It is a real toss-up as to which generates more bizarre comment in the international press: Beijing’s long-feared dumping of US Treasuries, or the use and value of the PBoC’s central bank reserves.  The revelation last week that Chinese holdings of US Treasury obligations fell in December by $34.2 billion, to $755.4 billion, generated a frisson of fear and excitement, leading one prominent newspaper to worry that “If there is one thing that gets investors twitchy, it is the fear that China is losing its appetite for US government bonds.”

And shouldn’t they get twitchy?  After all this reduction in Chinese holdings of Treasury bonds comes from the USG’s TIC data, so it must be true that China is dumping dollars, right?

No need to twitch, it means no such thing.  First of all, the data from which this was derived indicates national ownership of USG bonds only to the extent that foreigners are directly registered holders.  It says nothing about what happened to the large amount of bonds held by the PBoC and other Chinese investors indirectly or in street names. Those could have easily gone up by more than the reduction in bonds directly held by Chinese investors in their own name.  If the PBoC had let maturing Treasury bonds get repaid, for example, and reinvested the proceeds into the USG bond market through another account, or in a street name, its total holdings would have actually increased even though its registered holdings would have declined.

More importantly, the TIC numbers completely fail to disclose whether China’s reduced holding of USG bonds was matched by increased holding of other dollar assets, thereby increasing the pool of capital available to fund USG bonds by an amount equal to its reduced Treasury holdings.  If Chinese investors decide to take on more risk, for example, they might sell USG bonds and use the proceeds to buy corporate bonds.  Of course the seller of these corporate bonds will then have cash, which must be put to work, and ultimately this ends up back in the USG bond market.

China did not reduce its dollar holdings

So was China a net seller of dollar assets in December?  Almost certainly not.  Just look at the PBoC balance sheet.  PBoC reserves rose in December by $61.3 billion, of which $39.0 billion was the trade surplus.

Remember that China has a large current account surplus which necessarily must be recycled abroad, and the US has a large current account deficit which necessarily must be funded abroad. It would be astonishing if, under these circumstances, total Chinese holdings of USD assets declined, and of course it is impossible that they declined faster than the willingness of other foreigners to replace them.

Of course if the US current account deficit declines, net new foreign purchases must by definition decline too.  If the US wants its current account deficit to decline so that the USG can reduce the fiscal spending needed to generate any fixed number of jobs, this cannot possibly happen without a concomitant decline in net foreign, including Chinese, purchases of dollar assets.  But it need not result in any difficulty in funding the new, lower amount of debt issuance.  Depending on why it happens, reduced purchases by foreigners should probably be seen as a good thing for the US Treasury market, not a bad thing.

Confused?  How can a reduction in foreign purchases help the USG fund its massive fiscal deficit?  Because the purpose of the fiscal deficit is to create jobs in the US by boosting US spending.  Since some of the jobs that higher USG spending creates will accrete outside the US, via demand that “leaks” abroad through the deficit and creates employment for foreign manufacturers, a smaller trade deficit can itself be expansionary for the economy.  That means the USG will need to borrow less to create the same number of jobs. Fear of Chinese “dumping” of US treasury bonds, even if it were possible, should be a non-issue, but since it plays easily into various geopolitical conspiracies, we seem to love to worry about it needlessly.

Among other strange comments the TIC data generated last week were those by the Financial Times, arguing that “if the latest numbers mark the beginnings of a diversification by China away from US Treasuries and other dollar assets, a widely speculated rise in the value of the renminbi against the dollar is on the cards.”  Aside from the fact that it marks the beginnings of no such thing, it still wouldn’t be an indication of any future RMB strategy.  A rise in the value of the RMB may very well be in the cards, but this has absolutely nothing to do with what Beijing did with its USG bond holdings in December.

Why?  Because if China had intervened less in December, the RMB would have already shot up – in December, not at some time in the near future.  Of course if the PBoC believes that a rise in the RMB will cause the dollar to fall against the euro, it might have swapped out of dollars into euros as a clever trade based on its inside knowledge of the RMB strategy, but since the opposite is almost certain to be the case, it is hard to believe that any PBoC net sales of Treasury bonds would indicate its plan to raise the value of the RMB.

The TIC data in December tells us almost nothing about what will happen to the RMB.  To see why, it makes sense to discuss a little how and why the PBoC has accumulated dollars, and what those dollars mean for China and the central bank.  Here, the first thing to recognize is that the PBoC does not “decide”, as a banker, to lend money to the US.  It basically has very little choice.

Beijing is not Washington’s banker

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit.  And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets.  Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision.  It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar.  Why?  Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price.  What it does is far simpler.  It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price.  That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency.

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market.  Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest.

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar.  In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear.  The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value, as the FT article suggested.

Of course the PBoC must fund the purchase of these dollars.  It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars.

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets).   Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits).

Here is where things get interesting.  China’s reserves are often thought of as if they were a treasure trove available for spending.  They are not.  They are simply the asset side of the mismatched balance sheet.  If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100.  To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes.  Reserves are effectively borrowed money.

Can PBoC reserves protect China?

So the PBoC cannot give away the reserves without causing an increase in its net indebtedness.  This is why I have often said, to the confusion of some of my readers, that Beijing cannot just recapitalize the banks with reserves.  A substantial amount of NPLs will one way or another increase government debt.  The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes.  Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.

So what are reserves good for?  As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China.  They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption.  They can only be used to purchase or pay for things from outside China.  This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically.  It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.

Here is where a great deal of confusion arises.  The US crisis of 2007-08 notwithstanding, we seem implicitly to believe that a financial crisis is always caused by an inability to repay foreign debt and investment, in which case having huge amounts of reserves certainly should protect a country from financial crises.

But this is only partly true.  Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility).  As I pointed out two weeks ago, there are many cases of countries with huge amounts of reserves that nonetheless suffered from all kinds of financial crises.  It is just that they never suffered from external debt crises.

When it comes to domestic debt crises, large levels of reserves actually can make things worse.  Why?  Because financial crises are always caused by mismatched and highly inverted balance sheets, and the central bank’s accumulation of reserves is exactly that kind of balance sheet.

Of course when the rest of the country has an equally mismatched balance sheet in the other direction – like when South Korean companies in 1997 had huge amounts of won assets financed by dollar debt – the central bank mismatch enhances financial stability.  It acts against the mismatch carried by the rest of the economy, and the net impact is that the economy is less vulnerable to financial crisis.  In that sense reserves are a kind of insurance to protect against excessive foreign borrowing.  Because South Korea, unlike China today, had too few central bank reserves against the rest of the country’s too-large dollar obligations, its overall balance sheet was mismatched and it was susceptible to a collapse of the won.

But China has very little external debt – certainly very small compared to its reserves – and so this clearly isn’t an issue for China.  But then could the huge mismatch on the PBoC’s balance sheet create the opposite risk for China?

Balance sheet mismatches

Yes and no.  And this is where another great misperception occurs.  Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves.  After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms.

This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency.  Unfortunately this kind of confused thinking is nonetheless the source of some strange claims.  One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.

Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become.  The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings.  Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt:

If the arguments presented for RMB revaluation by the US administration have no factual basis, why are they being put forward? The real answer lies not in trade but in debt – as other writers, such as Daryl Guppy, have rightly pointed out. In asking for RMB revaluation, President Obama’s advisers were, in effect, asking China to donate $150-$300 billion in RMB to the US via debt reduction.

The arithmetic of this is simple. China’s holdings of US dollar assets, chiefly Treasury Bonds, are around $1.5 trillion, or 10.2 trillion RMB. A 10 percent devaluation of the dollar vis-à-vis the RMB would reduce the value of these holdings to 9.3 trillion RMB, and a 20 percent dollar devaluation would reduce their value to 8.5 trillion RMB. In either case the U.S. is asking for its debt to China to be reduced by 10-20 percent in RMB terms.  It may now be seen why President Obama’s advisers have a vested interest in not examining the factual situation of China’s trade. They are seeking a large debt relief package.

Sigh.  The arithmetic is apparently not as simple as it seems.  When one of my central-bank seminar undergraduates showed me this article in December, he was chortling with glee at its bad economics and suggested I used the article to teach the freshman class – the assumption being that no PKU finance student above the level of freshman could have ever made this kind of conceptual mistake.  Perhaps not, but certainly anyone writing about currency policy should have at least done the math first.

Although this article is more confused than most about the impact of an appreciation on central bank reserves, it is worth explaining why it is wrong so as to address the less excitingly conspiratorial mistakes made by the merely confused.  First, can an appreciation of the RMB reduce the cost to the US government of its debt obligations?  Of course not.

The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets.  Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt.  After all, if a revaluation of the RMB causes the euro to drop against the dollar (a highly plausible outcome), could it possibly be true that the USG would reduce its payments on $100 of obligations owed to Chinese investors while increasing its payments on $100 of obligations owed to European investors?  Exactly how would this work?

Are there no winners and losers?

It wouldn’t.  The claim is nonsensical and violates simple arithmetic.  But if the RMB is revalued are there no losses and gains anywhere?  Yes, of course there are, but the distribution of these gains and losses is completely different from what this article claims, and depends wholly on the structure of various balance sheets.  In a nutshell, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains.

First of all, will China as an economic entity lose?  Leaving aside the vigorous discussion about whether an RMB revaluation will increase or reduce China’s long term growth prospects (I think it will), the net balance-sheet impact of a revaluation depends on whether China is net long or net short dollars.  There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio.  The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.

