Morgan Stanley's Wang Misreads China

Last week, Morgan Stanley's China economist, Qing Wang, circulated a Forbes article keyed off his quotes regarding China's stimulus spending.

The article and his quotes contain some deeply flawed reasoning, which I think is worth highlighting because it illustrates some commonly held misconceptions, ones that seem especially prevalent within China.

I invite you to read the whole article, but you can catch the gist of Wang's argument here:

Since China has to invest its record foreign reserve holdings of $2.1 trillion anyway, building more roads and bridges at home will likely generate better returns in the long run than buying U.S. government debt, Morgan Stanley says . . .

. . . Thus the question becomes simpler and clearer: whether China should use its rising reserves to build more bridges, roads, and railways; or to buy more US government bonds – which is what China’s central bank does with most of its vast foreign exchange holdings.

“In view of the negative consensus outlook for US government bonds, we think that infrastructure investment is a better alternative for deploying China’s savings, especially when the cyclical conditions warrant a strong boost in domestic demand in a relatively short period of time,” Wang concluded.

For China, building bridges is a better bet than buying bonds.

There are two main problems with this line of reasoning. First, it presumes that China is reallocating its savings from U.S. Treasury bonds to domestic infrastructure investment.

But China's foreign currency reserves are not fungible in this way. When the Chinese choose to accept dollars for their exports, they receive dollars, and those dollars don't just disappear. The Chinese can sell them to someone else who wants dollars (which would decrease the value of the dollar relative to the RMB or whatever other currency the Chinese preferred to possess). Or they can buy goods, services, or assets denominated in U.S. dollars (usually imports from or property located in the U.S., but also global commodities such as oil).

Since China is generally unable or unwilling to allow these two actions, and their consequences, the Chinese government must buy the dollars and hold them itself, mainly in the form of U.S. sovereign securities.

But the point is, the portion of Chinese savings that arises from consuming less than it produces, and selling the excess abroad (in order maximize growth), is denominated in dollars (or other foreign currencies) and must be spent in dollars. If China doesn't want those dollars, or doubts their value, it has a simple option: demand more dollars in exchange for same goods, i.e., appreciate the Renminbi.

But China doesn't want to do that, because it want to keep selling, so it keeps piling up more and more dollars.

Wang's point would make sense if China's stimulus was being spent to buy goods and services from the U.S.--say, bulldozers to build roads or MRIs for new hospitals. In that event, China could take saved dollars invested in U.S. Treasuries and reallocate them to buy U.S. imports. But that is not what we see happening. And China's recent adoption of "Buy China" regulations for its stimulus package essentially guarantees that we won't.

China's stimulus investments are savings, to be sure. They have to be funded, either by issuing government bonds, or raising taxes, or through inflation (which is effectively a silent form of taxation). But this is new savings, on top of the dollar-denominated savings accumulated from its trade surplus. China isn't reallocating savings more effectively, as Wang would have it. It is adding to savings, at a time when most economists believe it should be decreasing its savings rate.

The second problem with Wang's analysis is it assumes that, just because U.S. Treasuries may not be the optimal investment, anything must be better. Right now, the nominal yield on a 10-year Treasury note is about 3.6%.

But the criticism of China's grander stimulus projects--one I can validate from my recent travels around the country--is that many of them may end up being "white elephants" that produce negative returns on investment.

I recently visited a brand new state-owned steel mill in Liaoning Province that, after a year of operation, had yet to fire up its furnace because of global overcapacity. Surrounding that plant, as far as you could see, were leveled construction sites where a huge new city was being built to accommodate roughly 3 million people. And this was just one of several massive port and industrial projects in the immediate vicinity--China's stimulus money at work. Visually impressive, yes. It provides jobs, too. But I'd never invest. I'd far prefer to put my money in safe, low-yielding Treasuries.

Wang raises two counterpoints that have some validity. First, he says these projects may have social benefits--positive externalities--that will enhance China's overall productivity, and therefore cannot be evaluated purely by looking at commercial returns.

True, but I'm not wholly convinced, particularly if the negative commercial returns involve substantial loss of capital. Purely social goods like water purification, parks, and health clinics may produce more benefits than they consume as cost centers. But 50% of China's RMB 4 trillion approved stimulus is earmarked for transport and other infrastructure projects--railroads, highways, airports, dams, power plants--that really should pay for themselves. If they don't, you have to wonder if they are viable.

