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.
Your comment:
“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.”
China’s reserves can also be used for FDI (foreign direct investment) transactions. China has recently made several investments in mining/resource companies in Latin America, Africa, and Canada.
Thanks much for your insights including:
1) “To put it another way, [China's] reserves are not a savings account, free for the PBoC to spend as it likes. Reserves are effectively borrowed money.”
2) “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… ultimately must run the corresponding current account deficit.”
If I take your comments collectively, then a viable means for China to proceed will continue to be to use its reserves to accumulate certain commodities outside China and to make investments in natural resource based companies outside China (with commodities that are in short supply within China) such as energy – oil, coal, uranium -, crops/farmland, most basic metals, etc.
Thus, if I assess your article correctly, then Don Coxe’s strategy since 1999 of “investing in those commodities that China needs to grow” appears just as viable today as last decade.
I have never commented before but I have to say this has to be one of your most enlightening posts ever. I don’t think anyone has explained more simply and elegantly how reserves are accumulated and how a revaluation will affect China. I plan to make it required reading in my macro class, and I know many others will too.
Wow, a real tour de force. This should be read by anyone who wants to understand how China’s reserves work and how they affect China and the world. I also notice that you are too polite to mention the name of the person who wrote that ridiculous article you skewer so casually. Why? He has not exactly shown the same level of courtesy to you or others.
This is a brilliant article. Thank you !
I particularly appreciated your lapsus
“The PBoC ruins (sic) a mismatched balance sheet…”, please don’t fix it !
When talking about distribution of the gains/losses, an important topic in this debate is the aggregate position of the power structure class (I.e. the Party and the Army). Using the analysis that you developed, my guess is that it is long dollar and short RMB (unless they lose power of course !). That could explain some of the resistance to a revaluation.
I would also enjoy to see the same analysis from you for countries like Saudi Arabia or Germany. Your article looks like a long argument in favor of reintroducing the Deutsch Mark !
Likewise, America has huge natural gas reserves that cannot now be touched. Economic
Wonderful, wonderful stuff, Mr. Pettis.
This is a very good explanation of how FE and reserves work. I know that it won’t change the thinking of many pundits who are wedded to their talking points, but I sure do appreciate it. Thanks!
Thank you so much for this post – best explanation of these issues I’ve ever read. I will have to read it through several times, however, but that’s just me, not your clear and elegant explanation.
I have to jump on the bandwagon with congratulating you on a fantastic post. One question that I had though, is whether the PBoC might be tempted to just print it’s way out of a balance sheet mismatch, which would of course fuel inflation and mute the impact of re-balancing on households. I am not saying that’s a good strategy, I know inflation is politically sensitive in China, but would seem to be more tempting as unrealized losses mount.
BTW, I am accutely short Euros as I am heading to Seville next week, if only they still had the peseta to devalue.
Micheal,
I am a bit confused by your remark;
“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.”
While technically I agree, would there not be a change in the purchasing power of the USD reserves? If the PBoC was to realize its loss that implicitly would mean that the USG would have to recognize the increased purchasing power of the RMB (or diminished purchasing power of the USD). Such a change in PP, would induce inflation in the US which it has managed to hide via the currency mismatch. Is that not correct?
Also, I am I begging you for an explanation of this, why would you state that a rise in the value of the RMB be the same as a decline in the value of the USD? As a Canadian looking at the relative value of the Canadian dollar against both, a rise in the RMB produces a whole different outcome than a decline in the USD. Obviously this would be the same for all the other outside parties.
BTW, you are an excellent teacher!
Professor Pettis: Bravo and many thanks for a brilliantly clear explanation of how a “potential revaluation” redistributes wealth within a country.
It also sheds light on the rationale behind China’s big push to export long-term capital abroad as a way of rebalancing its balance sheet.
best regards James
Just what is the explanation for: if the RMB rises against the US$, the Euro will fall against the US$?
Thank you. That was enlightening.
It seems that the debate within RMB revaluation is who will take the losses. In America, there is an implicit guarantee that has been solidified by the recent market bailout functions of the Federal Reserve, going so far as to violate their charter to maintain the “system.”
In China, there is an explicit perfunctory duty of the PBoC backed by a political regime that wont tolrate the instability created by financial panics. Essentially, the market is free as long as it behaves appropriately.
I would say then that the debate of who looses what … is exactly the question. Will the Communist government allow the free markets to topple it? Will the Democrat-Republican oligarchy allow the free markets to rattle their financial control of the American political system?
Who looses?
The practical debates of fiat currency are still in their infancy. Society largely used a barter system backed by hard currencies for 1000s of years … only recently to be replaced by paper money in the 18th Century. Given that relationship, how can one argue in terms of exactness that the political winds cannot and will not influence the PBoC’s keystroke’s that creates RMB out of thin air on a computer?
It can’t. The reality of the massive debt structures created in the current financial regimes by fractional reserve banking must be considered then in the nature of the political realm they now find themselves in.
Of in more simple terms … the gig is up.
Is the comment from “marks” correct?
Could China use its dollar reserves to engage in FDI in extractive industries abroad (e.g. in Africa), and for direct commodity purchases, instead of investing in U.S. Treasuries?
If so, how would one go about figuring out whether that is indeed happening?
I am not sure about your first few parts in this post. But in your last part on winner/loser and wealth transfer, your conclusion could not be more misleading. Discussing the impact of currency revaluation from the financial point of view, i.e. asset/liability, is useful. However, it misses the bigger picture: real economy, i.e. aggregate demand/supply.
In case of revaluation, exporters will be losers. But do most people become winners? Real life example: the crisis in the last three months in 2008 could testify that everyone in China was a loser when most exporters faced a disappearing export market (different reasons, same result: foreign demands decrease and foreign assets become cheaper). Actually many of your previous posts did say the same thing: external demand for China was so large that losing this demand would negatively impact the economic growth rate, which implicitly means that nobody is a winner.
There are so many reasons for RMB revaluation. Inflation, international relations…to name a few. But wealth transferring or people’s economic welfare certainly is not among them. The appreciation of the exchange rate only improves the ability to purchase foreign goods, which does not contribute to the aggregate demand, which drives the economic growth. Nor does the currency revaluation help boost the domestic demand in China relative to the external demand. Yes, the percentage of domestic demand might increase after the revaluation. But that is probably because the aggregate demand would decline or grow more slowly due to the revaluation. I am sure that we want to achieve a higher percentage of domestic demand by having a higher growth rate of domestic demand in a growing economy.
There are many ways to increase domestic demand. One is to transfer the large pool of unskilled labor to a group of skilled labor in China. Then, social insurance and health insurance, if implemented properly, can free a huge amount of household resources. Financial system in China is still inefficient. More competition and less government intervention certainly can improve it. General transaction costs in China have a lot of rooms to drop as well.
Also, I didn’t quite understand this:
“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.”
Why would China’s switching to buying other assets necessarily result in an increase in the pool available to fund USG bonds? Wouldn’t the yields have to be increased to entice replacement buyers, especially if China’s exit from that market were seen by others as a vote of no confidence?
Thanks very much for fleshing out the cause, significance and implications of the PBoC’s foreign reserves. Much appreciated.
Pretty good analysis. I especially liked your analysis of whom within China benefits. I’m curious if you have a similar analysis of whom benefits in the U.S. from this current setup of trade imbalances. Sure, as a whole the U.S. has benefited, but who exactly will win in the end?
Terrific stuff. Much appreciated.
All articles about China can be classified as either China threat or China collapse.
Bottom line there is never a good ending for China according to Western China Policy pundits.
This one belongs to china collapse theory.
Great article. But thinking wildly, couldn’t China do a lot with those reserves? Your discussion revolves around a linear, equilibrium world. What if they used the reserves to aggressively short Greek CDS, buy enriched uranium for Iran, fund the Green party in Texas, set-off nanoparticles to create global cooling, increase the cholestrol in Big Mac’s?
Michael,
I have a hard time understanding a couple of things (sorry); why doesn’t China benefit from its manipulated currency?
It looks like the factors are the following:
a) There is a real loss for PBOC
b) There is a real loss for exporters because the present Yuan value of future revenues declines
c) There is a real gain for households because the present Yuan value of future expenditures on imports declines
The last two items should offset directionally in the present Yuan value of future current accounts, shouldn’t they?
Therefore, although households gain, why wouldn’t the loss on the PBOC position become a big net loss for the nation as a whole?
Mr. Pettis
I admire your stylistically clean approach that gives the reader a deft, cutthroat debunking of many theories regarding china/us relations – sans the wonderfully “hyper-academic” prose.
More importantly, your posts leave the reader with an ever expanding, functional roadmap of all the moving parts of this massive game, that is us/china trade. The fact that you can do this in lay terms is nothing short of absolute genius. Elegant, man. Wow.
Thankyou, Thankyou, Thankyou
Prof. Pettis:
I am having trouble reconciling the following statement with my understanding of central bank balance sheets:
‘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.’
Rather than a hole, I tend to see the [fixed] set of liabilities collateralized by $100 less assets (i.e., a devaluation of the liabilities–in this case, the RMB).
From my perspective, this doesn’t seem much different than your description of the PBOC’s currency pegging regime (i.e., setting the number of renminbi per “dollar” by ‘buy[ing] or sell[ing] unlimited amounts of RMB against the dollar at the desired price’).
I agree that drawing down on the asset side of the balance sheet is different than a savings account, but I’m not sure, given what I wrote above, why the reserves can’t be employed from a policy perspective (noting the above consequences for the relative value of the RMB).
Do you have any alternative wordings that might trigger that epiphany in me?
Cheers,
Matt
What an education. Thank You. I hope you can keep writing here, even with the other demands in your life
As usual an excellent post Prof Pettis.
But surely for China as a net exporter a stronger RMB must lead to lower net RMB revenues/cash flow, which has to be a net negative?
Assuming it repatriates USD interest, there will be a simliar reduction of RMB revenue there too?
Cash is king!
Marks, yes, reserves can be used to fund outward FDI. As I mention in the entry, reserves are available for the purchase of foreign goods and assets, and for the payment of foreign obligations. As for your later point, technically if China accumulates or stockpiles commodities (which it seems to be doing) this won’t occur through the PBoC but rather as an increase in imports, and thus a reduction in the current account surplus, but ultimately yes, it represents a deduction to reserves. Note, however, that stockpiling commodities with an undervalued RMB will still result in a realization of the loss once the RMB is revalued, except that instead of occurring on the PBoC’s books, it will occur on the books of the owner of the commodities. In tat sense, we can think of stockpiled commodities as “outsourced’ reserves. I am not sure I agree that Coxe’s strategy is as viable today as it was in 1999. That depends on china’s future growth prospects and the extent of current stockpiling.
