume that in this case the monetary impact is zero. For example, if banks are holding more of their reserves in dollars, the PBoC has clearly been spared the problem of buying those dollars and so monetizing them, but at the same time those dollar holdings may free up RMB holdings in the banks that can now be used for loan purposes.
In that case I think the positive monetary impact (i.e.the fact that the PBoC did not have to create currency or bills to buy them) might be negligible – foreign currency inflows are still likely to cause an effective increase in domestic money. In general for any company or individual, and not just for the banks, if holding dollars abroad becomes a substitute for holding RMB investments domestically, I would guess that the monetary impact of dollar inflows is still positive and may be substantial. They do not necessarily need to show up on the PBoC’s books for them to affect domestic monetary conditions. I wonder if any of my readers might have any better insight and chime in here.
I don’t know if there is still a lot to transfer from the PBoC to the CIC before the end of the year (altogether $200 billion were to be transferred this year, and I am guessing that at least one-third was already done), but even if there is, total reserve growth at the PBoC plus the CIC will easily exceed $500 billion this year and may even exceed $600 billion. At 17-20% of GDP, this level of reserve growth cannot help but be a serious problem for domestic monetary policy.
on a different note, Yuan Li, a spokesman for the China Insurance Regulatory Commission, said today at a conference that the twenty mainland insurers that have received QDII licenses are expected to invest mostly in Hong Kong stocks. The insurance companies together have about $400 billion of assets, and since July they have been permitted to invest as much as 15% of their assets abroad – before that it was 5% (although my understanding is that none of them are anywhere near their limits).
QDIIs have been a hot topic since China Southern Fund Management launched the first successful mutual fund QDII on September 12. They expected to raise RMB 15 billion during the just-over-two-week subscription period to fill their QDII quota, but on their first day of subscriptions they received RMB 50 billion in orders (and closed subscriptions that day). SAFE subsequently doubled their quota to RMB $4 billion.
Two weeks later China Asset Management received orders of RMB 60 billion for the launch of their own QDII, whose quota was then also doubled, to $5 billion. The first QDII launch was actually in October of 2006, by Hu’an Fund Management, but they were only able to $200 million of their $500 million quota. This year’s crop was a lot more successful. By the way not everyone in China can be a client of a mutual fund QDII. The minimum investment is RMB 300,000 (about $40,000), so it leaves out nearly all of China’s many small investors.
I am not sure of the exact numbers but I think that there are ten approved QDIIs, not counting the insurance companies (eight fund management companies and two securities firms, CICC and China Merchants), and by the end of the year there will be around three more approved, to raise altogether about $20-30 billion. Next year most commentators expect there to be another $90 billion in funds raised to invest abroad through the QDII program – there are around fifteen fund managers and three securities firms that are slated to get approval.
In principle this is an unalloyed good thing. Not only does it help internationalize Chinese markets and give Chinese firms experience managing money in other markets, but anything that reverses capital outflows helps the PBoC manage the huge inflows China is experiencing through its trade and capital accounts. Money leaving China this way is netted out of the inflows that have to be converted into currency or central bank bills, and that is a huge relief for a central bank struggling to moderate its wild money expansion.
However given the currency situation in China I wonder how these QDII funds can possibly keep their clients happy. Because of the minimum investment size QDII clients are supposed to be sophisticated and knowledgeable about the benefits of diversification, but with the RMB expected to rise by anywhere from 7% to 10% over the next year (with only upside risk), and deposits earning nearly 4%, QDIIs are going to have to be very profitable to jump the low-risk 11-15% hurdle they will have to make in dollars just to break even relative to RMB bank deposits.
Diversification is a good thing, of course, but if all it means is that investors lose money, it is hard to see why anyone would want it; allegra effects side. At any rate from what I understand most QDII money is going to Hong Kong stocks, and the Hong Kong stock market has become pretty highly correlated with the mainland stock markets, so it is unlikely that they will provide much of a hedge, although on the other hand there is a built-in currency hedge for the Hong-Kong-listed stocks of mainland companies. A rising RMB should translate into an automatic rise of their net asset values in HK dollars, which may then result in an automatic increase in their HK share prices.
If QDIIs are conservatively managed they are most likely going to underperform local investment alternatives. In that case instead of more money pouring into QDIIs next year I wonder if we won’t see disgruntled investors begin to withdraw their investments as their returns significantly underperform simple bank deposits. We may see net redemptions next year, rather than more money going into QDIIs.
On the other hand If QDII managers feel compelled to beat the currency-related hurdle to keep their investors, there is the danger that they stretch a little too far for yield and take some ugly risks. If as a manager you expect prudent investing will lead to redemptions, does that create an incentive to go out too far on a limb? I think it might, at least in some cases, and I don’t doubt there will be some dodgy ideas peddled to fund managers. However a nasty performance for one of these QDIIs could sour the whole market, at least in the short term.
It is hard to see why investors should be taking money out of the country much longer when the best game in the world seems to be to bring money into China, especially as the pressure for RMB appreciation increases. If QDII investors do reverse their earlier decision, the monetary benefits of the QDII program could actually reverse next year as investors bring their money back home, and with reserves expected to grow anyway by another huge amount, this reversal will only make matters worse. This might not necessarily apply to the insurance company QDIIs, who may have a different set of incentives, but even for them several quarters of underperformance should at least retard the growth of their QDII appetite.