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

Local stock markets ended the week with Chinese investors once again ignoring the world markets. Rising markets abroad were met with sharp declines (albeit not without some large partial reversals in the early morning and early afternoon) in China. The SSE Composite dropped 2.0% to close near its low at 1722, more than 4% below the 1800 mark.

It isn’t hard to find good reasons for the local decline (although we hardly need fundamental reasons for what is still largely a technical and speculative market). News coming from the real estate markets continues to be very negative and suggests that downward pressure on real estate prices is not abating in the least. Sales volumes are also down (I just came back from a very morose presentation by one of my students on the housing market).

To make matters worse, but not unexpectedly, third quarter consumption figures in the US were released two days ago and indicated that consumption declined in the third quarter, after having manfully climbed upwards even during the financial difficulties of the first two quarters of the year. An article in yesterday’s New York Times describes it this way:

Consumer spending — which makes up more than 70 percent of American economic activity — dipped at a 3.1 percent annual rate between July and September, after growing at a 1.2 percent annual rate in the previous three months.

That was the largest three-month drop since the second quarter of 1980, a contraction that was in some sense artificial: the Carter administration, seeking to suffocate inflation, imposed limits on bank borrowing. Putting that episode aside, this year’s drop represents the sharpest decline in consumer spending since the end of 1974.

The symbiotic balance-of-payments relationship between China and the US requires US consumption and Chinese financing to support Chinese production for the export markets, and with the recent decline in US consumption – and probably more to come – it would take unrealistically high expectations of a surge in European consumption to prevent a slowdown in Chinese exports.

Most Chinese producers don’t seem to have such expectations. A Bloomberg article reports today:

China’s manufacturing contracted as the worst financial crisis since the Great Depression eroded export demand. The Purchasing Managers’ Index fell to a seasonally adjusted 44.6 last month from 51.2 in September, the China Federation of Logistics and Purchasing said today in an e-mailed statement. A reading below 50 reflects a contraction, above 50, an expansion.

…Manufacturing contracted in July for the first time since the survey began in 2005. It also shrank in August. The October index was a record low.

…The output index fell to 44.3 in October from 54.6 in September, while the index of new orders dropped to 41.7 percent from 51.3. The index of export orders declined to 41.4 percent from 48.8, the statement said. The inventory index climbed to 51.4 from 50.5, it said.

These indices are based on surveys of more than 700 companies in 20 industries, and only date back to 2005, and in the past they have not always been great predictors of business activity, but the fact that they are all pointing in the wrong direction is, of course, worrying. It has been hard to find equivalent good news. Cui Enze, one of the students on the Guanghua Students Monetary Committee, sent me an email yesterday with some work he had been doing on automobile inventories. He writes (with some light editing on my part):

As you can see from the chart, both the inventory-to-current-assets ratio and the inventory-to-total-assets ratio see an obvious continuous jump since 2008 Q1 while both ratios declined from 2007 Q1 to 2008 Q1. I think it is because the rapid growth of domestic economy in 2007 (11.4% YoY) lifted car sales, but since the beginning of 2008, under the credit tightening policy of central government and slowing down demand of external economies amid financial crisis, we are seeing a build-up in inventories.

From his piece I list both the inventory ratio and the receivables ratio.

	2007-Q1	2007-Q2	2007-Q3	2007-Q4	2008-Q1	2008-Q2	2008-Q3
Inventory/Total assets	12.6%	12.9%	13.2%	13.1%	12.4%	13.1%	14.7%
Receivables/Total assets	12.3%	12.2%	11.6%	15.0%	16.0%	17.2%	15.6%

He goes on the say:

The receivable ratio has been picking up since 2007 Q3, it can be seen as a sign of the slowing down of automobile industry, because the car distributors need more time on average to sell a car and thus they may delay the payment of the receivables.

He also notes that over this time leverage has been increasing, with total liabilities rising as a share of total asset from 57-58% during each quarter of 2007 to 59.9%, 62.0% and 61.2% respectively during the first three quarters of 2008 – probably to finance the rise of inventories and receivables, although I don’t have enough information to explain the fact that debt rose more slowly than inventory and receivables. I am pretty sure there were few, if any, equity deals done. Perhaps the counterbalance is simply declining cash, which implies, of course, that leverage rose even more quickly (in my way of accounting, cash is simply negative debt).

