Thursday, March 29, 2012

China's Foreign Reserves: What they Mean and How they Can be Used

China's Foreign Reserves are huge. Indeed they are among the largest foreign reserves in the history of the world.

Historically two other countries held huge foreign exchange reserves - the United States in the 1920s and Japan in the 1980s. Neither of those experiences ended well. 

Many commentators see these huge reserves as a marker of growing Chinese power and consequently, of American weakness given that a good deal of those reserves are invested in US dollar assets. I've also seen it written that China should use these reserves to spend within China instead of buying foreign currencies. The problem with this view is that they can't be used domestically. The best explanation on this topic comes once again from Michael Pettis.

In a post entitled "What the PBoC Cannot Do with its Reserves", Pettis starts by explaining how the Peoples Bank of China (PBoC - China's Reserve bank) goes about keeping the renminbi (RMB) (the yuan if you prefer - see here for explanation) at a lower level.
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.
No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price.  That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency. 
Now the reason the PBoC must buy dollars under the regime is because the rest of China is a net buyer of dollars. Remember China runs a current account surplus, which must be matched by a net capital outflow. 
This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market. Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest. 
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.
The next issue is how the PBoC funds these purchases of dollars.
It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars. 
This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets). Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits). 
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. 
Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility).
Pettis then goes on to explain why a revaluation of the Renminbi against the dollar does not cause the simple scenario of huge losses for China and huge gains for the United States that most commentators allude to when they discuss the so-called economic balance of terror between the United States and China. There are still winners and losers, but the equations are more complex than most assume.
Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves. After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms. 
This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency. One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.
Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become.  The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings.  Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt
An appreciation of the RMB cannot reduce the cost of the US government's debt obligations because:
The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets.  Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt. 
But this doesn't mean there aren't winners and losers including within China. Working them out requires an analysis of the "various balance sheets".
In a nutshell, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains.
For China, the equation is the same. Those who are short US dollars will gain. 
There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but 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.
Some people might make a more sophisticated argument that since China is a net creditor – i.e. it is net long dollars – it will lose by a revaluation of the RMB.  This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.
This is where it gets even more complicated.
If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one. It does not “realize” the loss, however, until it revalues the RMB to its “correct” value. 
In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation.  It occurred the very day the trade took place. When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB. This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB. 

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter).  Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that. The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take.
So a revaluation of the RMB will not cause any real loss to any Chinese entity today.  The loss already occurred but hasn’t been realized.
But wait, 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).
But there are important impacts within China. Who wins and who loses depends "on the structure of individual balance sheets." 
Basically everyone who is net long dollars against the RMB loses in an appreciation, and everyone who is net short dollars against the RMB wins.

Who loses?  Of course the PBoC is a big loser.  It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.
Exporters and their employees, too, are naturally long dollars and so they would lose. They are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.
Chinese companies with more assets abroad then foreign debt might also lose. 
Who wins?  Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life. The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team. Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB.
Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country. Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption. This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.
So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China.
But the fact that the PBoC loses big time does actually matter and although Pettis doesn't mention it, it would actually lead to the same sort of structural changes in the Australian economy that many people in Australia are worried about right now - namely a decline in manufacturing and (traded) services competitiveness. Pettis's point probably is that the rise in household wealth would help to balance the economy away from the investment and export dominated growth model.
But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them?
Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts. 

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP.  This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss.  (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be).   In that sense 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.
Simple right? If you're confused, you're not alone. It is easy to see why so many writers assume simple effects and consequences of actions because the real world complexity of a change in the value of the RMB is much harder to explain. Much easier just to say China loses from a revaluation of the yuan against the dollar!

Still I wouldn't want to betting on the certainty of anything in this field. As Keynes once said: "Markets can remain irrational a lot longer than you and I can remain solvent."

Friday, March 9, 2012

Graphs that Show a Little Pain: Mining, Manufacturing and Services

In my last post I included a graph showing the high level of mining investment past, current and prospective. The graph was from a speech the other day by Deputy Governor of the RBA Philip Lowe elegantly titled "The Changing Structure of the Australian Economy and Monetary Policy

The happy graph is this one. 

Mining investment is as high as its ever been in Australia, but this doesn't necessarily mean that all is fine in the Australian economy.

Lowe also discusses a range of other graphs that show how some parts of the economy are struggling.

