A while back I was asked by Brad Setser during a Twitter exchange involving many people spell out why I think China if it has banking system problems will also likely suffer a currency problems. This is a very good question. Let me try and answer that in detail and provide many reasons.
- I do believe it is possible China can deal with significant banking problems without having currency problems, but I believe it is much more likely that if there are systemic banking issues that currency problems will also arise. In other words, I am not ruling out his argument that it is possible but I think it is much more probable, one will precipitate the other.
- Let’s begin by assuming there is some type of “event” that requires Beijing to step in and provide capital in a systematic way to prevent larger problems. If we have learned nothing from watching Chinese financial markets over the past few years, we should know that market sentiment is incredibly fragile. Given the ongoing outflow pressures, it seems highly likely if there was an event that required or pushed Beijing to step in (I use “event” here to cover events ranging from pre-emptive large scale recapitalization to significant financial institution collapse) this would likely have a major negative impact on sentiment. This would likely require significant steps on the currency side ranging from full draconian measures to prevent problems with the RMB. Individuals are not taking currency out of China as a vote of confidence so any type of large scale bank or financial institution event would likely only redouble their drive to take currency out of China.
- I believe, as I have believed for some time, that the currency and financial system in China are intricately linked. Beijing is obsessed with preventing a fall in the RMB due to financial system concerns. Here is what I mean by that. Let’s assume right now the RMB drops 10% against the USD. What would happen to the real Chinese economy? Adjustments would happen but for many reasons, which I have covered elsewhere, I do not believe until you get to extreme numbers that a decline of the RMB would have a major negative impact on the real Chinese economy. So then why is Beijing working so hard to keep the RMB up and stop capital outflows? While some have argued it is US political pressure under Trump, China has been working to keep the RMB elevated for a number of years. Furthermore, they have never had any trouble ignoring US political pressure on economic and financial matters, so this seems a strange place to start. The much more likely explanation is that Beijing fears the domestic financial problems if it did not prevent large scale capital flight that either precipitated a fall in the RMB or followed. Even with steep drops in outflows, the Chinese financial system is facing significant liquidity problems even as the PBOC remains net provider of liquidity and its balance sheet continues to expand. If there was any move, not just of currency out of China, but out of the Chinese financial system, it seems unlikely that the Chinese financial system would be able to survive even a small move out of its walled off system.
- One argument that is made is that the government has a lot more space to bail out Chinese banks and so can avoid any entanglement with currency problems. However, even here, I believe it is less likely that currency problems can be avoided. Let’s take a couple of simple scenarios.
- Assume that China opts to issue bonds to recapitalize its banks. It cannot sell the bonds to banks, who by definition lack the capital, so it sells the bonds to the PBOC who increases the money supply above an already strong growth pace. Even stronger money growth would place significantly stronger pressure on the RMB. It seems inconceivable that China could materially grow the money supply above current trends and would not face some type of major currency adjustment. Consequently, even if the government can (has the fiscal capacity), which is another discussion all to itself, bailout/recapitalize the Chinese banking system, they cannot do it without lowering the value of the RMB.
- Despite many people believing the PBOC can bail out the Chinese banking system, there are numerous problems with this hypothesis. For instance, at this point the PBOC simply does not have enough money. Depository corporations in China have total assets of 236 trillion RMB. $3 trillion converted into RMB is only 20.7 trillion RMB or only 8.8% of assets. Any significant loss or recapitalization is going to require more than the amount of FX reserves held by the PBOC. Needless to say, if the PBOC depleted its FX reserves to convert into RMB and pay for the recapitalization, this would have a negative impact on confidence in the RMB.
- Another proposal has been to let quasi-public distressed asset management firms buy up bad loans as they did roughly 15 years ago. However, this fails to fundamentally address the problem also. Mechanically, this would work similarly to a straight bank recapitalization with bonds issued by the government and cash provided by the PBOC. In this instance, if the AMC’s bought loans from the banks at full face value to keep the banks solvent, this would solve the banks problems but merely move the losses elsewhere. If we assume that the AMC’s are buying at full face value to keep the banks solvent and recovering at 30 cents on the RMB, that still requires them to receive enormous capital injections for any significant loss level. The AMCs then must either receive some type of direct public capital or issue bonds to the PBOC or private investors. While the AMC’s have the expertise and guanxi, they do not have the capital. China has been ramping up these companies but so far, even though the numbers are not entirely insignificant, they are operating under the framework of the official 1.74% NPL rate cover roughly 91 trillion RMB in commercial bank loans. If we just increase the expected NPL rate or expand it to cover off balance sheet items owned by banks or include non-bank financial institutions, the expected numbers are simply blown out of the water. Ultimately, we return to the problem that any significant increase in capital to bailout the Chinese banking system will require an enormous increase in the money supply on top of the already robust rates. A large increase in money is going to place enormous downward pressure on the RMB
- There are other problems. Despite the belief China addressed its bad debt problems before, the reality is much simpler, it simply outgrew them. What is important is that not only did growth remain high it experienced a sustained acceleration. From 2000-2002, quarterly YTD real GDP growth ranged from 8.3-9.1%. From 2003-2011, the only time Chinese GDP growth was below the 2000-2002 range was right after the global financial crisis. Most of this time was marked by double digit growth topping out at 14.4%. China did not address its bad debt problem as much as outrun it. In one example, a Chinese bank went public in Hong Kong listing a complicated swap agreement where IPO proceeds would be used to pay off a decade old bad loan it had made. This matters because if we project forward, this implies that to manage its debt problem China must experience a significant shift between the rate of growth and debt. Either debt growth must enormously decelerate or nominal growth must rapidly accelerate. Taking this out of the macro-financial and into the micro-financial, a large amount of the “cost” of the previous bank bailout via AMC’s simply melted away from a growth acceleration as asset prices rose sharply. I do not think it is likely that China will enjoy either acceleration of nominal growth from current rates or continued double digit growth in asset prices to absorb the cost of financial system bailout. This returns us to the question of what will happen if there is a large increase in money to pay for the bailout? If the PBOC prints money in excess of the already robust rate of growth, the most likely outcome if significant pressure on the RMB.
