Bad Debts

Rosenberg Defines European Insanity


Wednesday, June 13th, 2012

The situation in Europe goes from bad to worse. Gluskin Sheff’s David Rosenberg is back to his bearish roots as he remind us that ‘throwing more debt after bad debts ends up meaning more debt‘. As he notes, the definition of insanity is (via Bloomberg TV):

When you realize that of the potential $100 billion to spend, 22% of that has to be provided by Italy and their lending to Spain is at 3% but Italy has to borrow at 6%. They have to lend to Spain $22bn at 3% – it is just madness. Everybody is getting worried again. The solution that they seem to have come up with seems to be worse than the problem in the first place.

As we have pointed out vociferously over the past few days, even though the assistance is being earmarked for the banks, the Spanish government assumes the responsibility and so this once ‘low national debt’ sovereign is following in Ireland’s footsteps as its debt/GDP takes a 10pt jump to 89% (based on the government’s data) and much higher in reality (when guarantees and contingencies are accounted for). As Rosie explains succinctly, this is right at the Reinhart-Rogoff limit of 90% at which debt begins to erode the nation’s economic fabric.

It is probably not long before this credit – two notches away from junk and having to raise money at 6.75% when its economy is contracting at nearly a 2% annual rate – is going to require external assistance as it follows Ireland onto the sidelines.

The situation in Europe indeed goes from bad to worse.

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World Bank Warns of Economic Crisis in China; Only 3% Growth for Decade Says Michael Pettis


Friday, March 2nd, 2012

A World Bank report to be released next week warns of an economic crisis in China unless state-run firms are scaled back. The Wall Street Journal discusses the report in New Push for Reform in China

An exclusive preview of an economic report on China, prepared by the World Bank and government insiders considered to have the ear of the nation’s leaders, offers a surprising prescription: China could face an economic crisis unless it implements deep reforms, including scaling back its vast state-owned enterprises and making them operate more like commercial firms.

“China 2030,” a report set to be released Monday by the bank and a Chinese government think tank, addresses some of China’s most politically sensitive economic issues, according to a half-dozen individuals involved in preparing and reviewing it.

The report warns that China’s growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the “middle-income trap.” A sharp slowdown could deepen problems in the Chinese banking sector and elsewhere, the report warns, and could prompt a crisis, according to those involved with the project.

It recommends that state-owned firms be overseen by asset-management firms, say those involved in the report. It also urges China to overhaul local government finances and promote competition and entrepreneurship.

China’s Difficult Transition From an Unsustainable Growth Model

Peak oil, a housing bubble, bad debts and over-reliance on investments with no genuine economic feasibility guarantee China’s current boom is not sustainable. China bulls are in for a ride awakening when various bubbles pop.

As for recommendations, the report  proposes a sharp increase in the dividends that state companies pay their owner (the government) in order to boost revenue and pay for new social programs.

Does China need to increase competition, break apart, and privatize the state-owned monopolies?
Or should China simply increase the dividends?

I vote for the former as does Michael Pettis at China Financial Markets.

Via email, Pettis says:

The report is good as far as it goes, but it doesn’t go far enough. Of course increasing SOE dividends to the government for use in social programs will transfer wealth from the state sector to the household sector, but if the total profitability of the SOE sector is less than one-fifth to one-eighth of the direct and indirect subsidies transferred from the household sector, as I have argued many times, then even 100% dividends is not enough to slow the transfer significantly, and remember the transfers have to be reversed, not merely slowed. This proposal falls in the better-than-nothing category, but just.

What we really need are much more dramatic transfers, for example wholesale selling of assets, with the money used either to clean up bad loans or delivered directly to households. According to the article, however, “neither the World Bank nor the DRC proposed privatizing the state-owned firms, figuring that was politically unacceptable.”

This is the problem. The best solution for China, economically, seems to be off limits because it will be politically difficult. In that case the second best solution, a gradual build-up of government debt as growth slows for many years, is the most likely outcome.

And how much will growth slow? The World Bank report apparently doesn’t say, but the consensus has been slowly moving down towards 5-6% annual growth over the next few years.

That’s better than the crazy numbers of 8-9% most analysts were predicting even two years ago (and some still are), but it is still too high. GDP growth rates will slow a lot more than that. I still maintain that average growth in this decade will barely break 3%. It will take, however, at least another two or three years before a number this low falls within the consensus range.

