Are state investors always stabilizing?
Sovereign funds — and those managing money for sovereign funds — argue that sovereign wealth funds are intrinsically a stabilizing force in the market. They have a long-term perspective. They aren’t leveraged (actually, that part isn’t totally true – some smaller sovereign are leveraged and the big funds invest in fund managers who use leverage). They are willing to buy when others want to sell, and sell when others want to buy.
Of course, it is hard to actually know if sovereign funds act consistently to stabilize markets since the biggest existing funds are also the least transparent funds – and the new funds don’t exactly have a track record. But it is hard to deny that they currently have the capacity to support markets in the US and Europe. China and the oil exporters have a lot of funds – they added over a trillion dollars to their foreign assets, I would guess, in 2007, though far more was managed by central banks than sovereign funds.
Nonetheless, few market participants are always stabilizing or always destabilizing. Most have a rather more ambiguous impact on the market. Hedge funds can pile on to a trend. Or they can bet that historic norms will reassert themselves. They can bet against a government’s efforts to defend the unsustainable. Or they can bet that large imbalances will remain for some time, and thus sell insurance against any change. They can bring new money to the market, or they can be forced to unwind leveraged positions quickly.
Sovereign funds will get into trouble. That is when they risk adding to market volatility.
The China Investment Corporation is a particular risk — and not just because it is new. The CIC has been given next to impossible set of tasks. It is supposed to take the risks required for China to offset the losses associated with the dollar’s depreciation against the RMB. But it also is not supposed to lose money either. And it is supposed to do all that while also supporting Chinese state firms. And unlike the oil funds, the CIC is playing with borrowed money – not the fiscal surplus generated from high oil prices.
We don’t yet really know how the CIC will act under duress. It hasn’t even deployed most of its initial allocation. However, we do have a bit of information about the activities of another set of Chinese state investors: the state banks.
The state banks currently manage far more of China’s foreign exchange than the CIC. By my calculations, they managed about $300b of state funds, both as a result of lthe decision to use foreign exchange to finance their recapitalization and as a result of swaps with the central banks.
The available evidence, and I want to stress that it is incomplete, suggests that they have acted like wounded giants, taking money off the table in times of trouble. Chinese state banks seem to have stopped buying foreign debt in the second half of 2007. That isn’t stabilizing.
The Chinese state banks were big buyers of foreign debt from the end of 2005 to early 2007. Their portfolio of foreign debt securities ("portfolio investment" or the red line in the chart below) went from $100b to $200b in a little over a year. 
But after q2 2007 the state banks stopped buying foreign debt securities and, judging by the PBoC’s data, started selling. Note the downward move in total "portfolio investment" over the last two quarters.
So what happened?
We really don’t know. But it seems likely that the state banks took more risks than SAFE in 2006. They probably bought a mix of higher yielding instruments – whether corporate bonds or “private” mortgage-backed securities, including MBS that had embedded subprime exposure. And it sure seems like they stopped buying in the second half of 2007.
Now this could reflect a surge in domestic demand for dollar loans. Domestic dollar loans have increased as time when dollar deposits have fallen, meaning that the banks fund such lending increasingly with foreign exchange borrowed from the government. Or it could reflect a desire to take less risk. In some sense it doesn’t matter – China’s state banks seem (based on the limited available data) to have scaled back their demand for risky debt at precisely the same point in time as everyone else.
No stabilization there.
The Chinese state banks have not done anything wrong. They have no obligation to buy just because others don’t want to. Like a lot of other players in the market, they were probably taking more risks than made sense back in 2006.
But the recent fall in their recorded holdings of foreign portfolio securities does suggest that they have added to the market’s current trouble rather than reduced it.
They haven’t been a stabilizing force that buys when others want to sell. Rather they bought when everyone else was buying, and seem to be selling when everyone else is selling. The market for a range of risky debt could have benefited from a stronger sovereign bid; it would certainly have added “liquidity” to the market.
One characteristic of sovereign money – setting the funds from the Gulf sheikdom’s aside, as the Gulf funds often seem to have been managed more like family funds of than public money – is a strong aversion to taking losses. They political costs of losing the people’s money on a foreign adventure are quite high.
That suggests, at least to me, that sovereign money will sometimes by a stabilizing force in the market, and sometimes will not be a stabilizing force. There will be times when they bring new money into the market. And there will be times when they are desperate to get out of an investment before they have to report holding an investment that goes bad.
For more information on the foreign assets of China’s banks, I (immodestly) recommend my new paper on the management of China’s foreign assets. It isn’t necessarily an easy read — as I have to make a lot of educated guesses about the funds that have been shifted to the state banks in particular. But it does have a great deal of detail on the management of China’s foreign assets.
China Devt Bank buying $5 billion stake in Nigeria’s United Bank of Africa
http://www.forbes.com/markets/feeds/afx/2008/01/27/afx4578405.html
BEIJING (XFN-ASIA) – China Development Bank is in talks to buy a stake in Nigeria’s United Bank of Africa (UBA), with plans to invest more than five bln usd, the Economic Observer reported over the weekend.
Western banks sell China bank stakes for short-term profits
http://www.guardian.co.uk/feedarticle?id=7244687
HONG KONG, Jan 22 (Reuters) – Western banks tempted to convert big paper profits on investments in Chinese lenders into cash to shore up subprime-battered balance sheets would do so at the expense of hard-earned access to the fast-growing country.
Bank of America has said it was looking to shed some of its stake in China Construction Bank. Bank of America paid $3 billion in August 2005 for a stake in China Construction Bank as part of the mainland lender’s IPO — which was the first by one of China’s “Big Four” banks. That stake, now worth about $13 billion, must be held until October.
