The debate about the renminbi rages on. But while economists debate the pros and cons of keeping the peg, widening the CNY/USD band or a large, one-off revaluation, little attention has been paid to the financial consequences for the People's Bank of China as it defends the current regime. These are important and our estimates suggest that the current regime is more sustainable than it might at first appear.
Hot and cold capital flows into China last year caused the FX reserves to rise $202 billion. Building a strategic stock of capital has important benefits. One can use it to recapitalise banks, buy oil from overseas or keep it for a financial crisis.
But while you are building up such a stock there is usually a cost: inflation. So, one of the problems that a country receiving such large FX inflows has to resolve is how to 'sterilize' all these inflows, ie how to ensure all this new money does not cause money supply, and thus inflation, to rise too sharply.
Sterilisation usually requires the central bank to issue securities to the banks, an action which takes money out from the banks and locks it up on the central bank's balance sheet. The banks cannot create money on the basis of the securities they receive from the central banks. Most central banks lose money when they sterilise since they have to pay a lot of interest on the securities they issue.
Was this the case for the PBoC in 2004? To work out the PBoC's net cash flow for 2004, we also have to look at the income it received from investing China's FX reserves abroad.
Sizing up the first part of the PBoC's income statement, the cost of sterilisation, is easier than the second, the investment profits. But we have come up with the two numbers, and adding them together tells us that the PBoC's cash flow in 2004 was positive. It made a profit.
Of course, this result is based on a number of assumptions. We try and spell these out below.
Although there is a lot we cannot be certain about, we can be pretty sure about a few things. First, the PBoC's costs are mounting as the volume of bill issuance rises to meet the large FX inflows.
Second, because where money market rates are - low in China, and rising higher in the United States as the Federal Reserve tightens - the outlook for the PBoC's cash flow in 2005 is good, at least in terms of cash flow.
Third, the result has not caused us to change our view that a band widening of, say, 3% would benefit China's economy.
In the rest of this article we report some of the numbers we have come up with, and explain what we think they mean.
How is inflation controlled?
First of all, we need to explain briefly what sterilisation is all about. China's financial authorities have used three tools to control money supply growth, and thus the inflationary impact, of the large FX inflows.
First, the PBoC has taken money out of the system and locked it up on its own balance sheet by issuing and trading securities. There are two main tools here - PBoC bill issuance and repo trading.
Both involve securities being sold to the banks, and the money the banks use is thus locked up on the PBoC's balance sheet. All this is money that otherwise the banks would have lent out to customers, which would have caused money supply to grow more quickly.
PBOC figures shows the net issuance of bills over the last couple of years - with a sustained run-up in net issuance during late 2004.
We estimate that the sales of these securities allowed the PBoC to sterilise about 37% of total USD inflows in 2004. That is a sizeable chunk, but it still leaves $128 billion of the FX inflows entering the economy freely.
If this was the only tool being used by the PBoC, then both money supply growth and inflation in China would be running much higher. So, how else is the government preventing inflation?
The second method is through higher required reserves ratios. Since the banks have to park more of their deposits at the PBoC, they have less money to lend to customers. This also suppresses money supply.
The PBoC raised the reserve ratio (after lowering in the late 1990s) from 6% to 7% in September 2003, and then to 7.5% in April last year. Another hike cannot be ruled out.
Manipulating this ratio was a common method in Europe and even the United States a while back. Now central banks in mature market economies prefer to use open market operations, ie trading securities.
Third, the PBoC has been providing 'window guidance' to China's banks. This guidance officially involves the PBoC guiding the banks on where they should be lending - less to steel plants, more to small and medium enterprises, for instance. One could argue that there is a case for this as long as bank interest rates remain controlled.
However, it is not just the direction of lending that has been affected - it also seems to be the volume too. Since April 2004, the banks' willingness to lend out new deposits has fallen dramatically.
Before this date, every new Rmb1 put on deposit with China's financial institutions would result in Rmb1-2 worth of new loans being made. Since this date, however, financial institutions have needed Rmb3-4 worth of new deposits to issue just Rmb1 worth of new loans.
Why such a sudden and widespread shift in credit behaviour at the banks? They seem to be extremely keen to meet the government's credit growth target. This sharp deceleration in the so-called bank multiplier is the most important means by which credit growth has been reduced.