And by the way when it does, metal prices should fall sharply. Copper prices have done reasonably well in the past few months as Chinese buyers have restocked, as we suggested might happen to our clients last fall. With the recent easing we may see more strength in copper over the next month or so, but I have little doubt that within two or three years copper prices are going to be a whole lot lower than they are today. Chinese investment demand simply cannot hold up much longer.

Sad State of Political Acceptability

The report makes feeble recommendations to ensure the proposals are “politically correct”. This is a bad practice for three reasons.

  1. You only damage your own credibility
  2. You presume perhaps incorrectly what is politically acceptable
  3. You plant false hope that incorrect solutions will work, when it’s clear they will not

It would be far better list the alternatives and the limitations of those alternatives, then provide an honest assessment rather than assume something cannot be done. Unfortunately, telling people what they want and expect to hear is the sad state of political pandering everywhere.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

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WSJ: Dark Side of Brazil’s Rise


Wednesday, September 14th, 2011

by Trader Mark, Fund My Mutual Fund

Brazil is probably the most exciting investment prospect in the Western hemisphere over the next decade, but with its rapid growth comes issues, some of which we’ve outlined in the past.

  1. [Aug 1, 2011: Bloomberg - Bad Debts Begin to Snare Banks in Brazil, India, and China]
  2. [Mar 25, 2011: Brazil's Housing Carnival Stokes Bubble Woes]
  3. [Jan 12, 2011: Canada and Brazil Taking on U.S. Characteristics in Debt Exposure]

Much like India and China, they are having trouble dealing with all the easy money being created by Uncle Helicopter Ben (and Japan).  There is little need for that money in a limp U.S. economy, with low yields – so outside of times of crisis, that money flows globally creating dramatic impacts on those countries.  Brazil is one of the destinations, as the performance of its currency (despite efforts to tax foreign investment) has shown the past few years.  The WSJ delves further into the ‘dark side’ of this country’s rise.