Economic, PBoC reserves and natural gas reserves are not at all alike except that they unfortunately use the same word. A country’s natural gas reserves, of any valuable minerals in the ground, are free wealth (less extracting costs). Reserves are borrowed money.
OGT, in principle the PBoC could monetize all its RMB debts and effectively inflate it away. In that case the balance sheet mismatch works to its benefits, since by monetizing the debt and creating inflation they would force the RMB down against the dollar. Of course there are other problems with that strategy. And as someone who grew up largely in Spain, I miss the peseta, and I am sure I am not the only one.
Glenn M, yes, of course an increase in the value of the RMB reduces the value of the dollar in “global purchasing power” terms, and this would have some impact on the “real” value of the reserves. I would argue that with China being just 8% of the global economy, this adjustment will be small, and anyway almost by definition much of the pricing impact will occur on things that China doesn’t buy, but sells a lot of. It would also be at least partially reduced if, as I suspect, an RMB revaluation would cause depreciation in other currencies, most notably euro, sterling, and the other floating rate currencies that have so far taken the brunt of the dollar adjustment. It is very difficult to work out exactly the net impact because there are so many moving parts working in opposite directions, but I suspect it would be small. Still, thanks for pointing that out.
As for your second point, I say a rise in the value of the RMB is the same as a decline in the value of the USD because the RMB is effectively set against the dollar. But anyway, if the RMB were raised against the dollar by 5%, it would also immediately rise 5% against every currency in the world. Of course this would then be adjusted by the subsequent impact, if any, on dollar cross rates of an RMB revaluation. Since a RMB revaluation should take pressure off the US current account deficit, I suspect that the dollar would immediately rise a little against the major floating rate currencies, including Canadian dollar, so that the RMB would rise even more against the Canadian dollar. This last, however is only a guess.
Zjin, the whole point of the piece is to try to cut through the confusion between balance sheet effects and long-term economic/employment effects. It is one thing to argue that revaluing the currency will or will not be good for China’s long-term growth prospects – and please remember to distinguish between short-term employment prospects, which revaluation will of course hurt, and the long-term benefits of rebalancing. I believe rebalancing, of which a revaluation is a part, is necessary for China’s long-term growth, as does nearly every Chinese policymaker. But as I have pointed out so many times, what is good for rebalancing in the medium and long term is likely to be bad for employment in the short term. This is the policy dilemma Beijing faces.
It is a completely different thing, however, to argue that China will lose the value of its reserves in a revaluation of the RMB. Unfortunately many people confuse the two sets of arguments. I am willing to concede that any of the various pro and con statements on either subject might be true, but I would insist that they are separate subjects and should not be run together.
As for your statement, “There are so many reasons for RMB revaluation. Inflation, international relations…to name a few, but wealth transferring or people’s economic welfare certainly is not among them,” I am afraid I disagree completely. In fact almost all the support for revaluation within China comes for one of two reasons, to contain inflation and overheating, and to rebalance. Rebalancing is just another word for transferring income from the state sector to the household sector. It is widely recognized among the revaluation camp in China that this is the most important reason for revaluing.
Karen, if China sells USG bonds, it must buy something. I have argued that it cannot buy RMB, it can buy very little other non-dollar assets without causing the US trade deficit to shift elsewhere, which would be unacceptable quickly, and so that leaves little else except other dollar assets. This increases the pool of money available for other dollar assets, which ultimately ends up in Treasury bonds. The net effect should be a slight increase in Treasury yields and an equivalent reduction in credit spreads. As for your condition “especially if China’s exit from that market were seen by others as a vote of no confidence,” I think that is circular. My point is that there is no evidence that China has exited from the market, and we can’t assume its exit from the market to argue that it has.
DJC, since you seem to be one of those mythical Western policy pundits, albeit perhaps with even less China knowledge than the average pundit, I wonder if perhaps your prejudices made you see collapse in an article that has nothing to do with collapse.
JT Ulu, acknowledging that I am not certain what that might mean, I nonetheless don’t think my argument revolves around a linear, equilibrium world, especially since the whole balance sheet approach assumes non-linearity and multiple equilibria. Please explain. As for your second point, if the PBoC wanted to be wildly speculative (very unlikely), they could do all the things you mention with their reserves and even more, but that changes nothing. When their investments win, they make money, and when they fail, they lose money. That is exactly the current situation they have today.
John Halasz, see my response to Glenn M. The basic argument in the market is that the dollar needs to depreciate, and since it can’t depreciate against Asian currencies because of active intervention, the euro (and other floating currencies) must bear the brunt of the adjustment. When China revalues, however, that release pressure on the dollar against the euro. Of course there are lots of other things that affect the dollar-euro exchange rate that can drown out the influence of the RMB revaluation, but in principle these are net neutral.
Dennis, I am not sure how that first into my piece. China’s has an undervalued currency because it is a way of trading off consumption for employment growth.
Matt, if I create a special purpose company (SPC) under my guarantee that borrows RMB 683 and then uses the money to buy $100, it will have a balance sheet with $100 in assets and RMB 683 in debt. In principle I can use the $100 to do lots of things, for example to pay for a nice lunch. The SPC will now have no assets but it will still owe RMB 683. Since I have guaranteed the SPC, my debt has increased by RMB 683. In other words I cannot use the SPC to get a free lunch. One way or the other I borrowed the money to do it.
Gareth, actually the rising RMB means that what China produces for exports will be exchanged for a larger number of imports. This might reduce exports, but so what? The wealth of a country is not measured in export revenues, or else China would already be the richest country in the world. It is measured by either the correct economic value of what it produces, or the correct economic value of what it consumes (opinions differ, and reasonably). If China is able to produce the same amount of stuff, exchange it for a slightly larger amount of foreign stuff, it is better off. Now of course I am ignoring the employment impact of a revaluation, which is important, but is a different kind of problem.
Wow! Nice post! I think i need to go through it at least once more! Have you ever considered some highlights from this blog and arranging them into a book / collection for publication?
Often when I read Prof. Pettis’ writings I am struck by not only the very clear and simple language and logical structure / progression, but also by the key role given to “balances” within the theory. As an occasional finance teacher myself, it is often evident that lack of understanding of balance sheets, balances between countries and balances within societies (economic structure) lead to many confusions.
I wonder if the author of that article down at the newly accused “hacking” university in Shanghai will make any attempt at defence? From past form, i suspect that he will move on to another topic.
Another question, sorry for forgetting in my previous post. I was wondering Prof. Pettis, if you could recommend any books (maybe just one or two) on the subject of, or written by Minsky? I know you are an admirer.
Is the book written by Minsky and Whalen useful? Or “Can it happen again?”.
Thank you in advance
Prof Pettis
Please bear with me, it sounds like the PBoC reserves would be assets “held in trust” for the companies and individuals in China who are paid in RMB?
Thanks.
Prof Pettis,
Like others, thanks for such a great article.
Continuing from your discussion of wealth distribution(when RMB revalues), is it sensible to deduce that the reluctance to revalue RMB means that China is extremely concerned with the fiscal status of PBoC, as well as the fragility of export businesses?
Professor Pettis:
I just finished reading your terrific posting yesterday when I came across Geoff Dyer’s FT 22/2/10 article “No one Home” concerning China’s building spree.
“Yet unless the bad debts become an avalance, China has the ability to absorb a large number of non-performing loans without it undermining the financial system.” …..”With $2,400bn in foreign exchange reserves, it can easily recapitalise the banks if they run into problems. Indeed, that is exactly what it did in the early part of the last decade after the main banks became technically insolvent from a previous credit binge.”
As Santayana said: those who fail to read history are condemned to repeat it. best regards James
Very complicated stuff – Thanks for tackling it.
I have some important points I’d like to add:
The Fed earned $43 billion in interest income in 2009 (mostly from US treasury holdings) while paying out $2 billion in interest expense. I presume the PBoC is earning even more in interest income each year.
The Fed is obligated to kick a big portion of its income back to the US Government each year, (but still has a huge pile of retained earnings). Any idea if the PBoC does the same for the Chinese government?
One might think of the trade gap as net income for China Incorporated, with the country amassing a very strong balance sheet over the years as earnings have been retained in the form of foreign exchange reserves. In truth, net income has been even higher because a very large portion of imports have been investments in capital goods, rather than on expensed items.
If the PBoC has distributed most of its portion of those earnings over the years and holds a huge dollar position relative to its RMB liabilities, then a significant revaluing could put the PBoC into bind. However, I don’t think the PBoC will have trouble finding ways to earn its way out of any financial hole over time, given its ability as central banker to create new money and loan it out at interest.
I invest in a bunch of Chinese companies that trade on US exchanges. When China was letting the RMB appreciate 2-3 years ago, these companies had to take write-downs on their US dollar accounts. I expect the PBoC had to take write-downs as well. The loss was real for Chinese investors, but as a US investor these write-downs were meaningless in dollar terms to me. Meanwhile, the value of assets denominated in RMB (PP&E and cash accounts) rose in dollar terms for me. I look forward to the next round of RMB appreciation.
While I don’t think its accurate to say that the typical Chinese consumer is short the dollar, it’s clear that Chinese consumers should benefit from an effective appreciation in their earnings as the RMB appreciates.
Chinese exporters would likely suffer from increased labor costs, but as China’s technological position improves it will offset the labor cost issue. I expect that China will only allow the RMB to appreciate as fast as its need to maintain full employment will allow.
China almost certainly was a net seller of US treasuries, and I expect it was a net buyer of Canadian and European assets in December. The dollar surged upward in December and has continued up in January and February (taking the RMB with it). I believe this was due to the unwinding of a great many bets against the dollar by hedge funds and other speculators, however, and from the net purchase of treasuries by other governments seeking to suppress their currencies relative to the dollar.
James, i saw that article too. Was a bit confusing, they did recapitalize the banks ten years ago, but obviously not using reserves, as Dyer states here. This is especially weird since i think i read an article by Dyer (but may be wrong) a year ago in which the AMC system was explained at length!
Michael,
What do you think of the following hypothetical:
Congress authorizes the Fed to peg the USD at 4 RMB to the dollar. So if you bring 4 RMB to the Fed they’ll give you a dollar, and if you’re missing a brain and take a dollar to the Fed (instead of to the PBOC) the Fed will give you 4 RMB. Since the Fed doesn’t own RMB, presumably it would need to go the PBOC’s window, give them a dollar, get 7 RMB, pay out the 4 RMB, and pocket the difference.