Late last year, Bank of America Chief Executive Ken Lewis said the No. 2 U.S. lender hoped to sell some of its Construction Bank stake starting in 2008 and was “talking to the Chinese to see what level they would be comfortable with us holding”.
from that opium wars link:
“…trading in goods from China was extremely lucrative for Europeans and Chinese merchants alike. Due to the Qing Dynasty’s trade restrictions, whereby international trade was only allowed to take place in Canton (Guangzhou) conducted by imperially sanctioned monopolies, it became uneconomic to trade in low-value manufactured consumer products that the average Chinese could buy from the British like the Indians did. Instead, the Sino-British trade became dominated by high-value luxury items such as tea (from China to Britain) and silver (from Britain to China), to the extent that European specie metals became widely used in China. Britain had been on the gold standard since the 18th century, so it had to purchase silver from continental Europe to supply the Chinese appetite for silver, which was a costly process at a time before demonetization of silver by Germany in the 1870s. In casting about for other possible commodities, the British soon discovered opium, and production of the commodity was subsidized in British India. Between 1821 and 1837 imports of the drug to China increased fivefold, as the demand for the equalizing of the trade balance reversed a previous decision by the British authorities to respect the Qing government ban on the drug…”
sound familiar?
oops! that was supposed to have gone in the post below, sorry
BEIJING, Jan 28 (Reuters) – China’s Baosteel (600019.SS: Quote, Profile, Research) and Aluminum Corp of China, the parent of Chalco (2600.HK: Quote, Profile, Research), are set to join a state-backed consortium to develop and build large commercial jets, the Shanghai Securities Journal reported on Monday.
In addition to Chinalco and Baoshan Iron and Steel Co, the nation’s largest steel company, the venture will include China’s two large aviation companies, AVIC I and AVIC II, and could be officially established before the National People Congress in March, the journal said, citing an unnamed AVIC I official.
The central government would inject cash into the venture from the state-owned Assets Supervision and Administration Commission to become the largest stakeholder, the report said.
The China Aviation Industry Corp I and II would together be the second largest shareholder in the planned company, which is designed to reduce the country’s reliance on Boeing (BA.N: Quote, Profile, Research) and Airbus (EAD.DE: Quote,
************************************
The next shoe to drop: China going to import substitution.
Sovereign wealth
Multilateral guidelines governing the behaviour of sovereign wealth funds – and recipient countries – are in the interests of both
Singapore fund promises greater transparency
Singapore’s Government Investment Corporation has promised greater disclosure about its activities, amid mounting concerns about the secretive fund’s influence after high-profile investments in UBS and Citigroup
Derivatives boom raises risk of bankruptcy
A boom in the use of derivatives is giving creditors strong incentives to push troubled companies into bankruptcy rather than help rescue them, according to new research and industry experts
The start of the great unwinding
Banks and their like need to do more to show they can be trusted, and that the public’s gain from hyperfinance is at least as great as their own
What has the Credit Crisis Taught Us?
Increase transparency among regulated institutions
Homogenize global accounting standards
Homogenize global regulatory frameworks
Aggressively strip conflicts of interest out of the system
Clarify the roles and responsibilities of fiduciaries
Develop common sense compensation policies and practices
china already has been doing a fair amount of import substitution, encouraged not by tariffs but an undervalued exchange rate.
bsetser: The CIC has been given next to impossible set of tasks. It is supposed to take the risks required for China to offset the losses associated with the dollar’s depreciation against the RMB. But it also is not supposed to lose money either. And it is supposed to do all that while also supporting Chinese state firms. And unlike the oil funds, the CIC is playing with borrowed money – not the fiscal surplus generated from high oil prices.
This is not true. CIC’s primary mission is to insure the long-term solvency of the PRC state pension system.
Most Chinese urban factory workers are covered by a pension system, which is extremely underfunded. CIC’s predecessor, the NSSF is a reserve fund which will be used to back pension claims when provincial and local governments don’t have the funds to pay pensions (and from all indications, this is what is going to happen). Looking at who ended as managers of CIC, it’s pretty obvious that CIC has been given the task, and the sole task of insuring that the PRC’s pension system is funded. Everything else is secondary.
Now, the other tasks that you mentioned are important, but they aren’t CIC’s responsibility.
bsetser: The available evidence, and I want to stress that it is incomplete, suggests that they have acted like wounded giants, taking money off the table in times of trouble.
True enough. In times of trouble state banks are likely to run for the exits and try to preserve capital, but……
How is this different from non-state banks? I’m still unclear as far as the argument you are making here. There seems to be an assertion that state intervention in markets through sovereign wealth banks is a bad thing, but the example given involved state-owned banks and funds acting exactly like private banks have done in the same situation (i.e. running for the exits when there is any uncertainty in the markets).
My argument is that CIC and the state-owned commercial banks in the PRC will be expected to behave like commercial entities, and in order to stabilize the markets you need institutions like the Federal Reserve and the People’s Bank of China to be in charge of macroeconomic policy.
I’d also argue that the distinction between state-owned and private isn’t the major distinction. The big distinction is between commercial banks, central banks, and regulators. CIC and the state banks are going to act more or less like Western commercial banks in making decisions, which means that they are going to be part of the volatility that exists within the markets.
“china already has been doing a fair amount of import substitution, encouraged not by tariffs but an undervalued exchange rate.”
You may have put your finger on another reason China doesn’t want to revalue the yuan. A cheap yuan discourages imports and stimulates domestic industry.
Brad, the Chinese yuan has already risen in value versus the US Dollar by almost 10 percent over the past year to the current 7.2 yuan to 1 US Dollar. By any statistical measure, an almost 10 percent rise is a huge move in any currency. The collaping monetary value of the US Dollar on world markets is a direct result of the Federal Reserve’s unfettered credit creation. The bills for the subsequent bubble-related distortions are now falling due – and the Fed’s credibility is in tatters.
