The Paradox of a Money Printer

This is a preliminary note on the very unique Chinese banking system, with a focus on the monetary operations.

The Chinese Banking System

China doesn’t have a well developed and sophisticated capital market and financial system. No pains, no gains.

Though constantly evolving, the perception is that Chinese banks are more of the old-day bank-at-the-street-corner type. They take deposits and make loans or buy government bonds. No securitizations, no excess derivatives.

The total assets of the financial sector is of RMB 50 trillion in size (1.7x GDP), over 90% funded by deposits. Market shares are concentrated. The big four – ICBC, ABC, BOC and CCB – controls over half of the assets, and the major shareholder of those four is the Chinese government.

Yes, the banking system is nationalized, in good times and bad, and it works in its own way. No free market, supply and demand mechanism for interest-bearing loans and securities: the central bank, PBoC, sets the entire ladder of interest rate, from that of deposits to loans.

Sounds like a boring, stable, socialist banking system, right? Oh, except the astonishing rate of non-performing loans (NPLs).

It was about 20% at its peak, though the situation is improving in recently years. At such a level, banks are easily bankrupt despite of hefty fee collection due to lack of competitions. An example here. I don’t know how they did that – it’s not easy. One possible explanation is that it’s policy-driven. More on this later.

But the good news is that banks are nationalized, so that the government is there for bail-outs, in good times and bad. No FDIC type of deposit insurance necessary.

PBoC’s Ever-expanding Balance Sheet, Reserve Ratio and Sterilization

Monetary policy is a completely different craft in China. Take a look at PBoC’s balance sheet and you would know why.

What drove the rapid balance sheet expansion is China’s foreign reserve accumulation, topping $2 trillion today. Besides causing trade tensions, safety concerns and controversies, the current account surplus pile-up is rather a headache for PBoC: it floods China with money and threats with inflation.

How is PBoC fighting against it? They do two things – reserve ratio escalation and sterilization.

The above is the deposit reserve ratio (a portion of banks’ deposit money kept with the central bank to control the upper limit of credit). It is climbing up, until later last year.

The other one is the bond issuance by PBoC to sterilize money supply, or to take money out of the marketplace. It totaled over RMB 4 trillion – not a negligible amount and it would keep ascending as long as there is CA surplus.

There’s another possible way – to spend it. It is an incredible amount of money to spend. I did some long posts on it.

An Example: Stimulus Package in Chinese Way

Remember China’s RMB 4 trillion stimulus package? (Admittedly, I didn’t do the homework well.) It’s a perfect demonstration of how powerful the system is.

Amazingly, it seems happened overnight, and no known complaints.

It is still developing and the result is yet to be seen. I might well be wrong.

Will PBoC be Insolvent?

Sounds like a crazy question, since it prints money (not exactly) freely. But it doesn’t hurt to contemplate either.

One issue is the exchange rate. I don’t know how exactly they do the book-keeping on the foreign assets (mainly foreign reserves, plus some gold and others), but notice that RMB has been appreciating. If marked to market, the decreasing value of the foreign assets would drag the net worth underwater. Funny, since PBoC sets exchange rate and they are doing so to bankrupt itself. If there’s an outflow, it would be cash-based.

Another issue is interest rates that determines the income statement. PBoC collects interest payment mainly from foreign assets and pays out on deposit reserve and bonds. If (well-controlled) domestic interest rate is higher than foreign, it eats into the capital. As you can see, not much is left.

It’s not risk free, after second thought.

Does it matter and what to do?

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An Argument Against the International Reserve Currency Proposal

Mr. Zhou Xiaochuan, Chairman of Monetary Policy Committee of the People's Bank of China (PBoC), has created quite some buzz with his proposal to Reform the International Monetary System. I expressed my surprise earlier here, and clearly I misunderstood it at first. After rereading his proposal carefully, I don’t think it is very much constructive.

