In 1956, Mao Zedong described the United States as a paper tiger:
In appearance it is very powerful but in reality it is nothing to be afraid of; it is a paper tiger. Outwardly a tiger, it is made of paper, unable to withstand the wind and the rain. I believe that it is nothing but a paper tiger.
Today, as Chinese foreign exchange reserves top $4 trillion, it too may be a paper tiger. The level of FX reserves are impressive to behold, but it may be unable to "withstand the wind and the rain." That's because the $4 trillion in reserves doesn't just sit there burning a hole in China's pocket.
Large FX reserves have costs
Consider this account from the San Francisco Fed of what happens when the PBoC gets USD in reserves:
Consider the example of a Chinese exporter earning $100 in U.S. currency from sales of goods to foreign buyers. Under China's closed capital account, the exporter is required to sell the $100 to the central bank at prevailing exchange rates, which currently equals approximately 600 renminbi in domestic currency. The central bank then invests its $100 in foreign assets, say U.S. Treasury bonds. If the central bank did nothing further, then China's money supply would go up by 600 renminbi. To avoid inflation, the central bank sterilizes the transaction, that is, it withdraws 600 renminbi from circulation by selling domestic assets worth that amount and retiring the proceeds.
That process of selling the RMB 600 in domestic bonds is called "sterilization." Of course, the process isn't perfect and there is a negative carry to the process under a closed capital account and fixed exchange rate regime. When Chinese domestic interest rates are higher than U.S. rates, it encourages a long RMB-short USD carry trade and, under a floating exchange rate system, the RMB should depreciate, not appreciate as many in the United States would like to see:
But what if the renminbi-denominated assets pay a higher interest rate than the U.S. Treasury bond? In that case, the central bank exchanges a higher-yielding asset for a lower-yielding asset, posting a loss. Thus, the PBOC faces a tradeoff. It either takes a loss from sterilization or it risks increasing inflation by expanding the money supply. Importantly, this tradeoff only happens under a closed capital account regime in which exporters can't hold foreign assets.
It seems that some of the leakages from unsterilized currency imports and the inflation rate differential have combined to balloon Chinese domestic debt. Indeed, Bloomberg reported that Chinese total corporate debt now exceeds total U.S. corporate debt:
China now has more outstanding corporate debt than any other country, having surpassed the U.S. last year, 12 months sooner than expected, S+P said.
Cash flow and leverage at China's companies, while better than global peers in 2009, have worsened in subsequent years, according to S+P, which compared corporates in Asia's biggest economy with more than 8,500 listed companies globally.
This development has increased the level of risk for the global financial system (emphasis added):
China's corporate issuers account for about 30 percent of global corporate debt, with one-quarter to one-third of it sourced from China's shadow banking sector, S+P said. That means as much as 10 percent of global corporate debt, about $4 trillion to $5 trillion, is exposed to the risk of a contraction in China's informal banking sector.
Michael Pettis (via FT Alphaville) became concerned when Chinese debt began going external. In effect, Chinese SOEs were borrowing on the back of the excellent credit rating of Beijing, while the financials of the SOEs tend to be poor on a standalone basis:
My concern was that as China began to face borrowing constraints from within its banking system, Chinese borrowers would be able to exploit China's excellent external credit ratings, its huge foreign exchange reserves, and the residual global excitement over China's unlimited economic potential, to turn to foreign creditors to raise money. It would be easy for Chinese borrowers to fund domestic projects with foreign money.
This, I suggested, was potentially very dangerous. If domestic debt capacity constraints were a consequence of poor investment decisions, the "correct" resolution of the problem was to constrain investment and redirect it into more productive, if less politically popular, projects, not to open new avenues of credit creation for the same old borrowers. The latter would only lead to even greater hidden losses and what is more would increase China's vulnerability to foreign capital markets, perhaps even subjecting China to the risk of a "sudden stop" in foreign lending.
For now, SOE credit quality does not seem to be an immediate problem:
This isn't happening yet. We are nowhere near the danger point for foreign borrowing in China. My sense is that foreign debt has risen quickly in the last year, but is probably only equal to roughly one-quarter of reserves, which is a fairly "safe" level. In fact I have no doubt that China specialists on the sell side will assure investors that it is silly to worry about foreign debt at all - just as they assured investors four and five years ago that it was silly to worry about domestic debt.
But they will be wrong again, and for the same reasons. Their data-drenched but theory-poor analyses failed to understand the dynamics of the Chinese growth model during President Hu's administration (2003-13) and there is little evidence even today that they fully understand the causes of the debt problem which, at least, they now readily recognize. Even a decade ago it should have been obvious that growth in China required mechanisms that severely unbalanced the economy and forced debt up faster than debt servicing capacity.
I detailed how Chinese non-RMB denominated external debt had reached $1 trillion (EM tail risks are rising). Today, many foreigners appear awed by the mountain of Chinese FX reserves. But it seems that holding such enormous foreign exchange reserves comes with unexpected consequences in the form of imbalances, such as inflation, bubbles and a risky buildup of debt that could eventually blow-back into the global financial system.
A paper tiger indeed!
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."
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