Off-topic – but this is what its all about:
Jan. 28 (Bloomberg) — The risk-taking model that emboldened Wall Street to trade with impunity is broken and everyone from Merrill Lynch & Co. Chief Executive Officer John Thain to Morgan Stanley Chief Financial Officer Colm Kelleher is coming to the realization that no algorithm or triple-A rating can substitute for old-fashioned due diligence.
Value at risk, the measure banks use to calculate the maximum their trades can lose each day, failed to detect the scope of the U.S. subprime mortgage market’s collapse as it triggered more than $130 billion of losses since June for the biggest securities firms led by Citigroup Inc., Merrill, Morgan Stanley and UBS AG.
The past six months have exposed the flaws of a financial measure based on historical prices that securities firms use idiosyncratically …
twofist: “CIC and the state banks are going to act more or less like Western commercial banks”
you mean like chinese ‘golf’?
“…the difference between golf in China and in the U.S. is there are many rules in the U.S., while in China you can play however you want. Just like McDonald’s and many other Western imports, golf has been changed by the Chinese — Mr. Qiao calls the result golfing with Chinese characteristics…” http://online.wsj.com/article/SB120051625538395295.html
Hallo
off topic: the number $6.5bn stands for “no other choice”?
“David Rosenberg, .. Merrill Lynch, .. said that “when you look at private sector debt that was over and above what can be explained by GDP, you are talking about $6.5 trillion beyond the economy’s capacity to handle that debt.” That debt will have to be either written off or paid back. People will have to stop spending, he said; they’ll have no other choice. Since their homes are decreasing in value, they can no longer borrow against them. And as they spend less, corporate earnings will fall, and that will inevitably cause the stock market to continue falling. “The problems are deep, widespread and intense,” he said. He said he didn’t expect a rebound anytime soon.
Is that gloom and doom enough for you? ..”
http://www.iht.com/articles/2008/01/25/business/wbjoe26.php
How this number is calculated?
What is about commercial sector debt?
globumedes
In summary, the entire US Foreign policy regime over the past two decades has been dedicated to maintaining US Global hegemony in the political, military, and economic spheres. Too late now. LOL. – Dave C.
Waving Goodbye to US Global Hegemony
http://www.nytimes.com/2008/01/27/magazine/27world-t.html?_r=1&ref=asia&oref=slogin
At best, America’s unipolar moment lasted through the 1990s, but that was also a decade adrift. The post-cold-war “peace dividend” was never converted into a global liberal order under American leadership. So now, rather than bestriding the globe, we are competing — and losing — in a geopolitical marketplace alongside the world’s other superpowers: the European Union and China. This is geopolitics in the 21st century: the new Big Three.
The Big Three make the rules — their own rules — without any one of them dominating. And the others are left to choose their suitors in this post-American world.
The more we appreciate the differences among the American, European and Chinese worldviews, the more we will see the planetary stakes of the new global game. Previous eras of balance of power have been among European powers sharing a common culture. The cold war, too, was not truly an “East-West” struggle; it remained essentially a contest over Europe. What we have today, for the first time in history, is a global, multicivilizational, multipolar battle.
DC — your last comment was entirely off topic. similar posts in the future will be taken down. I do plenty of posts on the changing global balance of power; this wasn’t one of them.
2fish –
the CIC isn’t a commercial entity. it borrows in RMB to invest in $ and euros. and in no way does that kind of fx risk make sense for a pension. Indeed, the CIC isn’t going to be able — barring a miracle — to cover its liabilities, let alone fund a pension system.
the SCBs have also been used as an instrument of policy — recently as instruments of exchange rate policy, and in the past as instruments of industrial policy/ jobs policy. there is no reason to think that will change. they are more commercial than they used to be, but also subject to state decrees like meeting their reserve requirement in $. Until that sort of thing stops, i have a hard time seeing them as “commercial banks” in state disguise.
the analogy between the SCBs and gov funds is imprecise. but it isn’t entirely off. the SCBs are cutting back their risk exposure at a time when the market could use more demand for risk. and they are not doing so b/c they are liquidity constrained — note their rising fx liability base. In principle, they have the funds to keep buying. they just didn’t.
moreover, the state banks are in some sense in a better position than the cIC. remember that both are financial intermediaries , with borrowed liabilities. the SCBs borrow fx from the pboc via swaps, and have additional fx capital from the CIC. That puts them in a better position than the CIC, which borrows in RMB unhedged, and thus is both leveraged and currency mismatched. If the CIC is facing a market move that would put it under water, how would it respond? by adding to its exposure or by taking risk off the table?
my point is that the talk that state investors — state banks playing with CIC and pboc money count in my book — are always stabilizing is a bit strong and needs to be qualified. sometimes they are. somethings they are not.
I would be interested in other examples where state investors have reinforced market moves and thus added to instability, as well as cases (setting the SWF recap of Citi, Merill, Morgan and UBS aside) where they have been stabilizing.
Brad, why are you always carping at the Chinese? Consumer spending accounts for 72 percent of US GDP, trade with China cannot account for more than 3-4 percent of US GDP. Please be honest and admit that the vast majority of economic issues that the US Economy faces are largely self-inflicted, not caused by the Chinese PBoC, CIC, or whatever. Explain to us why the charlatan Economists at the Federal Reserve don’t even understand the financial concept of a “sound monetary currency”? Even the “official” 4 percent inflation rate is clearly unacceptable, the “real” inflation rate including food and energy is much higher.
