My Blog

December 19, 2007

WED 19 DEC 2007

More worries about the stock market? By Michael Pettis

Shanghai was up 2.19% today, supposedly because of a new report that says that the government wouldn’t “massively” sell shares in companies it owns.  Separately it seems that the stock index futures, which have been on the verge of being introduced all year, have been postponed again.  Premier Wen is reportedly worried that the introduction of the futures may cause massive selling in the underlying stock.

 

This is becoming an increasingly difficult balancing act – managing the consequences of explosive monetary growth without creating too much damage to confidence or to the underlying economy, all the while using tools that don’t seem to work.  I am glad I am just an observer.

 

WED 19 DEC 2007

The value of the RMB DOES matter, but not for the obvious reasons By Michael Pettis

According to the Commerce Department, the U.S. current account deficit fell to $178.5 billion in the third quarter, the equivalent of 5.1% of GDP.  This is happening at the same time that Europe’s trade deficit is surging.  Part of this reduction in the trade deficit may be caused by a slowdown in the growth of US demand, but it seems pretty clear that relative currency values do matter to a country’s trade balance.

 

In today’s International Herald tribune there is a piece by Behzad Yaghmaian, a US-based academic, on why, regarding US-China trade, “the yuan is not the problem.”  Yaghmaian makes the argument that a revaluation of the RMB would not fix the US trade imbalance with China.  Part of the argument is pretty standard.  In his words:

 

The revaluation of the yuan would have had the desired effect were the goods imported from China also produced in the United States. Facing the rising prices of imports caused by the revaluation, some American consumers would have switched to domestic substitutes.  

 

But that is not the situation with most Chinese imports, for which there are few American substitutes. The Chinese apparel, computer parts, electronics, furniture, toys and many other things in the lengthening list of imports no longer compete with similar American products. If not from China, the United States would have to buy them from elsewhere. The deficit would remain; it would only be with other countries.

 

Yaghmaian adds the point, however, that a significant and growing component of the trade relationship between the US and China is the value of subcontracted imports.  This component tends to be priced in US dollars, and he argues that if the RMB were revalued it would not affect the relative value of the goods sold into the US, so it would not affect the trade balance.  He adds:

 

However, the revaluation hurts the profitability of the subcontractors that face a reduction in their income after conversion to the local currency. To make matters worse, many American firms have been demanding lower prices from their subcontractors, threatening to move to India, Vietnam or elsewhere

 

I don’t fully agree with this point for two reasons.  First, if Chinese companies were not able to absorb the lower value of the dollar by reducing profits, a revaluation would force them to charge higher prices on their contracts in the future.  This might not be soon enough to help many of them from avoiding bankruptcy, but it would nonetheless affect the price of Chinese goods in the US.  

 

Second, many countries in Asian are suffering, like China, from the monetary consequences of holding down the value of their currencies against the US dollar, and are only unwilling to allow their own currencies to appreciate because they fear losing out to cheaper Chinese production.  If China were to permit more flexibility in the value of the RMB, a number of other countries in Asian would also follow suit.

 

Still, I think he is right in pointing out that a revaluation would be painful for many small exporting companies who have not in the past been able to hedge the value of the dollar, and this must be at least part of the reason why Chinese financial authorities have dragged their feet for so long in adjusting the currency.  He agrees that streamlining the market and weeding out inefficient producers may be a welcome consequence in the longer term of the policy for China, but he still worries that such a policy would in the short-term effect pose greater hardship for Chinese workers

 

I don’t disagree at all with Yaghmaian’s argument as far as it goes, but I think he makes the same mistake that other American defenders of China’s foreign exchange policy make – he sees China’s RMB policy purely from the point of view of trade and only looks at the direct impact a revaluation will have on relative pricing.  But as I have argued many times before, the real reason China must revalue is to attempt to regain some control over its explosive monetary growth and, were it to do so, the trade relationship would indeed change, and change dramatically.  

 

It is not the cheapness of the RMB that is the primary cause of the huge and growing Chinese trade surplus.  It is the fact that China has locked itself into a monetary policy that forces excessive momentary expansion as the PBoC has to buy up the torrent of dollars that flow into the country via the trade and capital accounts.  Thanks to inefficiencies in its financial sector very easy money automatically forces industrial production to grow at unhealthy rates, and this growing industrial production has not and cannot be absorbed by rising domestic consumption.  The consequence is a currency regime that forces Chinese exports to grow more quickly than its imports, and so forces a rising trade surplus.  China’s trade surplus is basically a residual of the growing imbalance between Chinese production and consumption, and this imbalance is growing precisely because of the currency regime.

 

WED 19 DEC 2007

China buys more of Wall Street By Michael Pettis

Rick Carew has an interesting comment in his Wall Street Journal piece today. In commenting on the $5 billion investment by the CIC into a Morgan Stanley mandatorily convertible bond, he says:

 

For the first time, Chinese companies and the government bought more overseas than foreign buyers have invested in China.  Chinese buyers have spent $29.2 billion acquiring foreign companies so far this year, while investors from the rest of the world have bought $21.5 billion of Chinese companies, according to Thomson Financial.

 

Of course total FDI into China was greater – around $60-65 billion expected for this year, but Chinese acquisitions abroad, while still small compared to the size of inflows, seems to be rising.  One small caveat about Rick’s article, he says “The terms of the Morgan Stanley deal guarantee CIC a 9% annual return, well above the fund's 5% cost of funding, until it converts its investment to shares in 2010.”  Actually it is only above the CIC’s funding cost if the RMB appreciates at less than 3.8% a year.  Otherwise the CIC will run a negative carry on the deal, which will only be reversed if the bond trades up sufficiently and the CIC sells.

