China: The RMB And Capital Outflows by Michael Pettis, GlobalSourcePartners
Below is an excerpt where Michael Pettis challenges some assertions in Kyle Bass’ recently letter to investors which was obtained by ValueWalk. Check out the full letter for context before reading what Pettis has to say.
Special points to highlight in this issue:
Seth Klarman: Investors Can No Longer Rely On Mean Reversion
"For most of the last century," Seth Klarman noted in his second-quarter letter to Baupost's investors, "a reasonable approach to assessing a company's future prospects was to expect mean reversion." He went on to explain that fluctuations in business performance were largely cyclical, and investors could profit from this buying low and selling high. Also Read More
- Beijing’s FX reserves are substantial, and recent concerns that they will very soon be depleted are overstated, although there is no question that if net outflows continue at current levels for many more months, we will have to start seriously reconsidering.
- The idea, however, that China needs $2.7 trillion of reserves to perform the basic insurance functions of FX reserves is almost certainly not true. The appropriate amount of reserves China needs to guarantee necessary imports and the payment of obligations on the capital account is probably half that level.
- Beijing is clearly very concerned about outflows, and for now the PBoC’s strategy is likely to be driven by efforts to reduce these outflows. There are a limited number of strategies, however, and it is not clear to me that any of them are likely to cause outflows to abate.
China: The RMB And Capital Outflows
There has been a flurry of concern about China’s ability to continue withstanding current levels of capital outflows, and just as until recently the strength of China’s balance sheet was seriously overestimated, some of the recent concerns might be underestimating balance sheet strengths. On February 10, for example, Kyle Bass, the Managing Partner of Hayman Capital Management, sent a letter to his investors detailing his concerns about the vulnerability of the Chinese financial system. The letter was subsequently passed on through the press to the rest of the market, unleashing, as everyone knows, another round of worry, and even panic, about the state of the Chinese economy.
The letter has two main thrusts. First, Bass argues that the banking system is bankrupt and will require a huge capital injection to regain its footing. He refers to the mechanisms banks use to conceal their losses “a ticking time bomb”.
Regular readers know that I have no problem with Bass’s characterizing the banking system as insolvent, and in fact I argued many years ago that an unsustainable increase in debt was embedded within China’s growth model, and that its already high debt burden would inexorably rise over the next several years. But while there is always a risk of a banking crisis, I still think that we are unlikely to see the Chinese banks collapse.
Banking systems do not break down just because they are insolvent. If they did the Chinese banking system would have probably broken down many years ago, as would, by the way, that of much of Europe. Banking systems break down because they are unable to manage significant mismatches between assets and liabilities that at some point render the bank illiquid. A perception of insolvency may lead to a liquidity crisis if it causes depositors and lenders to withdraw their funding, but a withdrawal of funding need not happen when there is credible backing to support the insolvent bank’s liabilities. Without that sudden withdrawal of liquidity there will not be a crisis.
I know this from personal experience. I started my career in 1987 trading the defaulted and restructured LDC debt at New-York based Manufacturers Hanover, then the fourth largest bank in the US (and now part of JP Morgan). At the time it was widely known that if banks were correctly to mark their LDC exposure to market, every one of the top ten US banks, with the possible exception of JP Morgan, would be technically insolvent. And yet there was no collapse in the US banking system. Why not? Because of the widespread and highly credible assumption that the US government would stand behind the banks.
The same holds true for Chinese banks. As long as depositors and lenders have a limited ability to withdraw their funding from the banking system, and as long as the regulators are credible and can manage liquidity within the banking system effectively so as to resolve liquidity mismatches between liabilities and assets, there will not be a banking collapse. This is why in nearly every issue of this newsletter for well over a year I have stressed the importance of Beijing’s protecting its credibility. While it has clearly been weakening, especially since last July, overall confidence in Beijing’s guarantee continues to be high, so that as long as Beijing learns to husband this credibility and not dissipate it too freely in useless gestures, as it did last year when it tried to manage the stock market, there will not be a banking crisis.
But even without crisis the insolvency of the banking system isn’t irrelevant. It will affect the evolution of China’s financial sector over the next decade or so, and will determine to a significant degree how successful China’s overall economic adjustment will be. Surprisingly enough a zombie banking system can actually be a spur to productivity growth if it forces enough of a relaxation of the grip of big banks over the economy. In that case the financing process can migrate to smaller and more innovative financial institutions that specialize in financing the more productive areas of the economy.