I can see that this is akin to a short circuit, and if tried to lead to similar bang, but I’m curious how fast the PBOC would be forced to abandon its peg and whether it’s possible to estimate the losses to the Fed in the process.
In my previous comment I meant to say I “and if tried, would lead to a similar bang.”
Just to make it clear, I understand that no one would bring dollars to the Fed–private actors would bring RMB to the Fed and dollars to the PBOC and bleed both banks until one of them cries uncle.
What is there to stop China from simply printing RMB and spending them internally without that cash appearing as a debt anywhere on any government balance sheet? If they did this how would we ever know? Sure it would be inflationary, but as long as they didn’t overdo it, who would be the wiser? As long as China controls its exchange rate and labor costs it can get away with a hell of a lot. Keep in mind that China is a totalitarian system, and their internal books are not open to inspection. I wouldn’t make too many assumptions about what the PBoC and The Party can and cannot do.
It is true that if China sells its dollar assets it must buy something, and this won’t go unnoticed. The numbers are simply too large. The only way they could try to hide the action and play a shell game is to covertly buy forward contracts on a needed commodity, such as oil or gas. And this only works if the various sellers don’t know about each other’s secret sales. Otherwise, the price of that commodity will soar.
Well, maybe this is happening in oil, and pushing the price over $80??
It gets worse Michael – I’ve seen people with CFAs and who are allegedly great investing minds trying to pontificate about fx flows using total exports rather than net exports (lookin’ at you, Vitaly Katsenelson).
In the end, as soon as a debate becomes mainstream it becomes pointless to read the articles rather than just follow public opinion because the average person votes but is not particularly clever.
If I understand correctly the PBOC FOREX RESERVES result from the balance of China’s trade and services with the rest of the world.Being an overall net exporter its Central Bank thus accumulates foreign currencies [of which the US dollar in the main one].This surplus,instead of lying idle at the FED ,is invested in US treasuries,bonds,to purchase other assets or indeed to resort to FDI overseas.That stock of foreign assets cannot be converted back to the domestic currency as the counter value in yuan is already circulating in China.Thus it must remain overseas and only the MIX of that stock varies depending on PBOC’s portfolio strategies to secure the optimal returns.Revaluation of the yuan will therefore only affect FUTURE transactions to the extent that the overall trade/services current surplus may decelerate i.e the pace of accumulation of Forex reserves will slow down.
“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.”
This line helped me a ton. I had previously viewed the reserves as some form retained earnings of the export sector.
What should we make of the suggestion by some prominent Chinese generals to ‘dump treasuries’ in retaliation for Taiwan arms sales, or the like ?
This was a wonderful post. Thank you Michael.
I have a sophomoric question for you:
If the PBOC is raising RMB through the domestic money markets through selling bills, wouldn’t it push up domestic interest rates at the expense of maintaining the exchange ratio?
But of course we know domestic interest rates are very low. So that doesn’t fit.
What is the process that they use to balance this out to achieve domestic interest rate targets?
In the US, the Fed would buy bills/bonds through open market operations. But I’m guessing PBoC can’t do that because it would counteract their raising RMB in the money markets.
Any help would be appreciated. I’m trying to wrap my mind around it.
if China float the currency, can PBOC maintain the exange rate as desired? if so, at what cost?
Prof Pettis,
Thank you for your unequalled analyses and the additional time you take to read and respond with further clarifications to questions and comments from your readers.
I have a suggestion and a question for you in regard to this comment:
“I have argued that it cannot buy RMB, it can buy very little other non-dollar assets without causing the US trade deficit to shift elsewhere, which would be unacceptable quickly, and so that leaves little else except other dollar assets. This increases the pool of money available for other dollar assets, which ultimately ends up in Treasury bonds. The net effect should be a slight increase in Treasury yields and an equivalent reduction in credit spreads.”
My suggestion is: Rather than using the terms “can” and “cannot” when discussing the Chinese gov’t's options, which seems to be an economist’s shorthand for “the probability is really, really low that they would do so”, you might just use the long version. It seems that you end up having to explain why you assert that they “can’t” do such and such, anyway, and it might reduce the confusion on the part of many readers between impossibilities and improbabilities. This is perhaps especially relevant now, after so many economists presented their interpretations and predictions over the last decade regarding the choices and future behavior of consumers and bankers in the U.S. as absolutes that led almost everyone to buy into the “perfect equilibrium of the Great Moderation” scenario and to overlook or supress those who were pointing out that the implications of some of those choices and behaviors were becoming ever more drastic and ever less improbable.
My question is: If the pool of money available for dollar assets increases (for any reason) and ends up in Treasury bonds, wouldn’t the net effect be a decrease in the yields (increase in price due to increase in demand), rather than an increase in the yields?
The most disturbing aspect of all of this is the way it illustrates that even so called professional economists don’t understand how it all works. If Pettis is correct, then John Ross’s clients are all being conned by an ignoramus.
Professor Pettis,
I’d like to get your thoughts on the following.
I am not sure of this but I suspect it is wrong to suggest China had no choice but to accumulate so much foreign reserves in dollar. Instead, I suspect China end up holding so much dollar reserves because the Chinese central bank made a very basic investment mistake.
The key point is China didn’t just export to the US. China exported to the whole world and US is only a fraction of the total export. When a Chinese exporter sells to Europe for example, he ends up with euros. This exporter than exchange his euro for RMB with the Chinese central bank. However, the Chinese central bank first exchange euro for dollar and than buy US treasury! This last step, in my opinion is the big mistake. The Chinese central bank could have directly invested in European government bonds with the euro but why it didn’t?
Also notice China had to sell euro to buy dollar. That means the dollar would strengthen relative to the euro. In other words, the dollar China got is inflated in value relative to the euro. The stronger dollar also worsens American trade imbalance by making American imports cheaper and American exports more expensive than other wise. This could be a very big affect considering all the countries China exports to in aggregate.
Was my description above correct?
Here is what I really don’t understand. Diversification is a very basic and well understood idea in finance. Why was this mistake made? Is it simply because of the dollar’s role as the world’s reserve currency? Did China not have an option to invest in any other government bonds besides the US because of it’s dollar peg (I don’t see why)?
At any rate, China is at the current predicament now. The Chinese foreign reserve is a dollar denominated future claim on the world’s assets, not just the US. That reserve belong to the Chinese people and not the Chinese central bank. From the Chinese perspective, the key question is how to protect that dollar denominated claim? This also brings me to the next question.
What would happen to the US dollar relative to other currencies such as the euro if China revalue the RMB to dollar peg?
If changing the RMB to dollar peg also causes the dollar to loose value than that would weaken Chinese reserves claim on global assets. In other words, it is a wealth transfer from China to the world. I haven’t figure this out yet, but I suspect if dollar weakens against RMB, dollar would also weaken against other currency like the euro.
Mr Pettis
A trade surplus seems to be like cornering a market for a given commodity (corn, palladium etc). China’s reserves are so large it doesn’t seem like it could possibly sell without causing significant damage to it own economy.
Clearly reserves did not help US in the 30′s nor Japan in the 90′s
Summary: the consequence of continuing peg usd/cny; what happen to usd/cny when the bubble burst; investment theme in china through the next decade.
Great post Mike. Here are some questions I think of after reading it:
1.)reval CNY increase china’s consumption by wealthy effect, but part of the increased consumption will be diverted to purchase external goods, i.e it hurt net export, so net effect on GDP is uncertain?
2.)Reval CNY is gonna reduce China’s current account surplus and hurt China’s competitively on the global market, is it a good thing for China overall?
3.) if PBOC continue to peg usd/cny, its mismatched balance sheet can be rectified through higher domestic inflation (which decrease the value of its liability side — the real purchase power of CNY), so we need compare choice A.) allow nominal CNY price appreciation; and B.) through higher inflation, and see which choice is the better one. Your article has done a great job in analyzing the consequence of Choice A. so let me try to speculate what’s gonna happen down the road if they stick to choice B:
if they continue peg usd/cny at current lvl, swelling trade surplus forces pboc continue to print CNY to buy usd and support usd/cny rate, the constant increase of cny liquidity help to fuel inflation and raise Chinese worker’s nominal wage, so gradually Chinese exports will become more expensive and lose market share and reduce current account surplus or even turn it to a deficit.
At the same time, and more importantly, the increase of cny liquidity reduce cny denominated debt’s real purchase power and encourage more leverage in the economy, this gonna push up nominal assets price as well as inflation, so all asset’s real return will continue to drop as what we see in the past decade. If market remains rationale, the low real return will decrease cny denominated assets’ attractiveness to foreigners and help to reduce China’s capital account surplus or even turn it to a deficit.
And when current account plus capital account equal to zero, the FX market achieves equilibrium and adjustment process is over.
However the real danger in the process is that when cny denominated asset’s real return drop and inflation rate goes up, the nominal price of cny assets must be sky rocketing, given a pegged usd/cny rate the market will not remain rationale and they’ll be attracted to buy Chinese assets even if the real return has been very low, which create a big bubble like Japan’s in late 1980’s.
4.) when the bubble burst, what’s gonna happen to usd/cny rate? Counter intuitively, I think CNY will rally big time against USD (although the initial knee jerk reaction might be to sell cny buy usd). Since CNY’s money velocity will collapse and amount of cny liquidity collapse too. CNY short term interest rate will be very high (but long term interest rate collapse as market will price in a deflation) and the whole world will need CNY to scale down their leverage, which is a similar case to Japan in 1990 and US in second half of 2008. And the government will have to come in and bail out if they wanna keep a “harmony” society, then the economy might turn to one like Japan’s in 1990’s with low interest rate, low inflation, low real return until the amount of leverage are fully scaled down.
5.) what’s the investment idea for china in the next decades? unless a sudden big scale reval ( I think unlikely), above analysis in 3.) and 4.) should still hold. So the best trade probably still to bet on continuing decrease of real return in China. Too bad they don’t have a TIPS market, but REITs and Utility stocks are similar candidates since they benefit from both higher assets price inflation and decreasing real return. I’ll also avoid any assets that implying a high growth rate, after all, the real return will drop and the increased roll of government in the economy itself is good for maintain high growth. I’m also wary about the “consumption theme”, unless a sudden reval, the FX mechanism will continue to suppress consumption and subsidies exports.
What do u think?
Great post, Prof. Pettis!
Could you please help me with 2 questions?
1) China used FX reserve to recapitalize the banks in 2004/5. This should have resolved banks’ solvency problem because solvency concerns capital and it does not discriminate between CNY and USD capitals. However, I am curious if the banks use this USD capital to make CNY loans. Or for the banks to make CNY loan they have to switch their USD capital to CNY?