Some people might make a more sophisticated argument that since China is a net creditor – i.e. it is net long dollars – it will lose by a revaluation of the RMB.  This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one.  It does not “realize” the loss, however, until it revalues the RMB to its “correct” value.

In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation.  It occurred the very day the trade took place.  When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB.  This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB.

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter).  Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that.  The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take.

So a revaluation of the RMB will not cause any real loss to any Chinese entity today.  The loss already occurred but hasn’t been realized.

But wait, if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms.  Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations.  And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss.  It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it.  So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

Wealth is transferred within China

But that doesn’t mean nothing at all happened.  Although the Chinese overall balance sheet is probably a little better off with the revaluation, within China there are a whole set of winners and losers. Which is which depends on the structure of individual balance sheets.  Basically everyone who is net long dollars against the RMB loses in an appreciation, and everyone who is net short dollars against the RMB wins.

Who loses?  Of course the PBoC is a big loser.  It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.

Exporters and their employees, too, are naturally long dollars and so they would lose.  They are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.

Chinese companies with more assets abroad then foreign debt might also lose.  Who wins?  Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life.  The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team.  Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB.

Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country.  Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption.  This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China.  But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them?  Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts.

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP.  This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss.  (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be).   In that sense it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.

I apologize for such a long post, but I promised several people that I would try to address some of these issues, and it is hard to do so briefly.  In short, what the PBoC does to the value of the RMB and how it invests its reserves matter a lot to China and the world, but not always in the way China and the world think.  To get it right, we need to keep in mind the functioning of the balance of payments, the PBoC and other balance sheets, and the way the two are interrelated.

Tags: Balance sheets, Policy, wages

I am traveling in DC, NY and Boston over the next few days, and between meetings and jet-lag it is hard for me to do much on my blog, but I did want to extend a short piece I wrote that was published yesterday in the South China Morning Post.  This is because it is about central bank reserves, a topic that to my dismay probably generates more confused and mistaken thinking than any other topic in economics.

As many of my readers know (although I have not made any reference to it on my blog) hedge fund manager Jim Chanos recently made some headline-inducing claims about China.  Chanos, a successful hedge fund manager who has made his reputation – and fortune – by identifying and shorting seriously overvalued assets, most famously Enron, seems to have read the PivotCapital piece that got a lot of attention last year, and partly as a consequence he claimed that China is undergoing a speculative bubble that makes it the equivalent of “Dubai times 1,000 – or worse”.

His claim was met with incredulity by New York Times columnist Thomas Friedman.  Freidman is best known for his writings on globalization, and although I have no doubt that he is a very smart man when it comes to getting politics right, especially in the Middle East, which I believe is his area of specialty, I also have no doubt that he does not understand China much and understands almost nothing about central bank reserves and the functioning of the global balance of payment.  I have read many of his articles, and so far I am pretty sure that these aren’t his strong points.

In response to Chanos’ claim Friedman made a number of very questionable statements about China.  These are matters of dispute and although I think they are completely wrong, they are at least defensible.  For example he says its true that there may have been risks of bubbles.  ”In the last few days, though, China’s central bank has started edging up interest rates and raising the proportion of deposits that banks must set aside as reserves — precisely to head off inflation and take some air out of any asset bubbles.” 

Really?  I think you have to be a tad credulous to believe that the RMB 7.5 trillion lending target for 2010 and the slightly higher interest rates represents taking air out of the asset bubble.  I would argue that they simply mean that the astonishing rate at which they were pumping air into the bubble has moderated slightly, to merely excessive.

He also says:

Now take all this infrastructure and mix it together with 27 million students in technical colleges and universities — the most in the world. With just the normal distribution of brains, that’s going to bring a lot of brainpower to the market, or, as Bill Gates once said to me: “In China, when you’re one-in-a-million, there are 1,300 other people just like you.”

Aside from perhaps his overestimating the quality of the education system, this is very bad statistics, and perhaps shows how easily we can get intellectually overwhelmed by large numbers.  If China indeed has the same distribution of geniuses, or talent, as other countries, the fact that it has so many people won’t make it richer (and what about India?).  After all if you cut China into four countries, each country will have only one-fourth the number of geniuses.  Does that really mean that the four countries together are stupider?  If we combine the US, Canada and Mexico into one country, its a pretty safe bet that the total number of geniuses will be more than any of the three countries currently possess, but will average intelligence rise?  Can we really make the three countries richer that way (of course there may be good economic arguments for suggesting that unifying North American into a single country will make it richer, but the larger number of geniuses is not one of these arguments).

Ok, we can argue about these things, and we can agree to disagree, but where he completely blew it was, I suspect, on the one topic are where he was absolutely certain he could not be wrong.

Too bad, because he was.  Friedman proposed, yet again, a common misconception over the meaning of China’s huge accumulation of foreign reserves.  He argued that thanks in part to the size of the reserves it would be impossible to make money by shorting China. “First,” he warned, “a simple rule of investing that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.”

Really? Friedman proposed the rule sarcastically – as both untestable and too obvious to need testing.  It is so obvious that no country has ever had such high levels of reserves, so you can’t really test the hypothesis, but it’s also pretty obvious that a country with $2 trillion in reserves is in great shape.  Anyone who wanted to short it must be pretty stupid, right?

But it turns out that reality is not as obvious as he imagines. Let us leave aside that the PBoC’s reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion.  China’s foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.

But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP.  My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.

The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP.   By the late 1980s, Japan’s accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China’s does today.

Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.

Japan’s subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.

The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves.  Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability.  Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.

Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s.  The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits.  These risks include an explosion in domestic government debt directly and contingently through the banking system.

These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies.  And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).

In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.

We must be careful how we read history. The fact that the US and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched, and under conditions similar to those of China, does not necessarily mean that China too must have a lost decade or two.  Chanos is not being crazy when he worries, but it is still an open question as to whether or not he will turn out to be right.

But the history does indicate that facile statements about central bank reserves should, at the very least, be measured against the obvious historical precedents. Chanos might still lose this debate, but Friedman has already proven himself to be hopelessly wrong.

Tags: Jim Chanos, Thomas Friedman

Exports in March dropped a less-than-expected 17.1% from the same time last year – below expectations of 20% and the 21.1% drop for the first two months of 2009. Most of the articles I read in the Chinese and foreign press including, not surprisingly, comments from the customs bureau, hailed this as a sign that the export slump is bottoming out. According to an article in Saturday’s South China Morning Post, for example:

Many economists said the export slump of the past five months was finally showing signs of abating, with the Administration of Customs describing the latest export figures as a “marked improvement”. However, they cautioned that imports would remain weak in the near future, overshadowed by prevailing low commodity prices and the de-stocking of mainland factories and overseas importers.

“It is the beginning of stabilisation,” Citibank economist Ken Peng said yesterday. “We should have seen stronger import numbers last month. We had more money in place, but we’re not importing more and that’s surprising.”

A Bloomberg article had the following:

The “collapse of global trade and China’s exports in the last few months was not in small part due to a freeze in trade credit and aggressive de-stocking abroad as a result of extreme uncertainty,” said Wang Tao, an economist at UBS AG in Beijing. “As expectations start to stabilize, we expect to see export orders rebound in the coming months.”

I guess that different people have radically different ways of forecasting export growth. To me, it is completely meaningless to look at recent trends in China’s export performance in order to forecast the future. The only thing that matters is what will happen to net demand from the trade deficit countries – most of which is represented by US net demand – and so the recent improvement in China’s export performance (not really an improvement, of course, but an improvement in the rate at which it is deteriorating) really tells us very little.

The real question is will US gross and net demand continue to contract? Almost every serious economist I have spoken to believes that it will, with disagreements only on the speed, intensity and duration of the contraction. Someone whose blog I have been reading a lot lately (I like him because, aside from his Minsky-Fischer orientation, he has the audacity to claim that if you don’t know economic history then you don’t know economics and, what’s worse, he even insists that history extends to beyond the past twenty years), University of Western Sydney professor Steve Keen, suggests that from what he calls a non-orthodox, Hyman-Minsky point of view we should think of aggregate demand as “the sum of GDP plus the change in debt.”

That sounds right to me. Certainly debt accumulation seems to have represented the difference between the growth in US consumption and the growth in US GDP over the past decade, as I discussed in Wednesday’s post. If he is right, we should expect US consumption (and that of many other deficit countries, for that matter) to grow less than GDP by the amount of the deleveraging taking place. That is a lot of deleveraging.

In that case the export performance of countries like China can only get worse because the ability of deficit countries to consume China’s export of excess production will be contracting quickly, and in that light it doesn’t matter how successful you think the Chinese stimulus package may have been. Export growth depends on someone else’s import growth, which depends on their consumption growth, and in a world of contracting GDP, if consumption growth is even underperforming GDP growth, it is a little hard to be optimistic about export growth forecasts. The domestic stimulus is irrelevant.

Talking about the stimulus package, there has also been a lot of talk about its success as being evidenced by the way a number of indicators have bottomed out or even turned. Unfortunately it seems to me that most of those indicators fall into one of two groups. In some cases there were special circumstances that caused a surge, but whether the surge is sustainable, and in some cases whether it won’t be reversed in the future, is questionable. For example car sales have finally started to rise: China’s passenger car sales rose 10% in March from a year earlier. But this was after tax cuts and government subsidies boosted demand, and there are lots of rumors about government agencies and state-owned enterprises being persuaded to anticipate vehicle purchases. If that is the case, the surge in purchases may soon peter out, and in fact may slow sharply to the extent that planned purchases for later this year were accelerated.