Now Mr. Zhou is widely recognized as an achieved monetarist, with an extended knowledge and unparallel insights of international and domestic economic and monetary matters - I have admittedly learned a great deal studying his influential speeches.

On this specific issue, however, I would have to express a somewhat different opinion.

The Proposal

I don’t need to repeat the well known and escalating global imbalance – tons of literatures are available online. Mr. Zhou’s proposal is to expand the role of IMF’s Special Drawing Rights (SDRs) as the international reserve for transaction clearance among nations, replacing the prevailing USD.  A full page of SDR description here.

To summarize it, IMF allocate SDRs to nations on a specific quota. The initial quota is here (it reads like a will, with the U.S. being the favorite son) and the change of it requires “[a]n eighty-five percent majority of the total voting power.” The value and interest rate is equivalent to that a basket of major currencies - today consisting of the euro, Japanese yen, pound sterling, and U.S. dollar.

Why SDR Won’t Solve the Problem

SDR is a type of money. Though not the money that you can do shopping with, nevertheless it is money. The function of money is: a medium of exchange, a unit of account, and a store of value. Mr. Zhou’s worry comes from USD’s store of value, or inflation.

Is SDR inflation-proof? Think of it as a basket of currencies – expand to include all world currencies if you like – the shares proportional to trade volume (not that important actually), so that you can create synthetic SDR with that basket of currencies.

The value of SDR, or your basket of currencies, is measured by what you can buy on them. (Yes, value of goods are measured by money as well as the value of money is measured by goods. So wicked!) When some country for some reason prints a lot of money, it inflates and its currency depreciates. If the currency is in the basket, the purchase power of your basket depreciates as well.

If China exchanges a basket of USD for SDR, inflation remains a concern – except instead of distrusting the United States you have to distrust many countries’ monetary policies. I would argue that the United States appears a bit more reliable on this one – it takes much pressure (though increasingly possible) to inflate in the United States, a nation of whiners, on almost everything.

What To Do Then?

I honestly have no idea – told you that money is much a headache. It appears there is nowhere to run, except that China could manage RMB effectively, only without a large amount of foreign reserves as a byproduct of the export-driven growth strategy.

There are however several ideas to explore. One is the TIPS, though the Chinese reserve is oversized for it. Another one is holding assets correlated to inflations, and it introduces new source of risks. The U.S. treasury is risk free – check your corporate finance textbook if you have any doubt. Or should we maybe reconsider the Gold Standard? Historically it has been a source of problems.

Alas! Nowhere to run. Why is money necessary?

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What Should China Do with $2 Trillion? (Part 2)

This is the second part of the series. First part here.

The Alternatives

Holding $2 trillion dollars, the Chinese authority has several options.

A Portfolio of US Treasury managed by PBoC

This is the status quo. Don’t think it is risk free return. Besides risk of inflation as I mentioned earlier, there is also exchange rate risk and a hard decision of short/long term allocations.

While the yield curve is influenced by the Fed, the possible reallocation of the Chinese reserve would inevitably move the yield due to the size of the portfolio. Out of curiosity, I would like some transparency of the current arrangement, or will I be asking for too much?

A Sovereign Fund

This one has also been carried out. China Investment Corp (CIC), is managing $200 billion financed by debt issued by Ministry of Finance. Ostensibly the risk is transferred to another entity, actually if CIC goes under the government would be footing the bill.

Again, some transparency would help. At lease have some press releases, as does the Abu Dhabi Investment Authority (ADIA).

Financial Investment by Citizens

This is to offer global investment options to local citizens in China - saving rate is high. Instead of limited local personal financial options, offer choices of international equities, bonds, commodities, REITs, etc.

It may partially solve the problem of dollar flood, but it sounds a bit dangerous, doesn’t it? Besides, it seems out of line of the current Forex management philosophy of the government. The consumer protection regulations may not be ready as well.

M&A by Corporations

We live in a global village. A large and uncultivated local market notwithstanding, Chinese corporations have to be global in scale to contribute to the global economy. Foreign merge and acquisitions or FDI sounds a natural step.

