The IMF received its share of criticism over the past two weeks. 

The IMF governance structure is dated.  Europe is over-represented on the IMF board (and isn’t inclined to allow much change).  Asia is under-represented.    Countries guard their position on the board jealously.   The difficulty getting agreement on a modest ad hoc quota increase (Brazil and India objected because they were not among the winners) doesn’t necessarily bode well for the next set of more ambitious changes.

The IMF remains strangely (given its original mandate) unwilling to criticize countries with inappropriate exchange rate pegs (its silence on Saudi Arabia’s peg is a case in point; the IMF only delivers criticism in its regional outlook); hopefully the G-7’s call for the IMF to update its guidelines for exchange rate surveillance will spur a bit of change.

The IMF’s advice on how to reduce the surpluses of the world’s big surplus countries and the deficit of the big deficit countries is generally unheeded.    The US hasn’t shown any real commitment to balancing its budget over the economic cycle.  China has let its real exchange rate depreciate this year, even as its trade surplus exploded — not that you would know about China’s growing surplus if you just read the IMF’s public reports.   

For that matter, the markets — at least after June — don’t seem to share the IMF’s concern about imbalances.  Market players are bidding up the currencies of countries with large current account deficits (New Zealand, Iceland, the US – v. at least against the yen), and pushing the currencies of countries with surpluses down (Japan).

The IMF isn’t – despite what some argue – outgunned by the private markets.  At least not in the emerging world.  The $25b the IMF provided to Turkey is far more than the international sovereign bond market ever supplied Turkey (once you net out the bonds held by turkey’s own banks, which are effectively a foreign-currency denominated domestic loan).   But it is outgunned by the huge stockpiles of reserves held by many emerging markets.  $200b and change in loanable funds isn’t what it used to be. 

The IMF’s model for generating the income needed to pay its staff is in a bit of trouble.  The IMF used to pay its staff out of interest in got from lending to the big emerging economies ….  

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And exit an undervalued yuan; enter an undervalued yuan and a undervalued yen.

Schumer and Graham are dropping their bill – apparently for good.   It was pretty clear that they were unwilling to force the issue in any case.  Schumer represents New York City as well as Buffalo …

Manipulation and tariffs are out.  Misalignment is in. 

I think it is also quite clear that the Treasury will not find China guilty of manipulation this fall either.  Manipulation is not consistent with Paulson’s reputation as a China hand who works effectively behind the scenes.   Or with his recent rhetoric.  Though, consistent with past practices, it won’t actually issue the report clearing China until after the November elections.

The RMB — perhaps not coincidentally — broke through 7.9 today.  2006 may not prove be the year of the yuan, but September certainly has been the month of the yuan.  

Perhaps China is rewarding Paulson.   Or perhaps China’s top leadership decided in either July or August that they would allow a bit more RMB appreciation as part of a broader package of policy steps to cool their economy.

With August’s $19 billion trade surplus and accelerating export growth, it was rather clear that last July’s RMB didn’t devastate China’s export sector, to put it mildly. 

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• Dollar/ oil?
• The ten-year Treasury rate?
• The S&P 500?
• European policy rates?
• The fed funds rate?
• The RMB/ dollar?

At an on-the-record event at the Council on Foreign Relations this morning, Martin Wolf implicitly voted for the RMB/ dollar.  I can hardly disagree.

China has to purchase an awful lot of dollars — $250b this year and perhaps more next year – to keep the RMB from rising against the dollar in the face of China’s huge trade surplus and ongoing net capital inflows.   Those dollars are invested in US treasuries, agencies and mortgage-backed securities, helping to determine the ten-year Treasury rate.

But Wolf goes further.    He argues that China’s determination to keep its nominal and real exchange rate weak effectively ends up determining US short-term rates, not just shaping US long-term rates …   

His argument potentially applies to the eurozone as well, but to keep things simple, I’ll focus on the US. And rather than starting with the US, I’ll start with China.

Wolf argues that China’s determination to keep the RMB weak in real terms effectively forces China to maintain a savings surplus.   

That is more or less the polar opposite of Stephen Roach’s argument.  

Roach argues the US current account deficit reflects its own savings shortfall, China’s current account surplus reflects China’s own savings rate, and that both the low US savings rate and the high Chinese savings rate is independent of the RMB/ dollar.  