2) If banks have to convert USD to CNY, banks have to sell USD to PBoC and PBoC will have to print CNY for banks, and this can eventually weaken RMB vs USD. Does this reasoning make any sense?
What I am trying to say is
- whereas China as a whole made the USD only once when foreigner bought Chinese export (or when foreigner invested capital in China),
- PBoC can give this USD to Banks (thus reducing PBoC asset but not reducing liability)
- and then banks can bring this USD to PBoC and swap for RMB (increasing PBoC asset but increasing liability equally)
- then PBoC can give USD to banks again if the banks are in trouble again or to any domestic entity it wants to support (PBoC asset declines but liablities saty same)
- repeat repeat repeat –> result in big increase in PBoC net liability –> Reason for RMB value to decline vs. USD
Let me thank you in advance for your help.
Wow, this was great! Every now and then I read something that gives me a leap-forward in my understanding of macroeconomics: this was one of those days.
A lightbulb really went off when you wrote:
“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. ”
It seems so obvious now.
Prof. Pettis, thank you for this great entry! Could I just follow on to say that I believe that as china inevitably revalues rmb in the comming years (if not months) then we are finally going to see the outcome of all the central banks complacent monetary policies, namely, some world-wide inflation, dollar-euro-yen losing their current reserve currency status. That is why I, and apparently the PoBC itself, do not like to hear about one-off 10% revals, we are probably going to see more of that tight floating peg we saw in 2004-2007. Nedless to say we will get back to our last conversation about the costs and benefits of either strategies.
Best Regards,
Eduardo
I must say that was the best exposition of your argument so far. Also, must second the person who said you really should, if haven’t started to, edit these blog postings into a book. Well done, again. DJC, I thought you would have figured it out this time.
Andy Huang: if China float the currency, can PBOC maintain the exchange rate as desired? if so, at what cost?
I think floating the currency by definition means that they don’t maintain the exchange rate at a desired level. It means that the market determines the rate.
Billy: The most disturbing aspect of all of this is the way it illustrates that even so called professional economists don’t understand how it all works. If Pettis is correct, then John Ross’s clients are all being conned by an ignoramus.
What makes you think he has clients, besides of course his unfortunate students in Shanghai and a few “political” guys who are looking for accusations, not rational arguments? London used to be client, I guess, when he worked for our very own clown prince, Ken Livingstone, until we tossed the whole lot out, although not before they managed to seize themselves some scandalously large bonuses. I wonder how much his university knows about that.
Houhui, thanks, and yes, we don’t spend nearly enough time thinking about balance sheets. When I studied economics monetary and balance sheet issues were often treated as a veil that had no real bearing on underlying economics, even though Irving Fischer, Hyman Minsky, Charles Kindleberger, and above all Keynes should have taught us otherwise. Minsky’s books and papers, including “Stabilizing an Unstable Economy”, are very good and usually very readable. Whalen on Minsky is worth reading. The Levy institute at Bard is hard-core in the Minsky camp and you should get in the habit of trolling through their papers, and Minskyite Australian economist and blogger Steve Keen has great insights.
Maotai, no, the reserves are not really held in trust. They cannot be passed on, for example, without leaving a hole in the balance sheet. They are actually owned by the PBoC, while the PBoC of course is owned by the central government.
Kalasend, I think there are many arguments in favor and against revaluing, and this is likely to be just one of them. A professor here once did tell me that there is a bit of a political football game going on here in the sense that losses at the PBoC would need to be capitalized by the MoF and so would represent an unwelcome shift of power from the PBoC to the MoF, but I have no idea if this is true.
Yes, James, I saw that. The logic that reserves are borrowed money and not free wealth may be compelling but it is also a little counterintuitive, which is why I think so many people make the mistake. What happened if I remember correctly is that the PBoC used the reserves to buy newly issued shares in the banks, which I believe were then transferred at cost to CIC. Of course the PBoC can buy whatever it likes with the reserves, bank stocks as easily as Treasury bonds, but it cannot “give it away” without incurring a rise in net indebtedness.
SV, in principle the Fed can peg the RMB to an undervalued exchange rate in the same way that the PBoC can do with the dollar, but the Fed does not intervene in currency markets and stopped pegging the dollar after the break with Bretton Woods in the early 1970s (it pegged against gold). Anyway since the RMB is not an international currency, the Fed would not be able to pay anyone RMB. It can only open an RMB account with a Chinese banks in China, and of course the PBoC would not permit that if it were to be used to counteract the PBoC’s exchange rate policy.
Andrew P, it could simply create inflation, but then remember that its borrowing costs would rise and it would run a negative carry (i.e. its financing costs would be less than its interest income on reserves). Either way it would still erode the capital base.
Ttsing, yes, if I understand you correctly, that it is correct.
Purple, let’s just hope they are better generals than economists.
Mike, yes, but remember that the PBoC has a very strong way to control interest rates by setting the banks lending and deposit rates. It does regularly repo and buys and sells its own bills, but the auctions are often set by price (they sell whatever amount clears at the price) rather than by quantity (as the USG does).
Michael, I mean “cannot”, and not “is unlikely to.” It is literally true that the PBoC cannot use reserves to buy RMB without losing control of the exchange rate. It is also literally true that China cannot recycle the US trade deficit to Europe unless some other agent recycles it from Europe to the US. As for your question, if China shifts out of Treasury bonds and into USD risk assets in a large way, it would cause the price of Treasury bonds to drop enough and the price of risks assets to rise enough to entice someone else to do the opposite trade. That is why Treasury yields would rise a little and credit spreads would contract.
Silly things, this is a little long to explain briefly, but basically it might make sense in response to ask why, if the PBoC really wanted to hold SDRs and not dollars, it didn’t simply construct the composition of its reserves according to the SDR composition. I would argue that if that were to happen, the growth of China’s trade surplus would be constrained not by US ability to absorb the deficit but rather by the combined abilities of all the SDR countries to do so. Remember, a currently account deficit cannot exist without the corresponding capital account surplus.
DJ, great to know my big-shot former Tsinghua students are still reading my posts. For questions 1 and 2, I would say that in the short term the net effect on GDP is probably negative since a revaluation should hurt the export sector, but don’t assume that only the currency matters. Lot’s of other things matter too. Still, the purpose of revaluing (in fact all of the “rebalancing steps” is to create a healthier long-term growth path for China, and in the short term all of these things will have a negative impact on growth and employment.
You are right about the impact of monetizing the debt, but this does not necessarily eliminate the losses for the PBoC. If it causes domestic interest rates to rise, the PBoC will run a large negative carry that will also cause losses. You have too many interesting ideas in your comment for me to discuss easily, but much of what you say makes sense to me. As for your last question – what about short commodities and commodity-export currencies or long sectors that benefit from low commodity prices? It seems to me that the most obvious impact of slower growth will be on commodity prices.
U-pro-fish, there have been a lot of rumors that the PBoC has protected banks and the CIC from currency losses, in which case the dollar exposure really stays with the PBoC and the delivery of dollars to the banks really is no different from the delivery of RMBV. Aside from that, I think what you say makes sense.
Eduardo, although I agree with much of what you say, I am not sure I agree that dollar-euro-yen will lose their reserve status since those are basically (dollar and euro, really) all we have. In fact I know this always causes consternation and accusations of insanity, but I am convinced that in ten and twenty years the dollar will be as much (or maybe more) the main reserve currency as it is today, although, and this also causes surprise, I think the US should do everything possible to prevent that from happening.
It would be much healthier for the US if the status of the dollar as the sole reserve currency declined dramatically. The minor seignorage and hedge benefits are much less than the liability of US manufacturing employment to export pushes by countries looking to grow domestic employment. I wish the US could get behind the SDR, with some modifications – for example a smaller dollar share and more Asian participation – and have it enforced as the primary trading and reserve currency. This might slow growth in export-oriented countries sharply, but it would increase US growth and limit the kinds of disruptive imbalances we saw in the 1980s and in the past decade, and which we will almost certainly see again.
Michael,
I was wondering if you caught Pieter Bottelier’s take on the issue. Albeit a year and a half old, he does make an interesting observation regarding the cost to the PBoC via interest rate spreads. He also shows how raising bank reserve requirements and a rising RMB offset the carry loss.
http://chinastakes.com/2008/8/chinas-excess-liquidity-trap.html
The other aspect of this whole issue that is interesting is the political one. Short term vs. long term gain. No wonder James Buchanan was recognized with a Nobel for his work in this area.
Great article. However, one key point has not been discussed. The huge foreign reserves bascially represent China’s claims on US / Rest of World resources (capital and consumer goods, natural resources, human resouces/labour, as well as financial paper resources which in reality are just claims on current or future physical assets). The only consideration is “how such claims will be settled?” Settlement of claims can be gradual and somewhat mutually beneficial (China gets the goods and US gets a bit of demand stimulus) but usually represents a loss on the part of the payee. Or it can be abrupt, meaning wars (as in the past) for countries or in the case of individuals, collection agents (legal or otherwise). The Chinese people know this too well.
Great analysis, I’ll agree with all points on the monetary side but one. You write:
“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.”
You forget what money is. Money is not cost – what money buys is cost. That is the difference between real and nominal: I care about the real costs, not about the nominal costs. Example: if the US inflates, than it can transfer less physical goods to China in order to repay its debt, since prices of US exports have gone up (US inflated). In the extreme, the US can send a two trillion dollar Orange from Florida to Beijing and say: “It was nice trading with you.”
Also, if China appreciates the RMB, you’ll get the transfer problem. China will have a higher income (since it spends more at home because it stopped sterilizing so much), which makes everything there more expensive, while the US has a lower income (less net capital flows from China), which makes everything cheaper. If (marginally) Chinese consumers do not demand the same goods and services that US consumers demanded, then you get a problem. Relative prices will shift in response to a shift in effective demand, followed by restructuring in the economies of both countries.
Dirk, Pettis already discussed that in response to Glenn M’s similar point. My only addition is that Pettis says China is 8% of the world’s GDP. I think that is the worng metric. Wouldn’t China’s share of total consumption matter more than its share of total production? In that sense it is about 5%.
Michael,
Could you share some thoughts on how USD/RMB exchange rate impact exchange rates between USD and other major currencies? (such as Euro and JPY) How would the changes of those exchange rates affect the US’s balance sheet?
Thanks.
Michael,
So reserves are really no measure of savings at all (if I understand correctly) – and yet every discussion of the “high savings” countries that are supposed to represent the last investment opportunities on earth is accompanied by a chart of record holdings of fx reserves.
What do you think is the best measure of actual savings, in the “saving account” sense?