In the US during the 1980s, for example, when the largest US banks were struggling with their LDC and energy portfolios, and were more concerned about managing risk down and avoiding further trouble than about expanding to serve the changing needs of their customer base, it is not a coincidence, I would argue, that we saw an explosion of financial innovation, most importantly the creation of the junk bond market as a major source of financing, and including the emergence of new types of LBO and private equity funds, the beginnings of explosive growth in the financing of the high tech sectors in California, and the expansion of regional banks, most of whom weren’t crippled with LDC loan exposure.
The incentives for large banks are almost always geared towards reining in risk-taking and volatility in the economy and controlling the intermediation of savings, and it is probably not an accident that the most innovative periods in US or British economic history often coincided with periods of tremendous flux in the domination of the economy by major financial institutions. I have argued before many times before that we sometimes overvalue the economic benefits of stability within the banking system, and I often cite the great Belgian financial historian Raymond de Roover, who once explained that, in the 19th century, “reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada”
Because a punch-drunk banking system spends more time managing its bruises than looking out for new opportunities, it often ignores the needs of its frustrated clients, who will then turn eagerly to new sources of funding. In a sufficiently liberalized financial system, financial innovators can exploit this attention gap to go after the most profitable sectors of the economy. But this only happens if there are no powerful institutional constraints, usually implemented by the political allies of the big banks themselves, to help them manage through their difficulties that effectively prevent innovation and destabilizing change.
A zombie banking system, in other words, does not always lead to financial innovation. Japan after 1990 also suffered systemic bank insolvency, but very conservative regulations and tough restrictions on financial innovation left the economy without meaningful alternatives to the large banks. Like their American and Japanese counterparts in the 1980s and 1990s, respectively, large Chinese banks have become zombies, even more so once they are forced into absorbing the smaller banks, whose asset quality is far worse and whose liabilities much riskier, something I think we are very likely to see over the next decade. We will have to see then whether the consequence is an explosion in financial innovation or a zombie banking system unable to finance new, productive businesses. My instinct is that given very powerful and closely intertwined banking and regulatory institutions, China is more likely to resemble Japan in the 1990s than the US in the 1980s.
But maybe not. Potential competitors – including several financial boutiques, private equity funds, internet-related financing companies, and the asset management companies created to resolve the bad debt of the 1990s – have positioned themselves for rapid growth in the decade ahead, and may even have the political connections that allow them to escape smothering by the large banks. It is far too early to say, but one of the things I’ll be watching over the rest of the decade, and investors should also watch closely, is whether the Chinese banking system retreats into a fortress mentality or whether Beijing will tolerate a greater role for the markets in the evolution of its financial system. This will tell us a lot about how successfully China’s economic adjustment sets the stage for long-term growth.
Running out of reserves?
Whichever path China follows, there is little doubt, I think, that it will run through a zombified banking system. I think the Bass letter, in other words, is basically correct in its pessimistic evaluation of the solvency of the Chinese banks, although its language of ticking time bonds is perhaps a little more incendiary than necessary. The consequences of insolvency among China’s banks are less likely to consist of explosions, I think, than of the slow, purposeless lurching of the walking dead.
Bass posits a hole in bank equity of $3.5 trillion if banking losses are equal to 10% of assets, and he notes, correctly, that losses were substantially greater in earlier loan surges. Of course none of these earlier surges is at all comparable to credit growth in the past decade, during which time banking assets grew from “under $3 trillion to over $34.5 trillion”. The $34.5 trillion number may be overstated – total assets of depository corporations, according to the PBoC is around $4 trillion less, and $5 trillion of what is left consists of direct and indirect claims on the central government.
But these are all quibbles when we remember that fifteen years ago the amount of bad loans in the banking system may have been several times the 10% that Bass uses as his base case. The losses, in other words, may be substantially more than his base case, and although we just don’t know, we shouldn’t forget how self-reinforcing this number can be: higher losses in the banking system lead to even slower growth, and slower growth will result in higher losses.
