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It is rather hard to read Andrew Browne’s report of the building boom in Zhengzhou in last week’s Wall Street Journal --- or for that matter many other accounts of China’s current investment boom – and not come away thinking that the banks financing various mega-projects in various Chinese provinces won’t end up with a lot of non-performing loans. Not every interior city will be the “Chinese Chicago” -- let alone the next Shanghai.
I do think the improvement in the balance sheets of the Chinese banking system over the past few years is real. Tons of old bad loans (ones made to SOEs in the 1990s) have been moved off the banks balance sheets. Read Guonan Ma. Or read my article – but my data came from Ma.
Those bad loans are now parked in China’s Asset Management Companies, often after making a brief stop-over on the balance sheet of the People’s Bank (the PBoC has bought its share of bad loans at par).
Most of the loans that the banks have made during the current lending boom are performing. So relative to where they were say five years ago, the banks are in far better shape –
The risk is that a lot of these new loans will only perform so long as China’s boom continues. And booms usually don’t last forever.
Most people realize this. They worry about the future health of China’s banks.
And a lot of people think this fact is a good reason for China to be holding so many reserves. Friday’s FT leader, for example, suggests that China’s huge reserves might come in handy if a lot of the loans now being made turn bad.
“Some China watchers believe the sector's bad loans are so vast that the government may need every cent of its trillion-dollar reserves.”
I disagree. External assets -- like reserves -- aren't what China will need in a domestic banking crisis. Let me see if I can explain why in a convincing way.
I suspect that China’s rapid reserve growth is adding to the risk of a banking crisis in China, not reducing it. Rapid reserves growth is fueling a huge expansion of China’s money supply, as the PBoC hasn’t been able, or willing, to fully sterilize China’s reserve growth. The result: a huge surge in bank deposits – and in the banking system’s ability to make loans. The PBoC though doesn’t want the banking system to finance every provincial governors’ big dreams. For that matter, the PBoC doesn’t really want the banks to lend out all their deposits. But the banks make far more money (at least in the short-run) if they lend than if they do not. So the PBoC is constantly struggling to keep the banks – which are flush with cash -- from lending too much. And it often fails.
Moreover, holding the exchange rate down means holding Chinese interest rates down – and directing Chinese monetary policy toward maintaining exchange rate stability, not toward curbing the domestic boom bust cycle. That too has contributed to the current lending boom.
I am not the only one who thinks this either. Far more impressive vocies have made a similar point. Mike Mussa for one.
The People’s Bank of China (the Chinese central bank) finds it difficult to sterilize all of the monetary effect of the massive increase in its foreign exchange reserves, thereby contributing to rapid money and credit growth. This in turns fuels massive investment spending (as firms rather than consumers are the main recipients of bank credit.”
The Chinese leadership supposedly agrees (even if they haven’t been willing to take much real action). Washington Post, drawing on an interview with He Fan (of the Chinese Academy of Social Sciences).
China's leaders view booming exports and the resulting pile of foreign exchange reserves, now nearly $1 trillion, as added fuel for unwanted bank lending that is exacerbating the pace of investment. China's leaders have come to see a faster appreciation of the currency as a useful tool in the effort to slow investment and stave off trouble.
More importantly, I don’t think the dollars and euros that the PBoC is adding to its portfolio also will be of much use should boom turn to bust. China isn't building up something in good times that will help it whether the bad times associated with a domestic banking crisis. China’s government will not finance future bank recapitalization by drawing down its external reserves. Rather, it will finance future bank recapitalization by issuing new domestic debts (effectively substituting a government bond for a bad loan on the bank’s balance sheet).
Reserves are an external asset. External assets can be used to make up for a shortage of exports relative to imports. A country with tons of reserves, for example, could finance a current account deficit by running down its reserves rather than by borrowing from abroad. China doesn’t exactly have that problem.
Reserves are also useful if more capital wants to leave a country than come in. That is why reserves can come in handy in a banking crisis.
Not because most emerging markets use their reserves to recapitalize their banks after the banks make a series of bad loans. No one generally does that.
But if bank depositors want to withdraw funds from the domestic banking system and move their funds abroad, the country can finance that capital outflow by running down its reserves.
The precise mechanism depends on the nature of the country’s banking system.
If the bank deposits are in dollars, the central bank can lend out its reserves to the banks – acting as a lender of last resort in hard currency. The central bank provides the banks with the hard currency cash the banks need to pay their depositors, who wants dollars cash, not a dollar-denominated bank deposit. The balance of payments accounting on this is hard (though working on Argentina in 2000-01 provided a good crash course). A dollar-denominated bank deposit in the banking system of an emerging economy is a domestic asset while a dollar in cash is an external asset … so shifting from dollar denominated deposits to dollars cash generates a capital outflow. Think of it in the following way: citizens are substituting a claim on the US (a dollar bill) for a claim on the local economy denominated in dollars (a dollar deposit that is used to finance a local dollar-denominated loan).
All this doesn’t apply to China though. Its domestic bank deposits are denominated in RMB, not dollars.
If bank deposits are in local currency, the central bank doesn’t need dollars if its citizens want to withdraw funds from the banking system and hold cash – local currency cash – instead. The PBoC can print all the RMB it will ever need.
China would only need to draw on its dollar reserves if (and this is a big if) China’s citizens did not want to hold RMB cash -- or to shift their RMB from a risky local bank to a safer local bank -- but rather wanted to hold dollars (cash) or dollar-denominated offshore bank accounts.
In theory, Chinese depositors don’t have the option of moving funds offshore. China has capital controls and all. But China’s capital controls leak. We know that in 98 and 99 hot money flowed out of China. If depositors lost confidence in the banks and in the RMB, those outflows might resume.