The second group of positive indicators I would describe not as evidence that the fiscal stimulus is working but rather as evidence that some people are behaving as if they believe the fiscal stimulus will work. For example rising steel and concrete inventories and increased purchases of equipment suggest to me not that end demand has been created but rather that many producers are anticipating that end demand will be created. Perhaps they are right, in which case we should see more positive indicators in the future, but if they are wrong then we are likely to see nothing more than a temporary buildup that will have to be reversed.

But to get back to exports, China’s trade surplus for March was $18.6 billion. That sums to $62.6 billion for the first quarter, compared to $41.7 billion for the first quarter of 2008 and $114.3 billion for the last quarter of 2008. Although lower than the astonishing heights of January and late last year, the trade surplus is still much higher than this time last year. That means China’s export of overcapacity is still increasing, especially if you think, as I do, that February’s very low trade surplus ($5 billion), and possibly part of March’s, was caused by commodity accumulation to replenish strategic reserves.

More capacity?

In that light articles like this one from Friday’s Financial Times are not encouraging:

The aluminium industry has been hit hard by the global economic crisis with sharp falls in sales across the automotive, construction and aerospace industries. …However, a recovery has emerged in recent weeks and prices are 18 per cent off their lows. The concern in the industry now is that the nascent recovery could be nipped in the bud because Chinese smelters are busy ramping up production at a time when demand is continuing to fall.

As China accounted for about 35 per cent of global aluminium production and consumption last year, its supply and demand developments are of huge significance for the world market. Industry leaders warn that the outlook for demand remains weak

…However, Wen Jiabao, China’s premier, has made it clear that Beijing will do whatever is needed to maintain economic growth at “about 8 per cent”. This has led to huge pressure on local governments to ensure growth targets are met. One result is that aluminium smelters have been offered tax cuts and subsidised bank loans to encourage production to restart.

Last year’s price crash forced China to close about 3.1m tonnes (22 per cent) of its total aluminium production capacity as many of the country’s smelters fell into the red. But analysts at Macquarie estimate that 500,000-600,000 tonnes of capacity has recently been restarted in Henan province. “Local government officials, especially in Henan, have been urging the aluminium industry [the key income tax payer of the province] to restart spare production capacity immediately,” says Bonnie Liu of Macquarie.

China’s government has also been providing significant levels of support to the domestic market. The State Reserves Bureau, which has already bought 590,000 tonnes, is expected to expand purchasing up to 1m tonnes. The State Grid Corporation has bought about 400,000 tonnes and provincial governments have indicated they will buy up to 900,000 tonnes.

Too many people who should know better assume that trade policies are limited to raising import tariffs or devaluing the currency, and since both of these were addressed in the recent G20 meeting, we can all more or less relax. This is wrong. Anything that alters the gap between total production and total consumption must have a trade impact, and if capacity is boosted in the face of falling demand, that is as likely to force up the trade surplus as import tariffs or currency devaluation.

I do not believe that will go on much longer. Over the next few months we should start seeing even more pressure on China’s exports as either trade friction or exhaustion (on the part of countries who have had to bear more than 100% of the brunt of the contraction in US demand) forces continued global demand contraction to switch to China.

How important will that be? Ever since The Economist came out with a consensus-busting piece last year that China is much less reliant on exports than many people think (whatever that means), well-informed people have been assuring each other that “China is much less reliant on exports than many people think.”

Maybe. But it is still very heavily reliant on exports. When your total production exceeds your total consumption by 7% of GDP (in the past 12 months China’s trade surplus was $320 billion, while its 2008 GDP was $4.3 trillion), you rely very heavily on foreign demand to absorb a big chunk of your output.

According to a recent Andrew Batson article in the Wall street Journal, a trio of researchers at the Hong Kong Monetary Authority revisits the whole question of China’s dependency on exports. I was not able to find the cited piece, so I can only limit myself to the comments in the article, but, and sorry for the long quote, here is what they find:

The paper builds on previous work by one of the authors, Li Cui, who in a 2007 working paper for the International Monetary Fund presented evidence that China was becoming more dependent on external demand over time. Indeed, net exports contributed about 20% of China’s economic growth from 2005 to 2007, compared to less than 10% in the previous five years. But the authors of the new paper try to go beyond that number to capture the total effect of the export manufacturing sector on the economy, including investment in new factories by exporters, and spending by people employed in those factories. That leads them to conclude that the spill-over effects from the export sector are in fact quite large.

The authors estimate that a decline of 10 percentage points in export growth would be associated with a decline of about 2.5 percentage points in GDP growth. “This is about at least twice as large as what could have been expected if only the direct impact of exports is considered,” they write. Part of the explanation, they say, is that exports are extremely important to a group of Chinese coastal provinces, which themselves account for the majority of the national economy. So changes in export demand can cause dramatic fluctuations in those regional economies, even while the inland provinces are less affected.

But of course, China’s exports have recently slowed by a lot more than 10 percentage points. In volume terms, export growth rates have swung from around positive 20% in 2007 to nearly negative 20% in the first part of this year. The biggest effect of a decline in exports, the authors find, is on corporate investment, as companies scale back expansion plans. And since the sharp drop in exports is just a few months old, the full magnitude of the subsequent drop in capital spending may not yet be evident.

Foreign currency reserves

Besides export numbers the other piece of important news for me was the release of first quarter reserve numbers. According to Xinhua’s account:

China’s foreign exchange reserves rose 16 percent year-on-year to 1.9537 trillion U.S. dollars by the end of March, said the People’s Bank of China on Saturday. It represents an increase of 7.7 billion dollars for the first quarter, but the increase was 146.2 billion dollars lower than the same period of last year.

In March alone, the foreign exchange reserves rose by 41.7 billion U.S. dollars. The increase was 6.7 billion U.S. dollars higher than the corresponding period of last year.

This is the smallest quarterly increase we’ve seen in a long time. The first quarter of 2008, for example, saw reserves grow by an astonishing $153.9 billion, and 2008’s fourth quarter, the weakest quarter of the year by far, nonetheless saw reserves up by $40.4 billion.

2009	January	February	March	Q1
Headline reserve growth	-32.6	-1.4	41.7	7.7
Trade surplus	39.1	4.9	18.6	62.6
Net FDI	7.4	5.8	8.4	21.6
Currency gains or losses	-31.0	-16.0	15.0	-32.0
Interest income	6.8	6.8	6.8	20.4
Unexplained amount	-54.9	-2.9	-7.1	-64.9

With Logan Wright’s help I put together the above table to try to understand what is going on with reserves. The key thing on which to focus is the “Unexplained amount,” which is a proxy for hot money inflows or outflows. Of course my estimates for currency gains or losses and for interest income are nothing more than estimates and may be, especially in the former case, substantially off.

Nonetheless the picture the table shows is pretty clear and pretty consistent with what we would expect. January, a time of deep gloom, saw a large unexplained outflow at least part of which may represent flight capital from nervous Chinese businessmen. Confidence seemed to rebound in February and March, with widespread (but to me doubtful) claims that the fiscal stimulus was “working” and with the stock market rocketing up. During that time unexplained outflows collapsed to nearly zero. The only conflicting evidence was reports in the Hong Kong press of a serious increase in the amount of currency transactions among border money changers, in which the number of Chinese buying US and Hong Kong dollars with RMB rose to suspiciously high levels.

The overall picture is consistent with two different and popular predictions. First, the stimulus package is working and that China will soon emerge from the worst of the crisis. Second, that the fiscal stimulus represents a risky bet on the duration of crisis abroad, and if sustainable and recovery in global demand does not occur in the next few quarters, it will set the stage for a deeper contraction late this year and next year.

Trade determines reserve currency status

Finally, for those who might be interested in today’s version of my biweekly South China Morning Post piece, here is the original, pre-edited version:

People’s Bank of China Governor Zhou Xiaochuan generated huge controversy when he argued two weeks ago in favor of an international reserve currency to cure distortions in the global balance of payments. Although his reasons for worrying about excessive reliance on the dollar were probably correct, his proposal for an alternative currency based on SDRs was more problematic.

The SDR is not a currency. It is an accounting unit based on an artificial currency “basket”. As of January 1, 2006, the SDR valuation basket had the following weights based on their roles in international trade and finance: U.S. dollar 44%, euro 34%, Japanese yen 11%, and pound sterling 11%.

If countries accumulated reserves in the form of SDRs, they would effectively accumulate a basket of the above currencies. But of course no one needs SDRs to accomplish the same thing directly. If the People’s Bank of China, for example, felt that the SDR represented a more balanced and appropriate portfolio composition for its reserve holdings, nothing could have prevented it from apportioning reserves according to the SDR basket.

And yet informed observers believe that the US dollar accounts for anywhere from 65% to 70% of the PBoC’s total direct reserve holdings – even more if we include foreign assets of state-owned enterprises and minimum reserves held by China’s commercial banks.

But if holding more than 44% of a country’s reserves in dollars distorts the global balance and creates excessive currency concentration, why do the People’s Bank of China and other central banks willingly do just that? Dark mutterings about US hegemonic power notwithstanding, there are no legal or physical restrictions on the ability of central banks to choose the assets they purchase. For the past decade they could easily have purchased fewer dollars assets and more euro, sterling and yen assets.

The answer has little to do with geopolitics. It is a necessary requirement in global trade that capital and trade flows balance. Countries running trade surpluses must recycle their surpluses to the countries running trade deficits. Normally this is done through private investment flows, but following the 1997 Asian crisis a number of central banks, especially in Asia, began accumulating such large amounts of international reserves that their purchases of foreign assets completely dwarfed private investment flows.