Dirk, I think that analysis is a little one-sided. Inflation in the US means that sustained aggregate demand is exceeding the real supply of goods/services.
If this were the case, what would China be doing? Most likely running their factories at full capacity to provide the goods demanded (assuming no change in import/export composition). China would also be receiving more dollars since their prices would be rising.
China’s debt composition would shift toward higher yielding US Treasuries (assuming interest rates are rising with inflation), so while the older Treasuries would be worth less, they would be repo’ed into higher earning Treasuries. This is a simplification – there are a lot of assumptions needed in an inflationary scenario.
Professor Pettis,
Here is your response to my question:
“Mike, yes, but remember that the PBoC has a very strong way to control interest rates by setting the banks lending and deposit rates. It does regularly repo and buys and sells its own bills, but the auctions are often set by price (they sell whatever amount clears at the price) rather than by quantity (as the USG does).”
But wouldn’t this system cause even more problems domestically than it fixes? For example, if the PBoC set an arbitrary lending rate of 5%, and the demand for funds are greater than the funding/reserves commercial banks can access, wouldn’t many firms end up with no credit?
In other words, wouldn’t this system simply result in chronic shortages/oversupply of money in the domestic economy, similar to the situation that would occur if the government instituted price controls on any other good?
How does the PBoC deal with this issue?
Thank you very much for your help.
Brilliant post. Thanks.
I think China should just buy Taiwan using it’s foreign reserves.
Hi Michael, I keep on learning from you over so many years but never feel can close the intellectual gap between us. (you are the higher one btw
).
Regarding monetizing the debt, it increase PBOC’s carry cost, however I don’t see PBOC as an independent center bank and I tend to look at PBOC AND government’s balance sheet together. In that case, they actually are the biggest beneficiary for monetizing the debt, as in China majority of assets are owned by government or government controlled State Own Enterprise (such as land, mineral resources etc). And higher inflation transfer wealthy from household (mostly holding cash) to government entities through higher assets price, which is one of reason china government is reluctant to reval the currency I guess. i.e if reval, government wealthy transfer to household through lower value of USD reserve and their oversea assets and cash inflows; if not reval, household wealth transfer to government through higher inflation and assets price.
Also in my article I mean there will be lower REAL growth, not necessary nominal growth. Say in 1970’s real growth was very low but commodity shot up big time due to high inflation. And as long as Chinese assets price rise from increasing liquidity, it encourages more infrastructure and property building and fuels demand for more commodity?
Professor Pettis,
Thanks you for the reply. I have few more ideas on the issue mentioned in my previous comment. I’d love to hear your feedback.
You mentioned:
“I would argue that if that were to happen, the growth of China’s trade surplus would be constrained not by US ability to absorb the deficit but rather by the combined abilities of all the SDR countries to do so.”
I share this view. I’d also argue not diversifying foreign reserve holding is the key cause of the global imbalance today. The evident also suggest the “global savings glut” is merely an illusion viewed from within the US perspective.
The global GDP is 4X bigger than the US. This would roughly suggest the world has 4X bigger capacity than the US to absorb the Chinese current account surplus. However PBoC, like a magnifying glass under the sun, focused much of China’s trade surplus with the _whole world_ into one country: the US via the purchase of the US treasury bonds. More importantly, China isn’t the only country doing this. Many surplus countries, such as Japan, also held a disproportionate amount of US treasury bonds. We should also include the many Asian countries that learned they need a big foreign reserve after the Asian financial crisis of 1997. Therefore many countries acted in unison like a giant magnifying glass and beamed their foreign reserve into the US.
Considering the forces at work, the consequences should be severe. As illustrated by the example in my previous comment, the US dollar is bidden up relative to other world currencies to buy treasury. This made US export more expensive and US import cheaper and thereby worsen the US trade deficit. Second, the high demand for US treasury caused its interest rate to stay abnormally low. Since all US debt instruments are priced relative to the US treasury, this significantly contributed to the mis-price of debt instruments such as mortgage back securities. I vaguely remember around 2005, Greenspan complained that even through he raised short term interest rate, the long term rate didn’t move! Excessively low interest rate was a key ingredient for the US sub-prime mess.
Also notice, when viewed from within the US, as Greenspan and Bernanke do, the world did seem awash with a savings glut clamoring for US treasury. This is an illusion caused by the world’s central bankers’ preference for dollar denominated foreign reserve.
Had countries held a more balanced/diversified portfolio of foreign government debt, events could have played out very differently. Without the disproportionate demand for US treasury, US interest rate would have went up. Therefore the US sub-prime housing mess would have been less messy. Demand for US dollar would have fallen relative to other currencies since less dollar is needed to buy US treasury. US trade imbalance would have been considerably less severe. Lastly, various countries would have considerably less exchange rate risk in their current foreign reserve holdings.
In other word, market discipline could have worked on the profligate US if only the various central bankers, including China, didn’t pile their foreign reserves into the US treasuries and severely distorted the price signal.
It would seem this is herd mentality acted out by the world’s central bankers. Everyone thinks US treasury is the safest and everyone piled in. The whole world got hurt as a result of the inevitable price distortion. It is the classic outcome for herd behavior!
To unwind all this, the key to remember is the surplus countries exported to the whole world, not just US. Therefore, surplus countries, including China, do have a choice to buy more government bonds from other countries and less from the US. It is also critical that central bankers don’t just rush for the exit and do rebalance gradually. Any rush for the exit is simply MAD – Mutual Assured Destruction! :p
Politically, diversification is also a more palatable option for many governments.
Professor Pettis, what do your think?
Thanks.
Silly Things:
To a certain extend, I agree with you about the policy errors in converting Euro to US and put in ‘save heaven’(USGBond). However, I can also think of too many arguments which supports this policy.
e.g.
1. liquidity of the Euro currency in exchanging the goods PRC wants.
2. Europe structure problem can very well weaken the Euro FX value, as well constrain Europe’s long term development.
3. If you ask PRC to choose between holding Euro debt (Germ & Frence) over US, most likely PRC would prefer US debt, as US political and economical strength exerts guarantee to its debt.
Duan Jiancong,
while I agree with your argument/economic mechanism of this possible hyper asset bubble in 3) & 4), I still believe China is way too far from comparing to Japan’s asset bubble. In Japan’s post WWII history, Japan starts to develop its heavy industry in 1950s and its economy reached almost full saturation(as all existing technology is fully saturated in the country) at around 1980s. Then Japan signed Plaza Accord with States, which resulted your argument of hyper-asset inflation, lost of comparative advantage and foreign bailout.
If you look around China, I can see way too many places can be improved with current level of technology and resources. Japan kind of bubble will not occur to China for a long long time, definitely not through CNY revaluation (not even 20% reval).
Professor M. Pettis
I actually have completely different understanding of the reserve in PBoC. I believe your argument of PBoc Balance Sheet and CNYvsUSD debt situation does not apply to the case of China. Your argument of asset/liability argument applies to majority of relatively small scaled nations, but not in the case of China.
I always believed FX reserve in China is only used as a buffer to facilitate trade and capital flows. It does not require 1 to 1 match.
Reasons: China’s FX reserve is way too big to be deplete. Therefore, PBoC only needs a port of it to facilitate the trade&flow, as long as China keeps running a trade surplus, then PBoC never needs to worry about the Asset/Liability mismatch. (even if it does happen, CN Gov will devalue CNY again to maintain its trade surplus). By the time China is able to run a sustainable trade deficit (enjoys economic power of CNY) and FX reserve could become a potential problem, it is the time that China & US have worked together to combined their currencies to form an international recognized reserve currency. At that time, China would be required to be more politically stable, more comparative advantage.
Therefore, I believe the worry for PBoC’s worry of 1 to 1 asset/liability matching for its FX reserve is not valid.
Any thoughts folks?
btw Silly things, ur argument of global over capacity vs china over capacity is brilliant! Shockingly good!
cooldin, haven’t you missed the point? pettis didn’t say that china’s central bank should match its assets and liabilities like central banks of smaller countries. he said that the purpose of the reserves involves running a mismatched balance sheet. the PBC runs a mismatched balance sheet not as a strategy but because it has to, like all the other ones.
also when you say the government will devalue the rmb any time it needs to in order to maintain to trade the surplus, why do you assume that china can do that any time it wants without other countries responding. surely the only goal of international economic policy isn’t to maintain chinese employment? if china devalues so that it can continue forcing its trade surplus onto other countries, the rest of the world has every right to retaliate and probably will it always shocks me how so many chinese fail to understand that manipulating the currency is trade protection, and it should be met with equivalent protection from other countries.
This content is from angelfire web site. This talks about Russian crisis back in 90′s. Hope readers can get some insight on this re-valuation Prof Pettis is talking about.
For a currency to be devalued means that the issuing government has mandated that the price of the currency (in foreign dollars) is lower than it was before. For example: if the Russian government changes the exchange rate from 100 rubles = $1 to 150 rubles = $1, then the ruble has been devalued. Now, regardless of whether a country has a fixed or flexible exchange rate system, there exists a “true” (we say “equilibrium”) exchange rate. The equilibrium exchange rate is the exchange rate at which everyone who wants to sell the currency can find a buyer and everyone who wants to buy the currency can find a seller. By definition, a flexible exchange rate is the equilibrium exchange rate. This is not the case with a fixed exchange rate.
Consider the following analogy. The equilibrium price of a car is $10,000. If the government imposes no restrictions on car prices (i.e. car prices are flexible), then the free market price of a car will be $10,000. Further, there will be no surplus or shortage of cars — everyone who wants to buy a car (at $10,000) will find one to buy, and everyone who wants to sell a car (at $10,000) will find a customer. Now, suppose the government imposes a price floor on cars of $15,000. At the official price of $15,000, many people will want to sell cars, but few people will want to buy cars – there will be a surplus of cars. If the government wants to avoid ending up hip-deep in unsold cars, it will have to buy the extras itself. (Note: this is precisely what the government does in the case of farm subsidies.)
In the case of a fixed exchange rate, the Russian government declares that the official price of 100 rubles is $1. Suppose, however, that the equilibrium price of 100 rubles is $0.75. That is, people would be willing to trade 100 rubles for $1, but the government only allows trades of 100 rubles for $0.75. At the official price of 100 rubles to $0.75, many people will want to sell rubles (sellers receive $0.25 more than the equilibrium price), but few will want to buy rubles (buyers must pay $0.25 more than the equilibrium price). The result is that there will be a surplus of rubles: there are more people willing to sell than there are people willing to buy. As in the car example, if the government wants the market to continue, it must take up the slack. In this case, the Russian government must buy the surplus rubles (at the official price of 100 rubles to $1). How does the Russian government buy rubles? It pays for the rubles on the market with, for example, US dollars.
