Most of last week’s newsletter was dedicated to a discussion on Chinese debt, specifically on how we should think about the Chinese debt structure and on when would we know how much debt is too much debt. Every earlier example of the investment-driven growth model that China follows ran into the problem of an unsustainable increase in debt (once capital began to be misallocated) followed by a credit contraction and an economic crisis. For that reason it is important that investors, analysts and most importantly policymakers understand the way debt risks develop.
I discussed some of these issues in my July blog entry. Interestingly enough, today Reuters reported what many believe is a major new initiative in addressing what has clearly become a debt problem at the local government level:
China’s regulators plan to shift 2-3 trillion yuan ($308-463 billion) of debt off local governments, sources said, reducing the risk of a wave of defaults that would threaten the stability of the world’s second-biggest economy. As part of Beijing’s overhaul of the finances of heavily-indebted local governments, the central government will pay off some of their loans and state banks including some of the “Big Four” will be forced to take some losses on the bad debt, said the sources, both of whom have direct knowledge of the plans.
Part of the debt will also be shifted to newly created companies, while private investors would be welcomed in projects previously off-limits to them, sources said. Beijing will also lift a ban on provincial and municipal governments selling bonds, a step aimed at bolstering their finances with more transparent sources of funding. Many analysts see China’s pile of local government bad debt as a major risk to the economy, especially as the economy slows, but few see widespread banking fallout as they believe cash-rich Beijing can step in to soak up losses.
I was not able to find any mention of this in the Chinese media, but I suspect we will hear more about it over the next few days. How important is this announcement? It is good that the extent of the problem is being recognized and quantified, but this announcement doesn’t do much more than that.
And I think there is a lot of confusion given what I read in the Reuters and other articles. First, this announcement, if it is true, doesn’t much change the risk profile of either the local governments or the banks because they were anyway implicitly or explicitly guaranteed. Second, the real issue here is not who gets to carry the liability, but rather who is going to foot the bill for the losses, and of course that hasn’t been addressed. As I see it there are only three sources of repayment.
1. The government can privatize land and assets and use the proceeds to pay for the losses. This might be very difficult politically right now, but ultimately I suspect that they are going to move in this direction.
2. The government can tax or confiscate wealth from SMEs and the wealthy. This is politically expedient since SMEs don’t seem to have much power as a bloc, but this could cripple long-term growth prospects if it causes SMEs to disinvest.
3. The long-suffering household sector can bear the losses once again, but of course this pretty much eliminates any hope of getting the consumption share of GDP to rise and become the driver of future GDP growth.
It is of course good that they are formalizing and recognizing the extent of the possible losses — everyone’s favorite solution of ignoring the problem is unlikely to have helped much. Perhaps these huge numbers, now that they are quantified and recognized, can push the debate forward, but in my opinion we still haven’t addressed the main issue: how will this debt be repaid and when will they slow down and reverse what has clearly become an unsustainable increase in debt?
Who trades RMB?
So much for debt. To move onto another topic, my central bank seminar at PKU had a fascinating discussion this week about the internationalization of the RMB in trade transactions. To summarize, although the amount of trade denominated in RMB is still small, it is growing at a very rapid pace. This is often given as very strong evidence that the RMB is on its way to becoming a major, if not the dominant, currency in international trade. My ever-skeptical students, however, were not wholly convinced.
They pointed out that according to PBoC data on external RMB transactions, if you exclude the services component (which they believe consists mostly of remittances), 93% of the trade transactions denominated in RMB consist of Chinese imports while only 7% consist of exports. They argued that in fact export-denominated transactions are even smaller if you exclude intercompany exports, which dominate the export numbers but not the import numbers.
When a Chinese exporter sells something to its offshore affiliate, in other words, which is then sold on to the end buyer, a foreigner, the offshore affiliate denominates the sale to the end buyer in dollars while it denominates the purchase from the onshore affiliate in RMB. In that case it is not meaningful to say that the trade took place in RMB rather than dollars, although it does show up on the PBoC books as a foreign trade transaction denominated in RMB.
So why the huge imbalance between exports and imports? If transacting in RMB were genuinely more convenient for exporters and importers, you would probably see a much more balanced split. In fact since China exports more than it imports, you could even argue that exports denominated in RMB should exceed imports.