Assets which the central banks of trade surplus countries purchase will to a significant extent determine which countries run trade deficits. If central banks mostly buy US dollar assets, the US will run the corresponding trade deficit. Contrary to popular opinion, financing flows do not necessarily follow trade flows. It is often the other way around..

Let us assume that over the past decade Asian central banks had decided to acquire reserves in the amounts described by the composition of the SDR. This means, assuming trade surpluses were constant, that they would have purchased between one-half and two-thirds the amount of dollars they actually did. The balance would have gone into euro, yen and sterling.

One likely consequence is that with less demand the dollar would have been weaker relative to the other three currencies then it has been. This would have cause a relative expansion in the tradable goods sector of the US, and a relative contraction in the tradable goods sector of Europe and Japan. With the expansion in the US tradable goods sector, and its positive impact on employment, the Federal Reserve would have kept interest rates a little higher, and US consumption would have been a little lower relative to GDP. Of course the exact opposite would happen in Europe.

Lower consumption means lower imports, and vice versa, in which case the US trade deficit would have been lower and the European and Japanese trade deficits higher by roughly the difference in the amount of dollar reserves purchased. By choosing to buy euros instead of dollars, in other words, Asian central banks would have forced a large part of the US trade deficit to migrate to Europe.

But could Europe have sustained a large trade deficit for any long period of time? For both political and economic reasons too complex to discuss here, it is reasonable to assume that Europe would not have been able to bear the burden of a substantially larger trade deficit. Most Asian policymakers know this.

That is why the US dollar is the world’s reserve currency, and most especially the reserve currency of Asian countries using foreign demand to boost domestic growth. In the distorted trade environment of the post-1997 world, the US was the only economy large and flexible enough to absorb the trade deficits that Asian countries required for their growth. US hegemonic power or deliberations had very little to do with it. Asia had to accumulate dollars if it wanted foreign demand to power domestic growth, and SDRs would have prevented this from happening. That is probably a good thing for the world, but a bad thing for China and Asia.

Tags: Steve Keen

The market (or at least that part of the market that obsesses over balance of payment flows) has been swept with rumors today that foreign exchange reserves were down in January by $30 billion.  My experience with these sorts of rumors is that they tend to be fairly accurate, and I suspect they will soon be confirmed.

 

If true, what does this imply about hot money flows?  The PBoC’s accounts have been more opaque than ever and it is extremely difficult to figure out what is really happening, but let me give try at least to bracket the range of outcomes.

 

China’s trade surplus in January was $39.1 billion.  It probably earned another $6-7 billion in interest income plus the reported $7.5 billion in FDI.  This means that absent other effects reserves should have risen in January by $52 to $54 billion.

 

But there were other effects.  China holds part of its reserves in currencies other than the dollar, and these declined in dollar terms January (the dollar appreciated).  The total loss here may be around $30-40 billion.  That means that absent other effects reserves should have risen by at least $15-20 billion.  If reserves in fact declined by $30 billion, it would indicate at least $40-50 billion in unexplained outflows.  Is this all hot money?

 

Brad Setser recently wrote a widely-read entry in his blog in reference to an article by Jamil Anderlini of the Financial Times about SAFE investments in equity markets that may have lost them $80 billion or more.  If this is true, and it seems plausible, some of those losses may have occurred recently, although since the most vicious equity markets were last year, very little of that loss should have occurred in January – and it is anyway an open question whether the PBoC would value these investments at book or at market.  Perhaps a small part of the unexplained $40-50 billion represents equity losses, but this cannot explain much of it.

 

We also know that China has stepped up its purchase of foreign commodities, either directly (which would have shown up already in the trade numbers) or indirectly via investments in commodity producers.  The latter would have caused “unexplained” dollar outflows from the PBoC.  It is not clear that much, if any, of this happened in January, but perhaps some of the outflow represents new outward investment of this sort.  We don’t know.

 

Against that there is the question of whether December’s 150 basis point reduction in minimum reserves represents a reversal of dollar assets held at the central bank by commercial banks (remember that earlier increases in minimum reserves in 2007 and 2008 had been redenominated into dollars, and so their reduction should have reversed that process).  If it did, and this would consist of about $30-40 billion, it would actually increase the unexplained amount. For the sake of conservatism, let’s assume that this hasn’t happened.  We should know when the PBoC release its balance sheet numbers if the “Other dollar assets” account changed significantly.

 

Where does that leave us?  There are about $40-50 billion in unexplained outflows and however you look at it there it is hard to believe that we haven’t seen at least $20-30 billion of hot money outflows in January.  From my many years experience in developing markets I should say that the informational content of hot money flows is often wider than many people at first think.  Much of the discussion about whether Chinese businessmen are bringing in or taking out money hinges on their perception of whether or not the currency will appreciate or depreciate (and in spite of the popular view of evil foreign speculators masterminding the flows, the truth is that the vast majority of this money is likely to be controlled by local businessmen).

 

But I would argue that usually a much bigger driver of hot money flows is the local perception of risk in the country experiencing the flows.  If hot money is flowing out of China, it could be because local business owners believe the currency will depreciate, but I think it is more likely that the flows represent their concern that local investment opportunities – for example their businesses – have become increasingly risky and uncertain.  Hot money flows tell us at least as much about risk perceptions as they do about profit opportunities, especially when the world is in trouble.

 

By the way, this exercise should indicate yet again why all the discussions and debate in China and the US – about whether or not China should continue financing the US fiscal deficit – are wholly beside the point, as I have been arguing almost monomaniacally for years.  China cannot finance the US fiscal deficit, nor can any other country.  China can only finance the US trade deficit, and it must do so by recycling its current account surplus, either via Chinese investors, or via central bank purchases of US dollar assets. 

 

If there are hot money outflows from China large enough to cause the central bank to lose reserves, the central bank will not only stop buying US Treasury bonds and/or other dollar assets, it will have to sell something, which is most likely to be US dollar bonds.  It has no choice. 

 

Chinese investors who have taken money out of the country, on the other hand, will now effectively be responsible for recycling the Chinese current account surplus.  They might decide to buy US Treasury bonds (and I suspect indirectly and directly many will), but they could also buy gold, Venezuelan bolivares, Moroccan real estate, or in fact anything else they choose, and it is their buying that will determine how the Chinese trade surplus gets allocated among China’s trading partners.

 

The other point to consider in all this is the impact on Chinese monetary conditions.  A net outflow from the central bank has to be financed by retiring central bank bills or “destroying” RMB.  This implies monetary contraction, and it is still difficult for me to see how this would not have a contractionary effect on underlying money.

 

Note 1:  Wednesday’s edition of the New York Times has an interesting article on Pingyao, a stunningly beautiful town about an hour from Taiyuan, in Shanxi province which, if it weren’t for the coal-dust-infested air, would remind me of San Miguel de Allende or some of the other old and protected silver-mining towns north of Mexico City.  I visited three years ago and plan to go back because of my interest in Chinese financial history.  Pingyao was probably China’s first financial center (although temples already operated as early banks thousands of years ago) and headquartered the largest and most famous piaohao – 19th Century merchant trading companies whose businesses had expanded to taking silver deposits in one city and making them available in other cities (travelling was dangerous), collecting the emperor’s taxes and transferring revenues, and ultimately to making loans.  This is only marginally related to my blog, but for those readers interested in this kind of stuff, I encourage you to read about Pingyao and the piaohao.  It is a fascinating story. 

 

Note 2:  Once again my site is blocked in China.  I don’t know why– I hope it only has something to do with last week’s NPC meeting and will be fixed soon – but until it is resolved my formatting will be screwed up and I won’t be able to respond to comments.  For China-based readers, I think you can access this site easily on SeekingAlpha.com

I have been on the road for the past few (and next ten) days, in part because of Spring Festival, so I haven’t been able to post as much as I normally do, but I was asked to write an article for a Chinese magazine, which I recently finished, on comparisons between today and the beginning of the 1930s.   As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it.  I and a few others have discussed one of the similarities so many times and in so many different places that I think by now the whole issue of the trade impact of US overcapacity in the 1920s and 1930s and how it relates to China today is pretty widely recognized.

But there is more.  I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history).  One of the points he makes – in fact it is probably the main point of the book – is the way currency policies (i.e. adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis.  It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis.  Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold.  They were also the ones most harmed by the 1930s crisis.  I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions.  Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

1. The first I have discussed many times.  Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports.  However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries.  As international trade collapsed – especially after the US tried to force the adjustment abroad by the passage of import tariffs – domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically.  It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending.  This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment.  Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.
2. To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending.  The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract.  When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster.  According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all.  The first and most obvious is the scale of China’s overcapacity problem.  China’s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 – roughly 0.5% of global GDP – but its economy is less than one-fifth the relative size of the US in 1929.  Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts.  For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods.  In that direction lays trade friction, which would have a devastating impact on Chinese businesses.

Perhaps not nearly as strong as the US in 1930, China is nonetheless in a reasonably strong position fiscally – although municipal reliance on land sales for revenues, contingent liabilities in the banking system and in provincial and municipal borrowing, and overall lack of transparency, make it difficult to judge.  More importantly, however, there is widespread recognition among policymakers, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand.  Unfortunately it is not yet clear exactly how aggressively the Chinese government will expand fiscally and whether it will do so fast enough to replace declining US and European imports.