So now everything is fine. The official exchange rate is 100 rubles to $1. The Russian government buys up the surplus rubles that the market does not want, and life goes on.
Not so fast. The Russian government is buying these surplus rubles with US dollars. The US dollars are coming out of a stockpile that the Russian central bank has built up. What happens when the Russian central bank starts to run out of dollars? When the Russian central bank starts to run out of dollars, it becomes harder for it to buy up the surplus rubles. If the central bank loses the ability to buy up surplus rubles, then it becomes powerless to enforce its fixed exchange rate. The Russian government now has three options: (1) revert to a flexible exchange rate (which would cause the price of rubles to immediately fall to 100 rubles to $0.75), or (2) suspend trading in rubles (which is what the government did first), or (3) devalue the ruble so that the fixed exchange rate is closer to the equilibrium exchange rate (which is what the government did next). Note that option 3 does not solve the problem, but it does buy some time, while option 2 results in the formation of black markets in which the price of the ruble will fall more than it would were the government to revert to a flexible exchange rate.
What is the effect of having a fixed exchange rate which is greater than the equilibrium exchange rate? It makes it less expensive for Russians to buy foreign goods (so Russian imports are greater than they would otherwise be). It also makes it more expensive for foreigners to buy Russian goods (so Russian exports are less than they would otherwise be). Because GDP rises when exports rise and falls when imports rise, having a fixed exchange rate which is greater than the equilibrium exchange rate is bad for the economy. So, maybe devaluing the ruble is a good thing — if the ruble is devalued to, say, 100 rubles = $0.75 then (1) the Russian central bank no longer has to buy up surplus rubles (because there won’t be any surplus), (2) Russian exports rise (because Russian goods are now cheaper for foreigners), (3) Russian imports fall (because foreign goods are now more expensive for Russians). According to this formula, Russia should be on its way to a burgeoning economy.
Not so fast. Many foreigners have purchased Russian bonds. These bonds are IOU’s that state that the Russian government promises to pay a certain amount of rubles to the holders of the bonds at some fixed date in the future. Suppose you are the IMF. Six months ago, you purchased 100 billion rubles worth of Russian bonds. At the fixed exchange rate of 100 rubles to $1, you paid $1 billion for the bonds. Let us say that the bonds yield 10% interest and come due tomorrow. You will have earned 5% on the loan. So tomorrow, you will receive a check for $1.05 billion, right. Nope. Those bonds were denominated in rubles. You will receive back your 100 billion rubles plus 5%, or 105 billion rubles. BUT, now that the government has devalued the ruble, those rubles trade not at 100 rubles to $1, but at 100 rubles to $0.75. The 105 billion rubles you receive tomorrow are worth $787 million and change. Because of the devaluing of the ruble, you just lost almost a quarter of a billion dollars — and that is after accounting for the interest you earned. Thus, for the Russian government to devalue the ruble is tantamount to its defaulting on a portion of its debt.
Our story is not yet over. Combine all of the above with the fact that the Russian government has been ineffective in collecting taxes. Because it is ineffective in collecting taxes, the government does not have enough rubles to either pay off the debt it owes on its bonds or to purchase the products it requires to continue operating as a government. While the Russian government can devalue the ruble so as to eliminate some of the debt it owes, devaluation is not a panacea because: (1) the more the government devalues the ruble, the lower the probability that it will get another loan from a foreign government in the foreseeable future, (2) devaluing the ruble relieves the pressure of having to pay back debt, but it does not provide rubles for future purchases. In order to obtain rubles for future purchases, the government (absent tax revenue) has no choice but to “print” rubles. So, the government prints the rubles and buys the products it needs to stay in business as a government.
Not so fast. The average prices of products in a country is (roughly speaking) the ratio of the quantity of currency in the country to the quantity of products produced in the country. When the Russian government prints rubles, it increases the quantity of rubles without changing the quantity of Russian products produced. The result is that prices go up by the same percentage as does the money supply. But, because prices will rise only after the economy is aware that the government has expanded the money supply, if the government is quick to print and spend the new money, it will be able to buy what it needs with the new rubles before inflation reduces their value. Like a game of hot-potato, those who pay for the government’s purchase of product with “printed money” are the people who are holding rubles when the inflation hits.
To summarize: the current economic crisis in Russia is caused by a combination of factors. The government has been ineffective in collecting taxes which means that the government has to print money to buy what it needs. In an effort to escape the effects of the nearly world-wide economic collapse, investors want to buy strong currencies (like the dollar) and to sell weaker currencies (like the ruble). The flight to dollars causes the equilibrium exchange rate of the ruble to fall. The Russian central bank finds itself forced to sell off almost all of its stock of dollars in an attempt to support a now untenable fixed exchange rate. As the Russian government runs out of money to buy what it needs and the Russian central bank runs out of dollars to support the fixed exchange rate, two things are done: (1) the Russian government prints rubles (causing massive internal inflation), (2) the Russian central bank devalues the ruble (effectively causing the Russian government to default on its loans).
How could this disaster have been averted? One suggestion (which some economists have been advocating for over a year now) is to encourage the IMF not to bail out Russia. Economic forces are like the tides: if you are delusional, you might be convinced that you can stop them; if you are smart, you’ll realize that you can’t and do the best you can not to get dragged out to sea. Had the IMF refused Russia the loans it requested a year ago, Russia would have been forced to do the sort of thing it has recently done: devalue the ruble and print money. The difference is that the devaluing would have occurred when the Russian debt was much smaller than it is now, and the printing of money would have occurred when Russian prices were lower than they are now. In attempting to hold back the tide, we may have ensured that Russia, instead of starting the long trek for high ground while the water was still low, has a firm foothold on the beach just in time to be swamped by a tidal wave of economic collapse.
TC
In the case of NO-requirement for 1to1 asset/liability matching. PBoC could use its FX reserve to do anything, including bailout banks in foreign countries, or even waste it on anything, as long as the liquidity requirement is met for trade and capital flow.
I guess the reason you dislike my argument about ‘government can devalue its currency anytime’ is because you believe China is gaining its employment at the cost of US employment. If your believe is correct, then you are probably right about the ‘selfish-thinking’ that I shamelessly proposed. However, I truly believe the US unemployment rate is not caused my China’s FX policy.
reason:
1. from a macro perspective, if we can US and Chinas as two different people U & C. you see C worked so hard in the past 30yrs, 60hrs/wk to make some clothes and sell to U at very cheap price, and U enjoyed working for 1hr in exchange for 20hrs products from C. You find U had great capacity to develop more value added things e.g. Ipod, develop new theory, or try new business ideas at low cost. This trade relationship between U & C massively boost U’s capacity for development and achievement.
2. another example, you find in US a graduate, who works small number of hrs, could afford to buy clothes and other living necessities from China. This low hrs cost would spare him large amount of time to discover and develop his idea into something big and more value e.g. Google.
3. in the absence of China, US business entrepreneurs will either find alternative of China or US people will have to spend more time to work and less time for development (high employment rates in a sense, just lower productivity).
I really believe this trade relationship is in big favour of both US and China (as China is playing a big catch up). At the peak of GFC, I read from FT that the biggest group of people who went unemployed in States are unskilled workers, for which I do agree, this group of unskilled workers are replaced by overseas Chinese workers. But isn’t this the cost of enjoying higher productivity for the rest of educated workers?
In terms of currency manipulation, I actually agree with you. However, I believe currency manipulation of an underdeveloped country would never be able to challenge the comparative advantage of developed country. If Japan or Euro has the same policy as China does today, I would call it a very unfair advantage, and all countries have the right to fight it. However, in the case of China, which lacks heavy industry and technologically fall behind + political uncertainty & severe social structure problems. I wouldn’t say its FX manipulation amounts to an UNFAIR.
coldin, a trade suplus doesn’t exist because chinese worked harder or are poorer. if that were the case, then why doesn’t the chinese government increase the value of the rmb? the chinese will still work as hard, they will still, according to you, run just as lasrge a trade surplus, and the price of imported goods will be much lower, so that hard-woking chinese can enjoy even more the product of their work. by your logic, the poorer a country, the bigger its trade surplus should be, and the richer the country, the bigger its trade deficit. but that isn’t true.
if you are saying that because china is poorer than the US, it has the right to cause US uenmployment to rise in order to get its own unemployment lower, then what about countries that are even poorer than china? why doesn’t china allow them to run large trade surpluses with china? it seems that the only acceptable policy is what benefits china, whether or not the rest of the world agrees.
Prof Pettis,
Thank you for this indepth analysis. It seems that the PBoC has no option but to let the RMB appreciate or even float.
Another question that I have been intruiged by- was why is China buying such a hoard of commodities. A back of the envelope calculation shows that if the price of copper doubles to USD 14,000 a tonne- Chinese hoard of copper would be worth close to USD 50 billion more. If, and that is a big if- these long commodity positions are sitting on the balance sheets of entities who are net dollar long (who according to your article will loose out) – we could have an answer here! The great commodity hoard is the hedge that will allow the RMB appreciation.
Do you see any flaw in this logic?
How does price elasticity of imports and exports affect your analysis of the wisdom of RMB revaluation?
Prof. Pettis;
You say that
“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.”
If the PBoC can literally create money via the printing press, how does this cause the PBoc to incur a liability on their balance sheet?
All it takes is paper and ink, and “poof,” the PBoC just created more domestic currency with which to purchase (or exchange for) the US dollars earned by their exporters.
So, how does printing more money – literally, increase the liability of the PBoC??
If anyone can help me out here, I would greatly appreciate it.
I am still not convinced professor…
There is no rhyme or reason why the PBoC would not lend its dollars to Chinese businesses to go out and invest in the world. This hole in the balance sheet argument is much too academic and does not reflect reality.
A “temporary” hole in the balance sheet is a more apt description of what is going on whit Chinese firms that are now borrowing dollar capital from PBoC to invest overseas.
“Reserves are effectively borrowed money” Ha!…Tell this to all of the export manufacturers in China that have a member of the communist party in the accounting department. They are there specifically to make sure the dollars go to Beijing.
wrong, wrong, wrong!!!
I now see there are over 100 posts, too much to pour through. But I would like to make more clear the USD dilemma.
Let’s assume China wants to continue its USD peg but diversify into non USD assets, say Euro and Yen denominated securities. The only way to do so is to sell $ on the international currency market in exchange for those currencies. That would put downward pressure on the dollar relative to those currencies.