Quote of the Day from Economist Steven Roach:
http://www.telegraph.co.uk/money/main.jhtml;jsessionid=KMKID3DNESTTBQFIQMGSFFWAVCBQWIV0?xml=/money/2008/01/28/ccusecon128.xml
With SWFs in the spotlight, debate has raged this week over whether they ought to be more transparent, and to issue a voluntary code of conduct about their investment plans, but Roach said: “Why are we singling out sovereign wealth funds? Why shouldn’t we ask the same of hedge funds, private equity or any other group of investors?
“Is it because these funds are coming from the Middle East, from China – areas that make us uncomfortable. Is this not thinly-veiled financial protectionism?”
DC — without financing from China/ the emerging markets, the us would have to cut back. I am harping about China because china’s current account surplus has risen from 2% of its GDP to 12% its GDP, its foreign asset accumulation has doubled over the past year from $250b and change to $500b (or more) even as oil prices have increased and the combination of an emerging asian surplus with the commodity surplus has propelled unprecedented official asset growth and associated distortions, and by my estimates inflows from China now finance about 1/2 the US current account deficit. I am also harping on China b/c China had insisted that its policies are its own business even as its policies increasingly impact the world (something the US can rightly be accused of doing), and China’s exchange rate management has clearly constrained the policy options of India and Thailand.
Frankly, i would be a lot happier if my analysis led me the conclusion that the US could change on its own — but in a global equilibrium, measures to slow us demand growth (fiscal restraint) only have a modest impact on China’s external surplus and China’s financing of the us. Fiscal restaint from 05 to 07 didn’t slow the growth in China’s external surplus; indeed to the extent the us slowed and the $/rmb depreciated and that increased china’s surplus with europe and its capacity to finance the us it worked in the other direction. basically, china’s policy of adding to its foreign assets at an unprecedented rate impacts the world — not just china — and it is beyond the united states direct control.
the place where my analysis does suggest the us can shape its own destiny is energy policy. I hope for change in 09.
bsetser: without financing from China/ the emerging markets, the us would have to cut back.
No. The US would have been faced with a choice of cutting back or wrecking its economy, and my feeling based on the events of the 1960’s is that the US would have ended up wrecking its economy, and things would be a lot worse off than they are now. I just don’t see George W. Bush pulling out of Iraq or increasing taxes which meant that you would have had to wait until 2008 for any policy changes anyway, by which time things would look a lot like the early 1970’s.
Brad, over 50% of China’s trade is with other developing nations, only 20% of China’s trade is with the United States. The European Union is the largest trading bloc with China today. Booming inter-regional Pacific Rim trade exceeds trans-Pacific trade. So what if China runs a trade surplus with some other regions of the world, it is immaterial to the US Economy. Chinese economic trade relations with other sovereign nations including the Middle East, Southeast Asia, and Africa are now largely independent of trans-Pacific trade with the United States.
DC — you are wrong. sorry to be so blunt, but those are the facts. the scale of China’s global surplus is what allows it to finance the US. and the boom in China’s trade with europe reflects its policy of following the $ down v the euro. the same also applies to the rmb v other currency pairs.
2fish — the most likely cuts would be in us consumption or investment. and a sudden adjustment would indeed be disruptive.
China selling foreign debt in Q3+4 will not have had a “stabilizing” effect, for sure. But do we know who has been buying the corresponding paper? Where has this been buffered?
It is also very interesting to look at the trend of increased $ borrowing inside the RMB-zone. Intuition says that means more and more people are expecting to profit from a peg shift, sooner rather than later.
bsetser: the CIC isn’t a commercial entity. it borrows in RMB to invest in $ and euros. and in no way does that kind of fx risk make sense for a pension. Indeed, the CIC isn’t going to be able — barring a miracle — to cover its liabilities, let alone fund a pension system.
No. The Ministry of Finance borrows in RMB to invest in $ and euros. The liabilities associated with that exchange are on the balance sheet of the Chinese state and not on the balance sheet of CIC, and this is precisely so that CIC can focus on being a profit center and leave macroeconomic issues to other parts of government.
bsetser: the SCBs have also been used as an instrument of policy — recently as instruments of exchange rate policy, and in the past as instruments of industrial policy/ jobs policy. there is no reason to think that will change.
True, but not by CIC, and also not with the approval of the banks themselves. The Chinese government needs to balance a large number of conflicting priorities and it does so by separating responsibilities between different agencies so that you don’t have one group of people trying to do one thing and the opposite at the same time.
CIC and the PBC have conflicting directives and incentives, and by having this tug-of-war, I think you’ll end up with the same sorts of decision processes that you end up with in Western banks, where there is a tug-of-war between bank regulators, the Fed, and the shareholders.
bsetser: also subject to state decrees like meeting their reserve requirement in $. Until that sort of thing stops, i have a hard time seeing them as “commercial banks” in state disguise.
I don’t. The important part of the equation is that the SCB’s have to be ordered to do this, and they don’t like it. This means that the incentives on the managers are similar to that in a “private” bank.
bsetser: the analogy between the SCBs and gov funds is imprecise. but it isn’t entirely off
I think it is. The fact that both SCB’s and government funds have the same ultimate shareholders doesn’t mean that they are going to behave the same way. The fact that they are in different institutions means that they probably *aren’t* going to behave in the same way.
bsetser: That puts them in a better position than the CIC, which borrows in RMB unhedged, and thus is both leveraged and currency mismatched. If the CIC is facing a market move that would put it under water, how would it respond? by adding to its exposure or by taking risk off the table?
The risk of that exposure is being borne by the Ministry of Finance. MoF borrows RMB, exchanges for $$$ which is used then to capitalize CIC. If there is a bad market move, then it goes against the Ministry of Finance which can use tax revenue to fix the deficit or may choose depending on the macroeconomic situation, to do something else.
The currency risk isn’t on CIC’s balance sheet, which means that CIC can focus on capital maximization. CIC is set up so that it *isn’t* responsible for figuring out currency policy.