  • Brazil is booming amid a tectonic shift in global investing toward the developing world that has lifted its stock market, strengthened its currency and provided financing for new ports and World Cup soccer stadiums.  But while foreign investment is mostly a good thing, there are downsides. The abundance of cash has helped fund riskier bank loans and fueled a potential real-estate bubble. By some measures, the Brazilian real is now the world’s most overvalued currency, and many local factories aren’t competitive in global markets.
  • Daily life has become so expensive that movies, taxis and even a can of Coke cost more in São Paulo than in New York. Rio de Janeiro apartment prices have doubled since 2008, and office space in São Paulo is suddenly more expensive than Manhattan.
  • Concern about the strong real is a key reason why Brazil’s central bank late last month cut its benchmark interest rate by half a percentage point to 12%, reversing course after a year of rate hikes. The move risks spurring inflation and spawned a debate in Brazil on whether the central bank had succumbed to political pressure. But Brazilian officials say the country’s high rates have lured speculative foreign investments that pump up the real and hurt the economy.
  • Brazil’s real has weakened 6% against the dollar since the central bank cut rates, but even so it is still up some 36% since Jan. 1, 2009.
  • Some executives in Brazil fret that the cost of doing business has risen so fast that their country may be unable to become the manufacturing power it has aspired to be for generations. Brazilian industrial production actually fell 1.6% in June from May for the first time since the 2008 global financial crisis. Factories are losing their overseas markets and getting beat by cheap imports because Brazilian labor, parts and transport have first-world price tags—even though Brazil still has all its third-world drawbacks, like bad roads, poorly educated workers and high crime rates.
  • Brazil isn’t the only developing country encountering problems of plenty. In China, heightened investment flows have contributed to food inflation in cities that some economists say may provoke social unrest. In Turkey, the government has tried a similar approach to the one just adopted by Brazil’s central bank—slashing interest rates to prevent inflows from strengthening the currency too much. But the lower rates have helped spark a big rise in bank credit and fears of a credit bubble.
  • Money flows easily into Brazil because it has a free-floating currency and sophisticated stock, bond and derivative markets, unlike China. Indeed, many investors seeking exposure to China get it by investing in Brazil instead because it’s a major seller of raw materials to the Chinese. Brazil is the world’s biggest seller of iron ore, beef, chicken, sugar and coffee. And it just made new oil discoveries off its coast that could make it into a leading global producer of that as well.
  • Of course, capital that floods into a country can flood out of it. Leaders in emerging economies are concerned that a financial catastrophe in the developed world—such as sovereign defaults in Europe—could cause a sudden reversal of investment flows. That would prompt jarring falls in currency, real estate and other prices that have soared in places like Brazil during the boom.
  • Brazil President Dilma Rousseff’s eight-month-old administration has fought a difficult battle to keep the real from rising. Brazilian officials blame near-zero interest rates in the U.S. and Europe for making it possible for hedge funds to borrow cheaply in the rich world to place bets in Brazil.  “We have to defend ourselves from this immense, fantastic, extraordinary sea of liquidity that finds its way to our economies in search of returns that it can’t find in its own,” Ms. Rousseff told Latin American leaders on July 28 in Lima.
  • Brazil has been announcing new measures almost monthly to stifle the flow, such as a tax on bond purchases, or to offset its impacts, such as a multibillion dollar package of subsidies for manufacturers hit by the soaring real. Manufacturers say the currency is still too strong and the subsidies aren’t enough.
  • One reason the policies may fail: Even after cutting its interest rates to 12%, Brazil has among the highest real interest rates, or rates in excess of inflation, of any major economy. That makes Brazil a prime target for “carry trade” speculators who borrow money cheaply where interest rates are near zero, deposit it in Brazil and pocket the difference.
  • It turns out that international capital flows a lot like water. Close one hatch and it pours in another. Brazilian officials suspect that when the country moves to restrict speculative investments, the money is being disguised as direct investments in companies. The evidence is a 260% spike in foreign direct investment to $38.5 billion in the first six months of the year.
  • Armed with a strong currency and cheap financing, a new class of Brazilian jet setters are getting on planes and shopping like mad in countries where goods are cheaper. Brazilians spent $8.5 billion on overseas shopping sprees this year—60% more than last year. Malls near Miami are hiring Portuguese-speaking salespeople and opening Brazilian restaurants to serve them.
  • Credit bubbles are another concern. Credit is rising rapidly in the big emerging-market countries—Brazil, Russia, India and China. Lately, loan-default rates have ticked up in Brazil.

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Bloomberg: Bad Debts Beginning to Snare Banks in Brazil, China, and India


Tuesday, August 2nd, 2011

by Trader Mark, Fund My Mutual Fund

You never quite know when the bad debt is going to start poking its ugly head out from within the python that is the banking system but we’ve been waving the red flag for a few years about the steps China took to avoid a slowdown in 2009 [Feb 16 2009: Is China Pulling an Alan Greenspan?] [May 27, 2009: How is China Spending their Stimulus... and How Many Loans Will go Bad?] and more recently [Jun 2, 2011: China Now Beginning to Feel Hangover from Lending Boom - Government May Assume Some Local Debt].  When you blow out money in every direction, much will be misallocated. . [Mar 29, 2011: [Video] An in depth Look at China’s Empty Cities] [Jan 14, 2011: [Video] Behold China’s Nearly Empty Mega Mall] [Nov 13, 2009: Ordos - China's Empty City]

It wasn’t just China – more recently we’ve seen some bad behavior amongst the Brazilian consumer, many of which had access to credit for the first time.  They began acting like Americans circa 2004.  [Jan 12, 2011: Canada and Brazil Taking on U.S. Characteristics in Debt Exposure]

Brazil’s economy grew at a 8.4% clip in the first nine months of 2010—its fastest pace in more than 15 years—powered in part by a sharp increase in government-subsidized loans and a rapid expansion in consumer credit. That can be a lethal cocktail.

The data in Brazil are troubling: Late payments on credit cards and other consumer loans jumped 23% in November from a year earlier.  The country has witnessed a fivefold expansion in consumer credit over the past eight years

And… [Mar 25, 2011: Brazil's Housing Carnival Stokes Bubble Woes]

Apartment prices are popular dinner table — and beach — conversation in Rio, anecdotes of humble doormen and taxi drivers becoming real estate brokers are common, as are stories of people snapping up apartments without seeing them.

