China's foreign reserves - what they mean, what might happen

A post on my personal blog, Saturday Morning Musings - fall of the US dollar, pointed to the growing mismatch between the pattern of currencies traded and the evolving structures of the world economy. There I said in part

All I am saying is that I feel that, in the longer term, traded currencies are likely to better reflect real patterns of economic activity. In the past, the reserve currencies (gold, sterling, the US dollar) facilitated global transactions by providing a measurable store of value in circumstances where other currencies were either not traded or were of uncertain value. The position today is different. Who can really say that the US dollar is a secure currency?    

The types of changes that I am talking about will take time. However, that time may be less than we all expect.

This led a colleague (Denis Wright, an historian) to ask if I could write a simple non-technical explanation of the significance of China's foreign exchange reserves. It's actually quite an important topic, so here goes.

Important identities

In the comments that follow, there are just two economic identities that you need to bear in mind.

The first is that if one country has a surplus on its balance of payments, another country or countries must be running an equivalent deficit or deficits. The reason for this is that one country's exports are other countries' imports. Globally, imports and exports must balance. If one country is selling more than it is buying, it acquires foreign exchange reserves. However, since imports and exports must balance in total, that means that other countries are buying more than they are selling. They must be running deficits that exactly match others' surpluses.

The second is that if you are going to buy more than you sell, then you have to fund the gap through borrowings or capital flows of some type. Otherwise, you can't buy.

Growth in China's foreign reserves

Initially China's foreign exchange reserves were relatively small, then they started to accelerate. The following gives an indication of scale:

Year	Reserves $US billion
1980	2.5
1990	29.6
2000	165.6
2010	2,847.3
today	c3,200

The increase has obviously been quite dramatic, an increase of over $US 3 trillion in 20 years. To put this in perspective, Australia's total GDP is something over $US1,200 billion! 

Why did China's foreign reserves increase?

There is a lot of argument on this one, but I think that we can simplify.

On the Chinese side:

• The country had a high domestic savings rate meaning that local cash was available for investment.
• The country had a large industrious underemployed workforce, meaning that low cost labour was available for new activities.
• The Chinese currency, the yuan or renminbi, was largely non-traded. The Government was able to keep the value of the currency low, facilitating export growth.

It takes two to tango. Elsewhere:

• Reducing trade barriers facilitated China's export growth.
• Savings rates in many developed countries dropped. With rising asset prices, consumers felt able to increase consumption by more than income, thus providing a growing base for Chinese exports. This was aided by tax cuts, placing more income in individual hands.

Increasing Chinese reserves necessarily flowed back into into developed countries. In a very real way, the Chinese themselves were funding their own exports.

China's reserve conundrum

The accumulation of large quantities of investable funds by a country is not unique. The British Empire, the economic superpower of the nineteenth century, accumulated such investment wealth that it took the rise of the US, a great depression and two world wars to wipe it out. However, China is in a different position.

One difference lies in the then power of the City of London. This marshaled surplus funds and channeled them round the world from mining companies to railroad investments, from the Russian Empire to Argentina. China has no domestic equivalent.

A second and critical difference is simply time. China's accumulation has happened very quickly. China has looked for ways of redeploying reserves via things such as a $US 300 billion sovereign wealth fund and direct overseas investment, but all these take time to build up. In the meantime, China has to put its money in deposits or some form of financial investment. Here it faces a problem

To illustrate this, have a look at the attached graph. This was included in my original posts and comes from one of my favourite bloggers, Stubborn Mule.

The graph simply shows the most important currencies in the world in trading terms. The Chinese authorities simply cannot invest their reserves willy nilly, but have to put them where they can be realised as required. This means they have very few short term choices.

To illustrate their problem further, consider the Australian dollar, the world's fifth largest traded currency.

According to newspaper reports (I don't have the links), China has decide to place 1.6% of its foreign reserves in Ozzie dollars or Ozzie dollar denominated securities.  That sounds a tiny proportion, but it actually amounts to over $US51 billion. That's quite a large amount relative to the size of the Australian economy. You see their problem?