But for all its warnings about bad debt, the second part of the Bass letter received as much attention, if not more, with its claim that for all practical purposes China’s real FX reserve position is much weaker than that implied by its reported reserves, and well below the minimum amount of liquid reserves needed by China to meet the ordinary purposes of central bank reserves. Based on the standard IMF formula, the minimum reserve level cited in the Bass letter is $2.7 trillion. Against this amount, the letter claims that the $3.2 trillion official reserve level as of the end of January has to be adjusted downwards by over $1 trillion, leaving the PBoC with no more than $2.1 trillion in liquid reserves available to provide what we might call the “insurance” function that reserves are supposed to provide, well below the $2.7 trillion it needs.
here are two parts to the Bass argument. The first is that the real value of reserves, for all practical purposes, is substantially less than the stated value of $3.2 trillion. One of the main purposes of FX reserves is to insure the country’s ability to access vital foreign commodities and to fulfill contractual obligations on the capital account in a period in which it might otherwise have limited access to the foreign currency it needs. For this reason highly liquid and price-stable securities (basically government T-bills and their equivalents issued by the US, Germany, Japan, etc.) that can easily be liquidated, even in very difficult periods, should represent most of the PBoC reserve holdings. To the extent that there are other assets included in reserves – for example other highly liquid or illiquid securities that can be sold off at no political cost – there must be some substantial discount, or “haircut”, deducted from the value of the portfolio to represent the potential cost of liquidating these assets when the PBoC most needs them. Of course this haircut must reflect the fact that their liquidation is always likely to be at a time when the value of these securities is lowest and the illiquidity premium is highest. It is also important to remember that when these assets are most needed, general confidence is usually at its lowest point, and regulators have to be extremely concerned about the signaling impact of liquidating these securities.
China’s reported reserves were $3.2 trillion at the end of January, but beyond that we have very little information about the composition of these reserves. In his letter Bass makes three substantial deductions that reduce the value of the PBoC’s stated reserve by nearly one-third. He deducts about $0.1 trillion to represent policy bank and AIIB commitments. This isn’t a large number, but it does point out one possibly relevant issue, and that is that the PBoC might actually have access to other liquid foreign currency assets held by China’s policy banks and by other financial institutions in China over whom the regulators have control.
I don’t have nearly enough information to estimate the amount of such assets. We know, for example, that the CIC, China’s sovereign wealth fund, has foreign currency assets that in principle could be attached by the PBoC should the State Council so decide. We don’t know their total value, however, or how liquid they are. Of course, because it would be a damaging signal were the PBoC ever forced to call on these assets, we cannot simply assume that they are easily available to serve the insurance function. Calling on them might so adversely impact confidence that it actually exacerbates outflows by more than the value of the assets. To the extent that Beijing can force other entities within China to relieve the PBoC of part of the burden of funding foreign outflows, however, there are nonetheless other FX assets in China that we might think of as “hidden” reserves, and these can be conceptually added to total reserves if we want to measure the insurance value of the PBoC’s reserve position.1
Bass deducts a further $0.7 trillion from total PBoC reserves to represent the CIC. There is no explanation of exactly why he does so, and so I am not sure what this means. I have spoken to a number of people who follow the PBoC more closely than I do, and none of them could explain either why this amount was deducted. We don’t have a great deal of information about the value of securities held by the CIC, but I am pretty sure that when the PBoC reports the total value of its reserves, the CIC portfolio is not included in these numbers, in which case it’s not clear why they should be deducted from a proper accounting of total reserves.
Bass may be referring to assets held by the PBoC in exchange for the FX reserves out of which it swapped when the CIC was created, but the first tranche of the transfer, if I remember correctly, was swapped for RMB-denominated bonds, and these would not have been included in the reported PBoC reserves number. Bass may have much more detailed information than I do that explains the deduction, but I do not understand why he made the deduction and my instinct is to add it back, at least until I understand why it was made.
Finally Bass deducts another $0.2-3 trillion to represent what he calls “Open Short RMB Forwards by Agent Banks”. These would probably consist of forward commitments made by the PBoC in the offshore markets to sell dollars as a way of limiting the decline in the value of offshore RMB. Central banks have done this before, and I think I remember that the Korean central bank got caught up in just such transactions in 1997, leaving itself dangerously with a far smaller reserve position than the reported data would indicate. Since then investors have learned to expect such behavior.
These forward short positions, if they do indeed exist, would clearly represent a valid deduction from reported reserves because the dollars they represent are no longer available to sell for RMB. The PBoC is unlikely to acknowledge that such commitments exist, however, and there is no information of which I am aware about whether or not they have done so, and what their total value might be, but the Bass estimates are reasonable, and more or less in line with estimates I have heard from traders and PBoC watchers.