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It is perhaps a sign of the times that the US is encouraging China to provide the US with a bit less financing (the US of course, has a strong RMB policy, not a weak dollar policy) and New Zealand’s Finance Minister is practically begging for a bit of market discipline to help keep New Zealand’s 10% of GDP current account deficit from growing any larger. Gillian Tett and Steve Johnson in the FT:

“I think someone would have to be slightly strange to take a bet on the NZ dollar right now,” Mr Cullen told the Financial Times. “It is strange that with our current account deficit approaching 10 per cent, the market is not factoring it in.

“Just how badly do we have to do on the current account before [investors] notice?”

His comments follow a recent, sharp rally in the New Zealand dollar, which has left it hitting a seven-month high against the US dollar this week of about $0.67 – even though data last week showed the country running a current account deficit of 9.7 per cent of gross domestic product.”

Mr. Cullen's question is a good one.

Carry trades – borrowing in a currency with a low interest rate to buy a currency with a high interest rate – didn’t necessarily do all that well in the first half of the year.    Iceland blew up – and most carry trades had a rough May and June.  Turkey is the most prominent example. But things changed over the summer.  Most high-carry currencies bounced back – particularly in countries that raised interest rates after sell-off.  The Krona is one example.  The Turkish lira is another.   The Brazilian real too –  Brazil’s central bank has been intervening heavily to keep the real from rising even further.  And the Kiwi. 

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Mark Whitehouse highlighted the deterioration in the US income balance in yesterday’s Wall Street Journal.   The US paid more in interest and dividends on its external borrowing (and foreign equity investment in the US) than it received on its external lending (and its equity investment abroad). 

It many ways, though, the deterioration in the US income balance has just begun.   In this post, I’ll argue that that US lending abroad has a shorter-term structure than US external borrowing.   Most US lending and US borrowing is denominated in dollars.  Consequently, an increase in US short-term (policy) interest rates tends to increase the return on US lending abroad faster than it increases the interest rate the US pays on its borrowing.  

In the first half of 2006, this effect turned out to be quite significant – slowing the pace of deterioration in the US income balance.  US lending abroad is around $3.9 trillion (end 2005 data), so a gap on US borrowing and lending rates can have a significant impact on the overall income balance. 

But as US policy rates stabilize and the interest rate on US borrowing catches up with the interest rate on US lending, this effect will disappear.   The result: higher net income payments, even if the gap between the returns on US equity investment abroad (decent) and the returns on foreign equity investment in the US (embarassingly low) continues …

The gory details (and graphs) follow.

In absolute terms, interest payments on US external debt have grown faster than the interest the US receives on its external lending.   It should: The US external borrowing exceeds US external lending by about $2.5 trillion (mid 2006 estimate).   Rising net interest payments (and a stable surplus on direct investment) explain why the US income balance is now negative, as following chart shows.

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The one trillion dollar mark is a perfect hook.  Richard McGregor's excellent story in today's FT is the first of no doubt many stories on China’s phenomenal stockpile of reserves.

McGregor highlights my argument that the composition of China’s reserves is a second order issue, at least from China’s point of view.  Shifting reserves from dollars to euros won’t prevent China’s central bank (the PBoC) from taking losses if the RMB appreciates against both the euro and the dollar.  And, as my regular readers know, the RMB sure looks undervalued against the euro.   The size of China’s capital losses will be primarily a function of the size of China’s reserves – not the composition of China’s reserves. 

But that is not the reason to read McGregor.  I don’t have any influence over Chinese policy.   But a lot of the other folks that McGregor quotes do.  He provides a great window into the internal Chinese debate, and that is really the only debate that matters.

What struck me? 

The PBoC’s worries that it will be blamed for taking big losses on its foreign exchange portfolio, even though those losses were basically “baked in” — to use Dr. Swagel's phrase — at the moment China bought its current holdings of dollar bonds at an inflated price.

The PBoC’s concerns are understandable.   The last Chinese reserve manager who took large losses (by betting on the euro a bit too quickly) took those losses hard.  And the Bank of Korea has come under pressure for the capital losses (more here) it has taken as the won has risen against the dollar.

At the same time, so long as the state council instructs the PBoC to resist pressure for the RMB to appreciate against the dollar, losses are unavoidable. 

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A quick synopsis of the last five years.

The RMB tumbles against the euro (and most European currencies).

Chinese exports to Europe surge, growing faster than Chinese exports to the US (even though US domestic demand growth generally has been stronger than European domestic demand growth).  Right now, EU-25 and Eurozone imports from China are up around 25% y/y (in euros) while US imports from China are up 16% or so.

Many economists (and the Economist) conclude that exchange rates don’t influence trade, at least not trade with China. 

Apparently relative prices only matter some of the time … 

Many things have happened since 2002.  

