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A three-country stock-flow consistent model: A study of the diversification of

China's foreign reserves

Jun Zhao and Marc Lavoie

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Outline

Introduction

Other work on diversification

Theoretical framework

Experiments and simulation results

Conclusion

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Introduction (1)

China and Japan are by far the two biggest holders of foreign reserves as well as the two biggest foreign holders of US dollar securities.

China’s total foreign exchange reserves rose to US$1.7 trillion at the end of March 2008, the largest in the world.

A change of policy by the Chinese monetary authorities is likely to have an impact on relative exchange rates and economic activities throughout the world.

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Introduction (2) Some Chinese economists (Zheng and Yi , 2007; Wang,

2006) have emphasized that China’s actual reserves have far exceeded its normal demand.

They claim that huge foreign exchange accumulation has created large opportunity costs and wealth losses due to a weakening dollar. They have suggested to diversify foreign exchange reserves.

A sudden shift away from dollar assets could destabilize financial markets and, in their view, put upward pressure on US interest rates. They conclude that a gradual small-scale diversification would be beneficial and preferable.

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Introduction (3)

In order to assess the possible qualitative effects of diversification of the Chinese foreign reserves, we propose the use of a stock-flow consistent model, describing three countries each with its own currency.

The three countries are presumed to be China, the USA and the rest of the world, which we will call Euroland.

A important feature of our model is the assumption of imperfect asset substitutability.

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Introduction (4)

Europe is assumed to be on a floating exchange rate regime with the US and China, while China and the USA are tied by a fixed exchange rate (although this is only partly true, because China moved onto a managed float exchange rate regime in July 2005, with the renminbi having appreciated by about 13 percent relative to the dollar. So, our model could work as well with such a trend of appreciation but we may want to underline that such would only add a small complication to the

analytics without really adding substance.)

An important feature of our model is the assumption of imperfect asset substitutability.

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Introduction (5) In this paper, we present three experiments dealing with

the diversification of China’s foreign reserves – i.e., a shift away from dollar securities to euro securities:

The first experiment presents simulation results arising from a sudden diversification of China’s foreign reserves.

The second experiment includes a set of tests for parameter sensitivity.

The third experiment presents an alternative closure of the model by setting a target percentage composition of China’s foreign reserves.

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Other work on diversification (1) Dooley, Folkerts-Landau, and Garder (2004) argue that a portfolio shift

in the foreign reserves of Asian countries would lead to euro appreciation.

Blanchard et al. (2005) developed a simple four-region portfolio balance model. They discussed the impact of a change in the composition of reserves by Asian central banks. They found that the path of adjustment was likely to be associated primarily with a further appreciation of the euro against the dollar. An interesting result for the authors is that it is not by itself a catastrophe for the U.S., while the danger is more serious for Japan and Western Europe.

Using a simple three-asset-portfolio balance model, Dullien (2007) has also examined this issue. He concludes that if Asian central banks move from buying dollars towards buying euros, then the euro would strongly appreciate against the dollar and the competitiveness of European industries in world markets would be affected negatively.

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Other work on diversification (2) In what ways is our work different from that of Blanchard

et al. (2005) and also of Dullien (2007)?• It is based on a stock-flow consistent approach; • There are five sectors;• All relevant variables are endogenous, such as GDP,

consumption, investment, taxes, debt servicing, the money supply, imports, exports, the current account and the capital account, the exchange rate, … ;

• The model is solved numerically, by making simulations;

• Both the short-run and long-run impacts of internal and external shocks are examined.

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Theoretical framework (1)

The stock-flow consistent framework takes into account not only the stocks of assets and liabilities of the various sectors of the economy, but also the flows of income, investment and saving. “This framework makes it essential to analyze the behavior of all parties of any international transaction” (Godley and Lavoie 2004a, p.1).

Godley (1999), Izurieta (2003), Lequain (2003), Godley and Lavoie (2005-06; 2007a; 2007b, ch. 12) applied this framework to various open-economy models.

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Theoretical framework (2) – the matrices

House- Govern- Central House- Govern- Central Govern-

holds ment Bank holds ment Bank ment

Tangible K K1 K2 K3

Cash Hh1 -Hs1 Hh2 -Hs2 Hh3 0

Deposit M1 -M1 M2 -M2 M3 -M3 0

Bill1 Bh1,1 Bcmb1,1 -B1 Bcb1,1 Bh2,1 Bcb2,1 Bh3,1 0

Bill2 Bh1,2 Bcb1,2 Bh2,2 Bcmb2,2 -B2  Bcb2,2 Bh3,2 0

Bill3 Bh1,3 Bh2,3 Bh3,3 Bcmb3,3 -B3 0

Loan -L1 L1 -L2 L2 -L3 L3 0

Advance 0 0

SUM 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Items

 

0

Centra Bankl Sum

-Vg3 -Vcb3 -Vg2 0 -V3

A3

Balance -V1 -Vg1 0 -V2

Bcb3,1

Bcb3,2

Bcb3,3

Banks

-Hs3

the U.S.A. Euroland China

Firms Banks Firms Banks House-holds Firms

K

V

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Theoretical framework (3) – The Model National income identity and trade

Nominal GDP:

Imports in each country are determined by the relevant income and price elasticities, that is by domestic income and the exchange rate.

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The Model (Cont’d) Households

Consumption is a function of households’ disposal income and net wealth.

Households allocate their wealth among money, deposits, and government bills.

