"China’s Central Bank is Short of Capital"

Either the Chinese do not understand banking and investing or the line being fed the Western press about the struggle over the Bank of China’s reserves is a cover story of some sort.

Given the fact set, Dean Baker’s reaction ‘Is China’s Central Bank Run By Morons?” is not unreasonable. I have a different theory, which we’ll get to in due course.

The plot overview:

The Bank of China buys lots of dollar investments to keep the yuan from rising. However, as we all know, the yuan has been permitted to appreciate somewhat. Note that this means the value of those holdings in local terms has fallen.

However, the central bank has still had to keep buying dollars to keep the yuan from rising rapidly. It is running out of capacity and has to go to the Finance Ministry for a handout.

This is the bizarre bit. The Finance Ministry is mad that the central bank lost money on its dollar investments and wants no more yuan appreciation. This of course commits it to even greater dollar purchases, which guarantees that its eventually currency losses will be all the greater.

Key bits of the New York Times article:

The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

The two bureaucracies have been ferocious rivals. Accepting an injection of capital from the finance ministry could reduce the independence of the central bank, said Eswar S. Prasad, the International Monetary Fund’s former division chief for China.

“Central banks hate doing that because it puts them more under the thumb of the finance ministry,” he said.

Mr. Prasad said that during his trips to Beijing on behalf of the I.M.F., he had repeatedly cautioned China over the enormous scale of its holdings of American bonds, emphasizing that it left China vulnerable to losses from either a strengthening of the yuan or from a rise in American interest rates. When interest rates rise, the prices of bonds fall….

The finance ministry, however, has pushed for investments in overseas stocks. Last year, it wrested control of the $200 billion China Investment Corporation, which had been bankrolled by the central bank. That corporation’s most publicized move, a $3 billion investment in the Blackstone Group in May of last year, has lost more than 43 percent of its value….

But even in a country that strongly discourages criticism of its economic policies, hints of dissatisfaction are appearing over China’s foreign investments.

For instance, a Chinese blogger complained last month, “It is as if China has made a gift to the United States Navy of 200 brand new aircraft carriers.”…

China finds itself hemmed in. If it were to curtail its purchases of dollar-denominated securities drastically, the dollar would likely fall and American interest rates could soar. China spent more than one-eighth of its entire economic output last year on foreign bonds, and then picked up the pace during the first half of this year….

Victor Shih, a specialist in Chinese central banking at Northwestern University, said that when he visited the People’s Bank of China for a series of meetings this summer, he was surprised by how many officials resented the institution’s losses.

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

“A lot of policy makers in China, at least midlevel policy makers, believe this,” Mr. Shih said.

If US officials privately assured the Chinese government that Fannie and Freddie debt were government guaranteed, as reader Scott’s well-placed sources say, there is a germ of truth in the Chinese view.

Still, this is breathtaking reading. How could the Chinese have thought they could maintain a currency peg forever? At some point, the scale of the purchases becomes so large that they are unsustainable, the pegged currency rises and the country takes huge losses on its FX reserves. However, all of its local currency denominated assets are worth more in global terms. If this is a net plus, wealth-wise, why is there a problem? The computation of gains and losses is far from complete.

Equally worrying, neither of the two parties at odds is considering the only way out of this box: encouraging growth of China’s domestic economy so it is less export focuses and therefore less in need of managing its currency. Admittedly, this would be a long-term program, while the question of the central bank’s capital base is immediate, but it appears that no one is looking at the real problem, which is an economy overly dependent on a big customer.

Baker was more withering than usual:

It is almost inconceivable that anyone who followed economic data did not realize that the dollar would decline from the level it has reached in 2001 and 2002. The United States had a large and growing trade deficit…

It was understandable that China’s central bank might buy up dollars in a conscious effort to keep the dollar high and thereby sustain its export market to the United States. This would mean that China was effectively paying people in the United States to buy its exports. This would be a reasonable growth strategy if China for some reason lacked the capability to generate this demand internally….

However, it would be bizarre if China’s central bank bought up dollar denominated assets in the last 7-8 years thinking that they were making a good investment…..Apart from buying bonds from Zimbabwe, it’s hard to imagine how they could have made a worse investment.

If the people who run China’s central bank are really this ignorant, that should have been the headline of the article, which should have been on the front page.

Given the ferocity of bureaucratic battles and the anger in the public at large, the Times may have the story 100% right. But there is one way this might be a brilliant bit of gamesmanship.