• China joined the WTO. 
• The final assembly of most computers shifted to China.  
• Chinese productivity growth exceeded US productivity growth, increasing China’s competitiveness even in the absence of exchange rate moves (see p. 13 of Feng Lu’s presentation). 
• Chinese wage growth lagged Chinese productivity growth (as the IMF notes, labor income fell as a share of Chinese GDP), further increasing Chinese competitiveness.  

But, processing trade or no processing trade, the enormous acceleration in China’s rate of export growth (to the world) is clearly correlated with a change in the RMB. 

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The New York Times (emphasis added):

The People’s Bank of China, the country’s central bank, transferred $15 billion of the country’s foreign exchange reserves to the Industrial and Commercial Bank last year; a year earlier, the central bank transferred $22.5 billion apiece to the Bank of China and China Construction Bank, and both have since conducted initial public offerings here.

…  Although Chinese government officials continue to oversee the management of these foreign exchange reserves, the banks have been allowed to count the money as capital and have used it to offset large write-offs of bad loans. But Chinese banks have engaged in a surge of new loans over the last year that have diluted the proportion of nonperforming loans in their portfolios but have also raised questions about whether another large crop of bad loans may appear in the future.

There is a reason why I generally count the $60b in Chinese reserves shifted (nominally) to the state banks as part of China’s reserves, and add $60b to my global total (warning: the reserves link requires a RGE subscription).  It sure seems like SAFE – not the banks – manages that pool of money.

One point that I left out of my earlier post: when the PBoC shifted its reserves to the banks, it formally shifted the reserves to the state holding company that manages the PBoC’s investment in the state banks, and the PBoC in return received a claim on the holding company (I am not sure if the holding company pays interest to the PBoC though).  That kept the PBoC from taking a loss – if didn’t just give the banks its reserves, leaving it with more liabilities than assets.

Remember, those reserves (an asset) are offset by liabilities (cash, sterilization bills) on the PBoC’s balance sheet.   And any financial institution that gives its asset away will eventually have problems.  Giving reserves – the PBoC’s asset — to the state banks doesn’t eliminate the liabilities that the PBoC issued when it initially purchases the reserves. 

Of course, the PBoC now has so many assets (probably over a trillion now, not counting the $60b) than in some sense this doesn’t matter too much.   $60b is small …

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It is rather hard to read Andrew Browne’s report of the building boom in Zhengzhou in last week’s Wall Street Journal — or for that matter many other accounts of China’s current investment boom – and not come away thinking that the banks financing various mega-projects in various Chinese provinces won’t end up with a lot of non-performing loans.  Not every interior city will be the “Chinese Chicago” — let alone the next Shanghai.

I do think the improvement in the balance sheets of the Chinese banking system over the past few years is real.   Tons of old bad loans (ones made to SOEs in the 1990s) have been moved off the banks balance sheets.  Read Guonan Ma.   Or read my article – but my data came from Ma. 

Those bad loans are now parked in China’s Asset Management Companies, often after making a brief stop-over on the balance sheet of the People’s Bank (the PBoC has bought its share of bad loans at par).   

Most of the loans that the banks have made during the current lending boom are performing.   So relative to where they were say five years ago, the banks are in far better shape –

The risk is that a lot of these new loans will only perform so long as China’s boom continues.  And booms usually don’t last forever. 

Most people realize this.  They worry about the future health of China’s banks.

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Risk management standards do seem to be slipping.   Davis, Sender and Zuckerman in the Wall Street Journal: 

“The risk models employed by hedge funds use historic data, but the natural gas markets have been more volatile this year than any year since 2001, making the models less useful.  They also might not predict how much selling of one’s stakes to get out of a position can cause prices to fall.”

The models broke down because this year has been more volatile than any year since 2001?   That isn’t so long ago, except in hedge fund time …  

I suspect Mr. Geithner won’t be happy if stress tests — and risk management models — don’t look a bit further back. 

1998 might be a relevant data point.  Certainly for anyone betting on emerging markets, the yen/dollar (or the yen/ euro, since the dyanmics of an unwinding carry trade are similar) or the Treasury market.  1998 also might be a relevant data point for a few commodity markets.   

Mr. Geithner also wants – I suspect – those lending to hedge funds to assume that liquidity will dry up when their clients need it the most.  Getting out when you don’t need to is easy.  Getting out when you absolutely have to is hard.  Especially if you have a large concentrated position … 

That lesson may be relevant for another set of institutions with large positions.  A few central banks might also want to ponder the impact large, sustained purchases can have on market dynamics.  Davis, Sender and Zuckerman, again.

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