But that isn’t the case. One possible explanation is that denominating trade in RMB is convenient only for Chinese companies, not for foreign companies. In a world of deficient demand, it is buyers who have the power to dictate terms, not sellers, so in that case Chinese buyers (importers) can force foreigners to trade in RMB while Chinese sellers (exporters) cannot. This seems plausible to me, although as one student pointed out, it suggests that there is a limit to the amount of trade that is likely to be denominated in RMB – the size of China’s imports.
But it still seems like a huge imbalance, which brings in the other explanation. As the students making the presentation pointed out, the mechanics of the trade transaction denominated in RMB requires that foreign buyers must either buy RMB or borrow RMB in Hong Kong in order to pay for Chinese exports. On the other hand foreign sellers are long RMB in Hong Kong once they conclude the sale to the Chinese importer.
With so many foreign sellers ending up with long RMB positions and so few foreign buyers ending up with short RMB positions, it should be very easy for the buyers to close their shorts in the Hong Kong RMB market. But that isn’t the case. In fact it is very hard for them to buy RMB. In spite of the disproportionate amount of long positions versus short positions, no one seems to want to sell enough RMB to the shorts.
Why would that be? Most probably it is because the sellers want to take speculative long positions in the RMB, perhaps because they expect the RMB to appreciate. Is this truly what speculators believe? Yes, and we have corroborating evidence – there is a lot of demand for RMB-denominated assets and very little supply, and most proxies for hot money inflows suggest that the hot money demand is strong.
So what did the seminar participants conclude? They claim that what is driving the increase in the RMB-denominated trade is probably not any preference to transact in RMB but rather speculative demand for RMB. That sounds pretty plausible.
Isn’t it so that the monetary tightening triggers the surfacing of the debt problems? Local governments probably starting to have difficulties refinancing their debt under tighter liquidity conditions. Sounds like 2007 again when the FED tightened. “No serious problems just a few delinquencies with subprime loans. The issue is contained….”
Mr Pettis,
What in your opinion is the most likely (or ant one) outcome of a RMB trade turning against the “longs”.
I could imagine that if the trade turned against the longs there would be some huge deflationary event in another part of the world as people ran to the Aussie dollar US dollar or euro or Yen to prevent any losses.
“They claim that what is driving the increase in the RMB-denominated trade is probably not any preference to transact in RMB but rather speculative demand for RMB. That sounds pretty plausible.”
–that’s the real argument isnt? If the real cause for RMB trade is speculative then when the tide turn and we could easily see something reverse happening dramatically.
Dear Mr. Pettis,
Do you think that shifting loans opens more room to investments/malinvestments or not?
Best regards
Lemiwinks, no, no, this time it’s different. But anyway let’s see how serious the announcement is. For all we know it may simply have been leaked by someone (the CBRC?) who wants to see more movement on this front but who has been frustrated by foot dragging.
RS and Leo Liao, I am not sure there is much likelihood of a sharp drop in the RMB. That would almost guarantee trade retaliation by the US, Europe and other countries.
Ignacio, I view this (if it happens) as largely an accounting matter. The only benefit if it happens is to make more explicit to the doubters that debt is becoming a serious problem.
Mike,
This is probably off topic. However, if China does run into a credit contraction and an economic crisis, how will the government and people react accordingly in your opinion?
http://noir.bloomberg.com/apps/news?pid=20601087&sid=alDtEkuN2Mqw&pos=1
More loans?
I have a hunch that settling trade in RMB has increased and will increase China’s pace of reserve accumulation. Entities with trade surpluses versus China end up long RMB (which they are probably happy to hold) instead of draining some of China’s USD hoard. Entities with trade deficits must buy RMB first, which is functionally no different than exporters settling up their USD receipts with the PBoC. Holding other BoP variables constant, China ends up with more USD per unit time. And they don’t seem to be thrilled about it. The USD is going to keep getting sold against G10.
michael ,
you mentioned that households foot the bill when cleaning up banking crises/ financial crisis. Is there a limit that this mechanism can be use before it becomes ineffectiveness or no longer viable to do? China or other nations can’t continuous clean up /out their banks after consecutive and sequential banking crisis using household wealth , right? ( China has a shrinking population, this should limit the ability for the state to facilitate cleanups in future crises.)