Recall that China is suffering from a bad bout of inflation. That inflation is exacerbated by hot money inflows which have reached mind-boggling levels this year. The money is coming in in anticipation of a currency revaluation, and by pushing inflation higher, increases the odds of a revaluation.

Remember the ploy used by Henry Kissinger in his negotiations with the North Vietnamese? He presented Nixon as crazy, not the paranoiac that he was, but violent, impulsive, prone to extreme reactions if provoked. The notion that Nixon was an utter nut who would do something unthinkable (presumably the unspoken threat was dropping a nuclear bomb) was believed to have served Kissinger well.

Something like that may be at work here. Perhaps a genuine internal power struggle is being played up and positioned to persuade the hot money speculators that the finance ministry may soon have the upper hand, and the finance ministry is crazy enough and determined enough to keep the yuan weak, no matter how dangerous that might be in the long term. That would hopefully convince the hot-money players that their fast-profit revaluation hopes were misguided, and they’d shift their mony back overseas, providing some relief to inflationary pressures.

But it is just as plausible that the Finance Ministry is willing to cut off China’s nose to spite the central bank’s face.

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  1. Cash Mundy

    I do not pretend to know what is going on with Asia at present, but I have enough unusual data-points to be sure something interesting is going on. The rumors and denials about Lehman investment coming from China, Japan and Korea, the present article about China, the general Korean situation (The Chosun Ilbo is now suggesting that Korea as a whole may be victim of a shorting-rumor campaign, see below), all seem to make clear that something, probably something big, is playing out. I will not attempt to puzzle this out, but would very much like to hear someone more qualified attempt it.

    Malicious Rumors: From U.S. Beef to Financial Markets

    ‘No Danger of Second Financial Crisis’
    Gov’t Blamed for Financial Jitters
    Credit Raters, IMF Dismiss Korean Crisis Fears
    Government’s Crisis Handling Skills Have not Improved
    U.S. Dollar Shows Signs of Recovery
    Weak Won Begins to Tell in People’s Pockets
    Per-Capita GNI Likely to Drop Below $20,000 This Year
    Korea ‘Already a Net Debtor Nation’
    Can the Government Win the Forex Game?
    Warnings Sounded Over Financial Instability
    Rumors of September Crisis Rattle Markets

    Korea’s financial markets have fallen prey to malicious rumors, including one that claims the country’s economy will face a crisis this month or that its major business conglomerates are looking at a liquidity crunch. These rumors are harming businesses and investors. The impact of such rumors was first witnessed during protests against the resumption of U.S. beef imports earlier this year, and now they are felt in the stock, foreign exchange and bond markets, as well as the broader economy including big business.

    Financial authorities and experts say market players involved in “short selling” (borrowing a security from a broker and then selling it with the intention of repurchasing it later at a lower price to profit from the falling price of a stock) may be behind the rumors. Foreign investors in particular, who have led this practice, are being pointed out as the source of the rumors. The Financial Supervisory Service said Thursday it will investigate “the link between short selling and forces that have been spreading the rumors,” suggesting that foreign investors are under scrutiny. The FSC also suspects some foreign exchange dealers and currency speculators are the sources of these rumors. ….

    Whole Article

  2. Lune

    I’m by no means a professional BoC watcher. But I fall into Yves’ thinking. There’s more to this than meets the eye.

    Firstly, I really don’t think Chinese officials, either from the central bank, or the finance ministry, are that stupid. Even if there is a real difference of opinion over whether the yuan should appreciate, I would think someone higher up (e.g. the Premier) would set a firm policy and force everyone into line. You don’t leave a decision that important to two quarreling children.

    Secondly, China is desperate to get rid of the impression that they have to revalue. Right now, the closest thing to free money out there is to bet on yuan revaluation. At the very least, it won’t go down, and at best, there will be a nice sudden jump. That’s an even better bet than “safe” treasuries. Everyone understands the economics of the situation and China can’t convince anyone otherwise. So instead, they’re playing the crazy card. Are the Chinese crazy enough to cut off their nose to spite their face? In the past twenty years, they haven’t yet. I doubt they’re going to start now.

    Also, the Chinese should be careful what they wish for (they of all people should know that, right?). I’m not sure how much of their current FDI is hot money. But if the experience of places like South Korea and India is any guide, when sentiment turns, it turns fast, and they could find themselves depleting their trillion dollar reserve and still be facing yuan *depreciation*.