Since China can peg only to one currency,otherwise, there is an arbitrage (reader comments on this assumption would be appreciated)possibility, the USD and, therefore, China’s RMB becomes cheaper relative to those other currencies thereby exacerbating trade surplus/deficit issues with those other countries. As Michael says, it shifts the problem to other countries (the EU countries and in my example, Japan).
As the dollar/euro relationship has bounced around over the last 12 months due to many other issues (investor confidence, safe haven issues), I think it is fair to say that a movement of China out of USD assets into other currencies would merely move the problem to another country or set of countries who would be less able or willing than the US to tolerate the employment pressures it would bring.
I have to chuckle at the PBOC’s policy statements that it believes maintaining a stable RMB dollar relationship is good when its current account is so inbalanced. (‘Stability’ is a buzzword, just like ‘harmonious’, ‘democratic’, and ‘balanced”) To focus on one item like the exchange rate and saying keeping it stable is good is like the captain of the Titanic saying we are keeping a stable speed, don’t worry about what direction.
cooldin,
I disagree with your concept that hi-tech/creative business in US as a result of cheap products from China. Granted, cheap manufacturing from China might increase profit margins of some of these businesses. But you’ve gone too far by accrediting Chinese cheap exports as a factor of innovation. In fact, I think Chinese export industry actually does damage to the US middle class, in such a way that more of their tax money will eventually be spent on the benefits to those who lost jobs due to manufacturing shifting out of the States. This loss of tax value is more than offsetting the cheaper products.
cooldin,
Also, you seem to think along the familiar line that because China has hard working labors and has been lagging behind economically, therefore it is “entitled” to “regain” the wealth it “deserves”.
As a Chinese I thought like that before. Problem with that logic is, if there is such thing as “regaining deserved wealth”, the world wouldn’t be like what we see today.
Steve, you say:
“Reserves are effectively borrowed money” Ha!…Tell this to all of the export manufacturers in China that have a member of the communist party in the accounting department. They are there specifically to make sure the dollars go to Beijing.
wrong, wrong, wrong!!!
You are right that someones is definitely “wrong, wrong, wrong!!!” but not the person you claim.
Word of advice, on this subject if you are going to take on Pettis you should really make sure that you are a leading world expert. You are clearly not even vaguely aware of how this works. Even I can tell you that the idea that exporters are forced to donate their dollar revenues to the PBC is totally ridiculous. When they earn dollars from selling something abroad they then sell those dollars to their commercial banks, who turn around and sell their net dollar position to the PBC. The PBC buys the dollars and in order to buy those dollars, they either print or borrow money. This is so obvious.
kalasend
Undoubtedly cheap Chinese export is not a direct contributor for US innovative/hi-tech environment. I believe US’s ability of generating Hi-Tech/Innovation comes from its 200+ yrs of political & economical structure. US’s ability to provide talent with adequate resource for development is the key comparative advantage of US vs all other world powers. (in another word, 350yr history of WALL Street)
However, when people start to blame China for US 10% unemployment rate. I start to question myself – in the absence of China, would US be better?! (this is set on the foundation that we all agree NO-One/NO-Country has the right to take advantage of other countries). At the end, I draw the conclusion that
1. cheap Chinese export does have impact on US unemployment rate. However, the impact of Chinese export only impacts on the lower range of the US employment structure – unskilled workers.
With the current ability of Chinese exporters, Chinese products is in no position to challenge US’s comparative advantages, e.g. Ipod, MicroSoft, Google, any Chinese company have products that is close enough to challenge those giants?.
2. In terms of unskilled workers, they should be compensated by the massive boost in productivity of more-skilled workers through social safety network. The Social Safety Network should use the excessive cheap resource gained from China to provide opportunities for unskilled workers to study and become more skilful. This in turn would make US a more sophisticated country over all.
3. When I think the overall picture, I found US benefit massively from Chinese FX Manipulation, this provides US humongous amount of spare resource for development. In US, the more-killed class are wining from CFXM, and unskilled class lose out (primarily black in my FT reading).
Then I draw my final conclusion, the best way for US to walk out of 10% unemployment is through providing fairer opportunity for its people to train and develop. Once majority of those 10% unemployed are able for development, then US will take full benefits from China cheap export, and less & less people lose out.
Thus when I hear people blame 10% US unemployment and even GFC on China export (some economists believed so). I felt it’s so unfair.
Just to clarify, I NEVER believe China has right to gain its benefits at the cost of other nations. Anyone who born in the world is equally bounded under the world contract (social contract -Rousseau).
All that I am doing is to look for the truth and alternative ways to make the all-wins.
sorry, I just realize my last message left one part un-replied.
in terms of “regaining deserved wealth”
I do not consider having massive FX reserve is regaining wealth. I believe FX reserve is only a trading media, or a form of debt. The key reason for China to gaining on USD is because it’s the internationally recognized trading median. USD reserve does not equate Gold (at least since Greenspan took off the peg). Once the world start to use different median for trade, USD will be off the hook, however it also means a massive unwind of USD worldwide.
China does not gain wealth from exporters, it’s only for trading.
The real wealth sits in Google, Microsoft, US military D&R, Museum, and most importantly of course the US political and economical structure.
gaining FX is barely a trading median or a form of debt(very liquid debt).
For Confused
Paper money is the promise of the issuer to pay the holder the value of the currency. While this is somewhat nebulous, it is in fact an IOU or promissory note if you like – simply a liability. During the gold standard the central banks held bullion and issued a commensurate amount of paper currency. The currency issuers asset was gold and its liabilty was the cash. Given that it is difficult to sub-divide a bar of gold, transactions were easier to carry out with the paper currency which was backed by gold. With respect to the PBoC, its assets are USD investments and its liabilities are RMB notes. For example, should there be a surge in Chinese/US exports, the amount of USD it will receive will rise, and it will have to print RMB to pay the exporter. Hence both sides of the PBoC balance sheet will rise accordingly. In order to prevent RMB money supply from rising at too fast a rate, the PBoC has and does issue short term bills to borrow the RMB cash from the public – replacing one liability with another. The public can’t spend the bills and therefore saves.
To Hua Qiao
I would agree – the Eurozone as an entity runs a global trade surplus and as a result is a net lender of funds in other currencies. As you indicate should China wish to switch its reserve holdings to the Euro, the Euro currency will simply be bid up, and investment yields bid down. Obviously the opposite happens with the US dollar. If a dramatic reversal in the US dollar occurs such that the US consumer can no longer afford Chinese goods, the Chinese trade surplus with the US will shrink and the PBoC will no longer have to worry about the extent of its reserves in US dollar assets. Like you I have to smile when I read/hear that the PBoC is going to switch its reserves into another currency BUT continues to peg the RMB to the US dollar.
Professor Pettis: A great debate ! In response to your reply to Eduardo:
“It would be much healthier for the US if the status of the dollar as the sole reserve currency declined dramatically. The MINOR seignorage and hedge benefits are much less than the liability of US manufacturing employment to export pushes by countries looking to grow domestic employment.”
I would argue that the seignorage gains are quite big. I do not have recent data but old estimates were that US $ cash and bills outstanding (M0) were equivalent to $10 000 for each of the US’ 300 million residents. If most of this cash is held abroad — and I have not slipped a decimal — that is a one time transfer from foreigners to US “consumption” of $3 trillion over the past 10 or 20 years.
The USA’s key currency status also gives it lower servicing costs on its National Debt, with estimates ranging from 50 to 100 basis points on 10 year Treasuries.
In sum, these seignorage gains are huge and have allowed persistently large current account deficits, as well as unfunded domestic spending programmes and foreign wars — until the chickens come home to roost.
best regards James
@Confused:
I had the same question about the printed money. The answer I came up with is as long as the PBOC/govt maintains the USD peg, then any RMB created must be redeemable in USD. So printing is the creation of liabilities that must be satisfied with USD assets.
I’d also be grateful for others’ thoughts if I’m missing something.
JackieX, while I agree with you, perhaps Steve is not so wrong in the sense that the borrowings could be canceled (expropriated) by the CCP, by say, creating a tax on deposits or some other way. Of course, that would cause some business people to cry foul! (They can stand in line for compensation with all the people who have had their homes taken away from them so the government can sell the land to developers.)
To me, the unemployment in the US is more of a structural phenomenon, which is what cooldin was getting at, rather than a by-product of pegging the ER (though fixing the ER would contribute to unemployment).
The argument can simply be put in terms of comparative advantages. The US, being an educated and developed country, has high labour productivity because more capital is applied per hour worked. China is less educated and still developing, and so labour productivity is not as high as the US’s. It would cost more for an US worker to carry out labour-intensive work vs. a Chinese worker: China (currently) has a comparative advantage in more labour-intensive work so it’s more efficient to ‘outsource’ this work to the Chinese.
Doing so, means that the labour-intensive industries in the US and those in their employment, will ‘lose out’, but at the same time, it frees up resources in the US to other industries and value-added activities. To that extent, you can ‘blame’ unemployment on China, but that’s because they are able to do something better than the US.
I think this ties in neatly with one of Silly Things views (which I hope I do not butcher!), where overcapacity is a problem with developed countries not factoring in production capacity elsewhere (or being too slow to accommodate for it) and in doing so, will cause unemployment and a workforce readjustment.
Now if you add in a fixed currency regime, you are artificially keeping the cost of Chinese goods low, which adds pressure to employment in the US. I think by artificially depressing these Chinese goods, you are also sending false price signals to the market which will later cause employment and capacity issues in China in the labour intensive industries. By fixing the currency, I believe they are delaying the advancement of certain industries and the work force i.e. keeping demand high in labour intensive industries (say textiles) rather than letting go of some of their global comparative advantage (cost-effectiveness) in those industries. This will cause them to progress and find other value-add activities in other industries.
I don’t think having FX Reserves is a problem – they exist as a balancing mechanism when free market forces aren’t allowed to act. I believe the risk is having it concentrated in one currency and effectively relying on the ability of one country to absorb its trade surplus. I believe this can cause imbalances, though won’t be catastrophic. Much of these imbalances will balance themselves out in the long-term without much problem (assuming the correct political will by China) e.g. the wealth transfer from balance sheets that Professor Pettis outlines very well. In particular, I think the wealth transfer effect is very important in bringing balance not only to the FX Reserves issue, but will also help self-correct other imbalances such as the low consumption – high investment/infrastructure spend.
Now as to whether or not you think that FX manipulation is ‘unfair’ shouldn’t just depend on the fact that China has worked harder or has some structural or political problems. Having worked harder or having problems doesn’t justify one’s actions or give you the right of entitlement. ‘Fairness’ is something that is judged from where people stand – it is an argument based on your emotions and prejudices. I think the utilitarian view is something that marries better with economics.