It’s really, really important to figure out whose balance sheet these losses are going to be on. One mistake is to think that because everything is “state-owned” it doesn’t matter if it is a liability of the MoF or CIC since they are supposedly the same. They aren’t.
The sequence of transactions was:
MoF sells RMB bonds which then are used to buy foreign exchange. This is used to capitalize CIC. CIC is a listed company with assets/liabilities which are separate from the Chinese state. The liabilities of the RMB bonds remain with the Ministry of Finance and are not the concern of CIC. CIC gets US dollar assets which it uses to invest and maximize profits.
CIC is a listed company with a balance sheet which cannot go negative and with no taxation powers. The Ministry of Finance is part of the Chinese state which doesn’t have a formal balance sheet but does have taxation powers.
CIC is structured so that it doesn’t worry about currency losses, and CIC shouldn’t worry about short-term currency losses. The time horizon of CIC is about thirty years which means that any reasonable investments should grow by a factor of 4x to 8x, which is going to vastly overwhelm any a 20% currency loss.
2fish — you are right formally; the fx risk is with the minfin. but i find it hard to believe that the cic’s fx profits (if it makes them) will be used to support the pension system rather than cover the fx losses of the minfin. and if that is the case, it would be simpler to just issue minfin bonds to raise cash for the pension system, without going through the charade of buying fx at a loss (for the minfin) and handing the cic’s profits (if you ignore the fx loss) to another player in the system.
Pallj — yes, domestic fx borrowing is up, and since it isn’t financed with the deposits (down) it is financed by fx borrowed from the pboc (in my view). the hard part is knowing whether the “deal” here requires those borrowing fx to invest abroad. if not, the state banks are borrowing (via swaps) from the pboc, lending to domestic firms and then the domestic firms are selling the fx back to the pboc to profit from the expected fx moves. that tho doesn’t serve the interest of the pboc. I haven’t quite figured it all out.
Brad, previously you argued that CIC is not private enough. Now you accuse CIC, acting as a private fund, does not stabalize the economy. You are running out of excuse.
jin — i fail to see any inconsistency in my argument. the cic isn’t private. and, as i note above, it is too early to judge whether it will be stabilizing or not. the state banks are not private. and the available evidence suggests that they have not been stabilizing recently.
whether or not private actors act in the same way is irrelevant for my argument
I have to ask Brad if he ever sees any complaints from the Chinese side about the surplus it accumulates from its US trade. I haven’t seen any. In short, only the US complains about the relationship. If the Chinese were alarmed they would do something to reduce it but they do not. My general conclusion would be that the Chinese are quite happy with the situation and only the US is (mightily) upset. Of course the US would like to persuade the Chinese to be upset too, but it can’t. So my take is simply that the surplus reflects the US loss of control over world economic affairs. It used to have it but has lost it. And as a result the US is flaying about in frustration, whining and bitching.
Any thoughts on who has been picking up the slack against China’s selling of IOUs in Q3and4?
I don’t see much point in this post. Investors, regardless private or state, can stablize markets or destablize markets, depending on market conditions. You correctly pointed that out. There is no difference betwee a state investor that gets into trouble or a large hedge fund that gets into trouble. If they’re big enough, they will be bailed out (witness LTCM).
The only proven way to stablize the market is through regulations. With enough regulations, you can discourage most investments from turning into speculations. If the US had enough regulations few years ago, we won’t be talking about this market destablization or SWFs.
Brad,
What have we got…
Huge income inequality in the USA
Very highly leveraged newly-invented finacncial structures
Massive shadow-banking sector pumping money into markets
very large external deficits/surpluses,
property bubble,
…and then came the great depression of 1929.
The similarities with today are just too striking to ignore.
The only realdifference is that the US was the creditor to the world back then, while today it is China.
Back then the US allowed the dollar to slide in order to promote trade with the world, but the world couldn’tpay their debts (not enough gold),so eventually the trading had to stop and the US lost a lot of money on bad loans to Peru, Argentina, Europe etc.
Today we have the same situation in reverse but with no gold standard America is shipping T-bills to China not gold, but as the US slides into recession,the effect is likely to be much like the effect on the USA was in ‘29,and China is going to lose a lot of money.
Will we see a market collapse inducing a capital and consumer spending induced recession in the US resulting in financial hard-times for China? China has its own bubbles to worry about.
PS
I don’t know how you remain so calm in the face of some of the jingoistic pro-Sino contributors on this board!
Regards
bush is due to make his ’state of the union’ speech. is everyone looking forward to it ? will we have a clearer picture of the way forward from the leader of the hegemonic nation ? or will we see a tired little man who has run out of credit and ideas – marketing a soggy mush of spin ?
this is not an anti bush posting. i think that the man embodies the spirit of our age, selfish, greedy, complacent, averse to discipline or sacrifice. we are all part of it. i agree with the poster who suggested that control has slipped away from those who imagine that the levers of power are in their hands.
america and china, big actors as they are, are past being able to swim against the currents of history. when we have shot the financial rapids, debates will surface on regulation, transparency, cooperation and responsibility. in the meantime . . . we drift.
questions of stability or instability become more or less irrelevant. the bigger you are – the more you are constrained to avoid rocking the boat. it is size that upsets markets – big fat corporations are just as dangerous as big fat communists.
just as a private investor should have a spread of investments, so a s w f should be fragmented into a number of decision taking groups. instead of 5 billion, even 5 groups investing a billion each would be an aid to stability. its not the nature of the decision taking body – its the size. to understand why this is so, imagine a stock market with one client and one stockbroker – what could the professional advise his / her client to do ?
the model is simple. instead of a committee running a s w f – each member of the group should control a portion of the funds. stability is a function of fragmentation.
you can shoot an elephant dead with one bullet. now try to shoot a swarm of bees of equal total body mass to the elephant. that’s the stability of fragmentation.