    Sounds far-fetched, but just last year or so, India was complaining about similar things as the Chinese, i.e. that they were being forced to buy so many dollars to keep their rupee stable that it was contributing to inflation, etc. Now, after a 50% drop in their stock market and a rapid flight of hot money out the country, they’re struggling to keep the rupee from depreciating further and increasing the costs of their commodity imports. De-linking indeed…

  3. rahuldeodhar

    Emerging economies learnt the formula for growth in the past decade. It involved promoting investment and job creation, encouraging spending thereby triggering a virtuous cycle of development. This formula is great to initiate or prime the economy – but it is poor mechanism for transmission of wealth across income classes. Savings and host of economic factors ensure that the distribution of wealth so generated is lop-sided favouring the higher-income class.

    Most of the economies seems to have decided that answer to rising in-equality is in faster-higher-better priming. Partly, they cast their economies in the mould of market-share winning corporates. And like corporates these economies are intent on keeping “costs” down. The resultant “profits” were enormous and increasing. But there was a little difference with normal corporates. The employees of normal corporates interact back with the market. But employees of this nation-corporate only interact with themselves. (Either because of direct or indirect trade barrier like managed exchange rates) Therefore the higher profits could not be channeled into stake-holders – due to fear of inflation. So these had to be invested somewhere. So it is that this enormous forever-swelling pool of money found its way into US assets. Pushing the US consumer to carry this “little” extra burden. Then the unthinkable happened – US broke down – it was the last (Yuan) straw that broke the US back.

    Now central banks are looking for growth. Now the same old principles wont apply. US consumer is not going to take any more burden. New consumers will have to be introduced into the system. China and India – these two countries who can inject tremendous amount of vitality into the system because of sheer numbers. But at current exchange rates both China and India are too small to carry the burden of US consumer.

    To me Chinese currency play is a no brainer. The fun part is the more China tries – the bigger the appreciation will be. I hope sense prevails and we have some correction fast.

    But knowing China I wouldnt bet on it.

  4. Cash Mundy

    Again apropos Korea and not China, but perhaps there is a connection.

    Lone Star May Sue Korean Government

    John Grayken
    Lone Star Chairman
    By Kim Jae-kyoung
    Staff Reporter

    Lone Star, the largest shareholder of Korea Exchange Bank (KEB), is seriously considering suing the Korean government if it delays approval for a deal on the sale of the fund’s shares in the bank beyond September.

    The move came as the U.S. buyout fund, headed by Chairman John Grayken, is facing increasing complaints from investors due to the delay of its plan to sell Korea’s fifth largest lender to HSBC.

    Last September, HSBC agreed to buy a controlling 51.02 percent stake in KEB for 5.9 trillion won from Lone Star, but the deal has been deadlocked as the financial regulator is withholding approval, citing legal uncertainties over the U.S. fund’s takeover in 2003.


    Whole Article

  5. Francois

    “Equally worrying, neither of the two parties at odds is considering the only way out of this box: encouraging growth of China’s domestic economy so it is less export focuses and therefore less in need of managing its currency.”

    While this solution is obvious in theory, it clashes with a rather unpleasant political reality in China.

    Consumers engage in transactions ONLY if they have the (justified) perception the system isn’t tilted against them. Alas, it is the actual state of affairs in China. The consumer has very little recourse against bad products, shoddy business practices and so on.

    Hence, you just can’t grow a domestic economy without giving more power to the consumer. And that implies political reforms going in the direction of more power to the people.

    Contrast that with the paranoid fear of loss of control and chaos of the Communist Party in China, and we’ve got an interesting conundrum to study.

  6. Anonymous

    there is an obvious difference between China and India tho – namely that china has a big current account surplus and india doesn’t.

    i don’t think this is meant to signal that China is serious about not allowing more appreciation to limit hot money flows. that is a concern, but i would not think that this is what is driving this.

    my guess is that there was never internal agreement on who took the losses and now that losses have to be realized there is a real fight. note that the pboc and minfin are constantly fighting over the internal distribution of losses (and gains). there is a reason why the CIC wanted Huijin (which it bought from the pboc at book, transferring large paper gains). there is a reason why the interest rate on the minfin bonds the pboc bought to fund the cIC was a subject of contention. And so on —

    there is a huge rivalry between the two, and between their respective asset managers.

    and i wouldn’t be totally surprised if there wasn’t quite as much discussion of “who pays for the losses” at the top level of the government as one might expect. balance sheet losses at central banks from currency moves are a very abstract concept, especially in a world where many think they don’t have any practical impact and central banks can operate without capital. there is enough smoke here that it would be easy to leave decision makers uncertain if this would be a real problem, and certain it wasn’t something that needed to be decided at the time.

    just a guess.