The second point may be the more important.  Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth.  When this happens the financial system often responds by taking on excessive credit risk and over-investing.  Given the complexity of the China’s formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry.  Warren Buffett once quipped that you can never know who is swimming naked until the tide goes down.  The tide is receding and we are about to see how many naked bankers there are.

How the PBoC will respond to any signs of sharp money contraction is probably the most important question to answer and also the most difficult.  On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk.  The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy.  In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management.  This is one of Eichengreen’s key points.  Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain.  Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently?  Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency.  This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.

The PBoC has other tools: most importantly its influence on credit creation (I am skeptical about the usefulness of open market operations) which it can expand partly by reducing the minimum reserve requirement for banks and partly by moral suasion within the banking system, but I am not sure how effective this is likely to be.  Remember that much of the credit expansion from previous years seems to have migrated off the balance sheets of commercial banks (including into the informal sector) when the PBoC tried to constrain credit growth.  In my opinion when underlying monetary conditions are consistent with rapid credit expansion there, is little the regulators can do to prevent this from happening.  At best they can decide whether it happens in the regulated parts of the system or whether it simply migrates to other areas.

The reverse is also likely to be true.   Attempts by the PBoC and other policy-makers to force banks to expand credit may result in higher loan growth reported on bank balance sheets, but overall credit growth within the economy is likely to be much less.  If the underlying money supply is consistent with contracting credit, the system will most likely see contracting credit (and I am saying nothing about the possibility that much of the formal credit expansion reported by the banks will consist of empty lending into future NPLs).

With international trade falling, it is probably only a question of time before China’s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave.  This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces.  We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency  terms, the PBoC has limited ability to manage the domestic money supply.  If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending.  This would undoubtedly worsen China’s difficult economic adjustment to the problem of overcapacity.  It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans.  China can learn a lot from the mistakes of US policy in the 1930s.

By the way whenever I say that money outflows could become a problem for China, inevitably someone rushes in to pour scorn on the idea that China is vulnerable to a 1997-style Asian crisis.   I agree it isn’t, and I will repeat (again) that this is not and never has been the point of my concern about hot money outflows.   China does not have a currency mismatch risk worth bothering about.  The reason to worry about hot money outflow is that it has a domestic monetary impact.

Tags: Eichengreen

Between the holiday slowdown and the number of writing commitments I have it has been a little too easy to neglect my blog. What free time I have has been spent reading, and I am reading for the third time what I think is one of the best books ever written on financial history – Barry Eichengreen’s Golden Fetters: The Gold standard and the Great Depression.

Eichengreen’s book has an awful lot to tell us about our own current crisis, as does any good book on financial history. In spite of all the unending nonsense written about what went caused the financial crisis this time around – derivatives, securitization, deregulation, greedy bankers, overpaid traders, fraudulent behavior – the fact is that financial crises going back over at least 2000 years are disconcertingly familiar, and have nearly identical consequences and processes, even when they include none of the conditions blamed for the current mess. To focus on those particular triggers as being the main causes of the crisis is what I would call the “trigger fallacy.” They are merely the symptoms of the underlying problem – excess liquidity, which the financial system is forced into accommodating by taking on increasingly levels of risk, either inside or outside the regulated areas.

Not surprisingly then it is impossible to read Eichengreen’s book in the current economic climate without several “aha!” moments, but this passage (pp. 11 of the 1992 edition) I found particularly interesting:

The arrival of the Fed on the international scene was a significant departure from the pre-war era. Disputes between New York and Washington rendered the new institution unpredictable. Until the Banking Act of 1935 consolidated power, considerable influence was wielded by reserve city bankers from the interior of the country with little exposure or sympathy for international considerations.

Eichengreen is discussing how the advent of the US as a major financial center changed the “rules of the game” involving cooperation between the major European central banks – mainly the UK, France and Germany – when the closest thing to a US counterpart was the very well-managed and internationalist House of Morgan. During the end of the 1920s and beginning of the 1930s the Fed’s role became increasingly prominent and increasingly erratic especially after the death of Benjamin Strong, who ran the New York Federal Reserve Bank and who had a very strong relationship with Montagu Norman, the Governor of the Bank of England.

The point is that before power was consolidated under the Chairman of the Federal Reserve System in Washington DC, the US central bank consisted of 12 regional banks with quite a lot of independent power, and the regional banks tended to be, not surprisingly, more parochial, more beholden to the dominant economic interests of their region, less understanding of the US role within the global system, and less sympathetic to the need for the US to behave in a manner befitting what was later dubbed a “global stakeholder.”

This had consequences. It was very hard for the US central bank to act in a consistent way to manage its proper role within the global context, and this failure not only created a very debilitating uncertainty, but also ensured that parochial interests trumped international interests even when the US was better off parochially from understanding its role within the international context. For example US trade policies aimed at helping regional economic interests at the expense of the outside world ultimately ensured both a collapse in international trade and, as result of the US position of overcapacity, a brutal collapse in US capacity.

What does this have to do with China? Perhaps nothing, but I am of course not the first to observe that the PBoC has very little independence and is largely beholden to the State Council and senior officials within the Standing Committee for its policy decisions. This is, in itself, not a problem and might even result in better coordination between the country’s treasury and central bank functions. However there are persistent rumors of serious disagreements among senior policymakers and especially a split between one camp, dominated by provincial leaders more concerned about social issues arising from unemployment and income inequality, and another camp, based in the major international center and more concerned about macroeconomic imbalances at both the national and global levels.

Is there a possibility that the PBoC will find itself, like the Federal Reserve in 1929-31, riven by very different understandings of the country’s role within the global crisis and with different priorities in resolving the crisis – ones that misconstrue how the global adjustment will affect China’s adjustment? I have no idea, and perhaps the game of finding parallels between 1929 and 2008 gets a little carried away at times, but it is worth considering that monetary policy-making in China has not always been consistent and, like most major policy-making, can be easily subject to competing views of Chinese political priorities and China’s role within the crisis.

This is not to say that the illusionary triumph of parochial over global interests is inevitable, as occurred in the US in the 1930s, but it certainly is a possibility. This is yet anther reason why I am convinced that US, European, Japanese, and especially Chinese leaders need to get a clear macro picture of what the global balance of payments adjustment will mean for each country, and give up the silly blame game to work out a reasonable long-term period (at least three or four years), during which time China can adjust to the global adjustment. Any quick adjustment will be bad for the world and devastating for China.

But the prospects for understanding don’t look good. Local newspapers are filled with worried articles about rising unemployment, and on Saturday Premier Wen made an unscheduled and very surprising visit to one of our academic neighbors. According to an article in today’s People’s Daily:

Chinese Premier Wen Jiabao has pledged to university student that the government would seek to provide more jobs for graduates and “put the issue of graduate employment first.” “Your difficulties are my difficulties, and if you are worried, I am more worried than you,” Wen told the students at the Beijing University of Aeronautics and Astronautics. Wen made the remarks in a surprise visit on Saturday afternoon.

…He said the country is in a difficult period as the global financial crisis has continued affecting the country’s real economy. The government has begun measures to sustain the economy, such as the four-trillion-yuan stimulus package and interests cuts. “We are considering taking more measures at proper time. But currently we are most concerned about two issues, migrant workers returning home and employment for graduates,” Wen said.

The financial crisis and China’s slowing economic growth has forced 4 million migrant workers to return to their rural homes, according to a report from the Chinese Academy of Social Sciences. The report also said as of the end of this year, 1.5 million graduates are likely to have failed to find jobs, and the country could see an ever tougher employment situation in 2009 as there will be about 6.1 million seeking jobs (from 5 million last year).

Other headlines fret about the mass migration – well before the traditional Spring Festival period – of unemployed workers returning to their rural homes. According to an article in Friday’s South China Morning Post:

Up to 9 million migrant workers have left coastal areas this year amid diminishing job prospects and falling wages, prompting fears that unemployment in inland provinces may increase sharply next year. Home-bound migrant workers have packed major railway stations in major cities, catching the central government by surprise because the traditional passenger peak arrives just before the Lunar New Year, which is late next month.

There is still more about the rise of criminal gangs, more protests, and all the other indications of social tension. In these circumstances it is not hard to see why policymakers may decide that short-term unemployment pressures trump the global balance of payments adjustment, and push to subsidize and encourage more production, rather than worry about rapidly expanding domestic consumption. This would, of course, only exacerbate the Chinese overcapacity problem and increase the likelihood of trade tensions which, if they lead to global protectionism, could scuttle any chances of China’s recovering from the crisis. I guess this is exactly what they mean by “between a rock and a hard place.”

One other thing to discuss before I finish this long posting – Bloomberg posted the following article today:

China’s foreign exchange reserves dropped for the first time in five years as a result of the global financial crisis, Market News International reported, citing Cai Qiusheng, head of the investment management bureau under the State Administration of Foreign Exchange. The current figure must be lower than the peak of about $1.9 trillion, Cai told a trade forum in Beijing over the weekend, the English-language wire service said. He didn’t specify which period he was referring to or give a figure.

I am not really sure what is going on. We used to get regular and reliable monthly leaks about reserve figures but these have pretty much dried up since June, just as we needed the numbers more than ever. The last official numbers were released for September – they are released on a quarterly basis – and put reserves at $1.9056 trillion. The latest “leak” claims reserves are at $1.89 trillion, which with rounding suggests that reserves declined in two months by somewhere between $10 and $20 billion.

