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Today's WSJ says "China may show a slowdown in export growth starting with July's trade data, but the shift -- from a tax-policy change rather than concerns over recalls -- is expected to be limited."

I think the WSJ is right not to be overly impressed about the size of a possible shift.  We've been told since at least 2003 that the latest round of recording-breaking monthly surpluses are likely to be the last, but that has never turned out to be the case, and I think it is unlikely that we will see a sharp drop until there is a change in monetary policy.

China's trade surplus is part of the monetary trap in which it finds itself.  Capital inflows, caused in large part by the trade surplus, but beefed up by FDI and portfolio inflows, lead directly to monetary expnasion since, under China's currency regime, the role of the PBoC is largely limited to funding the purchase of the hundreds of billions of dollars that pour into the country.  A consequence of this monetary policy is, of course, loan and investment expansion, which itself results in greater industrial production.

Since a country's trade surplus is simply the excess of its production over its consumption, China's monetary expansion condemns it to rising trade surpluses, which themselves cause further monetary expansion.  We will need something a little more dramatic than a reduction of export tax subsidies to end this game. 

One of my former students who now trades local interest rates talked to me over the past few days about mysterious activity by the PBoC involving their buying large amounts of dollars forward from three of the Big 4 local banks and so forcing them to cover in the spot market.  The result had been to dry up onshore dollar liquidity.  It wasn't clear why they were doing this but there were rumors about a big cash transfer to ABC, and that somehow this was tied together.

We wondered if this didn't have something to do with the planned transfer of $200 billion from the PBoC to the new CIC.  How would it work?  There have been rumors that the CIC would sell the first tranche of bonds to ABC which, after a reasonable lag (supposedly to mantain the "independence" of the PBoC) would then sell them on to the PBoC.   If that were actually what happened, the net result would simply be a swap of long-term CIC bonds (denominated in yuan) for US dollars.  The monetary impact would be zero, unless the PBoC started selling these bonds in its open market operations (instead of central bank bills, which are a near-substitute for money) aimed at sterilizing the domestic money supply.

Yesterday there were reports that the CIC is buying Central Huijin from the PBoC and paying $65 billion for it.  Central Hujin in turn will use $40 billion to recapitalize ABC.  It will transfer a further $20 billion to China Development Bank supposedly as part of its transformation from a policy-lending bank to a commercial bank.

My student did suggest,a few days later, that the PBoC might have been trying to dry up onshore dollars because corporations were using onshore dollars to speculate on yuan appreciation.  There are at least two ways he suggested they are doing so.  One way involves borrowing dollars onshore from the big Chinese banks, who either have dollars offshore (think IPOs or the bank recapitalizations) or can acess them by borrowing.  These corporations borrow today to pay for deliveries of commodities or other imports, which they sell for local currency and so earn the "arbitrage" (i.e. the cost of borrowing dollars is negative in yuan terms after you take into account yuan appreciation, whereas the return on yuan deposits is low but positive).

Alternatively, corporations are doing something that the banks aren't allowed to do.  They are selling dollars foward on the onshore market (they are not regulated the same way banks are, or it is easier for them to fake it, so they can sell dollars forward even if there is no legitimate offsetting transaction), and then buying dollars forward on the NDF offshore market.  Since implied dollar appreciation on the offshore market is a couple of percentage points higher than on the onshore market, the corporations keep the spread.  

All this adds to the speculative inflow that is driving the PBoC crazy.  As usual, hot money is not just (or even mainly) foreign money but rather smart domestic money, and as usual one problem with capital controls is that an awful lot of brain power is used up figuring out how to profit from exploiting the rules rather than creating economic value. 

With $60 billion in recapitalizations for two banks (see below), does this have any impact on China's underlying liquidity?  Its hard to figure out.  On the one hand, it seems that the recapitalization should increase the two banks' ability to lend by increasing their risk capital, but on the other hand the banks cannot use dollars for domestic lending.   My instinct tells me that this transfer should result in the one thing that the PBoC should be most worried about -- a further expansion of domestic lending.  The numbers aren't small.  $60 billion is equal to somewhere between 2% and 3% of GDP.

A friend sent a story from which the following is excerpted.  Unfortunately he did not send me the source, but it has been widely written up and discussed:

China should use its massive holdings of foreign exchange reserves as a bargaining chip in its discussions with foreign governments, a senior advisor to Beijing said at a conference here at the weekend.

Xia Bin, an economist with the Development Research Center, a think tank under the State Council, noted foreign press coverage calling China's $1.33 trln in foreign exchange holdings the "nuclear threat" and said that the government should realize its potential.

