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Tuesday, February 27, 2024

The capital tsunami is a bigger threat than the nuclear option

The capital tsunami is a bigger threat than the nuclear option

Courtesy of Michael Pettis at China Financial Markets

Since this is another long posting, it might make sense to summarize briefly its two parts.  In the first part, expanding on an OpEd piece of mine published by the Wall Street Journal on Monday, I argue that China’s “nuclear option”, which has generated a great deal of nervousness among investors and policy-making circles in the US, is a myth, and what the US should be much more concerned about is its diametric opposite — a tsunami of capital flooding into the country.  I try to discuss the economic implications and perhaps the implications for asset prices.

In the second part of this posting I discuss the slowing of the Chinese economy within the context of what I believe to be its stop-go approach to economic policymaking.  The one-minute take: I think policymakers will soon be stomping again on the accelerator, although there seems to be a real debate going on about whether this would be the proper policy response.


An awful lot of investors and policymakers are frightened by the thought of China’s so-called nuclear option.  Beijing, according to this argument, can seriously disrupt the USG bond market by dumping Treasury bonds, and it may even do so, either in retaliation for US protectionist measures or in fear that US fiscal policies will undermine the value of their Treasury bond holdings.  Policymakers and investors, in this view, need to be very prepared for just such an eventuality

So worried have many been that last week SAFE even had to come out and calm people down.  According to an article in the Financial Times:

China has delivered a qualified vote of confidence in the dollar and US financial markets, ruling out the “nuclear option” of dumping its huge holdings of US government debt accumulated over the last decade.

But the State Administration of Foreign Exchange, which administers China’s $2450bn in reserves, the largest in the world, also called on Washington and other governments to pursue “responsible” economic policies. The statement on Wednesday, one of a series that Safe has issued in recent days in an apparent effort to address criticism about its lack of transparency, also played down the chances of China making major further investments in gold.

It’s good that SAFE is trying to soothe worried investors and policymakers, although, as I have pointed out many times before, the last thing China needs right now is for the US “to pursue responsible economic policies” if that means bringing the government’s debt level down and, with it, US overconsumption and the US trade deficit.  But the idea that Beijing can and might exercise the “nuclear option” is almost total nonsense.  This cannot and will not happen.

In fact the real threat to the US economy is not the dumping of USG bonds.  On the contrary, in the next two years the US markets are likely to be swamped by a tsunami of foreign capital, and this will have deleterious effects on the US trade deficit, debt levels, and employment.  Investors and policymakers should be far more worried that China and other capital exporting countries are trying their hardest to maintain and even increase their capital exports, while the capital importing countries are either going to see capital imports collapse, or are trying desperately to bring them down.

June trade

On Sunday, for example, China released its trade figures for June.  Here is what Bloomberg had to say:

China’s trade surplus widened to the highest this year and exports climbed more than estimated to a record in June, adding pressure on the government to let the currency gain after the U.S. said the yuan “remains undervalued.”

The gap increased 140 percent to $20.02 billion from a year earlier, the nation’s customs bureau said yesterday. That compares with the $15.6 billion median estimate of 24 economists Bloomberg News surveyed. Exports surged 44 percent and import growth moderated for the third month, rising 34 percent.

People’s Daily take on the numbers was a little different, stressing not the surge in June’s trade surplus but rather the relative decline in the trade surplus for the first half of 2010:

China’s trade surplus fell by 42.5 percent in the first six months this year from a year earlier to 55.3 billion U.S. dollars, the General Administration of Customs (GAC) said Saturday.

In the first half of 2010, exports rose 35.2 percent to 705.09 billion dollars while imports were up 52.7 percent to 649.79 billion dollars, the GAC said in a statement posted on its official website.

The trade surplus earlier in the year was low, at least in part I think because of a surge in commodity stockpiling which, in my opinion, should be treated as capital investments rather than as imports, but however you look at it, and especially when you consider the crisis in Europe, June’s trade surplus was very large, and I have little doubt we are going to see more big numbers over the rest of the year.

Needless to say, the US trade deficit has widened sharply. Here is Wednesday’s Financial Times:

A surge in imports from China pushed the US trade gap sharply wider in May, adding to a stream of weak data that has putBarack Obama’s administration under pressure for its inability to right the faltering economy and stimulate the stagnant jobs market.