The first graph below uses 2000 as its starting point and considers outcomes since that time.  Manufactured exports were growing substantially until the GFC, with the parts of the sector clearly becoming more export oriented (consider exports in ratio to output). Part of the cost of this transition was a gradual decline in employment. Since the GFC, exports and outputs have recovered somewhat although still well below the pre-crisis peak and well below the general recovery in world manufacturing trade, which has exceeded pre-crisis highs. Unemployment in the sector, meanwhile, has fallen in a hole.

It's harsh to say it, but the survival of the manufacturing sector (and remember that it's a remarkably varied sector) is probably dependent on more job losses as firms restructure and focus on higher value-added activities. Steel production, for example, is not going to survive in its current form. Car production is also probably dead in the water over the longer-term unless the government does something more than simply providing regular gifts to American and Japanese car companies to keep producing cars in Australia.

Just imagine the potential results for Australia's hi-tech manufacturing future if just 10 per cent of that largess delivered to American and Japanese investors had been put into research on new engine technology. Instead we paid the car companies to keep producing cars that fewer and fewer people wanted.

There is some indication that the manufacturing sector is restructuring in a good way in that a greater percentage of firms are embracing new operational processes than in other industries. Once again this means higher productivity and clearly fewer employees as a percentage of output. Currently manufacturing employs about 950,000 people and accounts for about 9% of output. As Lowe argues:

Realistically, Australia cannot hope to be a large-scale producer of relatively standardised, plain-vanilla, manufactured goods for the world market. But what we can be is a supplier of manufactured goods that build on our comparative advantages: our educated workforce; our ability to design and manufacture specialised equipment; our reputation for high-quality food; our research and development skills; and our expertise in mining-related equipment.
Inevitably, the high exchange rate means that the manufacturing industry has little choice but to move up the value-added chain in order to compete. This is, of course, a lot easier to say than to do. It means difficult changes for many firms and those who work for them. It also means ongoing investment in human capital and the latest machinery and equipment and constant attention to improving productivity. One piece of evidence that things are moving in this direction is in the ABS business characteristics survey, which asks firms a series of questions about innovation. In this survey the manufacturing sector clearly stands out as one where firms are actively reviewing their business practices and, over recent times, they have been doing this more frequently.

Two significant sub-sectors that have been growing are "professional and scientific" and "specialised machinery", while cars and metals and construction manufactures are in a dangerous decline. The problem for the car industry is that there is overproduction throughout the world and especially in Europe.

Another sector that has been doing poorly is tourism, although some sectors of the accommodation sector have not been doing so badly, highlighting that there is restructuring going on within sectors, not just between them (as in manufacturing above).

As those of us who live in Queensland will have noticed, tourism is in deep trouble. Sydney, however, is doing well as business travel remains high and as tourists seek city-based experiences rather than coast-based experiences. The floods and La Nina have probably not helped Queensland tourism.

Another sector that is going through a tough time is the real estate industry. Not only are prices in decline, but turnover rates have more than halved from their peak in the early 2000s. The fall over the last few years has also been significant. The trend is clear despite a couple of rises before and after the GFC. I live near a high street that must contain at least 6 real estate agencies on one side of the road over a distance of no longer than 200m. Might be difficult to maintain that sort of penetration of Logan Rd Holland Park if the turnover trend charted below continues.

As with accommodation, retail is a sector with varying fortunes. Clothing, footwear and accessories are doing poorly as are Department stores, but other retailers are doing quite well.

As I argued in The Internet and the Death of Retail the problem for the bricks and mortar part of the sector is not yet because of Internet sales, which are less than 5 per cent of overall sales, with o/s sales even smaller at about 25 per cent of total Internet sales.

Nevertheless, a recent study by the NAB reported that online retail had been growing rapidly, although the rate of growth slowed in the second half of 2011.

Australian retailers are not, therefore, powerless to take advantage of the Internet. Australian businesses, even those with stores, can sell online as well. But a little hint here to Rebel Sports and Super Amart, things have to be cheaper online.

After trying to find some running shoes in the US, I found that many of the cheaper retailers wouldn't sell directly to Australia, although there were companies that would provide you with a US address and then send the goods to your Australian address. This seemed more trouble than it was worth after I found an Australian site - - that sold shoes much more cheaply than the bricks and mortar retailers.

Undoubtedly we live in interesting times and clearly some sectors (and sub-sectors) are doing much better than others.