- Another reason any significant problems in the financial sector in China will result in currency pressures is the role of lending and asset prices. Assume there is any significant financial event (again ranging from pre-emptive significant recapitalization to institutional collapse), there are two possible responses. Now assume while managing the financial event, China opts to engage in counter-cyclical lending splurge to keep asset prices and economic activity high. For instance, at the moment YTD aggregate financing to the real economy in China (total social financing) is growing at 13%. Assume while recapitalizing its bank China tries to boost activity by increasing lending significantly above trend. If we add in the growth of money from PBOC bond purchases, this would cause Chinese money supply and then money flowing through the system via lending to increase enormously. This would result in significant pressure to move capital out of China in an inflationary environment or with major increases to the money supply. Take the opposite where China opts to recapitalize banks (or some similar event) but in this instance, China opts to constrain lending by some appreciable amount. This would have a major negative impact on asset values throughout China and by extension the rest of the world. Imagine a Chinese real estate market where mortgage lending isn’t doubling. What will happen to prices? They will fall and when they fall people will most likely look to get their money out of China. If people are worried about the fall of the RMB and try to get money out, imagine what will happen when real estate prices (responsible for about 75% of household wealth) starts falling. It is very reasonable to believe this will increase real estate price pressures with people looking to move money out of China.
- Now I can already hear people complaining, and somewhat understandably so, that in each scenario whether China deleverages or accelerates lending, after a “financial event”, I believe it is likely that currency pressures will increase. That is accurate but I also believe a reasonable position to hold. Not only are both logical positions they match the empirical data but return to a larger macro-financial theme which gets to asset price levels in China. Assets in China are simply enormously overvalued and need to fall. Michael Pettis has referred to this in similar terms as a “balance sheet recession”. I think of it slightly different, with regards to the currency discussion, in that I believe there is a much larger structural demand for foreign assets by Chinese citizens/firms in virtually any scenario than there is for Chinese assets by foreign firms/citizens. There are many reasons for this but it is simply very difficult to see where this structural demand tilts towards net inflows into China. One of the reasons for the focus on stability by Beijing is that as long as asset prices are stable and moving in the right direction, they will be able to minimize flow pressures. Even if we think about how to fund the public contribution to the bailout, it has been suggested that China sell off some assets to create a fund to bailout the banks. Who is going to buy these shares at some type of inflated price? Domestic firms do not have the financial flexibility required for any significant asset purchases having resorted to SOE’s playing circular IPO cornerstone and international firms will be incredibly reluctant to fund large scale asset purchases without a wide range of concessions. There simply appears a requirement that asset prices fall and part of this is a decline in the RMB.
- The last major question is whether this can be financed with a simple expansion of the Chinese government balance sheet. Partially but it is distinctly more complicated than that. For instance, just saying “expand the official level of government debt” to pay for a bank recapitalization does not answer where cash needed now to keep banks solvent comes from. The most direct way would be via bond sales purchased by the PBOC from printing money but that clearly brings a variety of issues and most importantly for our discussion, pressures on the RMB. Furthermore, and this is something that is poorly understood by many many people, is the virtually every debt is perceived as being backed by the government by Chinese investors. I want to emphasize this does not mean they have technical or even implicit state backing but from sophisticated institutional investors to small scale retail punters, there is a wide spread belief (which Beijing while officially denying in practice has not given people reason to behave differently) that virtually every debt product has a state guarantee. The simple reality is that in the event of a financial event that requires public action, large sections of “private” Chinese debt will simply be absorbed by the state. Now with total depository corporation asset of 316% of GDP at the end of 2016, it wouldn’t take a large bailout as a percentage of total asset to take Chinese central government debt soaring into Grecian territory. An explosion in government debt financed via some of the various channels here is possible but it is important to note there are greater constraints there than generally realized and the impact it would have on the RMB.
I want to emphasize this is what I view as more probable than no or minimal impact on the RMB given some type of financial sector problem but as I have noted many times, I think it is important to think in probabilities. Also, this is intended not as any type of personal attack but simply laying out what I see and expect. Finally, while individual points are important, I am also looking at the range of factors. Even if I am wrong on some of individual speculations, I believe the totality of evidence implies this is the most probable direction.