  7. Anonymous

    Don’t worry. These are just recycled dollars from Japan. The two can commiserate over their currency peg game.

  8. a

    “If US officials privately assured the Chinese government that Fannie and Freddie debt were government guaranteed, as reader Scott’s well-placed sources say…”

    I just don’t believe this. I can’t think of any reason for officials to do this, and it goes against long-standing U.S. policy.

  9. Subvent

    In many ways this discussion misses the point. In order to maintain the job growth necessary to allow an orderly migration of 150 MILLION peasants a YEAR from the countryside to the cities, and therefore keep political stability, China needs to keep the export engine growing.

    Losses on reserves are a small price to pay for that political stability. There are estimates that China had over 70,000 violent protests last year alone. Remember, while it true that some 300 million Chinese have move into their “middle class”, they still have four times that many peasants still looking for their own entrée to middle class.

    It is as if 240 million Americans lived in the old Appalachia and they saw only 60 million people prospering in (the old Detroit), and the rest of the old steel belt. You can be sure there’d be big problems. In fact, we had big problems when only a fraction of that number were migrantly looking for work in the early part of the 20th century.

  10. Richard Kline

    To me, there are four negatives for China in allowing further yuan appreciation. All are sufficient for them to fight that outcome, though the degree of resistance may vary a lot.

    The smallest of them is the actual losses on FX. Yes, these may be in the tens of billions, but that money ‘isn’t doing anything’ for China. It looks great, but they don’t have a plan for what to do with it (in part because absolutely no one expected they would acquire so much of it so quickly). Seriously, if $200B of FX vaporized, it would make almost no macrofinancial difference to China.

    The next in consequence, are the turf battles over _blame_ for that loss, and over subsequent _control_ of future policy. I think that Anon of 2:41 cuts close to the bone on that one. China’s policy actors are not the monolith they are perceived of as offshore. There are institutional (if not ‘political’) factions, and their struggles for advantage and power are real. Whoever is successfully blamed for the bad net effects of yuan appreciation will be a MAJOR loser in internal Chinese factional politics.

    Of more importance still is the perception of China’s begin stiffed, cheated, or taken advantage of, especially to the extent ot which this really happens rather then is perceived in the event of huge FX and foreign investment losses. What struck me most in reading the NYT piece was the reported pervasive animosity in the managerial bureaucracy to ‘foreign cheats.’ Now, some of this is a consequence of the diffuse sense of grievance in China which I’ve spoken to before here in comments. But some of it is a real political driver, that bigger richer players aren’t keeping to the rules and are expecting China to eat the losses in everybody’s game. The truth is sufficiently more complicated that we can’t all agree on it, but there is a knot of cartlidge about this perception. If the Chinese ‘political class’ thinks it’s been cheated in how the global credit bubble collapse plays out, that will have very bad consequences because very foolish policy acts may follow.

    But by far the worst result of yuan appreciation is that it will sharply erode the exporter employment and industrial development ripple effects which are China’s macroeconomic strategy. The domestic political consequences of having that strategy hit even a rocky patch are so worrisome that China’s decision makers simply will not go that route. It seems clear that those deciders can’t agree amongst themselves what to do now; there may not even be a ‘first best option.’ And I do think that the Chinese would and will accept some yuan strengthening if it doesn’t gut the exporters. But very little. A great deal of firepower will be expended to defend the export strategy.

    I am, as in the past, in favor of some Chinese domestic economic expansion—but it seems clear that the Chinese leadership is not. Corruption is a major issue, and they still don’t have a handle on it, not least because the courts are far weaker than the corrupt local and regional officials. And then there is the fact that domestic expansion _strengthens_ those regional officials into real power bases, something which I think the Party and Central bureaucracy fear, loathe, and will go to great lengths to dissipate. —And the easiest way to prevent regional powerbases is not to grow them in the first place. Then there is the issue that it is much in the interest of ‘the Center’ to keep Chinese individually small and weak. A wealthier citizenry tends to generate a politically efficacious middle class or a politically muscular oligarchy. The present powers in China have no liking for either outcome, and the easiest way again to prevent them is to have growth but little distributed wealth.