The immediate practical effect is that China is locked into holding US and especially US Treasury securities, something like $US2,000 billion. This makes what happens in the US kind of important to China in financial terms.  

The longer term

In both the short and longer term, economic changes in China and its trading partners will affect the equation. I will discuss these in another post. For the moment, I just want to focus on what might happen to the Chinese reserves on the assumption that they continue to be significant. This links to the point that I made in my original post, about likely changes so that traded currencies better reflects the pattern of trade.

Here I want to point to just three things:

1. As China globalises, its capacity to invest effectively in other countries will increase , thus shifting Chinese assets from financial to real investments.
2. As more trade and investment is written in Chinese currency, the Chinese will be able to invest more in assets denominated in their own currency.
3. The number of significant traded currencies will rise, making it easier for China to invest in a bundle of currencies, not just the US dollar.

If I'm right, these changes will have quite profound influences on the distribution of economic power and activity.        

Professional services management - reader interests July 11

At the end of each month I look at the most popular posts on this blog to get a feel for reader interests. The most popular posts on this blog and for Management Perspectives (I merged that blog into this one in February) in July were:

• Designing a simple performance appraisal system - sample policy statement - 81 page views
• The Importance of Demography and Demographic Change - update - 40 page views
• Problems with Performance Pay - 31 page views
• Allen & Overy's profit conundrum - 28 page views
• On financial metrics - professional services - 24 page views
• Ships, knowledge & management short term ism - 23 page views
• Common Management Problems Series 1 - managing up - 21 page views
• Changes in Public Administration and their Impact on the Development of Public Policy 1 - Introduction - 18 page views
• People Management in Professional Services - Effective Delegation - 14 page views
• Guidelines for Effective Negotiation - 13 page views
• Performance Measurement - Profit Per Equity Partner (PEP) - 12 page views
• Recession and the importance of fixed costs - 11 page views
• Corporatisation, Corporate Structures and the Law - The Case For - 10 page views

Australian Reserve Bank views on the economy

I really wanted to record this one for later use.

Measured by the official statistics, the Australian economy has been all over the place. We still have a looming boom, yet many aspects of the local economy are soft. Australia may not be in as bad a position as some other countries, but it's still confusing!

The Australian Reserve Bank has released two relevant papers that set out its views.

The first is the Minutes of the July 2011 Monetary Policy Meeting of the Reserve Bank Board released on 19 July. The second is The Cautious Consumer, a speech given by the Reserve Bank Governor.

I mention them now because I thought that it might be of interest to do a review of the bank's official thinking.  

People management dominates blog traffic

While I have been very slow in posting for some time, search engines have continued to draw some traffic to this blog.

It's interesting that eight in the top ten posts in the last month have been concerned with people managements issues. A similar pattern holds if I extend the time horizon to six months.

This has not always been the case. There was a time when business management issues dominated.

  What I don't get much traffic on, something that I find a bit disappointing, are my discipline of professional practice posts. This is an area I really care about as something that we all share across fields.

It may just be that search engine algorithms have changed. Still, it is disappointing.  

Problems with technologists

The Internet is important to all of because of the way if affects our profession and business. For that reason, I have written a fair bit about it over time.

On Friday 22 July I wrote Academic journals, the shuttle & the internet on my personal blog. It's there because it was triggered by my personal reactions. I said in part:

I am a very heavy internet use. Further, the way I use the net extends well beyond transactions or the discovery of immediate current information. To the ordinary user, the problems that I experience may be of limited relevance. Yet I think that they are quite important.

My thinking to this point has really focused on my own responses, essentially taking the net as a given. I am now wondering just how the net has to change if it is really to meet the needs of that minority group, Belshaw and his ilk.

A lot of the technologists and net enthusiasts I know are not much help. I have been meaning to write on this one for a while. The difficulty from my perspective is that I am expected to fit into their solutions and enthusiasms, whereas I want them to fit into mine! I am, after all, the user!