3,300 new brokers were registered in Rio state last year, a nearly ten-fold increase from 2005.

The explosion of credit in recent years has raised concern that Brazil is nurturing a new breed of sub-prime consumers who are not financially astute enough to manage their debts and who could default as the economy cools and interest rates rise.

Canada and Australia also seem to be in some form of credit bubbles – especially housing related – but strong natural resource backstopped economies seem to have shielded them (thus far) from any pain.  Again, knowing when exactly these ‘good times’ turn bad is very difficult to time – even if you see the train coming.

Whatever the case, it seems much of the BRIC is reaching a hangover level as the financial companies in these countries suffer.  The stock markets have been acting poor for all of 2011, and if one believes in ‘efficient markets’ (I find the theory doubtful in many ways), one should be asking what the stock markets are forecasting about the economies.  It’s all coming together for a very fun 2012….

Bloomberg has a very detailed piece on the situation in Brazil, India, and China… some snippets

  • Banks in the biggest emerging markets are losing the confidence of investors as loans turn sour after a two-year credit binge.
  • Brazil’s financial shares have lost more this year than counterparts in crisis-stricken Europe as consumer defaults hit a 12-month high in June and borrowing costs climbed to 46 percent.
  • Bank stocks in China are trading at lower valuations than global emerging-market indexes for the first time since 2006. The country faces a financial crisis with bad debt that may jump to 30 percent of total loans, Fitch Ratings said.
  • Chinese lenders expanded credit at a record pace in 2009 and 2010, making more than 17.5 trillion yuan ($2.7 trillion) of new loans as the government moved to offset a collapse in exports during the global recession. The surge in loans exceeded credit expansions in the U.S. before its financial crisis, in Japan before its stock and property bubbles collapsed in 1990 and in South Korea before the Asian financial crisis of the late 1990s, according to Fitch.
  • About a third of local government financing vehicles, used to get around laws prohibiting direct borrowing, don’t have cash flow to service their debt, according to China’s banking regulator.
  • In India, the cost of insuring banks against default has climbed to the highest level in a year. Loan-loss provisions at State Bank of India (SBIN), the nation’s largest lender, rose 77 percent in the first three months of 2011, while net income fell 99 percent.
  • Bad loans “are going to rise because we will have to pass on the rate increase,” the bank’s chairman, Pratip Chaudhuri, told reporters in Mumbai after the central bank increased borrowing costs on July 26. “Interest-rate sensitive sectors like real estate and education loans will most definitely be affected,” Chaudhuri said.
  • Loans to Brazilian shoppers, Chinese infrastructure projects and Indian developers have fueled the global economic recovery and turned emerging-market banks into some of the world’s biggest companies by market value. Now increased debt burdens threaten growth.
  • Brazil’s annual credit-growth rate accelerated to as high as 34 percent in September 2008, the fastest since at least 1995, before moderating. The pace has picked up again, exceeding 19 percent for 11 months through June, central bank data show.
  • Loan payments by Brazilian consumers climbed to 26 percent of disposable income in March, up from 24 percent a year earlier. The rising costs of debt signals Brazil’s consumers are “overstretched,” Neil Shearing, a senior emerging-markets economist at Capital Economics in London, wrote in a July 12 report. A retrenchment may drag down Brazil’s economic growth rate to 2.5 percent in 2013, from 7.6 percent last year, according to Shearing.
  • “The people doing the borrowing are the people in the lower echelon in terms of income, and that’s worrisome,” Simon Nocera, a co-founder of San Francisco-based hedge fund Lumen Advisors LLC and a former economist at the IMF, said in an interview. Nonperforming loans “will be higher than previous credit cycles.”

Russia is showing some issues as well:

  • Lenders in other emerging economies are also showing signs of stress. Bank of Moscow needed the biggest bailout in Russian history last month after racking up at least 150 billion rubles ($5.4 billion) of unsecured bad loans. The $14 billion rescue of the country’s fifth-largest bank signaled Russian lenders’ health may be “substantially worse” than most investors judge

Copyright © Fund My Mutual Fund

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The Health Care Opportunity


Sunday, March 28th, 2010

By John Derrick, Director of Research, U.S. Global Investors

The health care overhaul legislation that President Obama signed into law this week brought about strong opinions on both sides of the issue. There’s not much use in revisiting the debate at this point, but a look at the market’s reaction could be instructive.

