As a professor at Peking University at the Shenzhen campus, I am very privileged to work with some of the best and most ambitious students in China. Every year I work closely with a handful of students on their thesis projects and some years, there are some really interesting and insightful papers that result from this endeavor.
This year I was privileged to work with Michelle Zhang who will become a fixed income analyst for BNP Parisbas next month. She led the writing of a very interesting paper on how Chinese companies are holding copper to execute the carry trade with Chinese characteristics. The carry trade is where traders arbitrage interest rate differentials by borrowing in a low interest rate currency and lend in a high interest rate currency typically in a short duration and in liquid high credit quality instruments. Though hedging future currency risk is typically advised, the research on uncovered carry trades find that uncovered are typically profitable and currency movements do not move in the predicted manner.
In China however, the carry trade due to capital controls is decidedly more complex. China exists in an asymmetric financial market where FX transactions are largely though not entirely free but capital account FX transactions are tightly controlled. To move capital but disguise the FX transaction as trade rather than capital movement, firms have found an enterprising way around this. A firm will enter into a sham transaction to export, for use in our paper copper, a product with a clear market price. The firm will then secure foreign currency trade financing, typically in a currency fixed against the RMB like the USD or HKD with low borrowing rates and potentially additional leverage, convert back into RMB and bring the currency back into the country under the guise of goods trade. They will then invest in typically high credit quality short term products and then unwind the trade and the end of the term for the copper holding.
To avoid going into all the technical details both about how this trade is executed and the econometrics, let me just summarize the major findings. First, there is clear and unambiguous evidence that copper stock holdings are related to the Chinese carry trade. Given that by our official estimates, China now holds nearly 40% of the global copper stock in warehouses, which excludes ongoing consumption, this is not an insignificant finding. It is also worth noting that some estimates, have Chinese copper stock responsible for an even higher share of global copper stock holdings.
Second, the carry trade and copper holdings are driven by the approximately 4% interest rate differential between LIBOR and SHIBOR. Investing in even mildly higher risk instruments can significantly increase this differential. We estimate that every basis point differential between LIBOR and SHIBOR is responsible for approximately $1.5 million USD in copper stock holdings.
Third, there is little evidence that copper carry traders are entering hedging positions such as FX, interest rate, or credit protections. For instance, FX volatility or future prices in major currencies appear to have no impact on key variables for expected durations. While the PBOC maintains tight control over FX, granting traders an implied policy hedge, it appears that traders are insufficiently hedged against FX and interest rate movements.
Though this may seem to have semi-arcane financial market implications, it actually gets directly to one the puzzles of Chinese monetary policy. That is, if Chinese banks are flush with cash as the PBOC claims and loan demand is low, why does the PBOC continue to release cash into the system via reserve rate cuts rather than cut interest rates when even the best SOE is facing real interest rates of approximately 10%? This would seem to have a much larger impact on the economy. Given that debt durations throughout China are typically quite short, this would provide rapid pass through to borrowers and a broader based boost to the economy.
There appears to be a couple of reasons. First, China is still heavily dependent on capital inflows to finance its continued development. Given the already porous nature of its capital controls through a variety of means like fake goods trade or over invoicing, any reduction in the attractiveness of RMB assets risks turning the interest in non-Chinese assets into a stampede regardless of official capital controls. The PBOC appears to be making the tradeoff of trying to continue to attract capital by keeping interest rate high even if that risks choking off businesses with absurdly high real interest rates. With the decline in the accumulation of FX reserves from the revaluation of the RMB, China needs to find other methods to attract capital. Despite all the rhetoric from Beijing about rebalancing the economy, this speaks directly to their continued model of attracting capital in order to drive investment, even in a credit saturated economy.
Second, despite all public pronouncements to the contrary, this implies that banks are weaker than is believed. Though lending rates have been freed, deposit rates have yet to be freed and reducing interest revenue would really compress margins on banks that are experiencing slow loan growth and coming under pressure from rising questionable loans. Aggressively lowering interest rates in the absence of deposit rate liberalization would squeeze the banks. Conversely, removing deposit rate guarantees could further exacerbate the move away from major state banks shifting deposits to other financial institutions or prompt capital outflow. Given the PBOC and government mandate to buy up low yielding government bonds and continue lending to LGFV whether they are paying or have any prospect of paying, banks already appear weaker than public pronouncements. Slowing the capital inflow or giving reason for capital to flow out could really create problems for China the major banks.
Third, the PBOC and China have yet to really grasp the enormous change in monetary and financial policy required to become a major international currency. Evidence indicates that the PBOC is slow to respond to outflows in a fixed exchange rate regime and is not responding to the international demand for RMB outside of China but expecting and even pushing the IMF to make the RMB an international currency. While it politically may become an international currency, it is struggling to manage the financial transition. Recently, rather than directly channel RMB to offshore centers, the PBOC moved to begin international repo agreements where foreign branched Chinese banks would enter repo agreements offering foreign assets in exchange for RMB needed for trade liquidity purposes. It is clear that the PBOC is struggling to grasp the enormity of the shift before them.
The PBOC and China are caught between difficult trade offs with regards to the conduct of monetary policy. They can either demonstrate resolve to become a major international currency or they can politically push and shrink from managing the financial shift taking place with or without them. I personally can’t wait to watch what unfolds.
Note: Michelle Zhang while jointly responsible for the academic paper on the copper carry trade is not in anyway responsible my comments on the PBOC and Chinese economic policy.