The trade deficit grew by 4.8 per cent to $42.3bn, according to commerce department figures, the highest since November 2008 and at odds with the consensus of economists, who forecast the gap would shrink in May.

Trade surpluses must be recycled

What does all this have to do with foreign funding of USG bonds?  Everything.  The larger China’s trade surplus, the more capital it must invest abroad.  This might not seem evident from the change in the PBoC reserves.  Another article in Sunday’s Bloomberg had this to say:

China’s foreign-exchange reserves, the world’s largest, rose at the slowest pace in 11 years in the second quarter as expectations for a yuan appreciation diminished and the European sovereign debt crisis saw capital move out of emerging markets.

The nation’s holdings rose by $7.2 billion to $2.454 trillion yuan at the end of June from the end of March, the People’s Bank of China said today, the smallest increase since the second quarter of 2001. Reserves dropped 2 percent in May, according to data posted on the central bank’s website, the first monthly decline since February 2009.

PBoC reserves were up by a very small amount compared to the visible inflows.  Part of this may be explained by losses on non-dollar reserves – which has no flow impact – but probably at least part of the reason may be hot money outflows, which seem to be picking up, and much of this is likely to end up anyway in the US markets.

Clearly the PBoC and (other Chinese entities) are continuing to accumulate huge amounts of USG bonds.  So why not worry about Beijing’s “nuclear option”?  For a start, unlike you or me the PBoC cannot simply sell Treasury bonds, pocket the cash, and go home.  Dollar bills are just as much obligations of the US government as are USG bonds, only that they pay no interest.  If the PBoC wants effectively to reduce its holdings of USG bonds it must swap them for something else.

How to sell USG bonds

There are broadly four ways it could arrange such an exchange.  First, it could swap US Treasury bonds for other US assets.  How would this work?  Let us say that the PBoC decides to sell USG bonds and buy Manhattan real estate or IBM stock.  Obviously the seller of that real estate or stock will now have a bunch of money that he needs to invest.  Directly or indirectly (by buying another USD asset and so passing the problem onto someone else) the money becomes part of the pool of US savings that are available to fund the USG market.

In other words this swap would have little net impact on the US market except perhaps to cause a slight increase in Treasury yields and an equivalent, and welcome, contraction in US risk premia.  What if instead of leaving his money in US assets the seller uses the money to buy foreign assets?  That will have the same effect as the second way the PBoC can swap out of USG bonds.

In the second way the PBoC could reduce its USG holdings, the PBoC could swap USG bonds for assets denominated in euros or yen.  Of course any major exchange would immediately cause the dollar to drop sharply, giving the US economy an export-related boost as European or Japanese exports collapse and imports surge.  There might be a short-term rise in US interest rates in this case, but this would be tempered because the expansionary effect of a surge in US exports would reduce the need for the US Treasury to borrow – remember it is borrowing in order to create domestic employment, and the less the employment it creates leaks abroad through the trade deficit, the less it needs to borrow.

Aside from the fact that a large swap of this sort would ensure that the PBoC sells dollar assets at artificially low prices and buys euro or yen assets at artificially high prices, there is a larger political problem with this kind of transaction.  Europe and Japan would not be happy if PBoC purchases were truly significant and both countries would almost certainly retaliate strongly against Chinese trade.

They might also increase their purchases of USG bonds in order to reduce the currency impact of the PBoC’s purchases, which has the effect of recycling PBoC purchases into USG purchases anyway.  Remember if Europe or Japan do not intermediate PBoC-related inflows back into the US, this is the same as saying that the US trade deficit migrates to a very unwilling Europe or Japan.

In fact recent reports that the PBoC has increased its purchase of yen is already causing worry about its exercising the nuclear option, although that is a mistaken reading.  First, the numbers are small, and second, they are more likely to be shifting out of euros than out of dollars.  Here is what the Financial Times said in an article last week:

China bought a record amount of Japanese government bonds in May, in an apparent move to shift more of its massive foreign exchange reserves into Japanese debt.  Chinese net purchases of Japanese government bonds soared to Y735.2bn ($8.3bn) in May, far outpacing the Y541bn in JGBs bought from January to April, according to Japanese finance ministry figures.

The increase in JGB purchases comes as China appears to be diversifying more of its $2,400bn in foreign exchange reserves away from US Treasuries and, more recently, euro-denominated assets, because of sovereign debt problems in Europe.