But that doesn’t necessarily imply China would need to dip into its reserves.
Why not? Remember, China has an enormous trade and current account surplus. Its 2006 surplus is estimated at $220b by the World Bank. The August data suggests that the World Bank estimate may be low. Nick Lardy is now estimating a current account surplus of 9% of China’s GDP. China would only need to dip into its stockpile of reserves if the total outflows exceeded the inflow from the current account surplus. Actually, it would only need to draw on its reserves if the outflow from the banks exceeded the combined inflow from the current account and FDI flows.
Most of the emerging economies that had to dip heavily into their reserves when they had a banking and currency crises were initially running current account deficit, not surpluses. They needed to draw on their reserves while their current account adjusted.
Moreover, a banking crisis would likely be associated with a slump in new lending and slump in investment. That that would tend to push China’s current account surplus up.
The problem with running a 9% of GDP current account surplus during an investment boom is that it implies a far larger surplus in an investment bust. China’s current account surplus would likely rise to around $300b in Chinese investment slowed, reducing demand for imports.
Consequently, I would bet that China’s reserves would keep on rising even if China’s investment boom turns to an investment bust. China would cling to its peg even more tenaciously to support its exports as the domestic economy slowed. Barring enormous capital outflows, that the PBoC would continue to buy dollars to keep the RMB from appreciating …
Couldn’t China’s existing reserves be used to recapitalize China’s domestic banks?
The answer is not really.
Simple. China’s banks take in RMB deposits and need to match those deposits with assets denominated in RMB. Right now, those deposits are matched with RMB loans. It those loans go bad, the banks will need another performing RMB asset.
Dollars and euros, for all their respective virtues, are not RMB.
Giving the banks dollars or euros would create a currency mismatch in the banking system. That is a problem. Particularly since dollars and euros are likely to fall in value relative to the RMB over time.
The need to avoid a currency mismatch is a key reason why the vast majority of China’s recent bank recapitalization has been done in RMB, not in dollars.
The transfer of $60b in reserves to three state banks is small relative to the total recapitalization (see Ma). Plus, the Chinese government is reported to have promised the banks that it would make up for any currency losses on the dollars that the central bank gave them. That promise effectively turns the dollars into RMB – just in ways that don’t show up formally.
So how did China recapitalize its banks the last time around, if it didn’t do it primarily by giving the banks its reserves?
First, lots of bad loans were shifted to the asset management companies (AMCs). It works like this: the banks give up their bad loans (at par) and get an offsetting bond from the AMCs. The AMCs are left with the bad loan. That bad loan isn’t worth much. The AMCs end up with a promise to pay say 100 RMB to the banks, and an asset worth around 20 RMB. That only works if the government effectively promises to make up the difference and pay the AMCs bonds … so in practice, the banks have swapped a bad loan for a government bond.
Second, some bad loans were purchased by the People’s Bank at par. The banks get cash, which they can use to make new loans. The PBOC gets a dud loan, which it likely then gives to the AMCs. The PBoC can afford to take the loss associated with buying a bad loan at par because it makes a lot of money on a flow basis ….
Finally, the government can just give the banks a government bond.
It usually works like this. The banks write down their bad loans. That creates a hole in their balance sheet – their liabilities are unchanged, but their assets have shrunk. To make up for the “hole” the government just gives the banks a government bond. Usually a government bond denominated in the local currency.
Now, China didn’t always give the banks a domestic government bond – a promise to pay RMB in the future. It also gave the banks some of China’s reserves – effectively, US government bonds.
The government gives the banks a US Treasury bond and a promise to swap the payments on that bond for RMB at the current exchange rate, it effectively becomes a Chinese government bond.
That’s the rub. Chinese banks won’t need dollars if their current loans go bad. They will need RMB. And that likely means that the government will end up issuing a lot of RMB bonds. It just may hide those costs – whether by issuing AMC bonds that everyone assumes the government will have to ultimately pay or by giving the banks dollar-denominated treasuries and an implicit contract (a bond, effectively) to swap dollar payments for RMB at the current exchange rate.
To sum up, dollar reserves can be useful in a domestic banking crisis.
They are useful if the banking system takes in dollar deposits. That describes Lebanon, Turkey, Argentina (before 2001) and a host of other countries. But not China. China’s banks operate in RMB.
Dollar reserves can be useful if a loss of confidence in the domestic banking system leans to a surge in demand for foreign currency.
But China has capital controls to limit that risk.
And even if the controls leak, China’s huge current account surplus almost certainly will generate almost all the hard currency China would need to meet a surge in demand for hard currency from its citizens. And remember, the conditions that give rise to a banking crisis would likely push China’s current account surplus up to $300b.
That is a big. Almost certainly big enough that the Chinese would find themselves adding to their reserves – buying dollars – to keep their currency from appreciating -- not running down their reserves to cover capital outflows in excess of China’s current account surplus.
Of course, if China doesn’t need its reserves to cover a potential capital outflow, it might consider giving the banks some of the central banks’ extra dollars – really dollar-denominated US bonds -- rather than having the government issue RMB denominated bonds to make the banks whole.
But the banks still need RMB to be matched, not dollars. So giving the banks dollars only works if China effectively lets the banks swap out of dollars …
It turns out that giving the banks a dollar bond plus a swap that protects the banks from exchange rate risk works out to be the same as issuing RMB denominated bonds to recapitalize the banks, holding dollar reserves, and using the interest on those dollar reserves to help pay the interest on the RMB reserves.
All this is kind of complicated. It is balance sheet analysis 401, not balance sheet analysis 101. But I am pretty sure the PBoC gets it.
Think of it this way. Swapping a dud loan for a depreciating currency generally isn’t a good idea. Both imply holding assets that won’t hold their value of over time.