"Of course, China doesn't want any undesirable phenomenon in the global financial order but I personally believe we have so many foreign exchange reserves that we should be smarter in setting the issues. It should at least be a bargaining chip in talks," he said.

Not surprisingly, this talk of a nuclear threat (see entry below) has caused a lot of concern.  How credible is it?  Not at all, in my opinion.  In fact the whole thing is a little silly, for at least thee reasons, and I don't think any of the financial authorities in China believe otherwise (although if it helps to frighten US congressmen from behaving too irrationally on the trade front it is probably a good thing).

1.  It overestimates the importance of PBoC reserves relative to the overall market.  $1.4 trillion are a lot of reserves for any central bank, but the total amount of liquid securities in the US is many times that number and even weekly turnover dwarfs that number.  Every year the US trade deficit, which is roughly half that number, gets financed with absolutely no difficulty.

If there were a sudden major sale. what would it look like?  The last time there was a massive fire sale of US assets was probably during the start of WWI when, in order to finance the war effort, European belligerents dumped an amount of US securities equal to a greater share of total US securities than the amount China currently holds -- and this in a much less mature financial system.

The impacts on the US markets were not nearly as dramatic as one might have at first expected.  There was a brief panic and the NYSE was closed for a short time, but my understanding is that this had more to do with US Treasury fears of a short-term gold outflow than with the ability of the market to absorb the sales.

At any rate the net impact turned out to be a major transfer of wealth from Europe to the US as American investors snapped up years of carefully invested European savings at bargain prices.  A fire sale of PBoC assets would almost certainly result in a similar transfer of hard-earned Chinese savings to US and non-US bargain hunters.

2.  It ignores the likelihood that a massive sale of US assets by the PBoC would immediately trigger large offsetting purchases.  Remember that any decision by the PBoC to sell dollar assets is also automatically a decision to buy other non-Chinese assets.  What could they buy?  Almost certainly only euros, yen, sterling, and a few other currencies (even purchasing commodities would simply imply a recycling of PBoC dollars into dollars, euros, yen, etc. by the commodity sellers).

Any attempt to do so, of course, would cause these currencies to shoot up against the dollar.  It is hard to imagine that other central banks would stand idly by and watch this happen (with the attendant trade implications) without themselves intervening to support the dollar.  Throw in the foreign bargain hunters looking to buy up cheap US companies and US institutions who hold vast amounts of money offshore, who would be more than happy to bring it back home to buy cheap US assets, and there is plenty of buying power to set off against PBoC sales.

This is not to say that the market would immediately stabilize, nor that we wouldn't have some very scary moments, but rather that the disruption would be of relatively short duration, and would probably have a limited impact on the country's underlying economic health.

3.  Finally, let's assume a worst case scenario: the dumping of US dollars by the PBoC causes a sharp and damaging rise in US interest rates and a significant slowing down in the US economy.  For the reasons described above it would also cause a similar impact on most other major economies.

How would China benefit?  There would be a nearly immediate collapse in world trade as the US deficit shrunk to zero (remember, if no one finances it, it must be zero).  The economic impact on each country would depend largely on how flexible its financial system was in absorbing shocks and where global savings would flow.  In both cases it seems pretty safe to bet that the US would suffer least of any major country.  It has an astonishingly flexible financial system that has allowed it to withstand a whole series of financial shocks over the past several decades with almost no spillover into the real economy, and in times of trouble there is plenty of evidence to suggest that money will fly to the US as a safe haven.

China, on the other hand, would find it extremely hard to escape the consequences.  Not only is its financial system rigid and poor at processing information and capital, but its economy is highly dependent on the export sector.  

Today's AFP reports that President Bush said yesterday that any attempts by China to push down the value of the dollar in retaliation for US pressure over Beijing's currency manipulation would be "foolhardy".

This story has gone as far as it should, I think.  China cannot use its reserves in this way without creating much bigger problems for its economy than it could possibly create for the US, and they almost certainly know that (at least I hope that those responsible for policy do).  President Bush shouldn't respond to what was basically an empty article in a British newspaper.

Sovereign Wealth to the Rescue

Former U.S. Federal Reserve Chairman William McChesney Martin once claimed that the role of the central bank is to take away the punch bowl just as the party gets going. Today, ironically, several of the world’s central banks may be doing exactly the opposite. Just when the great global bull market of the past decade seemed to have run as far as it could run, and with deep rumblings in real estate and credit markets, the actions of several central banks in Asia may give global markets another big push towards rising prices and tightening credit spreads.

