...Commercial lenders earn only 1.89 percent in interest on required reserves, compared with a benchmark one-year deposit rate of 3.6 percent. That means banks pay the price for China's refusal to let the yuan strengthen faster to make exports more expensive and ease the inflow of money, according to Paul Cavey, an economist at Macquarie Securities Ltd.
"In the long term, the banks will be the biggest victims of the exchange-rate policy,'' Cavey said in Hong Kong. ``With a more flexible currency, China wouldn't have to move so often to absorb the liquidity.''
China has resisted U.S. pressure to allow the yuan to strengthen more quickly. The currency has gained 9.8 percent versus the dollar since a fixed exchange rate was scrapped in July 2005. The yuan closed 0.15 percent higher at 7.5384 against the dollar in Shanghai today...
I think Paul Cavey makes an important point and it indicates one of the dilemmas facing China. One of the few tools available to rein in money growth is to raise minimum bank reserve requirements. This hasn't had much effect in the past because banks had so much liquidity that they ran excess reserves anyway, but little by little the PBoC is eating away at the excess.
Of course the problem is that the banks lose money on reserves because their return is lower than their cost of funding. Reducing their profits reduces the amount of capital they have to absorb NPL losses. Fitch estimated earlier this year that total losses on existing NPLs would likely amount to 50% more than total capital and reserves, and this does not take into account the recent explosion in lending and the impact of a possible economic slowdown or contraction. If interest rates rise, as I discuss in the previous entry, this exacerbates the problem by accelerating principle payments, for reasons I discuss in an entry on August 22.
Therein lies the problem. One the one hand, it is crucial to strengthen the financial sytem before allowing the currency to aprreciate much, because one of the great risks is the possibility that an adverse shock may lead to a breakdown in the banking system. On the other, postponing the currency adjustment actually weakens the banking system in a number of ways.
it never has quite been clear to me why the banks are exposed to an fx appreciation -- apart from overlending to the export sector, and that problem gets worse rather than better the longer china waits.
the banks don't have any obvious unhedged fx risk -- at least not much obvious unhedged fx risk. they can finance themselves more cheaply in rmb than in $ so it isn't obvious why they would borrow from abroad to lend domestically (even setting the cap controls aside), and $ lending isn't a problem in the event an appreciation.
what am I missing? it is an article of faith among many that China's banks aren't strong enough to manage an appreciation, but i don't quite see the underlying exposure that creates trouble. it was clear, for example, why Argentina's banks would have trouble in the event of a peso depreciation -- they had massive $ loans to the non-tradables sector. Thai banks and finance cos were in a similar bind back in 97. Turkish banks had a huge open fx position from a hidden carry trade on the lira (done through structures that kept their books matched for the regulators eyes ...) in 2000.
I am quite curious on this point -- as not letting the currency appreciate and the resulting challenges associated with sterilizing china's current reserve growth is by contrast creating some very clear strains on the banks (forced low cost sterilization hurts their profits) and for the overall economy (negative real rates encourage over-borrowing and over-investment).
By bsetser - 9/8/2007 6:45 AM
One important point. The pre-1998 NPL's that Fitch talks about have been mostly moved off of the books of the banks to the asset management companies, and are no longer the responsibility of the banks. This makes comparisions between the size of the NPL's and the banks capital irrelevant, since most of those liabilities have been effectively assumed by the government. Also, a pretty large fraction of the pre-1998, NPL's have already been paid down.
The main risks that I've heard mentioned are not exposure risks but rather operational risks. That is to say that Chinese banks just don't have the processes in place to handle sudden jumps in exchange rate.
I think Fitch was talking about their estimate of existing NPLs and collection rates as of the end of 2006, and excluded the NPLs that were taken off the books and sold to the AMCs. In my opinion, by the way, even those NPLs assumed by the AMCs are not irrelevant to the riskiness of the banks because they comprise additional debt on the part of the banks' guarantor, the government (the AMCs are insolvent themselves, so the government guarantee on their debt is a real obligation).
The problem arises because I think the government has a lot more debt that we think (at least 60% of GDP, and probably more) and in a time of trouble this will come back to haunt them, and may even undermine faith in the banking system. Remember that before the banking crisis Japan's government debt was roughly zero, but the process of resolving the banking crisis drew it up to over 150% of GDP. I am not sure that China will have anywhere near that debt growth capacity. I know that comparisons with Japan are tricky, but there are some unsettling similarities.
By Michael Pettis - 9/8/2007 1:27 PM
Brad,
I think that the banks' main dollar exposure may largely consist of the IPO dollars they raised, and even here there are persisting rumors of their having hedged with the PBoC, although I am not sure what to make of them.