In Australia, the main law publishing firms are all in the process of releasing their publications as e-books. However, they are also trying to maintain their current charge structures. It's not going to work - the simple addition of a search facility is not enough to justify the cash cost.

When I said in my post that I wanted the technologists to fit into my solutions and enthusiasms I wasn't joking. The problem with technologists is that they won't do this and it's frustrating.

Technology is a means to an end, not an end in itself.

Recently I have been working on some internet based projects designed to streamline aspects of professional practice. I think that the thing that stands out most clearly in my mind is just how hard it is to get the interface right between the technology and the business or professional process.

One of the kickers is the hidden cost that lies in simple things like support and training.

I think that there are solutions, but they are going to come from the business, not technology side.     

Ships, knowledge & management short term ism

Back in February in Problems with maintenance I reported briefly on the problems that the Australian Defence Force was having with maintenance. Maintenance on its main transport ships was so neglected that it was now too expensive to fix them, so that they had to be taken out of service.

The report of the Rizzo review into support ship repair and maintenance has now been released. It recommends, among other things, that Navy rebuilds its engineering capability from the ground up. Now Australian Defence Minister Smith has announced a review into the availability of the Collins class submarines, another major problem area.

One of the big problems with the constant obsession with productivity improvement through cost cutting, one that I referred to in my February post, lies in the trade-off between the short and long term. It's usually possible to get apparent immediate gains by, for example, deferring maintenance or by outsourcing particular activities. However, this can then lead to later problems of the type that Defence has been experiencing.

Over recent years I have noticed what I have come to call the demise of experience, the loss of in-house knowledge and skills that can, as in the Defence case, mean that the organisation actually lacks the capability to carry out key elements of its core mission.

The problem is quite pervasive. Let me give a small and apparently trivial example.

A few years ago, I was asked to develop a training course for an organisation. Because of the nature of the training (objectives, content, timing, audience) the course was not suitable for on-line delivery. It required face to face delivery through a workshop format.  

The organisation had a variety of rules about public documents. The first thing I therefore did was to look for other course examples within the organisation that might provide a template. There were none.

Needing to design from scratch, I went in search of help on some issues with Microsoft Word. There were some things I wanted to do that I had forgotten because of the length of time since I had last done them. I found that there were no Word manuals, nor were there any people within the organisation who had the skills required to help me. In the end, I solved the problem by borrowing and then modifying a template used in another organisation. The whole process added about three days to course preparation time.

I said that this was a small and apparently trivial example, yet it is one that I have seen replicated time after time.

In thinking through this problem, the loss of experience, I ended by breaking it into two parts.

The first is the loss of what we might call background experience, the knowledge of how to do things in a general sense. As organisations have slimmed down, as people have become more narrowly focused,  organisations have lost the broader knowledge base that once could be drawn on for problem solving. At the simplest level, this leads to costs and inefficiencies in handling new challenges. More broadly, it increases the organisation's general vulnerability; more mistakes occur.

The second is the loss of mission specific experience of the Defence engineering type. In slimming down, in out sourcing, organisations reduce the number of people with the direct knowledge and skills required to carry out tasks.

The two problems interlink. When I was working in the aerospace and defence environment, the key delivery people were the commercial and project managers who combined broad based knowledge and skills with engineering and technical know how. They knew what to do because they had done it many times before. As new problems arose, they would automatically draw from experience to develop at least first pass solutions for further test.

Many of these people have gone. Initially their loss was not seen. But once things get to the point that they seem to have done in the Australian Navy, suddenly disaster occurs. When you have to scrap ships because of poor maintenance, when you cannot deliver on key tasks, then you are in trouble.

The Rizzo report recommends that Navy rebuild its engineering capability, adding some twenty positions. But where are these people to come from? How many years will it take for them to acquire the experience that Navy once had? And what happens if another emergency occurs in the meantime?

