Journal Issue

People’s Republic of China: 2011 Spillover Report—Selected Issues

International Monetary Fund
Published Date:
July 2011
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China’s annual saving is the largest in the world—even in dollars. During 2010–15, China is projected to contribute more than ⅓rdof global net wealth accumulation, which will impact domestic and external financial conditions. This chapter estimates the impact of this saving on asset prices. China’s closed capital account implies that the saving will significantly raise domestic valuations relative to the rest of the world. Should the authorities seek to alleviate mounting inflationary pressure on domestic asset prices by selling Chinese bonds (and sterilizing with foreign asset purchases), external valuations could also rise. An orderly opening of the capital account that results in net flows into China could lead to declining asset valuations elsewhere, particularly in non-S5 countries.

1. Large saving. On account of its large annual saving, China is projected to contribute more than 1/3rd of global net wealth accumulation between 2010 and 2015 (measured as net investment plus increase in net foreign assets). China’s allocation of this new wealth should have increasingly important, if gradual, implications for domestic and global financial markets.

Global Net Wealth Accumulation

(2010-2015, in trillions of US$)

Source: World Economic Outlook and staff estimate.

2. Analytical framework. To assess the implications of China’s growing influence on global financial markets under current policies, a set of asset market clearing conditions is used (see Appendix I). Relative valuations needed to clear asset markets are calculated for portfolio allocations across regions. An increase in demand for a country’s asset results in an increase in its valuation, under a given path for the exchange rate. (Consistent with the WEO, a constant REER exchange rate path is assumed, which also determines the saving and investment balances.)

3. Rising domestic asset prices. Given capital controls and an undervalued currency, among other factors, China’s non-reserve asset holdings reveal a high degree of home-bias. If, as is likely, capital controls remain in place for the coming years and the managed appreciation of the currency is gradual, the current configuration of asset holdings would likely persist into the medium term. This portfolio “preference”, together with high saving rates, would translate into high demand for Chinese assets that outpaces its supply, resulting in significant domestic asset price inflation. The chart shows the asset price changes (under the given exchange rate path) required to clear markets.

Asset Price Change

(relative to US, in percent)

Sources: World Economic Outlook and staff estimates.

4. Changing portfolios. In the absence of rebalancing policies to slow savings, the authorities may seek to control asset inflation by purchasing foreign assets and selling RMB assets. Such operations reallocate saving toward net foreign assets. A further accumulation of US$600 billion in reserves between 2011 and 2015 would be needed, on top of the baseline increase in reserves (US$2 trillion), to keep real asset inflation at the same rate as in the U.S.

Asset price response to more reserve accumulation from China

(in percent)

Sources: World Economic Outlook and staff estimates.

5. Impact on foreign asset prices. Purchases of foreign assets would result in noticeable asset inflation elsewhere over the 2011-15 period. The impact on non-S5 countries could be larger, should China choose to incrementally hold more of their assets.2 This would be particularly true if more outward direct investment is encouraged as an alternative to reserve accumulation, since 95 percent of China’s FDI goes to non-S5 countries.

6. Capital account liberalization. The gradual opening of China’s capital account would have an ambiguous impact on domestic and global financial markets. Liberalization would bring two offsetting forces: investment into China from abroad, and more Chinese investment in the ROW. The relative strength of these two forces will depend, among other things, on the sequencing and timing of reforms. The chart illustrates a scenario in which even relatively large outflows from China (6 percent of assets reallocated to the U.S., other S5, and the ROW in equal proportions) will not offset a small reallocation of global assets from non-S5 countries to China (to the tune of 1 percent of their assets). The result would be asset disinflation in non-S5 countries.

Asset price response to opening capital account in China

(in percent)

Source: Staff estimates.

Appendix I. Methodology

1. Analytical framework. The impact of China’s portfolio allocation on global financial markets is analyzed in a set of market-clearing conditions. The underlying assumption is that the asset price has to adjust to clear the market, once the portfolio preferences of all investors are given. The following conditions must be satisfied at any moment of time for country i

where Xt is the value of assets in country i; Et is the exchange rate of the currency in country i against a numeraire currency, which is assumed to be the U.S. dollar. So, XiEi is the value of assets in country i measured in U.S. dollars. Wj is the total net wealth of country j denominated in U.S. dollars, aij is the portfolio share of country i’s asset in country j’s portfolio, Ft is country i’s non-reserve net foreign assets denominated in U.S. dollars, and Bij is country j’s reserve held in country i’s asset. For countries other than China, reserves and non-reserve net foreign asset are treated as a single net foreign asset.