I think the appreciation fear is not because of a direct adverse impact on the banks' balance sheets but rather the worry that a shock could cause economic activity to unravel in unforeseen ways and, since everything eventually leads back into the banking system, affect the banks. One obvious way as you note would be through its impact on export profitability, although I think in most of its export markets China is such a dominant player that it has real pricing power and could slow down the impact of an appreciaton by raising prices of exports -- not to mention that half of its exports involve the processing of imports, so that an appreciation would have almost no net impact on revenues or profits. Certainly the last three years don't provide a strong case for arguing that a rising RMB would be accompanied by slowing export growth.
The impression I get about why they worry is different. In my conversations with PBoC guys and academics I think they are more worried about the "unknown unknowns", and from my Latin American experience, I think that isn't wrong. China is so tightly wound up around its furious monetary expansion that it is not clear how different parts of the economy might be affected by a sharp revauation, or how the interaction of these different reactions might pan out.
While I agree with all these fears, my problem is that I don't think they have a choice, and the longer they put it off the more problematic these things become. At any rate it always makes sense to adjust when things are going well, and if the world can get out of the US subprime crisis relatively soon and without too much damage, it would be much better for the Chinese to risk the currency adjustment now rather than later.
By Michael Pettis - 9/8/2007 1:41 PM
I'll try to find the Fitch report, but my memory was that they were talking about the entire amount of NPL's in the financial system, and broke up the amount of debt in each part. Breaking up the debt into parts is important because the Chinese financial system is rather fragmented, and I think the important thing crisis avoidance is not by looking at total amounts of debt, but by seeing who holds at and compare that with assets they have available.
The amount of debt that has been moved to the government of course has to be matched with the governments capacity to pay that debt. However, in this area, the known liabilities of the government look managable. I agree with the 60% GDP and I see it as financing social service payments to finance the cost of transition to a market economy (essentially the government was "buying out" people's "iron rice bowl" guarantees).
Seen in that light it's not an absurd amount, and it is a one time cost. There may be new NPL's, but they simply cannot be of the same type that were the result of the 1990's NPL's.
Finally, there have been huge improvements in the governments capacity to tax. China, after 250 years of trying, has finally gotten a working taxing system together. The other thing is that China now has a system where this liabilities are quantifiable.
As far as unknown liabilities, I do suspect that they are capped. An essential government liability is something that the government is legally bound to repay or else will cause large numbers of people to riot if you renege, and that limits the type of essential liabilities. Anything that isn't in the "large numbers of people will riot" category can (and probably will) be reneged by the government. The corrolary it is difficult to keep them invisible since you can ask around for what could someone to take to the streets.
At this point I do suspect that there are some essential differences between Latin America and China in the form of the government's taxing ability and class structure.
The only huge liability that I can think of in that category are pensions and those won't come due for another decade.
Interesting. It sort of seems to boil down to the usual fear of change, especially changing when everything seems to be moving along quite nicely ...
technically, there is no need for a slowdown in reserve growth to produce a slowdown in money growth tho. the central bank could just sterilize less, or, in the extreme case, start buying domestic bonds rather than fx for its balance sheet.
I fully agree that at some point china will have to change. To me the biggest surprise is that the current equilibrium (30% y/y export growth, $100b annual increase in cAS, rapidly rising reserve growth, large monetary expansion, growing reliance on banks as mechanism for low cost sterilization, domestic rates too low domestic conditions) has been as sustainable as it has been.
By bsetser - 9/9/2007 4:08 AM
Joseph, looking back at my notes I am no longer certain about which was and wasn't included in the Fitch NPLs. You may be right. Still, even if we remove the AMC debt the banks are still collectively bankrupt even without considering the possibility that a significant portion of the new loans will go bad, especially in a slowdown. Also, as you know, I don't consider the AMC NPLs to be resolved because they still represent a contingent claim on the MoF, the implicit bank guarantors, and I am worried that in a contraction there is enough reason to worry about government credit -- to the extent that the worry itself becomes part of the problem.
I agree with your distinction between renege-able and non-renegeable (am I inventing words now?) government debt, but I would include the hole in the banking system in the bad category. There have been bank runs in China and, as SARS showed us, government credibility is sufficiently brittle that a widespread bank run can not be ruled out. This may be the biggest point of contention between me and others. My experience in other developing countries, and indeed the recent experience of the sub-prime crisis, makes me worry about how quickly and suddenly perceptions can change for the worse, and so I worry a lot about a banking crisis here.
By Michael Pettis - 9/9/2007 4:24 PM
Brad, I am not worried about a slowdown in money growth. On the contrary, I think it is desperately needed.
You are right that there is a real fear of change here. It is true that the imbalances have persisted for a while, but I think the monetary expansion only really began going out of control since 2004. By the way I am very fond of a quote by, I think, Rudiger Dornbush which I paraphrase (because I can't remember or find the original) as: the crisis always seems to come much later than expected and is always much worse than you imagined.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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Comments (9) for "The banking trap"
- 9/8/2007 11:21 AM
December, 2007