 

WED 19 DEC 2007

Currency swapping does nothing to improve Chinese liquidity By Michael Pettis

Friends of mine who try to keep track of monetary conditions by tracking central bank reserves – like Logan Wright and Brad Setser – have not always had an easy time of figuring out what is happening in China.  Since August, however, things have gotten more difficult.  At $20-25 billion a month, growth in reserves during the past four months has consistently come in lower than what one would have expected by adding together the current account surplus, FDI, and estimates of hot money inflows – year to date,. For example, monthly reserve growth has averaged nearly $40 billion.

 

Normally this would be a good thing.  The faster reserves grow, the more currency and central bank bills the PBoC has to create in order to fund this growth in reserves (the PBoC must buy the net inflow of foreign exchange in order to maintain the desired currency level – and while reserves are the asset side of the balance sheet, they are matched by RMB liabilities).  This forces an expansion in the country’s already excessively large money supply.  If reserves are growing more slowly, as they seem to be, this should mean that China’s money supply is also growing more slowly, which is an unambiguously good thing for the country at this point.

 

But it turns out that there are at least two major sets of transactions that are clouding the figures we have for growth in reserves and their impact is to reduce the headline foreign exchange reserve figure.  First, and most obviously, the PBoC has completed or soon will complete the transfer of $200 billion of its reserves to the CIC, where it will presumably be managed more aggressively.  This will reduce the headline foreign exchange reserve level by $200 billion. 

 

Will this represent a real $200 billion reduction in the amount of currency and central bank bills in circulation?  Yes, but its net impact on overall liquidity will be somewhat less.  The CIC was able to purchase the $200 billion in reserves with the RMB 1.55 trillion it received from the MoF, who in turn got the money by issuing long-term bonds to the market.  These bonds all or mostly sit on the balance sheet of the PBoC or a commercial bank intermediary, but as the PBoC gradually sells these bonds into the market, the net effect will be an exchange of highly liquid central bank bills for less liquid MoF bonds.  Although these bonds are still effectively part of the country’s money base, their net impact on domestic liquidity will be positive (i.e. they will reduce domestic liquidity, although not one-for-one)

 

The second set of transactions is much more confusing, at least to me.  Beginning in August of this year, as it has been raising minimum reserve requirements, the PBoC has also been forcing banks to hold at least part of their new required reserves in the form of dollars at the PBoC.  One simple way of thinking about this is that it is as if Chinese commercial banks have had to increase their required RMB reserves, and then have been forced to swap these new required reserves into dollars – so that they go from holding RMB in their PBoC required reserve accounts to holding US dollars in the same accounts.

 

What is the point of swapping RMB required reserves into dollars?  It seems to do two things.  First, holding dollars in China is a losing proposition because of expected RMB revaluation, and so by forcing commercial banks to use RMB reserves to “buy” dollar reserves, the PBoC is effectively transferring the future foreign exchange loss from its own balance sheet to that of the commercial banks (unless it has hedge agreements in place, in which case it has no impact on profits and losses).

 

Second, by forcing a transfer of dollars from the PBoC account into the commercial bank accounts, it reduces the headline foreign exchange reserve number and seems to imply that there is both less pressure on the currency and less money in domestic circulation.

 

But I don’t think either of these two implications is correct.  It seems to me that forcing banks instead of the PBoC to hold dollars says nothing about pressure on the currency.  I would argue that the total net inflows are exactly the same except for one thing – commercial banks have been asked to assume part of the PBoC’s normal functioning (i.e. to buy dollars so as to maintain the country’s foreign currency regime), and as they assume this function the resulting purchases of dollars are whisked off the PBoC balance sheet.  But nothing real has changed, except that now banks, instead of the PBoC, will be forced to assume the foreign exchange losses.

 

Second, what is the effect of this “swapping” of currencies on the domestic money supply?  None at all, it seems to me.  Banks will have exactly the same amount of loans outstanding as they did before the currency swap, and all the other monetary aggregates will be the same. This is because the required reserves held at the PBoC are effectively “dead” anyway, and redenominating their currency changes nothing real.

 

Headline reserves will be lower, of course, but Chinese money supply will be exactly the same as if the required reserves had never been swapped into dollars.  It is the existence of minimum required reserve rates that presumably has an impact on domestic monetary policy, not the denomination of those required reserves.  The PBoC could force banks every month to swap from RMB into dollars and back again, and the only real impact would be to change headline reserves every month.  Real money supply in China would not change at all.

 

If my analysis is correct, (and if any reader thinks it isn’t, please correct me) I think the policy to force banks to hold part of their required reserves in dollars does nothing to improve China’s liquidity position but makes the PBoC less transparent.  I am not sure how this helps.

 

By the way Logan Wright (“Paying for RRR Hikes in USD”, Stone & McCarthy, December 19, 2007) estimates that impact of this swapping might have reduced headline foreign exchange reserve growth by an average of just over $20 billion a month for the past four months – he assumes that the four hikes during this period took about 190 billion out of the system each time, and that this amount was “swapped” into dollars in the PBoC accounts of the various commercial banks.  With reported monthly foreign exchange reserve increases of $23.4 billion in August, $25.0 billion in September, and $21.4 billion in October, he may have explained rather niftily why monthly reserve growth fell off from the average of just over $44 billion in the first half of 2007.