Of course we are all very eager to get a better breakdown of the recent figures so that we can estimate hot money flow directions. But given the we have had two world-record-smashing trade surplus months in a row since September, amounting to $75 billion (and three monthly world records before that), not to monition positive FDI inflows of $14 billion and about $10 billion of interest income in the past two months, it is very unlikely that the dollar value of the various non-dollar reserves can have declined by even a significant fraction of $99 billion increase in reserves from trade, FDI and interest income in the past two months (or the $110-120 billion implied by the new reserve numbers). Does this mean there has been significant hot money outflow? Perhaps, but without real numbers it is tough to want to conclude anything. January’s central bank data release promises to be very, very interesting.

But there’s more. My friend Victor Shih published a very good Op Ed article in the Wall Street Journal Asian last week. You can find it on his blog. He discusses how the new fiscal expansion plans – which are seriously constrained by structural impediments in the economy – are likely to cause significant pressure for bank “participation,” and this pressure is unlikely to lead to improved banking practices. He concludes:

In any event, everyone is too preoccupied with their own losses to comment on Chinese policies. Which is a problem, not least for China itself. With enormous political pressure from the central government to pump money into the economy and silence from the rest of the world, much of the work in the past decade is being undone.

What will happen to all this money? Stephen Green – one of the best bank research analysts on China, in my humble opinion – just published a research report called China – The best-laid plans of mandarins and ministers in which he tries to tabulate the various spending plans being proposed at the national and provincial levels. Not surprisingly, he has a hard time figuring out the numbers – one section of his report is titled “CNY 4trn, CNY 18trn, or CNY 320bn?”

The government is so worried about a slowdown that there is almost a feeding frenzy over who can proclaim the most spending – with very poor Hunan proposing $1.2 trillion in expenditures that surpass the entire US fiscal plan, as Green notes. Even if most of these proposals are rejected, clearly an awful lot of money is going to be spent awfully quickly with an awfully small amount of oversight. Elsewhere in the report Green notes:

One suspects that corners are now being cut to get the money flowing again. The bureaucracy must also be exceedingly happy; it is commonly believed that 15-30% of the cost of a project is absorbed by ‘administrative’ fees, ‘consultancy’ fees, and the like (which raises the question of whether we should be discounting the CNY 4trn by 20% or so, and assuming these other funds will form part of 2009’s FX capital outflows). The Party’s corruption inspectorate is already preparing teams to monitor the use of public and bank funds. But it is, as they say, a big country.

It certainly is. And yes, we should be increasing our estimates of hot money outflows next year.

Happy holidays to all my readers. Unless there is a lot of important news in the next few days I will probably not post anything for a week. For those living in Beijing, we do have an outstanding Christmas Eve show at my music club, D22, and another outrageous night on New Year ’s Eve. If you want a good feel for some of the best new music in China (and the world), don’t miss these two nights. Sorry for the advertisement, but the Beijing music scene is truly exciting.

Tags: Eichengreen

Fareed Zakaria usually writes very interesting pieces on international policy issues, but it seems to me that there is so much mystery about how the global balance of payments works that he, like so many others, makes simplifying assumptions that don’t take the balance into account, and for that reason just don’t make sense. In his latest piece for the current issue of Newsweek, for example, he says the following:

There is a consensus forming that Washington needs to spend its way out of this recession, to ensure that it doesn’t turn into a depression. Economists of both the left and right agree that a massive fiscal stimulus is needed and that for now, we shouldn’t be worrying about deficits. But in order to run up these deficits-which could total somewhere between $1 trillion and $1.5 trillion, or between 7 and 11 percent of GDP-someone has to buy American debt. And the only country that has the cash to do so is China.

In September, Beijing became America’s largest foreign creditor, surpassing Japan, which no longer buys large amounts of American Treasury notes. In fact, though the Treasury Department does not keep records of American bondholders, it is virtually certain that, holding 10 percent of all U.S. public debt, the government of the People’s Republic of China has become Washington’s largest creditor, foreign or domestic. It is America’s banker.

But will the Chinese continue to play this role? They certainly have the means to do so. China’s foreign-exchange reserves stand at about $2 trillion (compared with America’s at a relatively puny $73 billion). But the Chinese government is worried that its own economy is slowing down sharply, as Americans and Europeans stop buying Chinese exports. They hope to revive growth in China (to levels around 6 or 7 percent rather than last year’s 12 percent) with a massive stimulus program of their own.

The spending initiatives that Beijing announced a few weeks ago would total almost $600 billion (some of which include existing projects), a staggering 15 percent of China’s GDP. Given their focus on keeping people employed and minimizing strikes and protests, Beijing will not hesitate to add tens of billions more to that package if need be.

At the same time, Washington desperately needs Beijing to keep buying American bonds, so that the U.S. government can run up a deficit and launch its own fiscal stimulus. In effect, we’re asking China to finance simultaneously the two largest fiscal expansions in human history-theirs and ours. They will probably try to accommodate us, because it’s in their interest to jump-start the American economy. But naturally their priority is likely to be their own growth.

While I agree strongly with the thrust of Zakaria’s piece (cooperation between China and the US is extremely important to both countries), I disagree with his claim that “someone has to buy American debt, and the only country that has the cash to do so is China.” I was hoping that Brad Setser had already killed this argument, but apparently not.

Zakaria argues that the US needs a plan of massive deficit-financed fiscal expenditure in order to pull the US out of recession. This may or may not be true, but if it is true, the reason for the recession is that US households and businesses have found themselves overleveraged after years of excessive consumption, and must now cut back sharply on their spending as they increase savings. US fiscal expansion, in other words, will occur to offset the economic impact of a rise in US savings.

But if there is a rise in US household savings, don’t these increased savings need to be invested? Where will Americans put their savings? In fact almost all of it is likely to be invested in the US, and therefore the increase in savings is going to offset the need to finance a higher deficit (by the way, even if Americans decide to invest their incremental savings abroad instead of in the US, the net impact is the same). This is just another way of saying that the money that used to go towards financing private US consumption will now go to finance public US consumption, and we all hope (I think) and expect that overall US consumption declines from its clearly excessive levels of recent years, so the total financing will be smaller.

The net impact is that the US doesn’t need foreign savings to finance the fiscal expansion unless the expansion is so great that the US economy surges and Americans (private and public) spend more than ever, in which case the problem is not a recession but a boom.

There is more to it. The $2 trillion in reserves that China has is already invested, so it cannot be used for additional investment. If the US really needs larges amounts of Chinese financing in the future, this is simply another way of saying that China must run significant trade surpluses with the US in order to accumulate the dollars necessary to lend to the US government (remember, China doesn’t finance the fiscal deficit, it finances the trade deficit).

Basically what Zakaria is implicitly saying is that in order to boost the US economy – which means boosting US production of goods and surpluses – the US must run very large trade deficits with China so that fiscal deficits can be financed by the Chinese. But a trade deficit, by definition, is consumption supplied by foreign production, not domestic production, so insisting on a large trade deficit with China cannot be the way to boost US production. And of course if the US does not run a large trade deficit with China, then China simply cannot fund the US fiscal deficit.

Zakaria continues:

“People often say that China and America are equally dependent on each other,” says Joseph Stiglitz, winner of the 2001 Nobel Prize in Economics. “But that’s no longer true. China has two ways to keep its economy growing. One way is to finance the American consumer. But another way is to finance its own citizens, who are increasingly able to consume in large enough quantities to stimulate economic growth in China. They have options, we don’t. There isn’t really any other country that could finance the American deficit.”

I have a huge amount of respect for Stiglitz but I also wonder about the logic of this claim. He says that China can either finance its own consumption or American consumption, and we should somehow hope they are kind enough to finance American consumption. As I have tried to argue in several previous posts, we should actually hope for the opposite. If China boosts domestic demand sufficiently, that will go a long way towards adjusting the global imbalance between excess US consumption and excess Chinese production. The main purposes of US fiscal expansion, I think, would be a)to slow down the US adjustment process so that it does not fall into a downward spiral, and b)to give the Chinese fiscal boost more traction – program of coordinated fiscal expansion by the world’s major economies would be better, I think, than leaving any one country to try to bear the brunt alone.

By the way the view that the Chinese authorities will have an easier time in this crisis than the US because “They have options, we don’t” is not, fortunately in my opinion, universally held among Chinese authorities. It is increasingly obvious that policy-makers here are very worried. Yesterday’s Bloomberg pointed out that the RMB is depreciating:

The yuan headed for the biggest weekly decline in almost two months on speculation China is seeking to protect exporters and prevent a recession in the world’s fourth-largest economy. Bonds fell. …”There is some pressure for depreciation as the dollar is strong and other Asian currencies are softening,” said Patrick Bennett, a foreign-exchange strategist with Societe Generale SA in Hong Kong. “Still, record trade surpluses and strong investment flows suggest appreciation pressure is intact.”

The currency declined 0.17 percent this week to 6.8356 a dollar as of 11:44 a.m. in Shanghai, according to the China Foreign Exchange Trade System. The yuan is allowed to trade by up to 0.5 percent against the dollar either side of the so- called central parity rate, which was set at 6.8317 today.

Tags: Zakaria

I always seem to be traveling when exciting things are happening. I just got back this morning from four days in Paris, where I had to go for our annual Board of Directors meeting (and took the opportunity in addition to meet a number of investors and government officials), and so I was in a Paris hotel for the US elections.

I am delighted with the results, of course. Obama is a brilliant thinker and a charismatic figure, and has shown himself to be willing to listen to people who know more than he does, however without fobbing onto them the ultimate responsibility for making the decision. More importantly, he graduated from Columbia University, and so he definitely owns my loyalty. But like many others I seriously worry about whether he can even come close to realizing some of the fantastic expectations placed on him by Americans and by people around the world.

