By, Bludord H. Putnam, Stephen Jay Silver, D. Sykes Wilford Presented at the Cass-Capco Institute Conference April 14, 2011

1. Chinese Exchange Rates and
Reserves from a Basic Monetary
Approach Perspective
• By
• Bluford H. Putnam
• Stephen Jay Silver
• D. Sykes Wilford
• Cass-Capco Institute Conference
• April 14th 2011
D. Sykes Wilford: The Citadel wsykes@laudisi.com 1

2. Discussion Points
• We believe the Monetary Approach to the Balance of
Payments (MBOP) offers an interesting, yet simple, way of
considering Yuan valuation and Central Bank Policy
• By looking at the accumulation in Reserves from a MBOP
perspective many of the political issues surrounding the
build-up can be avoided and trade disputes put aside to
focus on general policy.
• Two very different periods of policy have been identified
for the Central Bank
• Monetary Policy post the Asian Contagion is similar to
other countries in the Region
• Data are not reliable, but our research supports the
reported growth rates which we believe drive the process
D. Sykes Wilford: The Citadel wsykes@laudisi.com 2

3. Discussion Points -- Continued
• Strong growth – putting capital to underutilized labor
and urbanization -- has driven the demand for money
• That demand during the recent period has not been
satisfied through domestic expansion of debt
(Domestic Credit) as the Government has attempted to
control Inflationary trends
• Foreign Reserves have filled the vacuum and driven
High Powered Money.
• Revaluation will not change this process and we
believe that the reserve buildup is a desired outcome
of policy.
D. Sykes Wilford: The Citadel wsykes@laudisi.com 3

4. Basic MBOP Model
D. Sykes Wilford: The Citadel wsykes@laudisi.com 4

5. Basic MBOP Model
• Ms = a(R + D), where R = stock of international
reserves held by the bank, and D = domestic
credit
• Combining the basic equations noted above and
moving to percentage change terms (d log terms)
we can write the reserve flow equation as
• (R/H)gR = gY + gP –di – ga – (D/H)gD , where gX
refers to the rate of growth in X.
D. Sykes Wilford: The Citadel wsykes@laudisi.com 5

6. Basic MBOP Estimation Model
• The basic equation in a simple OLS estimation
form with an intercept term yields:
• (R/H)gR =  0 +  1gY +  2gP – 3di –  4ga–  5(D/H)gD + 
• Focusing on
– Nominal Permanent Income Growth
• (R/H)gR =  0 +  1gY*– 3di –  4ga–  5(D/H)gD + 
– We can use Monthly Data
D. Sykes Wilford: The Citadel wsykes@laudisi.com 6

7. Growth in Nominal Income Proxy,
Smoothed, Using Industrial Production
and CPI data
50.00%
Year over Year Percentage Change, 12-
45.00%
40.00%
month Moving Average
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Jul-93
Jul-00
Jul-07
Mar-91
Mar-98
Mar-05
Nov-95
May-99
Nov-02
May-06
Nov-09
May-92
Jan-90
Jan-04
Jan-97
Sep-01
Sep-08
Sep-94
D. Sykes Wilford: The Citadel wsykes@laudisi.com 7

8. Basic MBOP Estimation Model
• (R/H)gR =  0 +  1gY* – 3di –  4ga–  5(D/H)gD + 
• Focusing on
– Domestic Credit Creation
• (R/H)gR =  0 +  1gY*– 3di –  4ga–  5(D/H)gD + 
– Monthly Data
D. Sykes Wilford: The Citadel wsykes@laudisi.com 8

9. Domestic Government Debt Owned by the
Central Bank (D/H)gD
40.00%
Year over Year Percentage Change
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
May-94
Jan-90
Oct-99
Aug-97
Jun-95
Jul-96
Apr-93
Mar-92
Feb-91
Nov-00
Nov-01
Nov-03
Nov-04
Nov-05
Nov-07
Nov-08
Nov-02
Nov-06
Sep-98
D. Sykes Wilford: The Citadel wsykes@laudisi.com 9

10. Basic MBOP Estimation Model
• Rewriting the basic equation in a simple OLS
estimation form with an intercept term yields focus
on permanent nominal income, the domestic credit
factor and the fact the exchange rate did change
somewhat during the period:
(R/H)gR =  0 +  1gY* –  2di –  3(D/H)gD –  4g(FX) + 
Where, FX = the value of the yuan per dollar
exchange rate.
D. Sykes Wilford: The Citadel wsykes@laudisi.com 10

11. Value of the Yuan per US Dollar Year over
Year Percent Change
15.00%
Year over Year Percent Change
10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
-35.00%
-40.00%
May-96
May-07
Oct-94
Jun-99
Oct-05
Nov-97
Nov-08
Jan-90
Jan-01
Aug-91
Aug-02
Mar-93
D. Sykes Wilford: The Citadel wsykes@laudisi.com
Mar-04 11