I am talking about strategic acquisitions and/or investment (vs. financial ones for financial gains). With global asset price depressed, it is never a better time.

The Chinese companies’ global footsteps have been intensifying, mostly in the resource acquisition area. Google it for more information. But I would like to stress the obstacles here, without an intension to be negative.

First, there is a huge historical, social, political, legal, cultural, linguistic gap. China has been a closed economy for a long time, seriously lacking experiences of global operations. Besides, we are commies. Chinese companies grew up under a different sets of rules and competitive environment. There are a lot to learn.

I have to point out one misconception: Chinese pundits like to distinguish mature market (i.e., developed economies) vs. immature market (developing economies) and insist that the later is more suitable for Chinese companies. The not-so-conventional wisdom makes less sense to me. The so-called mature market is called so for a reason – open market of greater size, well established infrastructure, a more complete legal environment – overall, a safer investment field in spite of competitive intensity. Why giving up?

Secondly, worthwhile competitive advantages have to be established. Chinese companies are perceived as low-cost producers - China’s nominal GDP per capita is $18k, while most developed countries are above $40k. Or you can look here.

However, cost leadership is an edge easy lost. sustainable global businesses require the emergence of some serious global brands, based on technology advance, management and operational capabilities. There are but few established examples.

Thirdly, it needs a capital market for financing needs – few companies can afford the bills by operation cash flows alone. Chinese banking system are nationalized and theoretically inefficient on capital allocation, not mentioning lacking international exposures.

Finally, it returns to the topic of exchange regime. RMB is appreciating at 5% per year, raising the bar of required rate of return. 

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What Should China Do with $2 Trillion? (part 1)

Suppose you are a maize farmer. I buy some maize from you with some money. Just another day in life, right?

What if I tell you that the money I pay you is not your kind of money, but my money, which I can print as much as I want to? Would you hesitate to accept that money?

Furthermore, you cannot really use that money, and you have to deposit it at a bank. Guess who is the bank? It’s me, and I set the interest rate.

Would you still selling the maize to me? Few will. But that’s more or less what the US is doing to many nations, especially those in Asia. China accumulated $2 trillion by exchanging goods with the United States for paper money that the country printed.

In this article, I will show you all sides of the story behind it.

The Dollar and US/China Imbalance

Money flow among countries via trade (of goods and services) and investment (in financial or hard assets). If you pay more and receive less, you are running a current account deficit.

The problem is countries have their own money, and it has caused headache for hundred of years because of the exchange rate and its related bunch of troubles. The consensus today is that dollar is the major international currency, so that countries write checks to each other in dollar.

Why dollar, you may ask? Well, it used to be gold, and the one with dollar is kind of a long and unpleasant story. The gist is counties don’t trust each other too much when it comes to printing money, and the United States is relatively a reliable one (and more importantly a rich one). Some country like Ecuador even gave up its own currency and dollarized (meaning they use the US dollar as their official local currency) – must have a lot of fond memories. On the other side of the Atlantic Euro is becoming a regional currency, with advantages and disadvantages.

Anyway, the United States has been running a current account deficit in recent years (chart below). The ‘08 number is $673 billion, around 5% of GDP. Among them $306 billion is with China.

So that along the way China is piling up US dollars. It’s almost $2 trillion as of today.

Now take a look from the China side.

In contrast to the United States, China is running a surging current account surplus, currently at $400 billion, or 10% of GDP.

What’s Driving China’s Trade Surplus?

The above chart may give you some clue. If you organize China’s foreign trade by type, you can see that the regular trade is almost balanced; there’s a deficit in other trade (I don’t know what that is); the processing trade (i.e., importing raw materials or components, assembling, then re-exporting the finished products) is shooting up through the roof.

Another way to look at the trade data is by type of corporations. The above shows the February's import/export data of state owned, foreign owned enterprises: 60% of export is by foreign owned. (BTW, the yoy trade volume dropped over 20%.)