Notice I have ignored the possibility that the PBoC buys assets other than in euros or yen, but aside from the fact that no other market is nearly deep enough to absorb significant purchases by the PBoC, the net result is no different.  The destination country would be forced either to recycle the inflows back into the US (counteracting the effect of PBoC selling of USG bonds) or it would have to absorb the US trade deficit – something no other country is capable of doing.

The third way the PBoC could swap out of its USG bonds is to exchange them for hard commodities.  Because of the positive correlation between Chinese growth and commodity prices, stockpiling commodities is a bad balance sheet decision for China.

Why?  Because by locking in relatively “cheap” commodities if Chinese growth subsequently surges, or relatively “expensive” commodities if Chinese growth subsequently stalls, it will only exacerbate volatility in China’s already incredibly volatile economy.  Remember that most analysts believe that quarterly growth, if correctly accounted, plunged from the low double digits in the last quarter of 2007 to zero or even negative in the last quarter of 2008, for example, before surging to low double digits again the last quarter of 2009.  This is already an very volatile economy.

This exacerbation of volatility is made worse by the widespread suspicion that China has already stockpiled huge amounts of commodities, but the main point is that even if the PBoC were to do this, it does not change anything material.  It simply reassigns the problem to commodity exporters, with almost the same net results, because if Brazil, say, sells more iron ore to China, Brazilians now have more dollars, which they must either spend on US imports – thus boosting US employment – or invest in US assets.  In this case Brazil simply intermediates the former PBoC purchases of USG bonds.

It’s all about the export surplus

Finally the PBoC could sell US Treasury bonds and purchase assets in China.  This would be most damaging for China because it would mean a drastic reversal in the country’s currency regime.  The PBoC currently sells huge amounts of renminbi to Chinese exporters in order to keep down the value of its currency.  Suddenly to switch strategies and to buy renminbi would cause the value of the renminbi to soar.  This would wipe out China’s export industry and cause unemployment to surge.

So basically any sharp reduction in China’s Treasury bond holdings is likely either to be irrelevant to the US or to cause far more damage to China than to the US.  I really don’t think we should waste a lot of time worrying about the nuclear option.

But that doesn’t mean there is nothing to worry about.  In fact the problem facing the US and the world is not that China may stop purchasing US Treasury obligations.  The problem is exactly the opposite.

The major capital exporting countries – China, Germany, and Japan – are desperate to maintain or even increase their net capital exports, which are simply the flip side of their trade surpluses.  The major capital importing countries, on the other hand, are likely to see their imports plummet.

China, for example, is unwilling to allow the renminbi to rise against the dollar because it wants to protect and even increase its trade surplus.  I already discussed the June trade numbers, and it is pretty clear that China is in no hurry to bring its trade surplus down.  Remember that whether the surplus ends up as an increase in reserves or as hot money outflows makes no difference.  One way or another the full current account surplus – most of which is the trade surplus – must be recycled abroad.

Japan is in a similar position.  In Japan, consumption growth has been glacially slow, and any contraction in its trade surplus will lead almost directly to reduced production and higher unemployment, so Japan, too, is eager to maintain capital exports.

Finally Germany, like China, has been reluctant to put into place policies that boost net demand, and in fact the collapse of the euro means that Germany’s trade surplus will almost certainly grow.  Needless to repeat, if the German trade surplus grows, so must its export of capital.

So who will import capital?

All the major capital exporting countries, in other words, are eager to maintain and even increase their capital exports.  But the balance of payments must balance, and all that exported capital must be imported somewhere else.  So what about the net importers of capital – aren’t they eager to absorb these flows?

Here the situation is dire.  The second largest net importer of capital until now has been the group of highly-indebted trade-deficit countries of Europe – including Spain, Greece, Portugal, and Italy.   The Greek crisis has caused a sudden stop to private capital inflows, as investors worry about insolvency, and it is only official lending that has prevented defaults.  These countries are unlikely soon to see a resurgence of net capital inflows.  The world’s second-largest net capital importer, in other words, is about to stop importing capital very suddenly.  I discuss this more generally in my May 19 blog entry.

This leaves the US.  Because it has the largest trade deficit in the world it is also the world’s largest net importer of capital.   So what will the US do?

At first nothing.  As net capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees net capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if US net capital imports surge.  And at first they will surge.  Foreigners, in other words, will buy more dollar assets, including USG bonds, than before.

