from Follow the Money


September 5, 2008, 12:59 am (EST)

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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One of my usual laugh lines is that the CIC isn’t a sovereign wealth fund; it is a sovereign loss-minimization fund.

After all, selling debt denominated in an appreciating currency (and one that, given China’s current account surplus, should face ongoing pressure to appreciate) to buy assets denominated in a depreciating currency is generally a good way to lose money. All the more so if the interest rate on the appreciating currency is higher than the interest rate on the depreciating currency.

The PBoC has long faced the same problem. Consequently, Keith Bradsher’s story in today’s New York Times shouldn’t be a surprise. Some analysts warned China rather publicly back in 2004 (and 2005) that it would eventually face large currency losses on its reserves. The IMF wrote a paper noting that a central bank that takes capital losses from currency moves risks losing a bit of independence, as it could end up needing a capital infusion from the Finance Ministry.

China’s policy of holding the RMB down to support its exports produced highly front-loaded benefits (fast export growth, jobs in the export sector) and highly back-loaded costs (the bill for the losses on all the dollars and euros the central bank has had to buy to keep China’s currency from appreciating). The benefits are now shrinking -- Chinese export growth to the US has stalled -- while the costs becoming more visible.

But the fact that the PBoC is seeking a capital injection is still interesting.

"the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China."

I guess falling US interest rates are starting to bite. Remember, the government of China is by far the United States’ largest creditor. China’s combined Treasury and Agency portfolio exceeds the total US holdings of the government of Japan.

Keith Bradsher is absolutely right to note that China has been pouring an enormous share of its GDP into US debt purchases and that its efforts to pass the costs of this policy onto the state banks and ultimately China’s depositors are an enormous subsidy from China’s savers to America’s borrowers:

" 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. .... Along with Treasuries, China has invested heavily in mortgage-backed bonds from Fannie Mae and Freddie Mac, the struggling mortgage finance giants that are sponsored by the United States government. Standard & Poor’s estimates China’s holdings at $340 billion (BWS aside -- that seems too low to me; China’s total Agency holdings are at least $465 and probably higher, and while not all are Fannie and Freddie, a lot are).

Some bond traders suspect that the central bank has scaled back its purchases of these securities, as have China’s commercial banks. But the central bank trades this debt through many third parties in many countries, making its activity opaque to outside analysts.

The central bank has gone to great lengths to maintain its foreign purchases. The money to buy foreign bonds has come from the reserves required that commercial banks must deposit with the central bank. In effect, China’s commercial banks have been lending the central bank more than $1 trillion at an interest rate of less than 2 percent.

To keep the banks strong when they were getting such little interest on their reserves, the central bank has kept deposit rates low. The gap between what banks are paying on deposits and the rates they are charging ordinary customers to borrow is several percentage points. This amounts to a transfer of wealth from ordinary Chinese savers to the central bank and on to Americans who are selling their debt to the Chinese. "

That though has been China’s own choice -- not something China has done because the US has sought its financial support.

Bradsher’s concluding point also illustrates something that has long worried me. He -- citing Victor Shih -- reports that many in China attribute the losses to bad US policy, not China’s efforts to keep its currency down:

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.

Many have argued that China’s investment in the US gives China a stake in the United States success, and thus should help to ease other sources of friction. I have always thought it was more likely to itself be a source of friction -- in no small part because investments that generate losses tend to be viewed rather differently than investments that produce gains. Creditors through the ages usually think that the debtor’s own behavior is at least partially responsible for the loss.

I don’t think the US can be blamed for the currency losses China is going to incur. The US has consistently indicated that it would not direct its monetary policy toward maintaining the dollar’s external value. But I do think that the US could be blamed if China’s enormous holdings of Agencies ever were not to be repaid in full. Maybe it shouldn’t be blamed, as the US government never guaranteed payment in full. But I also am a realist.

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