10 September 2015
China’s foreign exchange reserves declined in August by US$94 billion to US$3,600 billion. It serves as a reminder that after years of massive reserve accumulation, recent data seem to point to stalling reserves. This seems consistent with the overall decline in external imbalances and in particular the shrinking of the U.S. current account deficit. The stabilisation of international reserves should be seen as a good thing. Yet, at the same time it may signal an end to abundant international liquidity. A new scramble for international liquidity may have started.
In 1964, Robert Triffin inferred that the international economy may soon suffer "the end of the dollar glut."1 The view was based on the assumption that the U.S. may return to balance-of-payments equilibrium withdrawing needed dollar liquidity for the rest of the world. The slowdown in reserve accumulation may today raise similar concerns. Countries’ preference for holding abundant reserves may no longer be satisfied (Triffin’s argument holds strictly only under closed capital accounts).
The end of massive foreign exchange reserve accumulations may today mark a new phase in the demand for and issuance and distribution of international liquidity. Foreign exchange reserves have peaked in June 2014 at US$12,000 billion and have declined every quarter although only modestly through March 2015 to US$11,430 billion. The large accumulation of reserves started in the early 2000s, from US$2,400 billion in 2002, and can be attributed largely to China and emerging markets through 2011 (Chart 1). Since 2011, advanced economies, notably Switzerland, represented an increasing proportion of total reserve accumulation. The share of China and emerging markets in total foreign exchange holdings increased from 40 percent in 2002 to 68 percent in 2011 and declined to 66 percent in 2015. The accumulation of reserves has remained highly asymmetric in nominal terms with China, Japan, Saudi Arabia and Switzerland representing more than half of total official foreign exchange reserve holdings. China’s and Switzerland’s move to allow more exchange rate flexibility since the beginning of the year have been key developments to explain a decline in reserve accumulation.
The large reserve accumulation has been accompanied by important cumulative external surpluses of China and emerging markets. Reserves peaked at 26 percent of GDP of China and emerging markets in 2009 broadly in line with a subsequently more moderate increase in cumulative external balances (Chart 1). The important counterpart to China and emerging markets surpluses has been the large cumulative current account deficit of the U.S. The U.S. cumulative current account deficit in 2000-2015 was US$8340 billion compared with China and emerging markets cumulative reserve accumulation of $6859 billion and world reserve accumulation of US$9650 billion. The decline of the U.S. current deficit from 1.6 percent of world GDP in 2006 to an estimated 0.6 percent in 2015 illustrates the increasing scarcity of reservable assets (Chart 2).
The relative decline in international reserves may mark a fundamental shift in the international economy. The large reserve accumulation has allowed significant monetary expansions in many countries, as reserves have been funded by issuance of domestic currency, and offered cheap lending to the reserve currency issuing countries. This transfer of resources now ends. It will require countries to adjust.
The decline in reserve accumulation signals the end of abundant international dollar liquidity. It should give rise to a new debate of whether the international economy is sufficiently equipped to facilitate orderly balance of payments adjustments. The relative decline of dollar liquidity should strengthen focus on alternative sources of international liquidity. Mr Triffin would approve.
1 The Banker, London, June 1964, pp. 351-354.
China’s GDP growth slowdown is being announced as the next big risk for the world economy. Recent economic developments appear to confirm that China will continue to decelerate. However, it is not clear why a slower growing China poses a problem at all for the rest of the world. It is China’s current account that matters, that is whether China adds to or withdraws resources from the rest of the world.
The IMF annual assessment of China’s economy (2015 Article IV Consultation, 14 August) projects a further slowdown of China’s GDP to 6 percent in 2017 and a stable range of 6-6.5 percent through 2020. This implies indeed a significant decline from the average growth rate of 9.6 percent in 2000-14. China’s growing size implies that even at a slower pace it continues to contribute the bulk to world nominal GDP growth in US$ terms and has been adding more US$ GDP to world GDP than the U.S. since 2006.
It is the current account that matters though. The current account represents the interface between a country and the rest of the world. It shows how many net resources a country withdraws from the rest of the world. A current account surplus implies that a country is lending its resources to the rest of the world allowing trading consumption over time. China’s high current account surplus has allowed to transfer consumption abroad supporting higher levels of aggregate demand in the rest of the world (admitting other possible explanations on the effect of current account imbalances exist). The latter holds if the rest of the world is willing or able to pursue expansionary policies (which some countries notably in Europe may not).
China’s economic impact on the rest of the world will not depend on its GDP growth rate but on its current account. Luckily for the rest of the world, China’s current account surplus has been expanding in percent of world GDP since 2011 thus offering increasingly more net resources to the world economy (Chart). If only China would divert its continued lending binge away from largely the U.S. government, the rest of the world would probably benefit even more.
The relationship between fundamentals and the exchange rate has been lose at best. The most important international price, the eurodollar exchange rate, has shown remarkable volatility despite near convergence of inflation rates in the U.S. and Euro Area. Yet, the G20 Finance Ministers Communiqué of 5 September stressed the G20’s “commitment to more market-determined exchange rate system and exchange rate flexibility to reflect underlying fundamentals.” Prima facie evidence suggests that the poor correlation between fundamentals and the exchange rate makes the G20’s call seems wrong footed at best and bad policy advice at worst.
Exchange rates do often seem to exhibit a random walk. Fundamental variables such as relative outputs, money supplies and interest rates provide poor guidance for predicting floating exchange rates. The convergence of policy rates between some of the leading central banks has further reduced the importance of interest rate differentials for determining the exchange rate. While anticipation of changes in policy rates could be sufficient to induce an exchange rate adjustment, reasonable expectations of such differentials do not seem to warrant the sharp exchange rate adjustments observed. The euro depreciated by 24 percent from US$1.3953 in May 2014 to US$1.0552 in April 2015.
The G20’s call is aimed at China. China’s intervention in the exchange market are seen as inconsistent with the notion of “market determined exchange rate to reflect underlying fundamentals.” While it naturally holds that exchange market intervention may prevent market-based exchange rate formations, it may not necessarily be inconsistent with fundamentals. China would be ill advised to allow greater exchange rate flexibility to better reflect fundamentals. It would achieve a more market-based exchange rate but it is unclear that this would amount to reflect better on China’s fundamentals.