Every period of globalization in the past has had its origins in one or more events that gave a big boost to global liquidity. As liquidity expanded and risk appetite rose, capital poured into various risky ventures—from nimble new companies exploiting the latest technology to developing countries at the fringes of global markets. Whether it was the rapid creation of new joint-stock banks in the 1860s, the massive accumulation of gold in the U.S. in the 1920s, or the recycling of petrodollars in the 1970s, the secular bull markets that are a part of every globalization cycle were fueled by events that created growing underlying liquidity and rising risk appetite.

The most recent globalization cycle had its beginnings in the increase in liquidity caused by the securitization of U.S. mortgages, which converted one of the largest pools of assets in the world from very illiquid bank loans into some of the most liquid securities. But it seems reasonably certain that what has powered the boom in the last decade has been the recycling of the massive U.S. trade deficit. As central banks and sovereign funds around the world accumulate reserves as the flip side of the U.S. trade deficit, excess U.S. consumption is being converted into global excess savings.

If this is the case, predicting the ability of this bull cycle to continue means predicting two things: the future size of the U.S. trade deficit, and the way in which the recycling takes place. Predicting the future path of the U.S. trade deficit is not easy and involves complex predictions about currency, economic and political changes. But it is probably safe to assume that whatever happens to the trade deficit, the changes will take place slowly and gradually.

The way in which the trade deficit is being recycled, however, seems to be undergoing a material shift. With currency reserves among Asian central banks and OPEC nations swelling to levels never before achieved, governments of surplus nations are increasingly focusing on achieving higher returns than those with which their central banks have traditionally been happy.

When the primary goal of reserve management is to protect a country from interruptions in its ability to pay for imports and to service external debt, it was necessary to invest reserves in very safe, liquid and, for that reason, low-yielding securities. But reserves have soared to levels way beyond those recommended by even the most conservative economists. With nearly $1 trillion of reserves, Japan is estimated to need only one-quarter of its reserves for normal liquidity purposes. China, whose reserves are approaching $1.5 trillion, probably needs not much more than one-half of that amount. Smaller Asian countries, and the OPEC nations as a bloc, are also carrying levels of reserves well beyond their liquidity needs.

Since they have excess reserves, one of the hottest questions in reserve management has been what to do with these excesses. In this respect China has been among the leaders. For years there have been rumors of Chinese central bankers stretching for yield by purchasing securities that were riskier than those normally held by central banks—bonds issued by certain Latin American governments, mortgage residuals and the like. Earlier this year the government approved a more explicit measure. It plans to carve out $200 billion of reserves to be managed separately and more aggressively by a separate government entity.

With China’s reserves currently accumulating at the rate of over $100 billion per quarter, this already large number can easily grow. Other countries are explicitly or implicitly following China’s lead, and although the total amount of money that is being driven into riskier assets than those normally held by central banks is murky, there is little doubt that it is large.

With the massive hoards of reserves held by Asian and OPEC institutions being invested down the credit spectrum into riskier assets, the net result will be a material increase in global risk appetite that will show up in ever tighter credit spreads. From time to time, as happened with the emerging-market correction in May 2006, and as is happening now, the overall trend of the market will be interrupted and the market will be filled with momentary panic, but when this happens, markets will quickly stabilize and resume their upward trend.

Credit spreads for risky assets are at historic lows, and certainly for older and more experienced traders and investors it is hard to imagine any good fundamental reason for spreads to stay at these levels or, even harder to imagine, to continue narrowing. But whatever the fundamental arguments, there are good technical reasons for assuming that the party isn’t over yet. The large-scale shift of global reserves into what are being called sovereign wealth funds may provide the party with at least one more bowl of industrial-strength punch. Tomorrow’s hangover may get nasty, but for now the party is still going strong.

Todays' SCMP has an article claiming that the government has announced that it will make it easier for foreign entities to issue yuan-denominated bonds onshore, use the proceeds to purchase foreign currency, and deploy the money abroad.  In the past only the IFC and the Asian Develoment Bank have been permitted to issue yuan bonds, but they were required to invest the proceeds onshore.

But today Deng Xianhong, vice-head of SAFE, told a forum that "We will allow more foreign institutions to issue yuan bonds in China and expand the utilization of the proceeds.  We will allow them to use the proceeds to buy foreign exchange and then remit them out of China."

Obviously this makes sense from a monetary policy point of view because anything that causes capital outflows reduces the monetary pressure on the PBoC, but I doubt it will have much impact, at least in the short run.  If you borrow yuan -- say at 5% -- and then convert the proceeds into dollars, assuming a 4% annual appreciation of the yuan, you would be essentially borrowing at the USD equivalent of a little over 9%.  