12. Before Asian Contagion: 1990-1997
Dependent Variable: Foreign Reserve Growth (R/H)gR
Start Period: January-1990
End Period: December-1997
R-Square Statistic 58.19%
Estimated Beta
Independent Variable Coefficient Standard Error T-Statistic
intercept Term 0.36 0.06 6.13
Nominal Income (g(PY)) 0.71 0.23 3.08
Domestic Credit Growth (D/H)g(D) -4.85 0.59 -8.17
Exchange Rate g(FX) -1.46 0.24 -6.16
US Rate Changes g(I) -4.20 2.15 -1.95
D. Sykes Wilford: The Citadel wsykes@laudisi.com 12

13. Whole Period: 1990-2009 Monthly MBOP Estimation Results
Dependent Variable: Foreign Reserve Growth (R/H)gR
Start Period: January-1990
End Period: December-2009
R-Square Statistic 22.37%
Estimated Beta
Independent Variable Coefficient Standard Error T-Statistic
intercept Term 0.14 0.03 4.77
Nominal Income (g(PY)) 0.94 0.16 6.02
Domestic Credit Growth (D/H)g(D) -0.26 0.19 -1.38
Exchange Rate g(FX) -0.55 0.15 -3.70
US Rate Changes g(I) 3.98 0.84 4.72
D. Sykes Wilford: The Citadel wsykes@laudisi.com 13

14. Whole Period: 1990-2009 Monthly MBOP Estimation Results
Dependent Variable: Foreign Reserve Growth (R/H)gR
Start Period: January-1990
End Period: December-2009
R-Square Statistic 22.37%
Estimated Beta
Independent Variable Coefficient Standard Error T-Statistic
intercept Term 0.14 0.03 4.77
Nominal Income (g(PY)) 0.94 0.16 6.02
Domestic Credit Growth (D/H)g(D) -0.26 0.19 -1.38
Exchange Rate g(FX) -0.55 0.15 -3.70
US Rate Changes g(I) 3.98 0.84 4.72
D. Sykes Wilford: The Citadel wsykes@laudisi.com 14

15. Note the Sign Changes and R2
Recent Growth Period: 2002-2009
Dependent Variable: Foreign Reserve Growth (R/H)gR
Start Period: January-2002
End Period: December-2009
R-Square Statistic 77.53%
Estimated Beta
Independent Variable Coefficient Standard Error T-Statistic
intercept Term 0.12 0.04 3.15
Nominal Income (g(PY)) 1.14 0.23 4.94
Domestic Credit Growth (D/H)g(D) 0.12 0.10 1.19
Exchange Rate g(FX) 0.59 0.22 2.64
D. Sykes Wilford: The Citadel wsykes@laudisi.com 15
US Rate Changes g(I) 2.52 0.47 5.32

16. Side By Side Comparisons Imply
Significant Policy Changes
Dependent Variable: Foreign Reserve Growth (R/H)r
Start Period: Jan-90 Jan-02 Jan-90
End Period: Dec-09 Dec-09 Dec-97
R-Square Statistic 0.2237 0.7753 0.5819
Coefficient Coefficient Coefficient
Independent Variable (t-statistic) (t-statistic) (t-statistic)
intercept Term 0.14 (4.77) 0.12 (3.15) 0.36 (6.13)
Nominal Income py 0.94 (6.02) 1.14 (4.94) 0.71 (3.08)
-0.26 0.12 -4.85 (-
Domestic Credit Growth (D/H)d (-1.38) (1.19) 8.17)
-0.55 0.59 -1.46 (-
Exchange Rate x (-3.70) (2.64) 6.16)
3.98 2.52 -4.2
US Rate Changes i
D. Sykes Wilford: The Citadel (4.72)
wsykes@laudisi.com (5.32) (-1.95) 16

17. Recursive Estimations
• Eight Year Window Estimations of Betas
– Charts below report the Betas for variables based
upon an 8 year moving window
– For example in the chart December 1998 refers to
the period 1990 through 1998, and so forth
– Movement in Betas are then graphed
– Again, data are smoothed and monthly estimates
of Nominal Permanent Income and so forth
D. Sykes Wilford: The Citadel wsykes@laudisi.com 17

18. Estimated Beta Coefficient
0.5
1.5
2.5
3.5
1
2
3
0
Dec-97
Jul-98
Feb-99
D. Sykes Wilford: The Citadel
Sep-99
Apr-00
Nov-00
Jun-01
Jan-02
Aug-02
Mar-03
Oct-03
wsykes@laudisi.com
May-04
Dec-04
Jul-05
Feb-06
Sep-06
Apr-07
Nov-07
Growth in Nominal Income (Smoothed)
Jun-08
Jan-09
18
Aug-09

19. Government Debt Owned By Central Bank
1
0
Beta Coefficient Estimate
-1
-2
Government Debt
-3
is a driver of policy
-4 until the late 90s
-5
-6
-7
-8 May-04
Jan-02
Jan-09
Oct-03
Aug-02
Aug-09
Jun-01
Jun-08
Jul-98
Jul-05
Apr-00
Apr-07
Mar-03
Dec-97
Dec-04
Feb-99
Feb-06
Nov-00
Nov-07
Sep-99
Sep-06
D. Sykes Wilford: The Citadel wsykes@laudisi.com 19