2. Comparative statics. If the demand for a country’s asset increases, i.e., Σj=1naijWj increase, XiEi will have to go up as a response. This means either the currency appreciates or the asset price increases, or there is a trade-off between exchange rate appreciation and asset price inflation in the face of rising demand for a country’s asset. The above conditions can pin down a unique set of XiEi for given aij, Fi and Wi. That is, the asset prices in all countries can be determined, once net foreign asset positions, portfolio preferences, and the net wealth of each country are given. To study the impact of changes to certain parameter values, such as aij or Wi, on the asset value, XiEi, comparative statistics can be applied.

3. Calibration. To calibrate parameter values with actual data, the world is divided into four major blocks: the U.S., China, the other S5 (Japan, Euro Area, and U.K.), and the rest of the world (ROW).

  • Fj, namely, the net foreign asset position, is taken from Lane and Milesi-Ferretti’s dataset. When possible, these data were checked against official flow of funds data and official IIP data. These three datasets are largely consistent for Japan, the Euro Area, and the U.K. For the U.S. and China, the official IIP and Milesi-Ferretti data are very similar. The ROW is taken as the residual.

  • Xi, or domestic assets, is the domestic capital stock. Since all cross holdings of assets and liabilities among different domestic sectors will be netted out in the aggregate, the capital stock is the relevant asset for the purpose of this exercise. Capital stock data for the U.S, Japan, Euro Area, and U.K. are taken from the OECD. For China and ROW, a capital/output ratio of 2 is used to back out the capital stock.

  • ai, or the portfolio allocation: to calibrate aij, first, foreign assets were divided into portfolio investment and FDI. For countries other than China, portfolio investment data are from CPIS and FDI from OECD. Intra Euro Area investment was netted out. For China, the FDI data are from the official Chinese statistics, which break down the stock of FDI by country. For portfolio investment, official data are used from the U.S. and Japan, along with some CPIS data, and a few assumptions were made to back out the geographical allocation. Then, the weighted average of portfolio investment and FDI and the net holding of domestic asset were used to calculate aij. For countries other than China, reserves were treated as part of foreign assets, as they are generally small compared to a country’s overall foreign assets. Therefore, for all countries except China, aij also reflects reserve holdings and Bi is subsumed into Fi. However, for China, reserves are treated separately and aij is calculated by excluding reserves, given the scale and dominance of reserves. All calibrations are based on end-2009 data and all nominal variables are converted into 2009 U.S. dollars.

4. Summary calibrations. The following is a summary of main input to the scenario.

  • Portfolio allocation matrix. The rows signify the country or region whose net wealth is distributed geographically according to the columns. So, China holds 96 percent of its net wealth domestically, 2 percent of its non-reserve foreign assets in the U.S., and the remainder equally across the other S5 and the rest of the world.

Portfolio Allocation Matrix
China 1/0.020.960.010.01
Sources: Staff Calculation

Excluding reserve assets.

Sources: Staff Calculation

Excluding reserve assets.

  • Domestic asset and net wealth

Domestic Asset and Net Wealth(in trillions of US dollar)
Domestic Asset31.510.056.338.2
Net Wealth 1/
Sources: Staff Calculation

Excluding reserve assets for China.

Sources: Staff Calculation

Excluding reserve assets for China.

  • China’s foreign reserves

China’s Foreign Reserves (end 2009)(in billions of US dollar)

5. Change in net wealth during 2010-15. To calculate the increase in net wealth, WEO projections are used. Investment between 2010-2015 net of 4 percent annual depreciation of existing capital stock provides the increase in domestic asset. The cumulative current account balance between 2010 and 2015 yields the change in net foreign assets. For China, the change in net foreign assets is further broken down into changes in non-reserve assets and reserves, with reserves allocated to each region based on existing allocation. Portfolio preferences are assumed to be fixed. The following are the results:

Change in Domestic Asset(in trillions of 2009 US dollar)
Sources: Staff Calculation
Sources: Staff Calculation
Change in Net Foreign Asset(in trillions of US dollar)
USChina 1/S3ROW

Excluding reserve accumulation.

Excluding reserve accumulation.

China: Reserve Accumulation(in billions of US dollar)

Prepared by Kai Guo (SPR).

The S5 or “Systemic 5” economies are China, the Euro Area, Japan, the U.K., and the U.S. The assumptions are that China will allocate half of the reserve accumulation to the rest of the world (ROW), or about US$ 1.2 trillion. Of the remaining half, 2/3rd goes to the U.S. and 1/3rd to the other S3.

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