The New Dollar Carry Trade?

June 8, 2008

There’s been much chatter recently from bloggers covering China’s economy. It seems China is raking in foreign reserves at an astonishing rate so far this year. Perhaps as much as $365 billion through April. Drilling down into the sources of that cash suggests the emergence of a new and very sizable “carry trade,” in which investors sell a currency with a relatively low interest rate and buy a different currency yielding a higher interest rate.

[For a primer on the relationship between interest rates and currency values, see this tutorial.]

A very common carry trade the last few years has been to borrow & sell Japanese Yen and use the proceeds to invest in the U.S. and elsewhere. But after the Fed’s significant rate cuts the past few months, the dollar itself may be the new currency to finance speculative bets. China’s exploding reserves provide stark evidence.

China has been a net importer of currency for some time, given their large trade surplus and the interest payments their accumulated reserves generate. And yet these two sources of income explain less than half of the recent increase in reserves. So where is the rest of the money coming from? As discussed below, it appears the rest is being generated by so-called “hot money.” So much is pouring into the country, China’s central bankers may have lost control over monetary policy.

In its January issue, The Atlantic Monthly ran a piece, $1.4 Trillion Question, about the international implications of China’s huge foreign exchange reserves. As of the end of April, it had become the $1.7 trillion question. As I write this, it could be the $1.8 trillion question.

Most stunning isn’t the size of China’s foreign reserves, though that is stunning. It’s the rate at which their growth is accelerating. Note in the graph below, how the slope of the line is increasing.China State Administration of Foreign Exchange

In the year 2000, China had $166 billion of foreign reserves. By January 2004, that number had grown to $416 billion.

At the end of March, the figure was $1.682 trillion. And estimates for April suggest another $82 billion was added that month. At these rates China could accumulate nearly $1 trillion in 2008 alone.

Scary” as Brad Setser puts it, both for the U.S. and for China.

There are two interesting questions to examine in more detail here.

  1. Where are all these reserves coming from?
  2. Could this actually be a bigger problem for China than for the U.S?

Various China commentators, most notably Setser, have observed that less than half of China’s $300+ billion surge in foreign exchange reserves thru April are coming from sources you might expect: the trade surplus, interest income and foreign direct investment.

The trade surplus is the process by which China trades goods with the outside world in exchange for the outside world’s currency–hence “foreign exchange” by the way. China accumulates this foreign currency as foreign exchange reserves, which it invests in various assets. These assets pay interest, adding yet more foreign currency to China’s foreign exchange reserves. But these two sources brought in perhaps $85 billion of the estimated $300+ billion inflow through April.

The other usual suspect, foreign direct investment, brought in only $35 billion.

So what’s the other 60%? It’s so-called “hot money,” a crude term referring to various speculators betting on continued appreciation of China’s currency against the dollar. According to Caijing magazine:

Some experts say a hefty portion of the mysterious cash, if not all, was hot money from short-term investors — with eyes on China’s appreciating currency, real estate boom, credit market and other moneymaking options — who found ways to squeeze through cracks in China’s strictly regulated market.

It’s no secret that China’s economy is powering global growth more than ever. With the U.S. and Europe flirting with recession, and with the continued shift of wealth from West to East through China’s huge trade surplus, it makes sense that investors are going long China. Yuan/Dollar Exchange Rate, 5 years

A primary beneficiary of such China investments is the country’s currency, the Yuan. Three years ago one Yuan was worth 12 cents. Today it is worth nearly 15 cents, a 21% increase.

And speculators would likely have pushed up its value far more if the Chinese government didn’t continue to restrict the range in which it allows the Yuan to trade.

If my readers will permit me to drill down into more excruciating detail, it is fascinating to ponder all the sources of this speculative “hot money,” especially considering the highly restrictive policies that China has instituted to prevent such a destabilizing influx of capital.

Michael Pettis obtained a Deutsche Bank survey tracing the source of China’s “hot money” inflows. The survey showed that Chinese individuals and businesses have numerous ways to import currency.

Besides foreign direct investment, Chinese businesses employ the following tactics to get foreign currency into the country:

  • Under-invoicing of exports and over-invoicing of imports
  • Foreign “donations,” whatever that means
  • Underground money exchangers
  • Paying local employees with foreign currency
  • Borrowing in foreign currency

Individuals have their own clever means:

  • $50,000 per person per year transfers from foreign accounts that are allowed by law
  • Per day transfers of 10,000Yuan from Hong Kong banks
  • Exchanges with local relatives
  • Underground and legal money changers

All of the above are ways to bring dollars into the country (other foreign currency too, but primarily dollars according to Setser). Converting these dollars into Yuan is a bet that the Yuan will continue to gain value against the dollar. Writ large, you have a massive trade that is long the Yuan and short the dollar.

I hope I haven’t hopelessly confused everyone at this point…assuming I haven’t, we can move on to question #2 above: could this be a bigger problem for China than the U.S.?

Conventional wisdom in the United States is that as China accumulates so many dollars, the country can buy much of the U.S. economy out from under Americans. That certainly IS a threat that should worry all Americans.

And yet in the short-run, such massive inflows of capital pose significant challenges for China too. The first, of course, is inflation.

To keep the dollar’s value from falling even MORE against the Yuan—cutting into Chinese economic growth which is driven by exports—China’s Central Bank must mop up all those dollars that are flooding into its economy by way of the trade surplus, foreign direct investment and “hot money” inflows. It does so by buying up those excess dollars with Yuan.

This just floods the economy with Yuan instead of Dollars—feeding inflation, which stood at 8.5% in April.

Chinese monetary policy is at the mercy of speculators. As Pettis notes: “the currency regime has locked the country into a self-reinforcing feedback loop from which it is going to be very difficult to escape.”

As long as China allows its currency to slowly revalue upward, speculators–expecting continued increases–will bring yet more “hot money” into the economy, leading to more inflation and more pressure to revalue upward. Perhaps the only thing that can stop the speculative inflows, then, would be a massive one-time revaluation of the Yuan, one large enough to convince speculators no more appreciation is likely.

And yet such a move could decimate China’s export sector, making Chinese-made goods suddenly much more expensive in the U.S.

Whatever happens, China’s economy is in for a wild ride. And so are others that are intricately tied to it.

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