Micheal, thanks for the post. I have thought about this for a long time amongst all the nonsense I have read over the years on this subject. I have understood for a long time that the dollar is the basis of collateral for the majority of currencies around the world, especially in a country where there is little internationally exchangable paper and very dimly defined property rights. If the Chinese dumped their treasuries as proposed, the US wouldn’t the only outfit they would be taking down. I would like to see what they can get for yuan without the dollar backing. If the US is going to hell, it appears that there is a MAD amongst the world financiers, like it or not. The backbone of Chinese growth is the flow of dollars into the country and the only thing they can do with them in reinvest them or buy something with them. In essense, Chinese growth has inflated countries like Brazil and kept the price of oil high. It all goes in the tank if what I hear is proposed. The latest nonsense I have heard is that Citi claims the Chinese bought gold with the money. Tells me Citi might be speculating in gold, as I don’t hear too many non self serving claims out of NY banks these days (I know you are a Goldman ex from what I can recall reading).
It appears the only way the government could revalue the yuan upward would be gradually, if they needed a fixed balance sheet. I guess they could credit themselves with so many yuan or yuan bonds to balance out the act. I didn’t read much of that side of the equation.
I read an old book called “The Bubble that Broke the World”. You can get it off the Mises.org site if you haven’t read it. I think the author twisted things a little, but what really caused the great depression was that Wall Street financed US exports much the same way that China is financing their own today. Maybe China would merely take the loss, but that process created a international financial struggle for money. Involved was the circular looting Germany to pay France and England so they would pay the US for the WWI loans. So, to keep the game going, the US loaned to Germany so they could pay France and England so they could pay the US. It was a phony system of finance to have performing loans. Of course Germany defaulted and France and England banks and corporations withdrew their gold from the US. Being the US was engaged in massive exports in that time, of course their customer base diminished and the whole game got started. It is clear that if China quit financing the US, their(China’s) depression would start the next day.
Very interesting explanation.
China has a Current Account Surplus and a Trade Surplus. So, China continues to accumulate USD. But they still have choice: invest those USD in USD denominated securities e.g. Treasuries but they also can simply sit on their USD. Once interest rates in the US are going up/continue to go up then any sane investor would start selling those T-bonds. But that DOES NOT mean the chinese will sell their USD.
Prof Pettis,
I totally accept your arguments that the PBOC cannot reduce OVERALL dollar holdings in anticipation of a RMB move, but could there be any advantage in their switching holdings to 3rd Parties (eg UK holdings etc) or street names, or other USD ASsets with respect to this?
Or to write this question differently “Why would they purchase through the UK, or street names, rather than directly?”
Street Names make it easier for the Broker to transfer ownership to other clients i know, but if CHina were performaing a large sell off, i think the market would get a signal street names or no. I realize that i am asking you to speculate…but why would a country diversify from direct holdings into indirect holdings of USG debt?
Thanks for your blog. One question: what if the Chinese Gvt do not revalue RMB but start Keynesian policies based on import : for example pay foreign companies to come to China to build facilities to reduce water pollution, develop green energy … The counrty is huge, there is a lot to do, enough money to spend. Such policies of course would not help to prevent asset bublles, but at least it could balance the future gap between import and export, benefit the people and protect jobs in export industries. What do you think ?
To put a real life picture on the discussion of comparative advantage, below is an excerpt from China South Morning Post:
In the bone-chilling cold of a winter’s night on the outskirts of Shanghai, migrant workers huddle in overcoats and scarves behind dimly lit work stations as they toil until 11pm in a tin-roofed workshop to complete a major overseas order.
Crouched over the plastic figures they paint one after another, this daily grind earns the young men and women from Anhui, Hubei and other poor provinces a basic salary of 800 yuan (HK$908) a month, workers say. By the time 160 yuan has been deducted for bed and board in a nearby dormitory block across the road, their basic take-home pay is around 21 yuan a day.
From behind the workshop, a foul stench wafts in as waste from the painting process runs onto a bank above a canal that runs black from the industrial waste flowing into it from this and other factories lining the dead waterway.
The conditions at this workshop some 50 kilometres from the centre of China’s second city are, of course, no worse than those in many factories across the mainland where low-cost manufacturing has been a cornerstone of the nation’s economic transformation.
What makes Shanghai Fashion Plastics different, however, is that workers here are making official mascot souvenirs for the 2010 World Cup in South Africa and the contract to make them has been indirectly granted by football’s governing body FIFA.
(End Excerpt)
Somewhere, Karl Marx is rolling over in his grave.
@Huuhui
I’m sure you have a much better understanding of these things than me but if you were a country intent on managing your currency by purchasing your major trading partners debt obligations and maintaining your competitive advantage in this manner would you not be concerned that they could kick up a fuss if the extent of your operations was immediately obvious to everyone before you were ready to stop?
Another factor might have been a desire to spread the goodness in terms of paid foreign facilitators. This might help security by the possibility of playing one against the other to keep them on their toes. You now London, New York, London, etc.
Overall I would not be surprised if the Chinese powers that be never imagined they would be able to log such long years building the great export machine and building their reserve mountain. They probably under estimated the power, greed and malice of Wall Street Banksters who just loved the games they could play with all the free money and quite possibly used their lobby machines to prolong the party as much as possible. This would be yet another example of the crimes committed by wall street against main street.
Michael,
Like many others here, I think this is a very good post, despite its length. It is factual and does not speculate a lot. However, I think -but that is too much for this medium- that a more meaningful analysis of Chjina’s USD problem (looking at the apparent confusion about the term reserves among the audience) would start with the Chinese state in its manifestation as a huge industrial conglomerate, with lots of (private, but not aggregated or organized) minority interests and “visitors” attracted by the conglomerate’s location factors. The conglomerate as a whole (but it is very complex and riddled with organizational irrationalities and agency problems) is probably the world’s largest saver (and your analysis of its FX position is probably correct) and entities like the POBC, CIC and the state banks are merely corporatized finance departments fulfilling specialized roles within the conglomerate (and of course, this is China, battlefields for competing intra-conglomerate interests.
The conglomerate can use its savings to recapitalize anything, without touching the PBOC’s “reserves”, because (and students of pre-Deng China will appreciate this, it just requires administrative action. That is , as long as more recent institutional features of the Chinese in- ena external economy doe not interfere, like “listedness” of conglomerate companies and iys regulatory consequences, international regulation (for instance topping up SOE bank capitals after the lending spree, or after realizing the upcoming credit losses resulting thereof will require observing some of the Basle rules (re the type of inevitably incestuous instruments) and the maintenance of levels of independence and private sector participation required for admission to the US market, etc). So, finance within the conglomerate is not as inconsequential as it once was, but at the highest levels it is not constrained, and there appear to be few external constraints than the macro- sectoral and regional results the Party requires for social stability, and the leading group requires for internal Party stability. External money it the least of these problems.
Two other things that refer to your post:
(a) China’s net currency inflows are far in excess of its trade balance, so a sizable portion of the “reserves” may well represent claims by foreigners not under the control of the conglomerate (but probably visitors who have a contingent USD claim. (b) due to the recent rise of the USD against both EUR and JPY, China’s international price competitiveness should have diminished and as a result, its pressure on global imbalances. That does not trigger the internal dislocational effects that a CNY?USD appreciation could produce, but it should have some effect. Incidentally, there is an impressive new research paper by ECB staffers that describes an interesting attempt to model the links between trade and FX. One of the conclusions is that the relative strength of the USD has a much more complex effect on the US economy than previously thought (asymmetries). Also, that it was very difficult to model China’s role…
Prof Pettis, I did enjoy reading this post.
Would you be so kind to please answer a question for me.
China needs to spend its dollar mountain parked mainly in treasuries. However, if it sells those treasuries on any significant scale, it risks losses on the very large balance.
Maybe China can use the USG treasuries as currency to buy foreign assets. Particularly the Ts that are coming due over the next couple of years. The seller of assets can hold those treasuries to maturity and collect their dollars.
Is this a viable strategy for China to diversify out of USG risk.
This assumes that USG risk is still considered better than most other risk in the world and therefore USG treasuries can be used as currency in their own right.
-reducing cost to the US of servicing the debt;
-grasping the difference between a real loss and a realized loss.
The post is useful.
Thank You.
James Fallows referenced you in his daily blog, I’m sure the hits will rocket, deservedly so. Enjoyed the excellent summary – it’s nice when someone can write in Econ 101 terms for us.
Oh, my aching head. I can barely balance my 4 year-old’s piggy-bank in line with his weekly ice cream spend.
This whole topic seems clear to everyone else. However, I’m like a blind man in a maze on a moonless night. Not fun.
Onto my question:
Professor Pettis, you float the idea in reply to DJ,
“… short commodities and commodity-export currencies or long sectors that benefit from low commodity prices? It seems to me that the most obvious impact of slower growth will be on commodity prices”.
And yet I see the sense in DJ’s high inflation = commodity price rise example. He states:
“…Chinese assets price rise from increasing liquidity, it encourages more infrastructure and property building and fuels demand for more commodities.”
In your scenario the most obvious casualties being the Aussie and Brasilian Real, not to mention commodity suppliers BHP, RIO and Vale. Winners: all Chinese metal manufacturers through lower priced ore. Market demand may increase with lower cost.
In DJ’s scenario the above currencies hold their rally. BHP, RIO et al boom. Chinese metal manufacturers would also pass on the cost for goods consumed domestically, paid for thanks to domestic asset rises and wage inflation.
Won’t both examples eventually result in high commodity prizes long-term?
PS: I’m an idiot when it comes to economics, so please feel free to treat me like one if this is a dumb question.
Cheers
Chris
Regarding the PBoC’s balance sheet: what about returns on the reserves? and, the borrowing costs on the renminbi? The differences can create losses/gains as well? In fact the borrowing costs are probably higher than the returns (treasuries) at this point? What impact would this have?
Problem for China is they can’t convert all their reserves as selling will reduce the price of the dollar and reduce the value of the rest they still hold. Still have massive power over the US.
Thanks for the article, it gives nice insights into currency issues and Chinese domestic politics. My naive self would conclude the exchange rate games have meant that Chinese have been subsidizing the rest of the world for years at the expense of Chinese living standards (at the least the living standards of your average Zhou). But the average Zhou doesn’t have much leverage on the Party guys who are making hay while the current system lasts. I wonder if this sort of arrangement is a bit Soviet — the USSR also seemed to shift funds to investment and keep consumption down. This led to high growth rates for the USSR for a time, especially during the 1950s but it was inefficient investment in that investment continued well past the point of negative returns.