Thanks
Regarding the ‘bailout’ of LGFV’s, I beleive Patrick Chovanec covers the issue very well……
http://chovanec.wordpress.com/2011/06/02/beijings-bad-debt-bailout-problem-solved/
“Fifth, inflation. Let’s assume the lending boom was disguised fiscal spending, and the government can and will pick up the tab. When most governments borrow and spend money, in order to stimulate the economy, the worry is that they will eventually be tempted to “monetize” that debt — essentially, finance the spending by printing money and expanding the money supply, which can fuel inflation (this is why Arthur Burns, the former Fed Chairman, identified government deficits as the main cause of inflation). The problem in China, though, is that its latest burst of stimulus “spending” — even if it is ultimately funded by the government — was monetized right off the bat, because it took the form of a commercial lending boom that grew the money supply by more than 50% over the past two years. We don’t have to wonder whether China will monetize its public spending – it already has, and we are seeing the effect (in order of intensity) in rising asset prices, wages, and food prices.”
Hoang
I think Japan has just been doing this all the time since 1990. They use the postal saving system to finance the public debt that amounts to 200% of GDP. The public debt was accumulated by financing roads to nowhere and to prevent failure of zaibatsu banks. Japan also has a shrinking population.
I strongly presume China is going to follow the path of Japan.
Michael,
When explaining why Chinese exporters don’t set terms in RMB, couldn’t one factor be the unavailability of RMB in Hong Kong to foreign buyers? If your customers can’t get their hands on RMB, it’s no use transacting in that currency, particularly when your central bank is perfectly happy to exchange your dollars for RMB (but not your buyers’)
Mobi, the question is too vague to answer. It depends on a whole bunch of things, including of course the cause of the credit contraction and the external environment. I should point out that all the claims that a sharp drop in China growth will cause a surge in social instability are based, I think, on a misunderstanding of the rebalancing process. If China rebalances, a sharp drop in GDP growth will not require a sharp drop in household income growth.
SW, yes, the “internationalization” of the RMB seems to mean little more than a new legal way for speculators to take long RMB positions, and this means more reserves fro the PBoC, to its dismay.
Hoang, yes there is a limit, but it is hard to quantify. Basically the more households are forced to clean up bad banks, the less their consumption is to generate good growth.
Glen, aside from the CCP’s great fear of inflation, the inflation tax is not really a separate way of cleaning up the banks. Remember that inflation is just a tax that transfers wealth from those with assets denominated in RMB (eg savers0 to those with liabilities denominated in RMB. In that sense rising inflation has broadly the same effect as declining real deposit rates.
Lemiwinks, yes, the Japan precedent is a little chilling.
Louis, yes but foreigners can easily borrow RMB in HK. The problem is that no one wants to be short RMB. Since foreign sellers are massively long RMB, the fact that they won’t close their positions and allow buyers to get RMB suggests that there is a lot of speculative positioning driving the process.
Mike,
I think you are right and since I do not have enough information in that regard, I do not know how to refine my question, either. But to clarify, I did not say that a sharp drop in China growth will cause a credit contraction and an economic cris. I am only asking what if a credit contraction and an economic cris were to happen in China.
“1. The government can privatize land and assets and use the proceeds to pay for the losses.”
Pardon, could you please explain this. Isn’t the government already privatizing land and assets? Isn’t the massive sale of land is what fueling many local governments and why the RE bubble has been maintained (well, at least one of the main reasons).
Many thanks for your clarification!
Prof Pettis
Nice one on the debt “restructuring” move, could there be a fourth dimension in the “pass the debt” process? Perhaps, throw open the debt/bond market to “retail” investors, who have up to now been restricted in terms of investment options, and essentially draw “household” savings into the game, give slightly better return to the long suffering public, give the banks some breathing space and local authorities some “face”. Just a thought.
Just about everyone is long RMB and guess the hot money flow problem is inevitable, just the longer the vaunted paced soft landing takes, the larger the odds of a bone jarring hard crash.
Have a good summer people!
…i just see how my swiss francs are worth more and more of the chinese currency… i just dont understand why the rmb is supposed to be such a good investesment. or is it only the savety factor that the cny seems promise?
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