.
gillies –
interesting idea (letting more people manage the money). the big problem is that it might produce a collective outcome that undermines the centrally-determined currency policy.
I don’t have much interest in tonight’s speech; i do by contrast have a great deal of interest in the florida primary tomorrow, which should clarify the republican race, and the democratic race.
LC — I think premier Wen himself said that China has never been under such pressure as it is now, and there are no shortage of chinese voices asking why china has committed so much of its savings to investments in us dollars. the internal chinese debate over inflation is also indirectly a by product of china’s existing policy.
Despite the fact that the fx exposure is being borne by the finmin, it seems significant to me that Lou Jiwei noted that CIC was under significant pressure to make returns high enough to exceed its interest payments – or as he estimated, $40m a day.
http://online.wsj.com/article/SB119632900640407825.html
“the scale of China’s global surplus is what allows it to finance the US. and the boom in China’s trade with europe reflects its policy of following the $ down v the euro. the same also applies to the rmb v other currency pairs.” – Brad
Brad, let me reiterate, the Chinese yuan has already significantly appreciated by almost 10% versus the US Dollar over the past year. By any statistical measure, an almost 10 percent rise is a huge move in any currency. Why haven’t US Exports improved in competitiveness in the Chinese market. Please don’t tell me that the Chinese government restricts US imports over imports from Japan.
The Chinese run a trade surplus with the rest of the world due to a comparative advantage in labor costs. For instance, for the salary of 1 American or Japanese engineer, 7 Chinese engineers at the equilvalent educational level can be employed. It would be completely ludicrous to revalue the Chinese yuan by 700 percent versus the US Dollar to equalize industrial labor costs.
Despite high labor costs, both Japan and Korea still manage to run significant trade surpluses with China. Instead of continually scapegoating the Chinese, the prudent strategy would be for the US to emulate Japan by investing in human capital and leading edge industrial production technologies. Sorry to be blunt, but those are the honest facts of the global economy. The US isn’t competitive due to self-inflicted economic policies.
bsetser: but i find it hard to believe that the cic’s fx profits (if it makes them) will be used to support the pension system rather than cover the fx losses of the minfin.
CIC isn’t going to directly make any fx profits. It’s a stock fund, remember. One persistent problem with state owned enterprises is the question of why you should make a profit if the state is going to take it, but the PRC has had a lot of credibility requiring this (which has resulted an a lot of other problems).
bsetser: and if that is the case, it would be simpler to just issue minfin bonds to raise cash for the pension system
No. The pension system liabilities aren’t current ones but rather those that will come due in 10-30 years. In this situation rather than fund the system now, it makes sense to put the money into long run investment.
If the minfin issue bonds right now, then it’s going to have to park the money into something anyhow for 10-30 years.
No
Guest: I have to ask Brad if he ever sees any complaints from the Chinese side about the surplus it accumulates from its US trade.
The trend in the Chinese side is for faster revaluation. The problem isn’t the trade surplus per-se but rather that a peg forces China to attach its monetary policy to that of the United States.
One why of thinking about it is that if you keep trading goods for paper, then eventually the value of the paper is going to drop, and I’m pretty sure that China is going close to the edge of where it can keep subsidizing the United States get back paper dollars. Basically the national decision that the US has to make is whether the US wants to maintain its standard of living by selling off assets in US companies rather than paper.
My suspicion is that the decision is going to be that selling off assets is going to be more attractive than reducing living standards…..
However, the reason SWF’s are interesting is what happens *after* the RMB adjusts. After the RMB adjusts, the PRC is going to take a one time 10-20% currency hit, but it will still have $1.2-1.5 trillion dollars which will then be looking after assets that are relatively cheap. I think that after the RMB adjustment, the US is going to still maintain a large trade deficit with respect to China, but it is going to be financed by sales of US assets. This is sustainable of the growth in asset value is more than the trade deficit.
DC
The fact that the RMB yuan is not freely traded, where demand would decide price, is a Chinese decision. In the free world of trade China has one foot in the doorway but hesitates to take the full step. If the Chinese economy were a small one this wouldn’t matter to anyone, but it is actually huge -hence all the fuzz. The tension resides in the potential difference in the RMB value versus the $, the pegged value versus free market value.
China’s hefty FX reserve clouds the issue, and its investment abroad even more.
But the fact remains that this is China’s stance, not the rest of the world’s.
Of course it is relevant. A typical private player in this situation is either ‘cut and run’ or take advantage. No private player would like to take the stabilization as its job on itself. It is government’s duty to organize and implement the rescuing policy. I.e., during LTCM crisis, it was Fed to take the initiatives to unit all big private banks together and act.
You have been complained about CIC’s state role for so long that your blame on CIC’s acts like a typical private player in this post seems a little bit ironic.
Brad,
I admire your stamina in the ongoing debate against The Apologists, neither losing your patience nor letting your demeanor slip. Reminds me of “Neo” (yes, you) battling Mr Anderson (DC et. al), with the Matrix now having multiplied the number of Mr Anderson’s that Neo must battle. Yet the battle must be fought by someone. Bravo..!
dc — have you looked at the comparative growth in chinese exports to europe (ongoing rmb depreciation) v chinese exports to the us (rmb appreciation, but not really til this year, further real appreciation from higher inflation in china than the us) recently? it seems like the rmb’s appreciation is having an impact against the one currency it has appreciated against … the problem is that the current slowdown in chinese exports to the us is overdetermined; the rmb’s appreciation v the $ plays a role, but so has the broader us slowdown.