Rising inventory, rising debt, and rising receivables in the bellwether automobile industry – all balance sheet issues. I tend focus more than others might on balance sheets because of the impact they have on moving economies past our best expectations. Yesterday one of the comments on my previous blog entry included the following two questions:

1. What does “the self-reinforcing relationship between economic slowdowns and weak balance sheet” have to do with the wrong growth projections?
2. Why do you say the smartest projections “systematically” get the growth estimate wrong?

This is such a core part of my thinking that I suspect I breeze over these not-so-obvious points too easily. Let me explain what I mean and why I think the way I do.

In my view most economists focus on the development and changes implicit within the asset side of the balance sheet (the operating side of the economy or a company) and generally ignore liability-side structures in making their predictions and recommendations. Usually this doesn’t matter too much because in many cases a well-structured balance sheet means that debt structures have little impact on the operations of the economic entity, and simply serve to fund investment and consumption.

Monetary and balance sheet structures, in other words, are not part of the real economy. An economy with a flexible and diversified financial and monetary system and with few systematic balance sheet vulnerabilities (the US and Europe, for example, until the liquidity-inspired debt boom of the last few years) can generally be analyzed as if liability structures didn’t matter.

But sometimes they do matter. When balance sheets are badly structured they can enhance volatility by reinforcing asset side conditions, and of course increases in volatility can, in some cases (where leverage is high) significantly increase financial distress costs. When system-wide, these kinds of unstable balance sheets can create the boom and bust conditions typical of many emerging market countries (where balance sheets tend often to be badly constructed for a number of reasons I discuss in my book, The Volatility Machine).

This is true both for companies and for countries (in fact for any economic entity). To take a simple and obvious example, when South Korean companies borrowed dollars to fund their local operations in the early and mid-1990s, they did so mainly because dollar interest rates were much lower than the won rates and the won was fixed. This meant that Korean companies seemed to be lowering their borrowing cost significantly. In order to lower costs further, these borrowings were often short-term.

But they did so at a hidden cost. Actually by borrowing in dollars (especially short-term dollars) what they were doing was increasing their implicit bet on the Korean economy. During periods of solid growth in Korea, the won rose in real terms, making dollar-debt-servicing costs decline, along with the stock of dollar debt (measured in won). Consequently corporate balance sheets improved on both sides – a good economy meant rising asset prices and profitability, as well as declining debt-servicing costs and debt stock.

The sharp improvements in the balance sheet (and the supposedly low borrowing costs) allowed Korean companies to reinforce the already good economic conditions by increasing their investment, consumption, and wages. But when conditions turned, as they did in late 1997, both sides of the balance sheets turned negative at the same time.

A slowing economy and the accompanying liquidity crunch caused profits and asset values to decline, and the suddenly-depreciating won simultaneously caused debt-servicing costs and debt stock to soar, thereby forcing liquidations and financial distress onto Korean corporations. This of course caused businesses to cut back on planned investment and reduce planned expenditures, thereby making the economic contraction worse than it would otherwise have been, and of course worse than predictions based on those earlier plans. It is noteworthy that Korean growth often exceeded expectations before 1997, and vastly underperformed even the most pessimistic expectations in 1998 – in both cases economist forgot to include balance sheet impacts.

Another obvious example was the short term financing of Brazil’s very fiscal deficit in 1997 and 1998. Brazil had a very high fiscal deficit – which not surprisingly worried businesses – of which more than 100% was accounted for by interest payments. These interest payments were on a stock of debt that was extremely short term – nearly all of it of less than one-year in maturity and most of it less than six months.

This had a very important feedback effect. When conditions in Brazil were reasonably good and confidence rising, declining interest rates caused the deficit to drop sharply, thereby enhancing confidence further and encouraging further investment. Brazilian growth rates were quite high even though monetary policy was tight and inflation low.