But remember that an increase in net US imports of capital is just the flip side of an increase in the US current account deficit.  This means that the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.

I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior.  It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.

The US, in other words, is not likely to face the “nuclear option” of a Chinese disruption of the US Treasury bond market.  It is far more likely to be swamped by a tsunami of foreign capital.  This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment.  It will also force the US Treasury to increase the fiscal deficit as more of the jobs created by its spending leak abroad.

Therein lies the problem.  A reduction in net foreign capital inflows means a welcome decline in the US trade deficit, but the US is likely to see just the opposite.  Foreign capital will push desperately into US markets and as an automatic consequence the US trade deficit will surge.   So the problem isn’t too little capital inflow or a sudden boycott of USG bonds.  On the contrary, the US will see too much capital inflow.

All this may turn out to be very bad for the US economy, but in the past massive capital recycling has usually been very good for asset markets.  Might we see a surge in the US asset markets, at least until next year when Congress starts getting tough on the trade deficit?  I would be willing to bet that we do.


To move on to the second subject of today’s posting, net new lending for June was RMB 603 billion.  This is a huge drop from last June’s RMB 1,530 billion but, before we get too scared, remember that last year saw an astonishing explosion in lending.  June 2008’s total new lending was a more typical RMB 332 billion.

That leaves us with new lending year to date at 62% of 2010’s total quota.  It is hard to read too much into this ratio.  By this time last year we had already disbursed 77% of the year’s total, although a lot of that was short-term loans made to beat the quota.  By comparison in 2008 total new lending in the first half of the year accounted for 50% of the annual total,

What’s more, these new lending numbers may be totally distorted.  Charlene Chu and her team at Fitch Ratings, as usual way in front when it comes to sniffing out rotten things in the banking system, in a July 2010 report (“Chinese Banks: Informal Securitisation Increasingly Distorting Credit Data’) warns that there is an awful lot more “securitization” (also known as moving loans off the balance sheet) going on than is being recorded.  Included in their rather disheartening report is this chilling passage:

Data on the sale and repackaging of loans into CWMPs has always been sparse, but, historically, observers have been able to track activity by the number of CWMPs issued each month using information collected by small third-party data providers. However, as public scrutiny of informal securitisation has risen, Fitch has observed a noticeable worsening of Chinese banks’ already poor disclosure of this activity.

Some banks very actively engaged in transactions last year are showing up in 2010 data as minimally involved, yet the bank’s own salespeople (responding to Fitch’s enquiries) state that business remains as strong as ever. Meanwhile, private placements of products to institutional investors are becoming more commonplace, most of which are never disclosed to any entity but the CBRC. Because of this worsening in disclosure, data from third-party providers is capturing less and less transaction flow, with as much as 40% of deals in H110 going uncaptured, versus less than 10% prior to end 2009.

I have no idea of whether or not something risky is happening here, but I usually take it as an article of faith that when bankers spend more time obfuscating transactions (for example, check out Naked Capitalism’s worrying take on the European Financial Stability Facility), it is because there is a lot more they prefer us not to see.  Of course, I might just be wrong.

Real estate declining

At any rate credit creation drives growth in China, especially credit in the real estate market, and the slowdown in lending compared to last year seems to be having an effect.  Average real estate prices across the country officially declined in June, with many of us believing that there is a lot more to come.  Here is the relevant article in Monday’s South China Morning Post:

Mainland property prices in June recorded their first monthly fall since February last year, providing further evidence that a government drive to let the air out of an inflated market is working.

Average prices in 70 cities edged down 0.1 per cent from May, lowering the annual property inflation rate to 11.4 per cent in June from 12.4 per cent in the year to May and April’s reading of 12.8 per cent, the National Bureau of Statistics said on Monday.

Monday’s People’s Daily was a little less negative.  The entire article says:

Housing prices in major Chinese cities rose 11.4 percent year on year in June, one percentage point lower than the increase in May, the National Bureau of Statistics said Monday.

Apartment sales are way down in most big cities and last week’s South China Morning Post reported a “shocking” number of empty apartments:

Mainland’s property market remains dangerously overheated and failing to tame the speculative bubble could threaten financial and social stability, a prominent economist said in an official newspaper on Friday.