It was interesting to see the results in France. Of course in discussing this I am stepping away from any discussion of Chinese financial markets, but this seems to be enough of an historical event that it merits some digression. Most French seem to support Obama, but perhaps he has unfortunately become almost a messianic figure to some. I watched a television report from one of the poorer northern towns heavily populated by immigrants and their children, and the rapture and excitement of his election exceeded even the happiness in Hyde Park. Men and women were screaming with happiness, the halls exploded with dancing and cheering, and hundreds of those present chanted “We have our president, we have our president!” But he is not their president, and they may be seriously overestimating what Obama can do for them.

In the program the journalists interviewed two young Frenchmen – one black and one Muslim. They were very smart, very serious, and the point they were making worried me a lot. They explained that for years France was way behind the US in racism and its treatment of ethnic minorities. With the election of Obama, they said, the US had taken a huge step forward, leaving France even further behind, and they expected that France, too, had to take a major step forward. Obama was their inspiration to expect more from France (I suspect this kind of thinking is happening everywhere in Europe).

Of course they are right, but in the US the discourse on race and ethnicity is an old and fiery one, and far more advanced than any in Europe – when I grew up in Spain and France we were able to say and do things without thinking that, I later learned when I moved to the US for university, should have been completely unacceptable. Saying or doing many of those things still isn’t unacceptable in most of Europe.

I am enough of a realist to know that racism isn’t resolved by friendly dialogue and feel-good announcements by official bodies, but rather by confrontation, disputation and hard work. (That is why, by the way, I am afraid that the racism and discrimination in a country like China will persist for a painfully long time – it is practically forbidden even to acknowledge racism here, let alone fight over it.) But here is the problem. The world is in the midst of a financial crisis – one that will almost certainly see a significant reduction in global growth. Historically, disadvantaged minorities do worse during periods of low or negative economic growth than does the population as a whole. During these periods anti-immigrant feelings almost always rise.

I am afraid that for those two young men in France – and for many of those others who screamed and sang with delight and thankfulness Tuesday night – the next few years are not only going to see their welfare decline in nominal terms, but also even in relative terms. But expectations are for the opposite, and it seems to me that they have gotten so far ahead of reality that the next few years are going to be politically very difficult in the many parts of the world.

In the long run this is a good thing. Let minorities and the systematically excluded demand more everywhere, no matter how good or bad economic conditions are. It is only by demanding that they will get anything. In the short term, however, it won’t be easy.

But enough pontificating – Obama’s election has been so exciting that it has made philosophers of us all. There was a lot happening in terms of China’s economy and financial system, too, although not a whole lot of good things. I will disucss more of the really interesting stuff I have been looking at over the next week, but for now I will bring up just a few general points.

The first thing I want to bring up seems at first to be a good thing. The IMF says that China will be an oasis of stability in the global turmoil, and it sort of reaffirms its 9.3% prediction for 2009 GDP growth, but there may be less here than meets the eye. This, of course, is the same IMF that predicted in November 1997 that in spite of the surrounding turmoil South Korea was immune from the troubles afflicting its neighbors and in 1998 it’s economy was going to grow by 5-6% (fortunately they managed to pull the report just before it was due to be released, after the won collapsed). For those who are interested, South Korea’s 1998 growth rate was actually -6%.

Cheap shot, maybe, but the IMF – perhaps because it is a political institution – has a very weak track record in predicting trouble. Their economists also, I am afraid, have had an even worse track record in understanding the relationship between the economy and the structure of the national balance sheet – even though they did write an interesting report in 2003 or 2004 on the subject (which I suspect none of them subsequently read). Here is what the South China Morning Post said on Tuesday:

David Burton, the head of the IMF’s Asia-Pacific department, said that despite China’s own economic slowdown, the country had many ways to shore up its economic growth. Mr Burton said China’s export-driven economy had been dragged down by dwindling demand from the United States and Europe, and it could even miss the IMF’s forecast of 9.3 per cent growth next year. But the country was still sitting on almost US$2 trillion in foreign exchange reserves and had a relatively strong financial system.

“The global economy is slowing sharply and [the mainland] and Hong Kong are going to be significantly affected,” Mr Burton told the South China Morning Post before meeting Chief Executive Donald Tsang Yam-kuen yesterday. “With its robust reserves, I have no major worries about China, which will be a source of stability for the globe for the next year or two.” He said both the mainland and Hong Kong would be well positioned to get through the crisis.

I have no doubt that 2009 growth expectations are going to be sharply revised downward several times. They are probably going to lag the investment banks, who themselves are going to lag the independent analysts, but ultimately I expect all of us will soon reach the point where no one is predicting anything above 7%.

Meanwhile Bloomberg yesterday had the following article:

The yuan completed its best week in more than two months on speculation policy makers are allowing some gains to prevent money leaving as overseas investors pull out of emerging markets amid the economic turmoil. Bonds rose.

I hadn’t heard these rumors but of course after the third quarter PBoC numbers came out it was pretty clear that not only was China no longer seeing massive hot money inflows, but in September it was seeing outflows. I am curious to see the fourth quarter numbers. It would be worrying if hot money outflows really were becoming a problem.

Finally I saw another interesting Bloomberg article on Friday.

China’s Finance Minister Xie Xuren was called back from an international economic conference in Peru before the meeting began, following orders from Beijing to help resolve problems at home, an organizer of the event said.

Xie left Trujillo, Peru, where Asia-Pacific Economic Cooperation finance officials are meeting this week, shortly after arriving at 11:00 a.m. on Nov. 5, Gladys Otero de Swinnen, protocol director for the conference, said in an interview. “They told him he has to resolve an economic problem and that he’s the only one who could do so,” de Swinnen said.

…Deputy Finance Minister Li Yong stayed in Trujillo. Li declined to comment on measures to boost China’s growth. Xie arrived in Beijing to take care of some “urgent business,” two finance ministry officials, who declined to be named, said today. They didn’t elaborate.

I have no idea of what this is about, and I have not been able to find any further references, but in the cloaked, gossipy world of Chinese politics I am very curious to know why he was suddenly called away. I suppose we may hear more in the next few days. Perhaps one of my readers may have better information than I do.

In 30 minutes we have the weekly meeting of the Guanghua Students Monetary Committee. Last week’s meeting was pretty good and I am very interested to see what the students conclude today about monetary and credit conditions in China. I will of course report anything that comes out of there

Tags: Hot money, IMF

The stock market had its best day in a long time, with the SSE Composite rising 7.6% on the day to close at 2522.  Most of the run-up came in the morning, and several financial sector firms, which were the best performers, had to stop trading when they hit their 10% price-change limit, suggesting that tomorrow there will be early upward momentum.  Add today’s rise to yesterday’s 1.1% gain, and since Monday the market has recovered more than half of the 14.9% drop it suffered since the beginning of the Olympics.

 

There is less here than meets the eye, I think.  Two things seemed to have driven the market up today.  First there are a lot of rumors going around that the securities regulators are planning an important meeting with China’s major stock brokers tomorrow, to discuss market-boosting measures.  Regulators actually made announcements over the weekend about steps they were taking to support the market, but these had almost no positive effect on the market at all – on the contrary they were judged to be so disappointing that Monday’s market was down 5.3%.  In fact none of the measures announced during 2008 have affected the market by more than a few days.  Perhaps rumors about an announcement are far more powerful than any actual announcement. 

 

Second, Frank Gong, JP Morgan’s chief China analyst, sent a note to clients in which he claimed that China’s leaders are considering a RMB 200-400 billion stimulus package and further easing of monetary policy.  With GDP of around RMB 30 trillion, this would represent a stimulus of around 1% of GDP.

 

I am not sure a 1% stimulus – which was not exactly unexpected given all the fears of an economic slowdown – should have had such a massive impact on the market, but after plummeting so quickly perhaps it was time for a bounce, and participants just needed a good excuse.  We have seen lots of big 10% or more bounces in the past several months, and it will be interesting to see if this time around it lasts longer than the others.  I am skeptical.

 

According to the South China Morning Post’s article on the JP Morgan note:

 

On the perpetual debate of how China should manage its US$1.81 trillion of foreign-exchange reserves, Gong said Beijing may have intensified sales of some dollar assets. But it aims to keep the bulk of its reserves in dollars – even if they are not invested in the debt of US mortgage agencies Fannie Mae and Freddie Mac – because it favours a strong US currency.

 

Gong said it was unlikely that China would diversify into the euro, yen or commodity currencies in a big way as these currencies may already have peaked.  Instead, policy makers were studying a number of suggestions put forward by government researchers, including: Repatriating the money and investing it in on physical and social infrastructure to boost consumption; Using some of the money to set up a fund to stabilise the stock market, which is down 62 per cent from October’s record high; Diversifying into dollar-bloc currencies such as the Hong Kong dollar and other Asian markets.

 

I think there is an awful lot of confusion about what can and cannot be done with the PBoC reserves.  The authorities cannot take the reserves and use them for the first two suggestions – spending on physical and social infrastructure, or supporting the local stock markets – simply because foreign currency cannot be spent in China.

 

Let us assume for a moment that the government wanted to take $100 of reserves and spend them domestically – whether to build hospitals or to buy stock.  Once it received this money from the PBoC it would have to exchange these $100 dollars into RMB before it could spend them, and since the market is a net seller of dollars, who would do the exchange with them?  The PBoC, of course, who would have to buy the dollars back and pay for them either by creating or by borrowing RMB.  The net result would be no change in the total amount of foreign exchange reserves held by the PBoC. 

