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Thursday, November 13, 2008 7:11 PM

Strange Case of Falling International Reserves Explored

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Inquiring minds are pondering a chart from the Strange Case of Falling International Reserves.

As of August 2008, as you can see from the graph, International Reserves were growing at the explosive annual rate of 26.5%. Suddenly, since August, Reserves have stopped growing.


I’ll leave you with this question: what is the significance of the drastic change in the growth-trend of International Reserves, from explosive growth, to the sudden beginning of a contraction?
Hot Money Inflows

The enormous growth of reserves in China are a direct consequence of billions of US dollars invested in China and deposited in Chinese banks by US supranational firms. These US firms are using Chinese contract manufacturers or US subsidiaries to produce cheap goods for the US market and elsewhere. This requires the People's Bank of China (PBOC) to buy US securities as reserves against US firms' massive bank deposits in country.

Bernanke's Savings Glut

In an attempt to keep its export machine humming, China is printing massive amounts of Renminbi (RMB, frequently called Yuan) to exchange for dollars so as to suppress the value of the RMB. Printing RMB to buy dollars hardly constitutes "savings". Yet amazingly in June, 2008 Bernanke Blamed The Housing Bubble On A Savings Glut in China and emerging markets.

Diversification Calls Revisited

Most do not understand that the PBOC needs to hold US$ reserves against the massive amount of US firms' deposits due to the lack of direct convertibility of the Renminbi.

The Chinese banking system is too immature/fragile to deal with the scale of direct hot money flows that would otherwise occur were the Chinese currency directly convertible. It is arguable that the banking system has not done well with backdoor money flows via Hong Kong and elsewhere, which was the primary driver of the recent Shanghai bubble and crash.

Remember all those calls for China to diversify out of the dollar into Euros, Australian dollars, Swiss Francs, Canadian Loonies, New Zealand dollars etc? The reason China didn't is because it knew that someday there would be an exodus of hot money from China and it would need dollars, not some other reserve currencies when it happened.

This is just a trickle now, but imagine what selling massive amounts of Australian or New Zealand dollars to buy US dollars would do to the currencies of those countries. For a hint, look at Iceland.

Repatriation of US Dollars

When US firms need to repatriate funds from Asia (as is now happening), the PBOC is required to sell US securities via a book-entry transaction to the Fed which in turn is required to pay in US dollars for the security. The net reduction in the reserve balance technically has the potential to reduce Chinese deposits and thus loan growth and eventually money supply growth thereafter.

Please see Peter Schiff Hugely Right, Enormously Wrong as Hard Landing Hits China for more on the collapse of manufacturing in China, an exodus of workers from Chinese cities, and decoupling theories gone completely wrong.

What About The Trade Imbalance?

The rate of change of the growth rate of the US trade deficit has begun to suddenly contract, due to a collapse in consumer spending, exemplified by the plunge in the Baltic Dry Index. (See Baltic Dry Shipping Collapses).

This collapse in shipping may result in trouble at some point as shipments are held up by refusal to honor lines of credit. In other words, certain well-established chains of supply have given up the ghost, and this could soon be felt by consumers all over the world in the form of shortages.

Outside of US energy imports, most of US "imports" enter as "exports" from Asia, which are in fact goods produced by US subsidiaries and contract producers. In other words, US firms "export" financial capital, capital equipment, and knowledge goods to Asia and in turn receive "exports" of intermediate and finished goods returning to the US as "imports" (and to the rest of Asia and elsewhere).

If one were to adjust the US current account deficit for US imports from US subsidiaries and for energy imports from US integrated oil companies with capacity worldwide, the actual US trade imbalance is no more than 2% of GDP.

This is why economists will be puzzled in the years ahead as the reported US trade deficit dramatically shrinks in trade-weighted US$ terms with a firm or rising US$, falling "imports" (in reality a dramatic decline in, or contraction of US subsidiaries production in Asia), and a contraction in US "exports" (US firms' investments in Asia and elsewhere).

Expect to see a narrowing of the reported trade deficit from ~7% to 2% or less of GDP (now at slightly less than 5%). This is completely unexpected by most trade experts.

Mike "Mish" Shedlock
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