My Last Word on FX Swaps on Chinese Banks Net Foreign Asset Position

Just a few last words on FX swaps and Chinese banks based upon the recent Brad Setser follow up and next time we move on to new material.

First, we cannot say exactly who is taking the other side of this swap position but that in no way negates the point that they are being made and volume according to bank and market financials has risen enormously.  Based upon multiple data points it is clearly happening in large number.

Second, swaps are not “off balance sheet”. They are very much on balance sheet.  However, banks do not record the full cash or “notional” amount of the swap only some type of value at risk or expected gain/lost amount.  For instance, assume I buy a $1 million FX swap that returns the domestic currency at a future exchange rate that imposes a 1% loss plus say 0.5% transaction fee. I would say the “notional” amount is $1 million but I would carry as a liability the 1.5% (1% loss plus 0.5% transaction fee). This distinction will come important later.

Third, there is no explanation to the most fundamental of questions: how are Chinese banks obtaining foreign currency to fund this growth in foreign currency assets?  Again, how does a bank fund asset growth if it cannot access, via deposits or debt, capital to fund asset growth?

Fourth, the preferred explanation of higher foreign currency deposits in Chinese banks does not come remotely close to explaining the growth in foreign assets.  This is explained by noting that foreign currency deposits increased during this time.  However, during a period when net foreign assets increased $300 billion, foreign currency deposits went up by a total of $123 billion. This leaves a significant amount of unexplained foreign currency asset purchases even using those numbers.

What makes this increase in foreign currency deposits even more interesting is that it lines up perfectly with the preferred explanation of a move in to swaps to facilitate outflows.  Let me explain.  Though foreign currency deposits increased by $123b, $54b of this increase comes from overseas foreign currency deposits into Chinese banks. In other words, domestic Chinese foreign currency deposits have only risen by $69 billion since January 2015.  When a Chinese bank sets up an overseas operation, depending on whether they are a legally a branch or a subsidiary office, technically two different entities but typically sharing significant overlap, the financials of a branch are technically credited back to China.  Consequently, China is able to credit foreign currency deposits in overseas offices to its own balance sheet.  It is not uncommon for products to be combined for clients between branch and subsidiary balance sheets.

Here is how this explains the “swap” aspect.  Using the example of a client that has RMB on the mainland but can’t get the money out, when a Chinese bank offers via swaps to move this money, banks virtually always require this money be deposited with them in their overseas entity. For example, let us assume that Company A has a Chinese subsidiary with 700m RMB that they cannot get out of China they want to use for other purposes let us assume in London.  Chinese Bank A will facilitate a swap to “lend” money to Company A in London. However, as part of this transaction, Company A will be required to deposit 700m with Chinese Bank A in China. They will also be required to deposit some portion of the corresponding loan in London with the Chinese offshore entity.  For simplicity sake, assume Company A deposits $25m USD in London and uses the remaining $75m for other purposes, this would show a corresponding rise in the foreign currency overseas deposits of Chinese banks.

Last major point is that the numbers presented match the swaps story very closely.  For instance, if companies with mainland operations want to move capital and the Chinese bank requires them to deposit some percentage of the proceeds in an overseas account, this would match the growth in overseas foreign currency deposits and the growth in assets based upon a “foreign currency” loan being made overseas.

The discrepancies noted between the net asset positions and growth in foreign currency deposits are not just inconveniences or rounding errors but significant problems with the story that this net asset rise.  What is important to note is that everything that has been shown is perfectly consistent with an increase use of swaps to fund the growth of foreign asset purchases.  While it remains perfectly valid to ask who is the counterparty and he right in noting that list is pretty short, that in no way changes any part of the analysis and actually