But what are the costs?
So far this three-pronged strategy has worked well. Inflation appears under control and bank loan and M2 growth are back at manageable levels. As a result the peg and the FX inflows have not disrupted the domestic economy too much. This is actually a remarkable feat.
What are the costs and benefits of this policy? Start first with the financial cost to the PBoC. The PBoC has to pay interest on the bills and repos it issues to the banks. We calculate that the PBoC spent Rmb21.5 billion ($2.6 billion) on the interest payments on its bills and repos in 2004.
And the costs are rising. We estimate that February 2005 cost the PBoC Rmb2.6 billion ($313 million), compared to Rmb1.0 billion ($120 million) in February 2004.
What about the PBoC's income? China's FX reserves were invested in other countries' assets, which would have paid a return in 2004. But how much?
It all depends, of course, on how China's FX assets were invested. We created two portfolios, which generated $11 billion and $18 billion respectively in 2004.
How did we come up with our portfolios? We made a series of assumptions about what currencies and what assets were in the portfolio. We made educated guesses - only a few people staff within the PBoC and SAFE know the real numbers.
We split both our portfolios 76%-24% in terms of USD and EUR assets by the end of 2004. The portfolios started the year with a higher USD weighting because we suspect the PBoC was diversifying out of USD in its new purchases during the year.
Each portfolio was invested in a group of securities, the first being invested in a mixture of 2-10 year Treasury bills, the second in a mixture of lower yielding, shorter term notes and bills issued in the US during 2004. We invested the EUR assets in a range of EUR-denominated debt securities. We then generated revenues based on these assumptions. The portfolios delivered returns of $11-18 billion in 2005. We think the real number is probably closer to the higher estimate: it is about a 3.6% return on capital invested during the year.
Overall, our core finding - that the PBoC made money in 2004 - appears safe. Netting off the costs of domestic bill issuance, we can estimate that it made a cash profit of $8.4-15.4 billion.
Why is China's central bank apparently making a profit from the peg, while most other central banks lose money in such circumstances? Two reasons: low domestic interest rates and a large stock of FX assets.
Take Korea, for instance, where so-called FX stabilization one-year bonds were sold for 3.85% in March 2005. The equivalent PBoC bill was priced at 2.82%. Compare these to a 3.83% rate for the equivalent US instrument, and it is clear that - at least in balance sheet terms - China's central bank is under much less pressure than one might have expected.
But the profitability of these operations is also determined by the big difference in scale between securities invested overseas and securities issued domestically. It started 2004 with $405 billion to invest and outstanding bills of only 47bn. That helps a lot.
Sadly, however, the current arrangement is not costless. Far from it.
Credit is now apparently being controlled more by volume than by price. It seems that lending 'guidance' is encouraging banks to lend money into the money markets (driving down rates there) rather than lend to clients. And it seems that the competition among banks to lend out to customers is still so intense that none of them are willing to raise the rates on their banks loans for fear of losing customers.
As a result money is still probably too cheaply priced. This means that the bank loans that are made will likely be put into inefficient investments. The difficulties involved in getting access to credit will mean more corruption.
Profitability at the banks, particularly the big four, is being hit since they rely on the spread between deposits and loans to make money. As deposits mount up, and loan growth remains comparatively slow, and money market rates drop, the margin gets squeezed.
If there is a winner it is China's securities companies, who borrow vast sums through the money markets. Still, they deserve a break.
The other big issue is sustainability. The Standard Chartered CNY Barometer shows the pressure continuing to build for a revaluation of the CNY. The CNY has devalued on a trade-weighted basis of some 15% since 1997, and this is now resulting in a spiralling trade deficit.
Rates in China's money markets, on which PBoC bills and repo transactions are priced, are low and may even fall further. In the US we expect the Federal Reserve to continue hiking the federal funds rate, to 3.75% by the end of 2005.
This means that PBoC should continue making a profit since the spread it makes on every new dollar sterilised will likely rise. However, the danger is that the FX inflows continue to grow rapidly, driving money market rates to even lower levels, and overwhelming the PBoC's ability to sterilise enough of them to stop inflation.
If inflation does rise, and the People's Bank has to raise bank interest rates rise to contain it, then obviously the spread narrows and the costs will become more obvious.