However Brazil was inordinately vulnerable to a sudden reversal of this “virtuous cycle”. In 1998 the Russian crisis caused capital flight around the world and, in Brazil, rising domestic interest rates. Of course this caused the fiscal deficit to rise so sharply that it created further drops in confidence, and so further interest rate increases, in a self-reinforcing cycle.

With interest rates rising from just under 20% before the summer to over 40% by year end (while inflation stayed low at around 3%), there was an automatic (an unexpected) collapse in investment. The severity of the collapse shocked nearly everyone, but it should not have. Brazil’s balance sheet at the time ensured that there could be little middle ground because it implicitly doubled the “bet” on its underlying economic conditions. When things turned bad they had to turn horribly bad. The balance sheet permitted little room for a middle outcome.

Balance sheets often do not matter, but sometimes they matter vitally, and they almost always matter after a liquidity-induced debt binge. That is when leverage grows, and when companies in dozens of different ways all end up making the same balance sheet bet. Consequently what seemed like a smart and thoughtful analysis of economic conditions often turns out to be wholly inadequate, because the self-enhancing nature of the system blows out all reasonable and “smart” projections.

There may be another much more recent example of exactly such a process, although I don’t have enough details to determine if this is what happened – it just smells an awful lot like such a process. Russia, which only recently seemed to be in pretty good financial shape, has recently horrified most observers with the speed with which the financial system deteriorated. As an article in yesterday’s New York Times put it:

At the start of the global financial crisis, Russian authorities insisted they had ample cash reserves to weather any storm. But as sorrow has succeeded sorrow — plummeting oil prices, a 70 percent descent in stock markets here, a global credit crisis and a slow-motion bank run on this country’s private banks — Russia has had to spend its reserves faster than anybody imagined.

On Aug. 8, reserves peaked at just under $600 billion, the third-largest in the world. By this week, they had fallen to $484 billion, as money flew out of government vaults to support the ruble, prop up the banking system and bail out the businesses of the rich Russians known as oligarchs.

Whenever things deteriorate so quickly and so unexpectedly, my instinct is to assume that balance sheets were inherently self-reinforcing and so the country was unable to withstand shock.

On that note I should mention an interesting recently-published research piece at Wharton’s Financial Institutions Center by Allen N. Berger and Christa H.S. Bouwman, called Financial Crises and Bank Liquidity Creation. The study attempts to look at five financial crises experienced by US markets in the last 25 years, and among other things focuses on liquidity creation before and during the crises. Their conclusions:

First, there seems to have been a significant build-up or drop-off of “abnormal” liquidity creation before each crisis, where “abnormal” is defined relative to a time trend and seasonal factors. Second, banking and market-related crises differ in two important ways. The banking crises were preceded by positive abnormal liquidity creation by banks, while the market-related crises were generally preceded by negative abnormal liquidity creation. In addition, the crises themselves seemed to alter the trajectory of aggregate liquidity creation during banking crises but not during market-related crises. Third, liquidity creation has both decreased during crises (e.g., the 1990-1992 credit crunch) and increased during crises (e.g., the 1998 Russian debt crisis / LTCM bailout). Thus, liquidity creation likely both exacerbated and ameliorated the effects of crises.

Fourth, off-balance sheet illiquid guarantees (primarily loan commitments) moved more than semi-liquid assets (primarily mortgages) and illiquid assets (primarily business loans) during banking crises. Fifth, because the subprime lending crisis was preceded by a dramatic build-up of positive abnormal liquidity creation, our analysis hints at the possibility that while financial fragility may be needed to create liquidity, “too much” liquidity creation may also lead to financial fragility.

I was surprised to find that the last conclusion was considered by the authors to be unexpected. In my experience the idea that “too much” liquidity creation leads to financial fragility is more or less a consensus among financial historians, or is at least widely accepted among many (for example Charles Kindleberger, one of my favorites, seems to take it as a given).

The structure of balance sheets matter, and it has been one of the greatest sources of surprisingly large growth-prediction variations from the consensus (and, as an aside, I consider it to be the main cause of financial contagion). This is why I spend so much time trying to get a handle on the peculiarities of China’s national balance sheet.

Tags: Balance sheets