Almost any borrower permitted to issue in China can borrow dollars at a much better rate than that.  The only real risk here is a further sudden appreciation that could raise the borrowing cost substantially.  Perhaps the borrower would be permitted to swap the proceeds into dollars onshore, but in that case the whole benefit of the transction is lost to the PBoC.

The NBER published a paper in July by Robert Feenstra and Chang Hong on the employment effect of China's export growth.  The paper is called "China's Exports and Employment".  

The authors summarize one of their findings as "Growth in domestic demand led to three times more employment gains than did exports over 2000-2005, while productivity growth subtracted the same amount again from employment.  We conclude that exports have become increasingly important in stimulating employment in China, but that the same gains could be otained from growth in domestic demand, especially for tradeable goods, which has been stagnant until at least 2002."

The authors argue that exports are not as important as many think in stimulating employment, and that domestic demand is far more important.  This obviously has implications for currency management because one of the arguments against a too-rapid increase in the value of the RMB is the negative impact on employment.  If employment growth is not terribly sensitive to export growth, the negative consequences on exports of a currency appreciation are less worrisome.  

This jives with what some other research has suggested, although I guess arguments using productivity growth estimates run into a problem cited by Jon Anderson at UBS:  China's official employment data do not include rural migrants, so what may show up as an increase in productivity (output grows faster than employment) may actually only mean that rural migrants are an increasingly large part of the work force -- which is perfectly plausible.  

Last month's trade surplus of $24.4 billion was the second highest ever recorded, after June's $26.9 billion.  It was 67% higher than last July's surplus.  Exports in July were $107.7 billion while imports were $83.4 billion.  That brings the trade surplus for 2007 YTD to $136.8 billion.

For the record China recorded a $23.8 billion surplus in October 2006, a $23.7 billion in February 2007, and, to round out the top five, $22.4 billion in May 2007.

In theory July's surplus should have been a lot smaller.  Part of the explanation for June's record-busting number was the reduction of export subsidies beginning July 1, which was supposed to have exporters scrambling to move July and August exports to June so as to beat the deadline.  This should have left July numbers much lower.

But as I point out in an August 5 entry, I have always been very skeptical of asset-side or fundamental explanations of the trade surplus.  I continue to believe that China is caught in a trap in which trade surpluses are both the cause and consequence of monetary expansion.  Until something is done directly to change the terms of the trap, I believe China's trade supluses will continue to stay high, and will probably rise in the next few months as Christmas deliveries kick in.

What can get China out of the trap?  Probably only three things.  One, China can engineer a sudden and unexpected maxi-revaluation of at least 10-15% (as I explain in the June issue of Far Eastern Economic Review).  This would not have as big an impact on exports as the financial authorities fear, but it might boost imports and would almost certainly reverse or at least slow down hot money inflows.  I should mention, however, that the CEO of one major ($13 billion) New-York-based hedge fund told me two weeks ago that 10-15% was too little, and would merely trigger an immediate speculative inflow as people bet that the PBoC would be forced to revalue again.  Perhaps he's right, in which case the revaluation would probably have to be in the 15-20% range, but I suspect that he might not be.

Two, foreigners can choose significantly to reduce their imports, either through protectionist legislation or because of health and safety scares.  Although this would be far more harmful to China's employment growth than a maxi-revaluation, it would still have the benefit of reducing out-of-control monetary expansion.  Three, the great globalization party can come to an end and, with that, there would begin the slow grinding multi-year process of declining risk appetite and capital outflows to safe havens.  This would solve once and for all China's (and everyone else's) problem of too much liquidity, but it wouldn't be a lot of fun.

Inflation in the producer price index was 2.4% in July, less than the 2.6% the market expected and less than June's 2.5%.  This is obviously good news for the PBoC, who are getting nervous about inflation, but I don't think we should declare victory yet.

CPI numbers come out soon, and I believe market expectations are that it will rise from 4.4% in June to around 5%.  The consensus seems to be that this is no big deal because most of the price rise comes from temporary food shocks, and these should eventually work themselves out of the system.  Dong Tao at Credit Suisse, however, makes a plausible case that adverse food shocks should keep inflation high through 2008.

I am not sure I would be so blase about CPI rises due to "temporary" shocks.  First, if they persist they have a real effect on savers' perceptions of the value of holding deposits.  Second, I refer to an article in today's Financial Times titled "China inflation threat caps energy prices", which points out that the prices of certain products, such as power and energy. are capped by the government.  Effectively this means that a kind of payment that should have been called "inflation" is being renamed "taxes".  This may help keep CPI down, but expenditures are expenditures, and keeping the inflation proxy low is not the same as keeping the real cost of goods down.