The broad market rose this week, perhaps glad to put the health care uncertainties behind it. On the other hand, the initial reaction in the health care sector was positive, but by the end of the week, the sector was down 1 percent. While there were some stock-specific negatives unrelated to the legislation, certain groups in the sector fared worse than others.

The managed-care companies, such as HMOs, were among the biggest losers – as a group they fell more than 3 percent, and several stocks in that group fell even further. Because the new law expands coverage to 32 million currently uninsured, it may appear to be a positive for the insurance companies, which will have more customers. The potential downside, however, is that they may be more costly customers – such as those with pre-existing conditions – and the law reduced other subsidies.

Health care

In the long run, the biggest beneficiaries may be the hospitals, as they will have many new paying customers and a likely reduction in bad debts. The pharmaceutical industry may also benefit from an increased customer base.

Our focus on government policies and our contrarian tendencies tell us that, after a decade of compressing valuations, an opportunity may be at hand in health care.

Concerns remain that this legislation will compress margins in the industry and potentially stifle innovation, but landmark events such as this week’s bill signing often signal turning points in markets as negative sentiment bottoms out and then reverses course.

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Pressure Increasing on China to Revalue Yuan; What Can Go Wrong?


Wednesday, March 17th, 2010

By Michael ‘Mish’ Shedlock

Pressure on China to do something about its allegedly undervalued currency is mounting by the day. Please consider the following articles.

World Bank Calls For Stronger Yuan

The World Bank Says China Must Pare Stimulus to Counter Bubbles

The World Bank indicated that China, the world’s third biggest economy, should raise interest rates to help contain the risk of a property bubble and allow a stronger yuan to help damp inflation expectations.

The nation’s “massive monetary stimulus” risks triggering large asset-price increases, a housing bubble, and bad debts from the financing of local-government projects, the Washington- based World Bank said in a quarterly report on China released in Beijing today. The group raised its economic growth forecast for this year to 9.5 percent from 9 percent in January.

The World Bank’s call echoes the assessment of private economists — analysts at Morgan Stanley this week said higher reserve requirements for banks may be “imminent” and interest rates could start to climb as early as next month. China’s economic rebound has also sparked increasing calls for an end to its exchange-rate peg to the dollar, adopted in mid-2008 to help shelter exporters amid the global recession.

Senate Considers Currency Manipulator Regulation

Bloomberg is reporting Senate May Force Obama to Take Tougher Yuan Stance

Five senators including Charles Schumer of New York and Lindsey Graham of South Carolina introduced legislation yesterday to make it easier for the U.S. to declare currency misalignments and take corrective action. Even if the bill stalls, it may have “ripple effects” that lead the Treasury Department to declare China a currency manipulator, William Reinsch, president of the National Foreign Trade Council, said.

Obama’s goal of doubling U.S. exports in five years depends on his ability to get China to raise the value of its currency, said Sherrod Brown, an Ohio Democrat and co-author of the legislation. China’s intervention in currency markets to keep the value of the yuan, or renminbi, at a set value acts as a subsidy to exports and tax on imports, Brown said at a news conference yesterday.

Senator Debbie Stabenow, a Michigan Democrat, and Sam Brownback, a Kansas Republican, are also supporting the legislation. Graham is a Republican and Schumer is a Democrat.

The senators said the U.S. recession could boost the political prospects for the legislation, which Schumer has proposed in various forms since 2003. Schumer said the Senate proposal will be attached “very soon” as an amendment to “must-pass legislation.”

“The only way we will change them is by forcing them to change,” Schumer said.

The yuan is undervalued by as much as 40 percent, which is “blatant protectionism,” Bergsten said. Brown and Schumer quoted the analysis of Bergsten and Nobel Prize winning economist Paul Krugman in support of their efforts.

Business Sours On China

Please consider Business Sours on China.

China’s relationship with foreign companies is starting to sour, as tougher government policies and intensifying domestic competition combine to make one of the world’s most important markets less friendly to multinationals.

Patent rules imposed Feb. 1 threaten to increase costs in China for foreign innovators in industries such as pharmaceuticals, and let authorities force foreign drug companies to license production to local companies at state-set prices.