So here’s the story: foreign companies have established manufacturing facilities in China for processing goods and re-export. If you are like me, you would be wondering why….

Should RMB Appreciate?

Some guy accused China for manipulate currency and urge China to appreciate RMB. Is it justified?

The above is the historical exchange rate of RMB/USD. It used to be that RMB 2 was worth $1. (Really?) In recent years RMB’s been gradually appreciated.

Like many Asian countries, the Chinese authority pegs the RMB to USD, meaning the government decides and maintains the exchange rate. The other kind of exchange regime is float exchange rate, in which it’s decided by the market.

So is China cheating by setting the exchange rate too low (so that Chinese goods are cheaper and thus more competitive)? It is a rather complicated value judgment, but I will tell you what I think.

First it’s about the price level discrepancy among countries. There are measures comparing price levels among countries, and the major one is Purchase Power Parity (PPP).

The above is an international comparison of PPP-based GDP per capita and price levels (hint: find Iceland, the allegedly recently bankrupted country). The rule of thumb is that the higher PPP-based GDP per capita (consider it a measure of productivity) leads to higher price levels. In other words, low-income countries set the exchange rate low. And I don’t think all the low-income countries are running a trade surplus. The point is that by such a rule only (don’t ask me who sets the rules on what ground), trade surplus seems not the reason to justify currency appreciation.

Secondly, as I mentioned earlier the export driver of China is really the processing trade by foreign owned companies. Think a minute about how these companies operate. They import materials in USD, pay wages and expenses in RMB, export finished goods in USD for a profit (after wage and tax) also in USD.

If RMB appreciates, they have to pay a higher wage so that the cost would be higher. Although the reality is more complex, if there is another equivalent country with the same investment environment but lower cost level, they may plan to move. Would RMB then be depreciated again?

Thirdly, some evidence from Japan.

Japan depreciated Yen by half in the 80s to around 100:1 to USD and kept it there, but it’s been continuously running a trade surplus and current account surplus ever since. Price level induced by exchange rate may not be the only reason of trade imbalance.

Is It Good for China?

First of all, everybody says that free trade is good yet trade negotiation always fail. We live in a bizarre world.

In the case of China, consider the foreign owned enterprises and the resulting trade surplus a stimulus package. It creates jobs and boost local economy (the multiplier). As for the MNCs, they use China as a lower cost production center and selling goods at the same price at home. Consumers also benefit from low inflation. It seems a good deal for everybody.

There’s one problem though. The entire process creates total money supply around the world. It’s well depicted by Wu, the former chief of Foreign Exchange Management Agency. It’s a kind of asymmetric process, and I’ve raised the issue.

Is the Money Safe?

Is it safe to hold so much dollars? The Premier expressed his worry recently.

Fundamentally different from Russia or Mexico that defaulted on their sovereign debt (USD denominated), the United States would not – they can simply print money instead. Under such a guideline, I sold a bunch of CDS on the US treasury and booked a huge loss recently. How could it be?

Besides, the US GDP is 25% of the world (the EU another quarter). If that guy cannot pay his mortgage, what would be happening?

I guess the Premier is worried about inflation and with good reasons. Would there be inflation? I don’t really know. But I guess the time when we see inflation, It would probably be the time when we are out of the recession (though history says otherwise).

What Should China Do With the Money?

The Chinese government has been responsible with the foreign reserve assets. Still, it is a problem, ironically caused by having too much money – image you are a mutual fund manager just raised $2 trillion.

Currently the Chinese government holds most of the reserve in US treasury bills. Probably in an effort to diversify, China Investment Corp, a $200 billion, CDO-type sovereign wealth fund was created. Disappointingly, nobody knows what those guys are doing with the money (ponder this: whose money is it really?).

There is, however, another way to go: encourage the Chinese corporations to invest abroad.

(too tired, to be continued)

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