 

So where did the money come from?  If the government purchased the dollars from the PBoC, either taxes or its net domestic borrowing would have to increase by that amount.  If the PBoC were forced to donate the money, either its own debt would rise (if it borrowed the RMB by issuing central bank bills) or the domestic money supply would rise (if it simply created RMB).

 

Either way, the Chinese government could only spend the money if it financed it by raising taxes, by borrowing – either directly or through the PBoC – or by simply creating money.  It turns out that no matter how high or low the level of reserves, the Chinese government can only fund domestic spending by raising taxes, borrowing, or inflating.  All three of these things the government can do without the need for PBoC reserves.

 

The only reason the reserves matter in this case is that if China were to reduce its net savings significantly by a large amount of government-related spending, so that total consumption exceeded total production, the result would be that China would run a trade deficit, which would draw down reserves.  With reserve accumulation running at 20% of GDP, however, it would have to be a pretty large dollop of spending before it began to cause a decline in reserve growth, and with $2 trillion of reserves, China could survive a large trade deficit for quite a long time.

 

I am not arguing that China cannot or should not spend much more aggressively at the government level, although I would not want to see such spending directed at the stock market, since that would pretty much ensure that China’s stock markets would be inefficient and ineffective for several years more.  On the contrary, although I am less optimistic than most other analysts are about the strength of China’s fiscal position, nonetheless I think China badly needs to alter the balance of factors affecting economic growth, and clearly domestic spending needs to be much stronger – preferably consumer spending.  The point is that this spending cannot come from PBoC reserves.

 

In a few days the Olympics will be over, and we will probably see more serious measures and debate on economic issues.  Over the last few days there has been a flurry of front-page articles and speeches by government officials assuring everyone that the economy will do very well after the Olympics.  They seem worried.  Electricity prices are moving up and fuel prices will probably do so too, given how severe the shortages have been.  A number of analysts are arguing that hot money inflows are slowing and will perhaps even begin to reverse very soon, but I think they are wrong.  The RMB is still undervalued, and if the economic stimulus measures have any impact at all, in the short term they will fuel the kind of growth that creates monetary pressure for revaluation and profit opportunities for investors.  RMB non-deliverable forwards traded up sharply today, perhaps in response to news about the fiscal stimulus.  The monetary debate has been put on hold, but it is far from resolved.

There is an interesting, if perhaps predictable, June 17 Bloomberg article by Patricia Lui that discusses China’s holding of US dollar reserves. According to the article:

 

China is adding to its holdings of U.S. assets, data from the U.S. government showed yesterday, easing concern the Asian nation will sell dollar investments.  Total holdings of U.S. equities, notes and bonds among foreign investors rose by a net $115.1 billion in April from $79.6 billion the previous month, the Treasury Department said yesterday in Washington. China’s holdings of Treasuries gained $11.4 billion to $502 billion, holdings of U.S. agency debt rose $11.9 billion and U.S. corporate bond investments increased $6.9 billion, data showed.

 

The discussion about whether or not China will continue funding the US deficit by buying dollar assets has been going on for a long time, and has caused an unnecessary amount of alarm among analysts worried about the consequences of a possible Chinese decision to stop buying dollar assets – without Chinese purchases of US securities, they worry, how can the US possibly finance its ballooning trade deficit?  Yet time after time the data show that China continues to add to its dollar hoard – sometimes in amounts close to or even greater that the US deficit, as Brad Setser recently implied – and so for a little longer those concerns “ease”.

 

If you believe that the explosive growth in the US trade deficit since the late 1990s was caused primarily by a sudden massive increase in the desire of US consumers to consume, then it may make sense to worry about how the deficit must be financed.  After all according to this view, the cost of out-of-control consumption by Americans exceeds American income, and so this requires some foreign saver to finance the consumption.  At the individual level it was the wealth effect of rising stock markets and real estate prices that allowed Americans to increase their consumption, but in the aggregate a country running a current account deficit by definition needs external financing.  Should this financing stop, US consumption would have to drop drastically in order to eliminate the current account deficit, and with it the US (and world) economy would slow sharply.

 

But if you believe, as I do, that the global balance of payments disequilibrium is driven primarily by the increase in external savings of a number of developing countries – mostly East Asian and OPEC, with China being by far the largest player – then worrying about how the deficit will be financed shouldn’t take up a lot of anyone’s time.  The deficit exists primarily because of the need for China and other countries to invest the current account surpluses their monetary and fiscal policies were designed to create (or the windfall current account surpluses from high commodity prices, if they are commodity exporters).

 

I have explained why I think the latter is a better description of the global balance of payments disequilibrium several times in my blog, the last time in a June 4 entry (“Chinese savings and US deficits”) and in two longer entries on September 15 (“China and the savings glut” Parts One and Two).  As I pointed out in those entries, I think a very plausible argument can be made that the 1997 Asian financial crisis created such a strong impression on Asian policy makers that their decision to protect themselves from a reoccurrence prompted them to put into place very strong mercantilist policies guaranteed to save them from a future external debt crisis.  This implied substantial trade surpluses and rising reserves.  It also required that some other country or countries be willing and able to run corresponding current account deficits.

 

The data show that after 1997-1998 Asian current account surpluses grew so quickly, and central bank reserve accumulation along with it, that for the first time developing countries as a group became net exporters of capital when reserve accumulation exceeded net private capital inflows (you can find the actual numbers in Jorg Bibow’s “The International Monetary (Non-)Order and the Global Capital Flows Paradox”).  China was by far the biggest factor in this process, and of course as long as China was running such a policy, it needed to invest those surpluses.  They were invested in the US.

 

The point is that China had no choice but to finance the US current account deficit.  As long as it ran mercantilist policies aimed at generating trade surpluses only four things could happen:

 

1.        China finances the US current account surplus directly by buying US dollars assets.

2.        China finances the US current account surplus indirectly by buying euros and yen, and Japanese and European investors (most probably their central banks), buy US dollar assets.

3.        China buys euros and yen and Europeans don’t compensate by buying dollars, in which case China’s current account surpluses shift to Europe and Japan, who end up running current account deficits to replace the rapidly declining US current account deficit.

4.        China stops buying foreign assets, in which case its current account surplus disappears.

 

Since the whole point of the exercise was to generate current account surpluses and foreign currency reserves, China could not choose Option 4.  In addition, as its currency regime locked it into a self-reinforcing system in which rising trade surpluses forced more surpluses (I explain why in “The value of the RMB does matter to the trade balance” Parts One and Two) there was no way for China to choose Option 4 without a serious adjustment to the currency regime and the possibility of a sharp and difficult collapse in exports.

 

Either China had to finance the US trade deficit, or it had to find someone else willing to accommodate its trade surpluses.  The only important question, then, was whether Europe could absorb the necessary current account deficits or not.  If so, China could begin to shift its reserve holdings into euros and so cause enough strength in the euro relative to the dollar that the US trade deficit would shift to Europe.  To a certain extent this has been happening, but I am not sure it can continue for too much longer.

 

So as I see it, the question of whether the US trade deficit can be financed or whether China can suddenly “change its mind” about financing the deficit is not a very worrying one because the US trade deficit and, increasingly, the European trade deficit are consequences of foreign financing, not their cause.  However something very important has changed recently, and I am not completely sure about its implications.

 

Specifically, for many years China’s burgeoning reserves were powered primarily by its burgeoning trade surplus (with net FDI playing a secondary role).  In that case it was pretty easy to trace out the balance of payments flows and their consequences.  I agree with most pessimists that the balance of payments numbers were becoming unsustainable, but not mainly because the US current account deficit was unsustainable.  In fact I don’t think it is, for reasons I explain partly in “Demographic projections and trade implications”.  For me the biggest problem with the existing balance of payments relationships was that China’s reserve accumulation was becoming unsustainable because of its domestic monetary impact.

 

Recently this has become an even bigger problem.  In the past few quarters China’s reserve accumulation has mushroomed to levels that make the 2006 and 2007 numbers, as incredible as they seemed back then, almost laughably small today.  And yet China’s trade surplus and net FDI have not grown to nearly the same extent – in fact the trade surplus, while still incredibly high, has actually shrunk, and FDI, which is much smaller but has grown sharply, probably includes a healthy dose of speculative inflows disguised as FDI (as does, many of us suspect, the trade surplus).

 

It now seems that China’s rate of reserve accumulation, seemingly unsustainable even two years ago, has reached even higher levels, but what is powering it now is not the (relatively) stable trade surplus and FDI accounts but rather highly unstable speculative inflows (for an explanation of how reserve accumulation has been generated see “What? $74.5 billion? Is this a mistake?”).  If I am right, it seems to me that there has not just been a quantitative change in China’s and the world’s balance of payments accounts in recent months (i.e. even more rapid growth in an already unsustainable rate of Chinese foreign currency reserve growth), but also a qualitative change – the cause of China’s reserve growth has shifted significantly.  The old mechanism, large trade deficits in some countries balanced by rapid reserve accumulation in others, has been converted into something much more complex and maybe even pro-cyclical (hence volatility enhancing): large trade deficits in some countries plus massive speculative inflows in others are being balanced by even more massive reserve accumulation in the latter countries.

 

I still need to work out in my mind what some possible implications are, but I would be lying if I said I didn’t find this change worrisome.  My instinct is that because of the intensely pro-cyclical nature of speculative inflows, this new system is a lot less stable than the old one.