    There really does seem to me to be A Plan, or at least a policy objective, in the _way_ in which growth is being pursued in China. It is very interesting from the sociopolitical standpoint as the first example of planned macrodevelopment on this scale ever attempted. It isn’t the way I would want to plan such a thing personally, but there does seem to be a strategy. And that strategy does not include major domestic economic stimulus, especially with regard to consumption.

  11. James

    Nice post richard. I think china’s reluctance to embrace any kind of consumption does explain the commodities drop. Perhaps bernakes global savings glut thesis has some merit. Its chinese leadership that is preventing savings from being spent in the chinese domestic economy.

    Its possible the dollar bears become very very wrong in the next year or two.

  12. Stuart

    I think we over estimate central bankers. I think the Chinese actually bought the US kool-aid hook, line and sinker that it was in their best interest to buy treasuries and GSE debt. Now they feel shafted and rightfully so. As the US Treasury would say….. “sold to you suckers”.

  13. Matt Dubuque

    I don’t have any evidence at all to rebut Yves’ post here and some facts support it.

    Here is the short view of my take.

    Paulson, as the point man for Goldman on China, was put at Treasury to oversee that relationship. The fear at the time was the the largest financial risk we faced was Chinese dissatisfaction with our policies that could pose trouble for the dollar. Paulson was supposed to take care of all that.

    We live in an era of information warfare. Managing the news and perceptions is part of the battlespace.

    Recall the 1980s, when the US was pushing Japan very hard to stimulate their domestic demand. My judgment at the time, drawn largely on inferences and not enough empirical data points, is that it seemed likely that the US was exploiting the Mayekawa vs. Miyazawa rifts at the Japanese Finance Ministry v. the Bank of Japan.

    Keep in mind that Japan at this time had a ROTATING arrangement between the Finance Ministry and the Central Bank and very similar issues were at play back then as well.

    For me there is a substantial likelihood that Paulson has panicked somewhat and has planted this “bright idea” into a vaguely competent NYT reporter, in hopes of stimulating Chinese domestic demand.

    Matt Dubuque

  14. Anonymous

    Why do you assume that the news is leaked by China. It can easily be leaked by IMF or some other parties.

    I think Richard Kline made a comprehensive and objective conclusion.

  15. mxq

    I agree…Richard and Francois are dead on.

    At the risk of repeating what they’ve said…Maybe the socialist/pseudo-capitalist model works for exporting only. Maybe China is simply incapable of cultivating a thriving domestic economy. One of the hallmarks of western countries is the ability to seek recourse/liability. Regardless of how miserable our justice system is, it still acts as a huge deterrent to obvious fraud and corruption.

    That said, the socialism/despotism that China adheres to and the capitalism that they need to succeed domestically look to be mutually exclusive.

  16. vox p

    “It is almost inconceivable that anyone who followed economic data did not realize that the dollar would decline from the level it has reached in 2001 and 2002.”

    And I thought that you couldn’t predict FX markets… except with the benefit of hindsight of course. The United States has been running those deficits for decades, and even though it was clear knew that those deficits were unsustainable on the long-term, nobody could really tell when those imbalances would unwind.

    Those deficits are unwiding today instead of 10 or 20 years ago beccause we have an unlikely combination of a credit crisis, a real-estate crisis and a commodity boom. Unless Baker correctly predicted those events back in 2001, which I doubt, he can’t seriously tell that “It is almost inconceivable that anyone who followed economic data did not realize that the dollar would decline from the level it has reached in 2001 and 2002”

  17. mxq

    China could also start the military sabre rattling that seems to be fashionable these days (up there with iPhones)…threaten Taiwan or Japan or somebody. That would really scare living fdi out of the country.

  18. Anonymous

    I feel stupid in posting this, because it's so obvious, but I hope somebody in China reads it and forgets this "Currency War" nonsense theory. The cause of your problems are self-inflicted, and not the result of a conspiracy by the Neocons & Bush to wreck your economy. How do I know this? To paraphrase Bill Maher, "Because it worked."

  19. Anonymous

    I’m having a difficult time thinking of an authoritarian regime without inflation.

    An independent central bank and a treasury with some distance from political consideration is key to a healthy economy.

    The obvious is neither China or the US can claim fiscally responsible economic policy, though at least the US has a higher degree of transparency (Sarbanes-Oxley) and public accountability working in its favor. That is no small advantage.

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