Putting all of this together, I would guess that the PBoC probably has a tad under $3 trillion directly under its control in available reserves. Indirectly it probably has an additional few hundred billion dollars held by other institutions that could in principle be sold in order to help maintain the value of the RMB. In addition, one of the great worries that we have had over many years is the amount of metal and energy commodities stockpiled in different locations in China, often purchased after every sharp fall in prices because of the incorrect belief that long positions were “hedges”, and that price declines represented buying opportunities. I do not expect metal prices to revive (in fact I expect continued declines) especially in the event of a financing crisis that requires exercising the insurance value of FX reserves, and while all countries have these kinds of inventories, to the extent that Chinese inventories are substantially greater, and more likely to be incorrectly classified, they imply two things. First, the domestic debt burden is higher dollar for dollar than the figures indicate. Second, however, FX reserve equivalents are dollar for dollar higher in China.
What minimum reserve level?
So while China may actually have the equivalent of more FX reserves than reported, perhaps around $3.5 trillion in reserves and reserve-equivalents, and not one-third less, as the Bass letter argues, the much bigger problem I have with its warning really concerns the other side of the equation, i.e. the amount of reserves the country needs to insure its ability to access vital foreign commodities and to fulfill contractual obligations on the capital account. The letter applies the standard IMF formula for calculating the minimum amount of reserves needed by developing countries. This formula, I would argue, is almost useless.
The optimal amount of reserves a country needs is a function of several very different factors. These include credibility, the underlying volatility of export earnings and of import prices, the structure of the country’s balance sheets, its currency regime, and a number of other qualitative factors that can vary tremendously from country to country.
A formula, however complex, that can be meaningfully applied to different countries was always unlikely, and it is only because the average economist seems to value precision far more highly than he or she values accuracy, that we would ever consider such a formula to be anything more than a very, very rough first pass which must immediately be adjusted to reflect qualitative factors, and one only applicable even then to the most “average” of developing countries – i.e. those with balance sheet structure and balance of payments positions typical of developing countries. It’s not as if the IMF doesn’t know this. Their December 2014 paper, “Assessing Reserve Adequacy”, recognizes many of the problems with determining adequate reserve levels, but they still fall back on the formula.
Anyone who looks at the components of the IMF’s Minimum FX Reserves equation, in other words, should be extremely skeptical about its usefulness, and it turns out that this is especially the case when the formula is applied to China. The IMF formula Bass uses sets the minimum required reserves for a country as being equal to the sum of four different values, which in China’s case adds up to $2.7 trillion:
(10% of Exports) + (30% of Short-term FX Debt) + (10% of M2) + (15% of Other Liabilities)
In their 2014 paper the IMF revise the formula for countries with fixed-rate currencies by raising the total value to include 20% of other liabilities, not 15%. For countries with floating-rate currencies they reduce the M2 and export components to 5%. China’s is technically a floating rate regime, but it acts enough like a fixed-rate regime that we can think of it as a kind of hybrid. There is, in other words, a credibility cost to them of switching from their current interventionist policies to a truly free float.
When we examine the formula more closely, it is clear that China’s has a relatively high ratio of exports to GDP. The first value is consequently a fairly large number in comparison that of with most other countries, although at $0.2 trillion it represents less than 10% of the final $2.7 trillion number. The immediate and most obvious problem with this value is that Chinese exports are more diversified than those of most developing countries, which tend to be heavily commodity dependent, and so their value is likely to be far less volatile. China is less susceptible than other countries, in other words, to the kind of collapse in export revenues that we’ve seen in cases in which a country’s exports are dominated by energy or industrial metals. With so much less risk of a sharp, unexpected reduction in its ability to generate foreign currency revenues, there is simply no way that the amount of FX reserves China needs to insure against export disruptions can be anywhere near the amount that say Brazil, Venezuela, Russia or even Thailand, with its strength in global rubber exports, might need.
I am also very suspicious of the M2 component, which in the Chinese case represents a massive $2.1 trillion of its proposed minimum required reserves of $2.7 trillion, or nearly 80% of the total. There is no question that the size of the domestic monetary base must matter in any calculation of the amount of reserves a country might need because the size of the money base and underlying liquidity more help determine the ease with which outflows can be monetized. In the case of China we’ve seen very explicitly how the PBoC has struggled to balance the demand for looser money from illiquid borrowers unable to make debt-servicing payments and the impact of looser money on outflows.
But while the size of the money supply clearly matters, the definition of what constitutes money is extremely complicated. In fact every class in monetary finance begins with a discussion of the impossibility of measuring the money supply, or even of defining exactly what money is. Too often this discussion is treated perfunctorily as an impediment that can be immediately dismissed once we get to the serious business of counting money, but the many different monetary aggregates we employ, from M-zero all the way up, simply reflect the fact that we don’t really know what money is.