The financial assets are imperfect substitutes. The allocation of the assets varies in response to changes in rates of return and risk consideration.

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The Model (Cont’d) Firms

The targeted capital stock depends on sales and the target capital to sales ratio.

The target capital to sales ratio is inversely related to the interest rate.

The net investment of firms is financed by loans from commercial banks.

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The Model (Cont’d) Commercial banks

Commercial banks supply loans on demand to firms. Commercial banks set deposit and lending rates by

marking down and marking up Treasury bill rates.

In China, in addition to the deposits from households, the liabilities of commercial banks include advances from the central bank of China.

In the U.S. and Euroland, besides loans to firms, the assets of commercial banks include Treasury Bills.

In China, advances from the central bank play the role of a buffer; in the U.S. and Euroland, Treasury bills play the role of a buffer.

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The Model (Cont’d) The government

The newly issued Treasury bills are equal to government expenditures (including debt servicing) minus government revenues.

Pure government expenditures, that is government expenditures excluding debt servicing, are an exogenous variable.

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The Model (Cont’d) The central bank

Central banks set the interest rate on Treasury bills.

Central banks hold Treasury bills. The central banks of China and Euroland also hold

foreign reserves in the form of U.S. Treasury bills (initially).

Any monetization is demand-led.

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The Model (Cont’d)China’s central bank

The main model – equations for China’s foreign reserves:

(73)

Where , and

The alternative closure:

(73b)

dt

dt BcbBcb ,1,3,2,3

0

0

tdt FRBcb ,31,1,3 t

dt FRBcb ,32,2,3

1

11

12

121

)( 1 t

Tt 0

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Experiment 1: At time T1, the U.S. increases its propensity to import goods from China, and at time T2, China starts to diversify its foreign reserves.

Figure 1: Impact of the diversification of China’s foreign reserves on the exchange rate

Value of the dollar in euro

T1 T20.5

0.6

0.7

0.8

0.9

1

1.1

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Experiment 1:

Figure 2: Impact of the diversification of China’s foreign reserves on trade balances

the U.S.

Euroland

China

T1 T2

-40

-30

-20

-10

0

10

20

30

40

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Experiment 1:

Figure 3: Impact of the diversification of China’s foreign reserves on GDP

the U.S.

T1 T2

Euroland

China

260

360

460

560

660

760

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Experiment 2 – Sensitivity analysis: At time T1, the U.S. increases its propensity to import goods from China, and at time T2, China starts to diversify its foreign reserves.

Figure 4: Impact of changes of parameter (beta) on the value of the dollar in euro

=0

=0.2

=0.6

=0.4

=0.8

T1 T2

=1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

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Experiment 2 – Sensitivity analysis:

Figure 5: Impact of changes in the parameter (beta) on the trade balance of Euroland

=0

=0.2 =0.4 =0.6

=0.8

=1

T1 T2-250

-200

-150

-100

-50

0

50

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Experiment 2 – Sensitivity analysis:

Figure 6: Impact of changes in the parameter (beta) on GDP of Euroland

=0

=0.6

=0.2=0.4

=0.8

T1

=1.0

T20

60

120

180

240

300

360

420

480

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Experiment 3 – Alternative closure: Gradual diversification

Figure 7: Impact of the diversification on the share of the euro in the China’s reserves, comparison to that in the main model

The alternative closure

T2

The main closure

0

4

8

12

16

20

Per

cen

tag

e

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Experiment 3 – Alternative closure: Gradual diversification

Figure 8: Impact of the diversification on the value of the dollar in terms of the euro, compared to what occurs in the main closure

the alternative closure

the main closure

T2T10.6

0.7

0.8

0.9

1.0

1.1

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Experiment 3 – Alternative closure: Gradual diversification

Figure 9: Impact of the diversification on the trade balance of Euroland

the alternative closure

the main closure

T2T1

-70

-60

-50

-40

-30

-20

-10

0

10

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Experiment 3 – Alternative closure: Gradual diversification

Figure 10: Impact of the diversification on GDP of Euroland

T2

the alternative closure

T1

the main closure

280

320

360

400

440

480

520

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Conclusion (1) The simulation results show that with the diversification

of China’s foreign reserves, the euro appreciates against the dollar and RMB. There is an overshooting effect on exchange rates.

China benefits from the diversification, so does the US since there is also a mechanism by which the US exports to China increase because of the US import component of Chinese exports. However, the Euroland economy slows down. These findings are consistent with those obtained by Blanchard et. al (2005) and Dullien (2007).

Through sensitivity analysis, we find that the larger the diversification of China’s foreign reserves (the bigger the share of the euro bills in China’s foreign reserves), the larger the negative effects on the Euroland economy.

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Conclusion (2)

Gradual diversification, in place of a sudden one-step switch in the composition of reserves, can overcome the overshooting effect on exchange rates. The value of the euro against the dollar and RMB increases gradually to a higher level.

The results on long-run exchange rates, GDP and trade balances are qualitatively similar, but quantitatively different in the alternative closure relative to the main closure. In the long run, gradual diversification is more favorable to the U.S. economy and less favorable to the Euroland economy.

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Conclusion (3)

What seems particularly interesting is that the models uncover some sort of path dependence. How the central bank of China achieves its target diversification rate has an impact on the steady state values of the model.

In other words, the transition path towards the diversification target influences its long-run equilibrium. The equilibrium levels of the key endogenous variables (such as GDP and trade balance among others) depend on the path taken to achieve the target diversification rate.