A year ago, in a move foreign critics called protectionist, Chinese regulators rejected a bid by Coca-Cola Co. for China Huiyuan Juice Group Ltd., saying it could crowd out smaller companies and raise consumer prices. The two combined held just a fifth of China’s juice market.

In July, four executives of Anglo-Australian mining giant Rio Tinto were detained, initially accused of stealing “state secrets,” amid tense negotiations between global miners and China’s steel industry over iron ore prices. Rio Tinto denies wrongdoing by the men, who await trial on reduced charges of bribery and theft of commercial secrets.

Google Inc.’s woes highlight the angst. The search company, long troubled by Chinese censorship rules, threatened Jan. 12 to depart China after it said a Chinese hacking attack penetrated its computer network. Related attacks hit dozens of other multinationals. Google is expected soon to close its Chinese site, Google.cn., leaving local companies dominating an Internet market of 400 million users.

“The Google issue has had a crystallizing effect,” says Lester Ross, managing partner in Beijing for U.S. law firm Wilmer Cutler Pickering Hale and Dorr. “It raised the consciousness of government and of the boardrooms and other stakeholders” about the difficulties of doing business in China, he says.

Krugman Wants To Take On China

Inquiring minds are reading Taking On China by Paul Krugman.

Tensions are rising over Chinese economic policy, and rightly so: China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done.

Today, China is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. The International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion — 10 times the 2003 figure. This is the most distortionary exchange rate policy any major nation has ever followed.

So how should we respond? First of all, the U.S. Treasury Department must stop fudging and obfuscating.

If Treasury does find Chinese currency manipulation, then what? Here, we have to get past a common misunderstanding: the view that the Chinese have us over a barrel, because we don’t dare provoke China into dumping its dollar assets.

It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.

Looking At Half The Equation

For starters, Krugman conveniently ignores one side of the equation.

A sinking dollar is good for exports, however, given China’s regulatory policies as noted in Business Sours on China, it’s not at all clear exports to China would rise by much. Indeed, I suspect that China’s regulatory restrictions are a far bigger impediment to trade than currency fluctuations.

Furthermore, one cannot (or at least should not) ignore what would happen to the price of imports. A falling currency is not a free lunch.

While I agree with Krugman that China would not dump US Treasuries, the idea that the U.S. has China over a Barrel because is preposterous. Mutual deadly embrace with unbalanced winners and losers is more like it.

What China Can and Cannot Do With Reserves

Please consider What the PBoC cannot do with its reserves by Michael Pettis.

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.”

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.

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.

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.

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.

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. …..

… 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).

Yuan is Undervalued by as Much as 40 percent?!

For the sake of argument, let’s assume The RMB is undervalued by 40%. Who is the winner?

To answer the question let’s return to a snip from Pettis:

“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.”

If that is true generally speaking, then the US is a beneficiary now, generally speaking. This implies we should be careful of what we ask. However, the situation is more complex because as Pettis explains there are individual winners and losers:

“..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.”

Shock Effect

Let’s consider the global shock effect of a sudden large revaluation of the Renmimbi. The key is the RMB does not float. To get a 40% rise in valuation, China must buy or sell unlimited amounts of RMB against the dollar to maintain the desired price. That might mean a huge hike in Chinese interest rates to make holding the RMB attractive.

In turn, sharp interest rate hikes would likely cause a huge slowdown in China, decreasing China’s demand for imports. This is yet another factor that Krugman and those crying “currency manipulator” miss.

And should the US impose a revaluation via tariffs, I would like to point out a little thing called Smoot-Hawley.

By the way, I am all in favor of a huge slowdown in China. I think China is on an unsustainable course, and the sooner and harder China slows the better for everyone in the long run.

However, the consequences of such a slowdown would be huge on the commodity exporters like Canada and Australia. Moreover, a slowdown in trade would slow global consumption.

I happen to think those are necessary adjustments along with more debt writeoffs, but believers in free lunches and Keynesian claptrap sure won’t see it that way.

Hopefully this gives you a bit more of an idea as to just what might go wrong with all these simplistic “the Yuan is 40% undervalued – so label China a currency manipulator” ideas floating around.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

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