But just because we don’t know what money is doesn’t mean that we cannot usefully measure changes in the money supply. The various monetary aggregates, including M2, are proxies for money that allow us to estimate the direction of these changes, but in using them we must remember two things. First, these are rough proxies, and none of them is satisfactory, which is why we have so many different monetary aggregates. We can calculate the actual numbers with great precision, but this is a totally spurious precision, made possible only because of the way arithmetic works. I recently re-read William Greider’s 1987 account of the recent history of the Federal Reserve, and much of chapters 7 to 10 recount the enormous frustration that Paul Volcker and his colleagues experienced as they switched from one aggregate to another as each seemed to fall apart as a description of changes in the US money supply.
The second thing we must remember is that even though any monetary aggregate we choose to use is “wrong” as a measure of the money supply, it can nonetheless be useful as a measure of certain kinds of change. However the monetary aggregate we choose to use is only comparable to the same aggregate in another country or at another time if the two countries or periods have broadly similar financial systems, regulatory frameworks, debt levels, and so on. When the underlying institutions vary significantly, we cannot assume that a unit of M2 in one country has the same impact,
or even roughly the same impact, as a unit of M2 in another country.
I made a very similar case in a May blog entry in which I explained that the PPP adjustment to GDP for China is thoroughly meaningless exercise. Like the monetary aggregates, GDP as measure of wealth creation, and even as a measure of economic activity, is always “wrong”, and for those who are not convinced I can recommend Diana Coyle’s gem of a book on the history of GDP, whose main purpose, it seems, is to leave readers wholly frustrated about the usefulness of GDP as a measure of anything.
But while GDP measures nothing useful because of all of its biases, it is nonetheless the case that under correctly-specified conditions the comparing of GDPs across countries or across time can provide useful information, as long as we understand – and unfortunately we often don’t – the specific conditions under which GDP can be a useful measure. The biases in the GDP measure must be consistent. This is an obvious statement, but while economists don’t dispute it, many of them seem to ignore its implications, perhaps again because while it may be inaccurate, it nonetheless allows for precision. This is why I am digressing, a little more forcefully than I might otherwise on the subject of M2.*
There is absolutely no question that a unit of Chinese M2 is not the equivalent of a unit of M2 in the US, in Nigeria, in Switzerland, or in any other country – nor for that matter, are American, Nigerian or Swiss units of M2. Chinese M2 is probably less “money-like” (in the sense Robert Mundell would have used it) than M2 in many other economies, mainly because of substantial rigidities and distortions in the Chinese financial system. I remember reading a few years ago, for example, about how the transmission of PBoC monetary policy among different provinces varied, and while this undermines the effectiveness of PBoC policy, it also implies lower liquidity per “unit” of Chinese M2 than that, say, in the US, and, with it, a lesser impact on capital outflows.
Bad debt kills money
It cannot be the case that all M2 is created equal, and this is all the more obvious to anyone who believes that China has a significant amount of bad debt it hasn’t written down. Bad debt is effectively a kind of “dead” asset. Writing it down technically would not affect M2 because deposits, not loans, are part of the definition of M2, but this I would argue is one of the accidental problems with the definitions of the monetary aggregates: it is through their existence as financial assets, and not as liabilities, that “money-ness” in an economy is determined, but we define the aggregates in terms of liabilities, probably because many of the most high-powered forms of money are liabilities of the central bank.
We implicitly assume, in other words, a stable and even rigid relationship between the liability and the asset, but because China’s banking system carries more unrecognized bad debt than that of most other countries, there must be some downward adjustment to China’s M2 equivalent reflecting a downward adjustment in the reported assets. In fact I’ve long suspected that one of the reasons inflation in China has never seemed consistent with the pace of monetary expansion is that its rising NPLs constrain the “money-ness” of the various monetary aggregates.*
Nearly 80% of the very large $2.7 trillion minimum reserves predicted by the version of the IMF’s Minimum FX Reserves equation used by Bass consists of the value associated with its M2. The revised version of the IMF formula might slice off another $500 billion – because China is a floating-rate regime that has tied its credibility to its behaving like a fixed-rate regime, perhaps we can split the difference between 5% of M2 and 10% of M2 given by the new formula. This still is a large number, and leaves China with total minimum required reserves of around $2.1 trillion, $1.6 trillion of which consists of the M2 component. That is why it is important to understand why Chinese M2 is so high and how exactly it translates into an “insurance premium” equivalent, but there are other jarring notes associated with the equation. It ignores the structure of the balance sheet, which is itself affected by the history of the country’s currency regime, so that even though China currently works under a floating-rate regime, after over twenty years with effectively a fixed-rate regime the structure of its financial sector has many of the vulnerabilities associated with fixed-rate regimes. The formula also proposes that, other things being equal, the minimum level of reserves for a country with large current account deficits is no different than that for a country with large current account surpluses, except perhaps to the extent that differences show up in the form of gross external debt. The formula even proposes that the recent collapse in oil prices, which shows up in a country like Venezuela as much lower export revenues, has reduced the appropriate minimum reserve level for countries, like Venezuela, that are heavily dependent on energy sales for export revenues.