The focus on current problems in the Australian Defence Materiel Organisation ignores, it seems to me, the fact that the genesis of the problems lies in changing management approaches that began to come into effect two decades ago.

I find that as a manager and consultant I have become less tolerant of what I see as short term ism. This is not a good thing because in a professional sense I have to deal with what is now. Yet so often I can see problems coming, I can see steps that might fix or at least improve things, but it requires management to change what they do now. And that can be hard to get across!    

Allen & Overy's profit conundrum

Back in February 2010 I recorded UK law firm Allen & Overy's Australian opening. Then in February this year Clifford Chance entered the Australian marketplace. Both moves were part of a shift east towards new growth markets.

Wednesday 6 July Allen & Overy announced their results for the year ending 30 April 2011, effectively the end of the firm's first full year in Australia. The results were headlined "Robust growth and investment" with the key features summarised as:

• Turnover up 7% to GBP1.12bn (USD1.87bn; EUR1.26bn)
• Profit per equity partner stable at GBP1.1m (USD1.8m; EUR1.2m)
• Distributable profit up 6% to GBP455.8m (USD759.8m; EUR512.6m)

On the surface, not bad. However, I was curious to know more, so downloaded the accounts. These showed a considerable increase in the number of partners and an actual decline in operating profit, as well as a small decline in the firm's net assets. How, then, did A&O achieve an increase in distributable profit so that profit per equity partner remained stable?

The answer lies in the treatment of Canary Wharf costs. I quote:

The Board decided that as the cost of exiting the Canary Wharf office is only payable in the future and benefits the partners in the future, for the purpose of determining the distributable profit for the current year, the charge would not be taken into account.

This may be fair enough, but it does suggest that the quoted key figures on firm performance may be a little misleading when it comes to assessing the firm's actual results.

So far as Australia is concerned, an article by Samantha Bowers in Friday's Australian Financial Review noted that A&O in Australia has grown from 17 to 21 partners with about 100 lawyers. She quotes Finance Director Jason Haines as saying that Australia had produced high revenue growth but not much profit growth since A&O in Australia were still in an investment phase.  

If you have a hammer, everything looks like a nail

Back in May in Clients are their own worst enemies, I returned to one of my recurrent themes on this blog, the need for professionals to educate clients. In the period since, there has been an interesting discussion in other fora on issues associated with cognitive dissonance and the law.

The latest post in this discussion is Legal Eagle's The Art of Law. The post includes links to earlier posts, including two I wrote. In the comments Jacques Chester made a very interesting comment @4. It begins: Here in software-land we often quote the old saying that “if all you have is a hammer, everything looks like a nail”.

Jacques' comment drives to the heart of the point that own professional backgrounds dictate the way we see and respond to client problems even if that way is not in fact appropriate. I mention this now because I want to come back to Jacques' points in the context of improving professional practice in a general sense.

 

Asia-Pacific IT services growth projections

I see from IT Wire that IT service revenue in the Asia-Pacific region have finally rebounded from the global economic downturn and are expected to hit $US205 billion over the next four years. Ovum forecasts an annual compound growth rate of 6.6 per cent over the period to 2015.

Fujitsu retained the number one slot in IT services revenue in 2010, with a market share of 13.9 percent.

I was actually a little surprised at the projected growth rate. It seems a little low. 

 

Australian March 11 capex figures surprise

The Australian Bureau of Statistics capital expenditure figures for March were higher than some expected. You can clearly see the upwards trend.

The expectations data  on future capital expenditure also continues strong.

The multiple speed nature of the Australian economy continues, with some data very soft indeed.   

Postscript

In this morning's Australian (27 May), Sarah-Jane Tasker reports that the Australian Bureau of Agricultural & Resource Economics & Sciences planned investment in Australia's resources sector has hit a record $173.5 billion.

Some care must be exercised in interpreting these major project figures. I know from my own experience, my then area was responsible for similar monitoring back in the early 1980s, that the numbers can bounce around. If prices fall, projects can be deferred or re-scheduled.