Korea is a case study for my point, after the won appreciated in 04/05, korea’s overall current account started to adjust. the yen is evidence that exchange rates matter as well– yen weakness v the euro seems correlated with the rise in japanese exports to europe.
2fish — i don’t quite get your point.
the cic gets $. it presumably borrows them from the minfin, and has to pay a $ interest rate back — or something. otherwise it is free money, with the minfin taking on the fx risk and paying the coupon on the borrowed money. let’s say it pays 4% in usd to the minfin. let’s say it earns 8%, getting a 4% margin .. not bad at all, really. That margin is then handed over to the state pension system?
let’s then say the minfin loses 4% a year over ten years (a 40% plus counting compounding cumulative appreciation, which i think is conservative) on the fx risk. the net result is effectively a transfer from the fin min to the pension system, with a lot of funky intermediation and i-banking fees thrown in. the minfin picks up the fx loss that allows the cic to show a profit. I honestly don’t get it.
agree tho with your point about importing us monetary policy being the main force pushing china to change; the balance sheet risk i drone on and on about has long been there.
I have followed the debate on this board with interest and I have to say I have a certain sympathy for Mr. Chiang’s much-maligned inputs.
I would make a number of points:
- correlation between the US current account deficit and the Chinese current account surplus is low. The bulk of the widening in the US current account deficit, measured as a three-year change, came in the period 2000-2003. The Chinese current account surplus has only widened substantially in the last few years when the US deficit was already at record levels.
- no-one denies that the Chinese surplus is currently an important source of finance for the US current account deficit. But most econometric studies i.e. Warnock and Warnock have struggled to place the value of stepped up central bank purchases of US debt at more than a 100bp; significant but not decisive. The key to the US housing bubble and the attendant over-absorption that it produced was the explosion in ARM mortgages produced by the Federal Reserve putting in place and then sustaining the lowest ex-ante Federal Funds rate since the early 1970s between 2002-2004.
- the strident (shrill?) criticism of China’s monetary arrangements seems to imply that China should not be allowed to choose the monetary arrangements that it considers best because, despite the fact that it is still an incredibly poor country, it now has global responsibilities. I find this a tough sell. More generally, is it really the case that the choice of a fixed or semi-fixed exchange rate regime is now essentially unacceptable in the 21st century? Must all trading economies be forced to accommodate the US’s loose money policies of the last 5-10 years or else they are impeding global adjustment? Is this really the point we have arrived at? As a Chinese policy maker recently remarked, aren’t rumours of a 25% devaluation in the $ shocking!
- blaming China for the US profligacy seems to be on par with my excuse for running up an unfeasibly large student overdraft now nearly 15 years ago. For those of who can’t work it out, I blamed the bank manager for my indebtedness on the basis that he had lent me the money. Given that like the US consumer I could resist everything apart from temptation at that tender age, it was clearly his fault! Looking at my expensive suit my bank manager had a rather different perspective and found my accusations of predatory lending on his part baffling.
- I also find odd that China and the oil exporters are roundly criticized for ‘impeding global adjustment’ when the US is seemingly granted absolute impunity to pursue whatever policies it desires that clearly perpetuate imbalances. Is it not a little rich that former Treasury Secretary Larry Summers, who has vocally spent the last few years fretting about the US deficit and the ‘global balance of financial terror’ immediately becomes a cheerleader for US fiscal easing the moment it appears US growth might slow below 2% per annum? The current account deficit is a product of excess absorption produced by over-valued asset prices. But living standards and the US deficit it appears must be preserved if it looks like adjustment will begin to cause anything other than a modicum of economic discomfort. In this world view, I’m afraid it seems ‘adjustment’ is something foreigners must do. Whatever happened to the old ‘rules of the game’ when it was the deficit country’s obligation to deflate its economy? How about a few posts on how US policy makers are impeding global adjustment to level up the playing field?? How exactly does the current combination of loose fiscal policy and ultra-loose monetary policy in the US help global rebalancing? A substantial gas tax hike bringing the US energy taxation levels more into line with those of Europe would be a useful contribution to global rebalancing. And if all these Arabs buying up Wall St is such a bad thing perhaps the President tonight should help global adjustment by advocating wearing more woolen outer garments to cut back energy consumption like Jimmy Carter did nearly 30 years ago?
- finally, could we have some commentary on the savage downward revisions to Chinese GDP measured on a PPP basis recently unveiled by the World Bank? The large wedge between Chinese GDP measured at market prices and estimates of PPP GDP has frequently been adduced as strong evidence of RMB undervaluation. Doesn’t a 40% cut in PPP GDP dent the case for a faster pace of RMB appreciation?
bsetser: the cic gets $. it presumably borrows them from the minfin, and has to pay a $ interest rate back
In exchange for providing start up capital, the Chinese government gets 100% equity ownership of CIC. Part of the cost of forming CIC was buying out Huijin. It’s really important to keep in mind that these are separate companies. They are 100% owned by the Chinese government, but they are not part of the Chinese government.
bsetser: money. let’s say it pays 4% in usd to the minfin. let’s say it earns 8%, getting a 4% margin .. not bad at all, really.
CIC doesn’t have any liabilities to the Chinese government. In exchange for providing $200 billion to CIC, the Chinese government now owns 100% of CIC stock. The money that was used to start CIC is counted as shareholder equity, which the Chinese government can cash out if it wants to.
bsetser: That margin is then handed over to the state pension system?
No. CIC is the reserve insurance fund for the state pension system. If a provincial or local government is unable to meet its pension requirements (which is almost certainly going to happen in ten years), CIC will sell its stock and then pay out the pensions.
