ARE SINGAPORE & CHINA GUILTY OF CURRENCY MANIPULATION? (PART II)

In Part I (see here) I shared how a persistent Current Account surplus in the Balance of Payment invariably forces the domestic currency to appreciate. In such a situation, if the country is not a pure free float regime, its central bank will intervene in the forex market to buy up the foreign currencies and sell local currecy in their market. The result is a huge increase in the official foreign reserve balance in the books of the central bank and a weakened local currency. A policy to control and undervalue its domestic currency makes the country more competitive as their exports are cheaper. This causes a structural imbalance in world economy and infuriates disadvantaged countries that leads to trade negotiations and tariff wars. Is it possible to camouflage the build up of foreign reserves? In Part I, I showed how creative accounting made foreign reserves disappear from the books of MAS. In this Part II, let's take a look at China.

A timeline will make the picture clearer:

1978 -- Deng Xiao Peng opened up China
1994 -- China pegged the CNY at 8.28 to USD. The peg remained for next 10 years.
2001 -- China allowed to join World trade Organisation
2005 -- China allowed CNY to appreciate by 2.1 to appease pressure of trading partners.
2005 -- China switched to managed float regime. CNY appreciated by 21% next 3 years.
2008 -- World financial crisis caused an export slump. China put a brake on CNY appreciation with the rate at 6.83
2010 -- CNY allowed to appreciate again.
2013 -- PBOC declared purchase of reserves no longer necessary
2019 -- In August, China lowered the baseline to CNY7 = USD1 after huge tariff imposed by US.

The flat vertical or horizontal patterns in the rate chart above indicate controlled rate movements.  In 2013, Chinese central bank, People's Bank of China (PBOC) declared the accumulation of foreign reserves was no longer necessary. This signals non-intervention and a switch to a lesser controlled free float regime. The post-2013 sea-saw tooth pattern indicates indeed a more open market scenario.

The current account balance provides the background to central bank action on exchange rates.

China's entry to WTO in 2001 emancipated the country in international commerce. Napoleon's 'sleeping dragon' was awakened and its exports went into overdrive. Its current account surplus took on massive numbers to hit US$400b by 2008. Exports plummeted in the 2008 world financial crisis and the pandemic when trade surpluses decreased just as dramatically. The economy is so huge and export driven that any blips on world trade tend to hit their current account dramatically. As the economy recovers from the pandemic, the surplus is building again.

Once again, just as for MAS, the current account surplus and forex intervention to manage rates by China can be seen in the balance sheet of Chinese central bank.

After trade liberalisation in 2001, with trade surpluses building up, PBOC had to accumulate foreign currencies to keep the CNY pegged to the USD at 8:1. The under-valued CNY caused huge trade imbalances in the world. Other countries were robbed of opportunities, so China allowed the CNY to appreciate by 2.1% in 2005. That had little effect as China's trade surpluses continued to build up. PBOC then switched policy to a managed float to try a soft landing for the rates. CNY appreciated very quickly and PBOC had no choice but to continue accumulating foreign reserves to slow the CNY appreciation. By 2013 with China trying to move away from export-driven growth to domestic economy, and trade surplus figures dropping by about US$300b, and CNY appreciated to 6.0000 levels to USD, PBOC declared it was no longer necessary to accumulate foreign currencies.

All these are reflected in the balance sheet of PBOC which show foreign reserves building up all the way to 2015 in line with trade surplus growth. Though PBOC declared in 2013 that it was no longer to accumulate foreign currencies, trade surplus was building again and in the interim period 2013 to 2015, it was still buying up foreign currencies. From 2015 trade surpluses noose dived again, and PBOC sold foreign currencies to support the CNY which had depreciated. The balance sheet shows PBOC holdings of reserves dropped during 2015-2017.

During the period 2015-2017 PBOC shed some USD250b of Treasury Bills. Reading this against the back drop described above, it is apparent China's disposal of US Treasury Bills is nothing but part of normal central bank monetary open market actions to support the CNY. The populist notion that China was trying to get rid of US Treasury Bills to depose USD as world reserve currency is a fallacy.

Then something strange happened in 2017. Trade surpluses began building up again by US$250b to the level of US310b today. The CNY rate showed volatility of usual sea-saw pattern of currency movements in open markets. But from 2017 till today, the foreign reserves with PBOC has remained flat.

The huge current account surplus accumulated from 2017 till today means a massive net inflow of foreign currencies. No one was borrowing that huge amount of money from China and PBOC foreign reserves did not increase. If those funds entered the country, who is holding them? It has to go somewhere.

For years, China's commercial banks hold a consistent amount of foreign assets. From 2015 as PBOC weens itself of trillions of CNY worth of foreign reserves, Chinese commercial banks began building up their holdings of foreign assets. Is that a coincidence? Of course not. Chinese banks could not have acted without the central bank's instructions.

It is very apparent, China now allows foreign currencies to be deposited in local commercial banks to take the heat off criticism of PBOC accumulation of foreign reserves to suppress rates.  This is similar with Singapore central bank shedding reserves off its balance sheet by transferring some holdings to the sovereign wealth fund.

One final chart to look at is China's forex reserves to GDP ratio.

China has the second highest public foreign debt in the world of US$13T, behind the US which has US$30.7T. Yet compared to Singapore's huge reserves to GDP ratio which topped more than 105% recently, China's ratio is currently only about 8% now. It has never exceeded 21%.

At the moment China has about USD3T in foreign reserves. This seems like a massive amount of money but the economy is so large if a financial shock happens, the reserves can run out very fast. China has no worries about reserves for import contingencies because of its huge trade surpluses. At this level of reserves, it is susceptible to a credit crunch. This is especially so because almost all commercial banks are owned by the government. Thus China's reserves are considered low and a credit crunch carries a high risk of a collapse of the banking system.

From 1994 when CNY was pegged to USD at 8.2800, right up to 2015 when it seems PBOC allowed the currency free float, the Renmenbi appreciated about 27% against the dollar. Compare this to the Yen during Japan's meteoric economic rise from 1970 to 1991, in similar 21 years run the Yen appreciated 61%.

In the earlier years between 2001 to 2013 when the economy was export driven, China was reluctant to re-align the USD peg which will cause CNY to appreciate and loose export competitiveness. It probably became more receptive of CNY appreciation as it moved towards a domestic driven economy. In 2019 in response to President Trumps massive tariff, China allowed it's baseline peg to drop to 7.000. The rates since 2019 are free floating within 7.0000-6.2000 band. Trade surplus is building up again, but PBOC forex reserves are flat. It seems foreign assets are parked at commercial banks instead. However, the growth of foreign assets are not at a level that suggest PBOC is depressing the rate.

The answer to whether China is manipulating the CNY is not so clear cut as far as post-2015 is concerned.  Allowing the commercial banks to hold foreign currency deposits looks like a new development of Asian Currency Units in China. How this will play out quantitatively and the consequences is not yet clear.

I guess the bottom line is this. Many countries also peg their currency to some major currency and the economic consequences are the same - reserves build up with trade surpluses. But when an economy is as large as China, this causes major trade imbalances and needs to be addressed. When a country tweaks its exchange rate, whether it is to manage domestic inflation or to gain export competitiveness, the difference is a very thin line. Perhaps it boils down to whether it is done openly, or covertly via creative accounting. Then again, all advanced western countries use the interest rates as their monetary tool. By adjusting their interest rates to control inflation, it has similar effects as managing their exchange rates. What is the ethical difference?