Yi Xianrong, an economist at the Chinese Academy of Social Sciences, a government think tank in Beijing, noted estimates from electricity meter readings that there are about 64.5 million empty apartments and houses in urban areas of the country, many of them bought up by people wagering on a constantly rising property market.

In the overseas edition of the People’s Daily, Yi said the ”shocking” level of empty housing showed the dangers brought by the country’s property boom, which the central government has been trying to cool.

And it is not just the real estate sector that seems to be slowing.  John Garnaut has a very good (as usual) article in Tuesday’sSydney Morning Heraldabout the hard economic choices China faces.  He points out the recent decline in steel production and discusses what seems like major misallocation of capacity in wind power generation – a symptom perhaps of the haste to invest in prestige projects without clear economic benefits.

Meanwhile, perhaps as a harbinger of the coming debate about currency appreciation, China’s textile lobby group is issuing dire warnings.  according to an article in Tuesday’s People’s Daily:

Half of China’s textile companies risk going to the wall if the yuan appreciates 5 percent against the US dollar, an industry lobby group warned.China National Textile and Apparel Council Vice-President Gao Yong attributed this knife-edge existence to the industry’s thin profit margins of around 3 to 5 percent.  ”If the yuan actually appreciates 5 percent against the US dollar, over half of China’s textile companies will go bankrupt,” Gao said.

…More than 20 million people are directly employed in China’s textile industry, while a further 140 million are involved in cotton farming, according to the Ministry of Commerce. Therefore, a large upward revaluation of the yuan could cost millions of jobs.

Time to relax?

In this context it is interesting, and significant, I think, that I am hearing rumors that there is an increasingly urgent argument within policymaking circles about the whether or not we need to maintain relative tightening, especially in lending and real estate.  One group – perhaps include the next generation of leaders? – has been arguing that it is too soon to start relaxing and that Beijing needs to keep its foot on the brakes.

The other group is claiming that the economy is decelerating too quickly, and it is time once again to reverse course.  The head of one of China’s Big Four banks, for example,  seems to agree with the latter.  According to an article in Monday’s Financial Times:

Faltering confidence in the Chinese economy could threaten the plans of the country’s banks to shore up capital reserves, the head of China Construction Bank, has warned.

…Guo Shuqing, the chairman of China Construction Bank, said overall confidence in the economy was more of an issue than the availability of investor funds. “The risk is not the volume of issuance that will come from the banks, such as ABC’s IPO. It’s more people’s confidence, how worried they are about the Chinese economy in general,” he said.

Mr Guo played down concerns about China’s property bubble and the damage that could do the banks’ asset quality, saying “the value of mortgages is only about 15 per cent of GDP, much lower than in Europe and the US.”

…He also rejected alarm generated by a recent wave of reports about sky-high local government debt in China, which some analysts have put as high as Rmb7,000bn ($443bn). Mr Guo confirmed that the regulator had asked banks to slow lending to local government companies but said that many of them were in fact cash-generative businesses which could service their loans. “Quite a lot of these companies are commercial companies, which are operating businesses with cash flows, like tollways, ports and railways. Many of these cities and counties are developing very fast, so there is no problem in paying back these funds.”

Mr Guo quoted estimates of local government debt of Rmb3,000bn, only about one-third of which were to companies which are not generating cash flow. “The total government debt to GDP is very low in China. Even if it increased by about 10 percentage points, it would only be about 30 per cent. So it is very affordable.”

Obviously Mr. Guo has very different estimates – or at least definitions – of government debt levels than mine, but clearly he and many like him seem much less concerned about overheating than about a too-sudden stop. Regular readers know that in my view for the past two years we have veered from panic to panic – stomping on the accelerator at one time and then stomping on the brakes as few months later – and I think it is only a question of time before growth slows sharply, and we panic once again and stomp on the accelerator.

Perhaps not every research analyst agrees with me. In the the SCMParticle cited above they quote a very welcoming Merrill Lynch as saying, about the renewed push among Chinese banks to expand real estate lending,“Banks always like to test the resolve of policymakers. We are glad to see more people are coming around to our view that there will be no policy reversal and policy easing very soon on the property front.”

But I am not sure there will be much alternative. Beijing wants to keep growth stable while reducing China’s reliance on the “bad” growth caused by real estate bubbles, unsustainable borrowing, and more excess capacity.  But what if the only growth we’ve got is bad growth? 

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