I am traveling in DC, NY and Boston over the next few days, and between meetings and jet-lag it is hard for me to do much on my blog, but I did want to extend a short piece I wrote that was published yesterday in the South China Morning Post. This is because it is about central bank reserves, a topic that to my dismay probably generates more confused and mistaken thinking than any other topic in economics.
As many of my readers know (although I have not made any reference to it on my blog) hedge fund manager Jim Chanos recently made some headline-inducing claims about China. Chanos, a successful hedge fund manager who has made his reputation – and fortune – by identifying and shorting seriously overvalued assets, most famously Enron, seems to have read the PivotCapital piece that got a lot of attention last year, and partly as a consequence he claimed that China is undergoing a speculative bubble that makes it the equivalent of “Dubai times 1,000 – or worse”.
His claim was met with incredulity by New York Times columnist Thomas Friedman. Freidman is best known for his writings on globalization, and although I have no doubt that he is a very smart man when it comes to getting politics right, especially in the Middle East, which I believe is his area of specialty, I also have no doubt that he does not understand China much and understands almost nothing about central bank reserves and the functioning of the global balance of payment. I have read many of his articles, and so far I am pretty sure that these aren’t his strong points.
In response to Chanos’ claim Friedman made a number of very questionable statements about China. These are matters of dispute and although I think they are completely wrong, they are at least defensible. For example he says its true that there may have been risks of bubbles. ”In the last few days, though, China’s central bank has started edging up interest rates and raising the proportion of deposits that banks must set aside as reserves — precisely to head off inflation and take some air out of any asset bubbles.”
Really? I think you have to be a tad credulous to believe that the RMB 7.5 trillion lending target for 2010 and the slightly higher interest rates represents taking air out of the asset bubble. I would argue that they simply mean that the astonishing rate at which they were pumping air into the bubble has moderated slightly, to merely excessive.
He also says:
Now take all this infrastructure and mix it together with 27 million students in technical colleges and universities — the most in the world. With just the normal distribution of brains, that’s going to bring a lot of brainpower to the market, or, as Bill Gates once said to me: “In China, when you’re one-in-a-million, there are 1,300 other people just like you.”
Aside from perhaps his overestimating the quality of the education system, this is very bad statistics, and perhaps shows how easily we can get intellectually overwhelmed by large numbers. If China indeed has the same distribution of geniuses, or talent, as other countries, the fact that it has so many people won’t make it richer (and what about India?). After all if you cut China into four countries, each country will have only one-fourth the number of geniuses. Does that really mean that the four countries together are stupider? If we combine the US, Canada and Mexico into one country, its a pretty safe bet that the total number of geniuses will be more than any of the three countries currently possess, but will average intelligence rise? Can we really make the three countries richer that way (of course there may be good economic arguments for suggesting that unifying North American into a single country will make it richer, but the larger number of geniuses is not one of these arguments).
Ok, we can argue about these things, and we can agree to disagree, but where he completely blew it was, I suspect, on the one topic are where he was absolutely certain he could not be wrong.
Too bad, because he was. Friedman proposed, yet again, a common misconception over the meaning of China’s huge accumulation of foreign reserves. He argued that thanks in part to the size of the reserves it would be impossible to make money by shorting China. “First,” he warned, “a simple rule of investing that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.”
Really? Friedman proposed the rule sarcastically – as both untestable and too obvious to need testing. It is so obvious that no country has ever had such high levels of reserves, so you can’t really test the hypothesis, but it’s also pretty obvious that a country with $2 trillion in reserves is in great shape. Anyone who wanted to short it must be pretty stupid, right?
But it turns out that reality is not as obvious as he imagines. Let us leave aside that the PBoC’s reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion. China’s foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.
But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.
The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP. My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.
The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan’s accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China’s does today.
Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.
Japan’s subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.
The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves. Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.
Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s. The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) are of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system.
These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies. And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).
In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.
It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.
We must be careful how we read history. The fact that the US and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched, and under conditions similar to those of China, does not necessarily mean that China too must have a lost decade or two. Chanos is not being crazy when he worries, but it is still an open question as to whether or not he will turn out to be right.
But the history does indicate that facile statements about central bank reserves should, at the very least, be measured against the obvious historical precedents. Chanos might still lose this debate, but Friedman has already proven himself to be hopelessly wrong.