How to value China’s reserves

March 27, 2011, 9:28 p.m. EDT

How to value China’s reserves

Commentary: Inflation trumps interest-bearing asset performance






By Richard Cooper






BEIJING ([You must be registered and logged in to see this link.]) — One of
the arguments put forward for resisting the revaluation of the Chinese
yuan is that China will “lose value” on its large foreign-exchange
reserves, held mainly in U.S. dollars but also in sundry other
currencies. If China’s exchange rate is moved, for example, by 10% from
6.6 yuan per dollar to 6.0 yuan per dollar, the yuan value of China’s
reserves will fall by 10%, thus reducing China’s wealth.




This argument is arithmetically correct, but economically incorrect.
China’s wealth will not decline with revaluation of its currency.



This point is perhaps most dramatically illustrated when considering the
impact of a devaluation of a country’s currency. With devaluation, the
local-currency value of foreign-exchange reserves will rise. The greater
the devaluation, the greater the rise, goes the thinking.



But of course, currency devaluation will not make a country richer
(although it might make its products more competitive in foreign
markets); its wealth will not have increased. Similarly, currency
appreciation will not reduce the wealth of a country. To believe
otherwise represents an inappropriate application of conventional
accounting to the balance sheet of the monetary authorities (including
the State Administration of Foreign Exchange, in China’s case).



How can China’s reserves lose value, i.e. purchasing power? The basic
channel is through higher prices in dollars for the goods and services
it purchases in world markets. If world prices in dollars rise, the real
value of a given value of China’s dollar reserves will fall.



To avoid this, China should be concerned with worldwide inflation, or at
least increases in prices of the goods and services which China is most
interested in buying. It is general inflation that should most concern
China.



If it is concerned about price increases in particular products, such as
oil, the indicated action is to buy those products when their prices
are low and store them (assuming they are storable) until they are
needed. Of course, storage is not free, so the expected increase in
prices must be sufficient to cover the storage costs.



And of course, large purchases of such products may bring about the
price increases that are anticipated and even lead to a drop in prices
once the anticipatory purchases cease. Speculation on the future price
movements of commodities is tricky, to say the least; while fortunes
have been made when future price movements have been correctly forecast,
many fortunes have also been lost when the forecasts turn out to be
incorrect. We generally hear more about the winners than about the
losers.



Holdings of foreign-exchange reserves have some built-in protection
against general inflation (as opposed to the price increases for
particular commodities). Reserves are held mainly in the form of
interest-bearing securities, and over time, interest rates will reflect
the rate of inflation.





Lenders generally do not want to see an erosion in the purchasing power
of their investments, so they will lend willingly only when they are
protected against general inflation. That is, if inflation is expected
to rise, interest rates will rise to reflect that expectation. Thus
interest rates on reserve holdings will, over time, adjust to the
expected rate of inflation: The higher the inflation, the higher the
interest rate.




So only “surprise” inflation, not anticipated by market participants,
should result in an erosion of the real value of foreign-exchange
reserves. And these days both Britain and the United States issue
inflation-indexed bonds, so by buying such bonds, agents can even insure
themselves against surprise inflation, at least those captured by the
consumer price indices in the Britain and the United States.




There is a second sense in which analysts may be concerned about a “loss
of value” in foreign-exchange reserves. If the reserves are held wholly
in U.S. dollars, for instance, and the dollar depreciates against other
foreign currencies, such as the euro or the Japanese yen, the reserves
will have lost value when measured in euros or yen. This possibility is
bound to occur from time to time when major currencies are floating
against one another.



When dollars (in the example above) depreciate, citizens may fret about
the decline in value measured in, say, euros. But of course, as we saw
in late 2008 and again in 2010, such movements are typically not always
in one direction. When the dollar appreciates against the euro, the
value of dollar reserves rises when measured in euros.



The broader point is that when we are free to choose the unit of
measurement, all interest-bearing financial assets decline in value
unless they happen to be held in that currency which is appreciating
most rapidly. But the most rapidly appreciating currency is constantly
changing. So to avoid losses when measured in this way, the
currency-composition of reserves would have to change constantly. That
is, financial managers would have to anticipate correctly which currency
will appreciate most during, say, the next month, and move reserves
into it.



There are at least three objections to such a strategy for China. First,
China’s reserve managers cannot foresee accurately which currency will
appreciate most in the next month, month after month, for years. (No one
else can either.) Second, China’s reserves, now in excess of $2.5
trillion, are far too large to move in more than small percentages
across currency markets every month. Third, and most fundamentally, such
a strategy would make central bankers (or other monetary authorities)
into currency speculators.



But central bankers should not be currency speculators. They are in
constant contact with other central bankers around the world, and they
have access to information to which normal market participants do not
have timely access. This makes them insiders, and in well-run financial
markets, insiders are properly penalized for acting on the basis of
their insider information. China’s central bankers have become members
of the international club of central bankers. They should be excluded
from access to other club members, and their analyses, if they have
become currency speculators.