China does need infrastructure, particularly in its less developed interior, but I've also seen plenty of examples of political vanity projects and other boondoggles that have never justified their costs. Shanghai's maglev train, which runs from the airport to the middle of nowhere, and thus carries virtually no passengers (although it runs constantly), is merely the most glaring example.

Second, Wang hints at Chinese fears that inflation in the U.S.--brought on, ironically, by rampant stimulus spending, which Wang now seems to assume is unproductive--might undermine the value of the dollar. If that were the case, real after-inflation returns on U.S. Treasuries could be negative for China. It is true that such fears partly account for the market demanding higher yields on 10-year Treasuries, up from 2.1% in December 2008.

But yields are still lower than they were a year ago, before the real crisis broke. That implies that most global investors still find Treasuries a relatively attractive option, particularly as a "safe harbor" for capital preservation.

I will admit that the second point, about the relative risk-adjusted returns of U.S. Treasuries versus China's infrastructure investments, is arguable. It really amounts to a judgment call on U.S. finances and Chinese state planning.

But the first point, regarding the non-fungibility of China's dollar-denominated savings, is far more important. There is no "better way" to use China's foreign currency reserves, as long as it remains wedded to an export-dominated growth model. They cannot be "reallocated" to fuel purely domestic growth. The only way to unlock China's savings is for China to open its economy to buy and invest more abroad. "Going it alone" is simply not an option.

Disclosure: No positions

Comments

[sligoo:]

It is never too late to pick up more shares in FXI. This is a basket of the best companies in China that are as "safe" as you can find.

Aug 16 09:18 AM

[James Lewis:]

Qing Wang from Morgan Stanley should go and work for a Chinese Bank where they can all agree how amazing China is and how rubbish the USD IS.

I havce read her piece and frankly its the biggest load of garbage I have ever read. I thought economists are meant to be driven by objective analysis by economic indicators not driven by 'pseudo-nationalism'


The only reason why China holds its holdings in USD, is because if they sold them. The RMB would rise to its natural level and further erode China's export driven economy. Not to mention devalue their current holdings.

China should not be moaning about the dollar being devalued relative to the RMB because they are setting the initial rate. By running a mercantile agenda they are also making it impossible for the USA to do anything but create more money through QE. Maybe if they imported as much as they exported for the past 8 years. The USA would have other options. On this point China should expect a 'depreciation charge' on their USD holdings, due to the monopoly on manufacturing they are trying to create by circumventing every free trade and WTO rule in the book.

To then go and say that building useless roads that lead to no where. Dams that are totally useless. Is o.k. because it has a number of other benefits to the PEOPLE. Rubbish, how about instead of building useless roads, the money is spent on giving the Chinese clean drining water, improve the polluted air. Raise the living standards on those left behing in the west.

I really wish these people would be true nationalists and genuinly care about the people. As apposed to living a fantasy world.

Aug 16 02:59 PM

[johnqh:]

Is there a confusion what foreign reserve is in the financial circle?

Foreign reserve is not debt (or even trade surplus) owned by the government. Rather, businesses make money in USD by exporting, and held the USD in local banks. Add hot money and simply USD holdings by locals, you get a huge sum of USD (2T) which the banks hold.

The banking system held the USD for their clients, and have to use the USD in some safe way to earn some investment income. By holding US treasury and make 2% to 3%, but only paying the account holders 1%, the bank make some money.

Foreign reserves is not owned by the government. It is the collective holding of foreign currencies of all entities in the country.

Knowing that, Chinese government does not own 2 trillion US treasury. Rather, the collective Chinese economy (through banks) own it.

So, Qing Wang's article makes no sense. 1. The stimulus spending is made in RMB, not USD. 2. The stimulus add to the government deficit. It has nothing to do with foreign reserve holding.

Aug 16 08:04 PM

[fran:]

TWO POINTS--

is the chinese stimulus spending more wasteful than that of the current stimulus of USA toward future growth/productivity?
seems like the USA is buying little that will strengthen our future competitive posture.

the chinese actions remind me of USA actions of 1950s/1960s--build infrastructure and industrial capacity for future national growth. i remember this USA action well; i worked on the initial interstate system. my father supervised building the construction materials infrastructure industry for this investment.

it matters little about the what/how of chinese use of reserves. they have the reserves; the USA doesn't have the reserves.
all we have is debt and impending bankruptcy.

Aug 17 09:48 AM

[Tony Daltorio:]

The article is nothing more than the usual biased American crap about China.

If the author was in China, why did he only go to areas like Liaoning Province in eastern China? Perhaps he didn't want to see anything that would not fit with his preconceived notions about China.