One reason for centralizing stock investments is that local governments have proven horrible at stock investments. When CIC the State Council can take a look at CIC and see that they are doing rational things and more importantly, that they aren’t stealing from the till. If you let each province or local official invest in stock, you get a huge mess.
bsetser: let’s then say the minfin loses 4% a year over ten years (a 40% plus counting compounding cumulative appreciation, which i think is conservative) on the fx risk. the net result is effectively a transfer from the fin min to the pension system,
Yes. But getting to the “net result” is not easy. One criticism I have about neo-classical economics is that things “magically” happen. Supply magically matches demand. Rational investors “magically” select the investment with the highest return. Things don’t “magically” happen, and there are a lot of gears and pulleys that investors ignore.
bsetser: with a lot of funky intermediation and i-banking fees thrown in. the minfin picks up the fx loss that allows the cic to show a profit. I honestly don’t get it.
The part you are missing is that by having CIC act as a pension fund manager, the total losses that the Chinese state will encounter are going to be smaller than what they would have been had CIC not been spun off.
The amount that the Chinese government is going to lose via FX isn’t going to change no matter what CIC does, but by having CIC around the total bill to the Chinese government is going to be smaller, since by having professional money managers, the return on CIC is going to be bigger than it otherwise would have been.
Once the Chinese government takes out the currency risk, you can find a set of money managers, tell them to maximize risk-adjusted return, and just check on them from time to time, and you can tell whether they are doing their jobs, and you can tell when you should fire them and hire new people.
If you try to put everything in one pot, it’s not clear what the managers of CIC are supposed to do, and more importantly, it’s not clear whether they are doing their jobs or not, because it’s not clear exactly what their job is.
Suppose the reference index goes up 10%, and the portfolio managers at CIC have a portfolio that goes down 5%, At that point, they will get fired for not doing their jobs. If you don’t remove currency risk, then it is unclear what you should do if CIC assets go up 5% or down 5%, especially since the managers at CIC have no control over exchange rates or monetary policy.
bsetser: the balance sheet risk i drone on and on about has long been there.
What’s changed is that the limits of sterilization are being reached, and the current situation is turning into Chinese inflation. The fiscal stimulus package everyone is talking about right now is just going to make things worse.
One point. There is nothing to keep the US from “just saying no.” The US government can impose capital controls if it wants to and just prohibit CIC from buying US companies.
Sure this goes against twenty years of stated US policy, but its no worse than the US screaming at China for not floating its currency, after spending the 1990’s trying to argue that a fixed currency was essential to economic growth, that emerging countries had to defend currency values even in the face of economic hardship…. Blah… Blah…. Blah….
David Chiang rails against self-serving inconsistency and hypocrisy. I don’t because I’ve gotten used to it. People will argue whatever helps them at that moment, and if it happens to be 100% different from what they argued five years ago. Oh well… Too bad…..
Self-serving inconsistency is what will keep the US from doing what it takes to stem the flow of foreign money. Sure the US could prohibit Chinese investment in US banks, but at that point, you end up with lots of angry people without jobs, whereas I can’t think of a single person who will lose their job or lose money if the deal does go through.
Milton Keynes — I appreciate your comment even if I do not agree with it; it is well argued. I don’t have much to add to the PPP v nominal exchange rate gap beyond what menzie chinn has already said. The strongest evidence of undervaluation is the strong contribution of net exports to Chinese growth, China gaining market share from other emerging asian economies, the substitution of Chinese content for imported inputs and the extent of Chinese intervention. The PPP v nominal exchange rate gap was just an additional bit of supporting evidence.
I disagree with you that China gets a pass because it is a poor country. it is now one of the world’s largest exporters, probably the largest extra-regional exporter (i.e. us sells a lot to canada and mexico, Germany to the EU and so on). it is the largest single global investor. It may be poor, but its size makes it a global player — and creates global responsibilities.
Summers position is consistent with a fear that absent fiscal stimulus, the US really might just stop borrowing, cold turkey. that would be a shock to both the us and to china. the oversupply of dollar reserves (see US treasury pricing) opens up policy opportunities. I suspect that Summers still believes in the need for gradual adjustment but is worried about the prospect of an abrupt adjustment.
2fish — you are right about capital controls. in effect, restrictions on what china’s government can buy are a form of controls. if china maintains an exchange rate regime that effectively gives China’s government a monopoly on outward flows, i suspect that is where we are headed.
i still don’t quite get your pension fund point. the CIC’s external assets cannot be used to meet domestic pension fund liabiltiies any more than they can be used to fund domestic infrastructure investment. Until China adjusts is exchange rate and starts running a current account deficit, it will need to add to its external assets.
and the complicated reshuffling you mention where the CIC generates equity profits that are dedicated to one set of needs while the MinFin takes large currency losses that it absorbs to free up the CIC’s profits for other uses frankly makes little sense to me.
bsetser: i still don’t quite get your pension fund point. the CIC’s external assets cannot be used to meet domestic pension fund liabiltiies any more than they can be used to fund domestic infrastructure investment.
It can’t be used to fund current domestic pension fund liabilities. We are talking about bills that come due between 10-30 years, at which time CIC can sell its holdings which will be worth a lot more than they are now. What CIC buys today in dollars could very well be sold for RMB in twenty years.
bsetser: and the complicated reshuffling you mention where the CIC generates equity profits that are dedicated to one set of needs while the MinFin takes large currency losses that it absorbs to free up the CIC’s profits for other uses frankly makes little sense to me.
It’s a management thing. CIC is a for-profit entity with a balance sheet. Ministry of Finance is a government entity without one. By creating a money fund, CIC can be managed in much the same way (and perhaps by the same people) that manage Calpers or the state pension funds in the United States.
If you don’t split off the CIC, then you can’t use any portfolio managers to manage the holdings. At that point, it’s unclear how you manage the state’s stock holdings to maximize investment return.