In short, China has chosen voluntarily to build up its foreign-exchange
reserves. It should not be unduly concerned about an apparent loss in
value, whether measured in yuan, goods and services, or other
currencies. [You must be registered and logged in to see this link.]








Richard Cooper is the Maurits C. Boas professor of international economics at Harvard University.








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Craig Stephen's This Week in China


March 27, 2011, 7:32 p.m. EDT

Chinese inflation goes global

Commentary: New China price, as we all pay for wage hikes






By Craig Stephen






HONG KONG (MarketWatch) — Inflation has become a growing concern for
mainland Chinese authorities and is now set to become everyone’s, as
higher-priced made-in-China goods are exported around the globe.




Last week, Hong-Kong-based logistics and consumer-good sourcing company Li & Fung
/quotes/comstock/22h!e:494
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38.30,
-0.75,
-1.92%)

/quotes/comstock/11i!lfugf
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5.00,
-0.47,
-8.59%)
warned that we are now entering a new age, where sourcing
in China will come with higher prices. The company, which is one of the
largest suppliers of Chinese goods for Western retailers, described in a
release that due to China, “the world has basically been in a
low-supply-cost era for the last 30 years. The change in wage policy in
China in 2009 — and the subsequent significant higher export prices —
brings this status quo to an end.”




It added that increased product cost “seems inevitable.” What is more
uncertain is whether consumers around the world will be willing to pay
higher prices for goods, and how this will impact corporate margins and
the global manufacturing landscape. It always seemed inevitable there
would come a time when mainland workers would tire of working for pocket
change to keep the West flush with an endless supply of cheap consumer
products.







Asia's Week Ahead: Hutch & China


Investors will get a look at Hutchison Whampoa's full-year results
and two reports on March manufacturing activity in China, plus
industrial-output data from Japan. MarketWatch's Lisa Twaronite in Tokyo
looks at the week ahead.






Rising mainland wages has been in focus since Foxconn
/quotes/comstock/22h!e:2038
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4.93,
+0.04,
+0.82%)

/quotes/comstock/11i!fxcnf
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0.66,
+0.05,
+7.32%)
hiked wages in response to worker suicides last year. A
new survey last week from Standard Chartered Bank of its clients in
China said they expect wages to increase between 9% and 15% this year,
which is less than some reports, although it said labor shortages are
also widespread.




It added that this is policy-driven, as the central government wants to
raise minimum wages despite broader worries over inflation. But it also
reflects the market dynamics as firms struggle to find workers. Standard
Chartered’s survey found that 45% of firms were finding it harder to
recruit workers this year, despite generally paying more than the
minimum wage. The firms surveyed pay 1,800 to 2,000 yuan ($270-$300) a
month, which is already 30%-40% above the minimum wage.




The response of firms surveyed has been to move production inland,
rather than leave China itself, and increase the use of capital
equipment to boost productivity.




This comes at a time when there is a widening appreciation that, this
time, inflation in China is not transitory, caused by bad harvests or
the like. There is a new China price.




Economists at Bank of America Merrill Lynch describe it as “the new
normal for a new decade.” Put simply, they say consumer-price-index
inflation will be elevated at around 4% in the coming years on the
steadily rising cost of labor in China as it passes the Lewis Turning
Point — that is, the point at which a developing country sees wages
begin to rise quickly as surplus of labor from the countryside tapers
off.




As this is digested, it will have various implications for investors.
For many years, buying what China is buying, and selling any company
that is making the same product as China, has been an investment theme.
Whole industries have been outsourced, as China effectively hollowed out
the industrial base from the U.S., Europe and the rest of Asia, with
its gigantic manufacturing machine primed on cheap labor. Meanwhile,
demand from China’s army of factories sent the price of everything from
steel to coal to copper soaring.




While China’s labor is still relatively cheap, it is no longer the
global cost leader. Given China’s size, it is going to be difficult to
find anyone else to take its place. This means the era of China being a
source of deflation in global markets and easy productivity gains for
many companies looks to be over.




One investment theme getting more attention to play this transition is
manufacturers of machinery and robotics, as China seeks to move up the
value chain. Another area worth taking a closer look at will be
industries that no longer face the same level of price competition from
China. This could give a few more countries the chance to compete with
China.




Li & Fung are in the fortunate position that they take a commission
on all their trading business, so higher prices tend to be good for
them. But many others margins will be squeezed unless companies can pass
these rising prices on to the consumer.




On a wider perspective, China will now move from being a source of
deflation to a global exporter of inflation. That is unlikely to be
accepted by China’s leadership, who have recently complained the U.S.
has been stoking inflation with the Fed’s quantitative easing. The end
game may well come when these higher prices arrive in the U.S. and will
force the Fed’s hand to begin tightening. Then everyone will end up
paying for higher wages for China’s factory workers.


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