Of course, a biased commenter like James Lewis wouldn't even bother to visit China since he already "knows" everything about China.

American usually only talk about the eastern, coastal part of China which is dependent on US exports. They ignore the western and central parts of China which are booming and have little exposure to the US and where you can really see Chinese internal consumption coming to the fore.

Aug 17 01:17 PM

[lazzybum:]

To James Lewis

China's export droped over 21% last month. US and Europe are not buying. China is still doint fine. Thank you. The truth is that US consumer sector accounts 70% of the GDP. This is ridicules. We need to save more, like the Chinese people. We need to produce more, like the Chinese. Envy will not get you out of poor house.

Aug 17 05:56 PM

[HaavBline:]

I am not an economist. But it seems to me those economist who accuse other economists of not knowing the basic concept about the Foreign Exchange Reserve is probably at risk of living in the Ivory Tower themselves. In this case, Qing Wang from Morgan Stanley China is talking about make best USE of the Foreign Exchange Reserve, not about who OWNS that Reserve. That is not as much of a conflict as you might think.

I think a close enough analogy can be made to house owernership. Many American house 'owners' now have close to ZERO equity of the house they 'own', yet they continue to have the right to live in it and can make whatever use or abuse of the house even thought their mortgage banker own close to 100% of the equity of the house.

All central banks in the world have a way of deciding how the Foreign Exchange Reserve can be invested, managedm or leveraged, even though technically they don't 'own' those reserves.

Aug 22 12:29 AM

[sasha sha:]

Patrick Chovanec,

I don't know who you are, and what's your motive, but I felt compelled to at least point out one example of your glaring lack of truthfulness in your description of China's state plan...

You said that "...Shanghai's maglev train, which runs from the airport to the middle of nowhere, and thus carries virtually no passengers (although it runs constantly), is merely the most glaring example."

Nothing could be further from the truth. I was there in Shanghai in August last year. I took the maglev train. It was nearly full. It took about 8 minutes from the airport to one of the busiest section of downtown Shanghai: JingAnShi. You must be either an ignoramus or someone with a twisted mind to call JingAnShi 'middle of nowhere'... It was an awesome 8-min ride, which would otherwise take about 75 minutes... It does not run constantly. You have to wait for one of the shifts ...

I stop here... I cannot help but wondering how editors at Seeking Alpha sort out facts from opinions ... unless they are there themselves...

Aug 24 10:45 PM

[Patrick Cho...:]

I'm glad you enjoyed the maglev ride, and that it was convenient for you. I can only say that my experiences visiting Shanghai have been different than yours, and that my opinion of the project is widely shared.

Not that Wikipedia is an indisputable source or anything, but for convenience I would refer you to their entry for "Shanghai Maglev," which states "Following the opening, overall maglev train ridership levels were at 20% of capacity. The levels were attributed to limited operating hours, the short length of the line, high ticket prices and station at the upmarket financial hub of China in Pudong at Longyang Road Terminus." It also notes that in 13 June, 2007, Asia Times reported that it "could hardly be called a commercial success", in part because "it virtually goes nowhere".

It could be that these observations do not agree with yours, or that they are out of date. But I assure you, my comments weren't made out of malice.

On Aug 24 10:45 PM sasha sha wrote:

> Patrick Chovanec,
>
> I don't know who you are, and what's your motive, but I felt compelled
> to at least point out one example of your glaring lack of truthfulness
> in your description of China's state plan...
>
> You said that "...Shanghai's maglev train, which runs from the airport
> to the middle of nowhere, and thus carries virtually no passengers
> (although it runs constantly), is merely the most glaring example."
>
>
> Nothing could be further from the truth. I was there in Shanghai
> in August last year. I took the maglev train. It was nearly full.
> It took about 8 minutes from the airport to one of the busiest section
> of downtown Shanghai: JingAnShi. You must be either an ignoramus
> or someone with a twisted mind to call JingAnShi 'middle of nowhere'...
> It was an awesome 8-min ride, which would otherwise take about 75
> minutes... It does not run constantly. You have to wait for one of
> the shifts ...
>
> I stop here... I cannot help but wondering how editors at Seeking
> Alpha sort out facts from opinions ... unless they are there themselves...

Aug 31 11:16 AM

[pweicorpnyf...:]

I am originally from Shanghai and I agree with Patrick. Even though capacity can rise occasionally, on average it's very much sub par due to several factors Wikipedia mentioned.

Sep 01 09:51 AM