20. Betas suggest government debt changes
are not driving the process by the late 90s
1
0
Beta Coefficient Estimate
-1
-2
-3
-4
Reserve flows are driving
-5 High Powered Money, not
-6 Debt as was the case
-7 earlier
-8 May-04
Jan-02
Jan-09
Oct-03
Aug-02
Aug-09
Jun-01
Jun-08
Jul-98
Jul-05
Apr-00
Apr-07
Mar-03
Dec-97
Dec-04
Feb-99
Feb-06
Nov-00
Nov-07
Sep-99
Sep-06
D. Sykes Wilford: The Citadel wsykes@laudisi.com 20

21. Estimated Beta Coefficient
0
-10
10
20
30
40
50
60
70
80
Dec-97
Jul-98
Feb-99
D. Sykes Wilford: The Citadel
Sep-99
Apr-00
Nov-00
Jun-01
Jan-02
Aug-02
Mar-03
Oct-03
wsykes@laudisi.com
May-04
Percentage Change)
Dec-04
Jul-05
Feb-06
Sep-06
Apr-07
Nov-07
Exchange Rate (Yuan per US Dollar, Year over year
Jun-08
Jan-09
21
Aug-09

22. Alternative Estimate of Data
• We can observe the policy changes by the way
Reserves and Domestic credit changes over the period.
• Can we find Causality?
– Domestic Credit to Reserves?
– Reserves to Domestic Credit?
• No. We cannot prove causality
– Policy appears to change dramatically however
– Interruptions occur due to crisis management
– Reserve build up important after the Asian Contagion
• The following graphic uses IMF data in a more raw
form, although smoothed of seasonal disruptions
D. Sykes Wilford: The Citadel wsykes@laudisi.com 22

23. Smoothed Changes in Reserve and
Domestic Credit
1200
(d(H-R) and d(H-D))
1000
800
600
Smoothed Series
400
200
0
-200
-400
-600 Date
D. Sykes Wilford: The Citadel wsykes@laudisi.com 23

24. Issues to Consider
(Ceteris Paribus)
• Revaluation without floating will raise the relative cost of
labor to capital faster than if left to domestic inflation in
labor costs alone but ……
• Attempts to control domestic inflation through tighter
monetary policy seems simply to attract foreign reserves to
fulfill the need for a larger money supply to meet demand,
or The open economy overrules closed economy monetary
policy efforts.
• Today’s Chinese reserve policy is consistent with the needs
of an aging population. Build up the reserves now to use
later as the population ages.
– When will this change
– Who is the loser when it changes
D. Sykes Wilford: The Citadel wsykes@laudisi.com 24

25. Issues to Consider
• Politicians in The U. S. and Europe have benefited from the
Policy followed by China for the last decade:
– Lower inflation in the West
– Deficits are financed easily
• Spend baby Spend
• One could even argue poor banking system governance and
policy was covered up for some time by the demand for
foreign reserves in China
– Policies of not charging significantly capital for bank purchases
of government debt in Europe
– Low interest rates due to excess demand for government paper
D. Sykes Wilford: The Citadel wsykes@laudisi.com 25

26. Risks to Think About
Ceteris Paribus
• Sins in the West could be covered up by bubble
demand
– Fast growth in China led to demand for assets from abroad
– Poor domestic policy covered up
• Housing in the US
• Government debt in the hands of banks
• Spendthrift governments all over the West
• What happens to this demand with revaluation
– Nothing really; there is a one time effect on Reserves
– Everything is a one time event
– The average Chinese wealth will rise relative to the West
• However: TOURISTS with Cameras will arrive!
D. Sykes Wilford: The Citadel wsykes@laudisi.com 26

27. TOURISTS
D. Sykes Wilford: The Citadel wsykes@laudisi.com 27

28. When will China Float the Yuan?
• What happens with a float – Lots of Uncertainty
– Is the Chinese banking system ready for it?
– Are the Western governments ready for it?
– Will labor unrest with slower employment growth arise?
• Demographics may be key
– Can they create enough jobs to keep labour peace?
– Will the domestic banking system develop enough to allow this to
occur without causing disruptions?
– Will the Chinese savings rate drop as aging sets in
– Will the Chinese want to diversify?
• That is the effect may be for the Yuan to actually fall in Value as expectations
adjust.
• Reserve flows reverse and diversification may trump expected return on
capital as the Chinese investors discover Disney Land
D. Sykes Wilford: The Citadel wsykes@laudisi.com 28

29. China Demographics 2005
D. Sykes Wilford: The Citadel wsykes@laudisi.com 29

30. India Demographics: 2005
For Comparison
D. Sykes Wilford: The Citadel wsykes@laudisi.com 30

31. Chinese Demographics
2025
D. Sykes Wilford: The Citadel wsykes@laudisi.com 31