None of these make sense, which is why we must be extremely skeptical about the usefulness of this or any formula. To summarize, here are a few of the most obvious adjustments to the IMF’s minimum required reserves formula as applied to China:
- China’s export revenues are less volatile than those of most developing countries, so it is less susceptible than they are to a sharp fall in export revenues.
- The type of country most susceptible to an FX crisis is one committed to a fixed exchange rate and in which there has been a significant build-up of external debt, and China has nearly the opposite position in terms of its balance sheet.
- More generally, as a net importer of many major commodities, the impact of a fall in commodity prices typical of a global financing crisis is positive for China’s balance of payments, and not negative, as it is for most developing countries.
- China’s rigid financial system, the distortions that impede the smooth transmission of monetary policy across the economy, and very large amounts of unrecognized bad debt undermine the relative “money-ness” of M2 and other aggregates.
- China runs a large structural current account surplus, which means that interruptions in global trade or capital flows are far less likely to create a need to insure access to foreign currency.
- More generally China is a creditor nation and, even ignoring reserves, has a larger accumulated surplus on its capital account than is typical for developing countries (although there is reason to believe that its initial forays into foreign investment will have resulted in significant losses in many of its external positions).
- China’s main import requirements are for basic commodities whose prices have plunged in recent years and of which China is reputed to have substantial inventory.
China probably “needs” less than $1.5 trillion
These imply substantial adjustments to any standard evaluation of its minimum required FX reserves, so that the minimum reserve position for the Chinese economy was always likely to be far less than $2.7 trillion, or whatever other value determined at any time by the old or revised IMF formula. I am not able to quantify the specific impact of these adjustments, many of which cannot anyway be quantified, but given their magnitude, if someone proposed that China’s minimum required reserves were actually 50% of the IMF number, I would not find that proposal to be at all unlikely.
But while China might in fact need only around $1.5 trillion or less in reserves to guarantee its access to needed commodities and to fulfill its contractual obligations on the capital account, this doesn’t mean that the $2.7 trillion number is irrelevant. I spent two weeks in late January and early February travelling in New York, Washington DC, and other parts of the US, and I heard a lot of people point to $2.7 trillion as the “danger” level for Chinese reserves. While this number has no fundamental credibility at all, once a “trigger” has been collectively determined in a speculative market, it can easily trigger the expected outcome no matter how irrelevant it turns out to be fundamentally. If the market convinces itself that $2.7 trillion is some kind of risk threshold, as China’s actual reserves decline and begin to approach that number, we risk falling into a self-reinforcing trap.
What is more, if China continues to lose between $40 billion and $100 billion a month in reserves for many more months, the depletion in reserves itself becomes self-fulfilling as credibility is undermined and there is an increasing concern that Beijing will enforce existing capital controls, much more vigorously, or even impose new ones. One risk is that Beijing take clumsy steps to disguise the amount of outflows, or that are perceived as disguising outflows, thereby undermining credibility further and causing an acceleration in outflows. On Friday, for example, the PBoC changed the way it records foreign exchange purchases, in a way the Financial Times describes as “likely to provoke suspicion that the government is attempting to conceal the extent of capital outflow” and duly setting off a flurry of concern. According to the South China Morning Post:
Sensitive data is missing from a regular Chinese central bank report amid concerns about capital outflow as the economy slows and the yuan weakens. Financial analysts say the sudden lack of clear information makes it hard for markets to assess the scale of capital flows out of China as well as the central bank’s foreign exchange operations in the banking system.
The article then went on to list the two changes:
Figures on the “position for forex purchase” are regularly published in the People’s Bank of China’s monthly report on the “Sources and Uses of Credit Funds of Financial Institutions”. The December reading in foreign currencies was US$250 billion. But the data was missing in the central bank’s latest report. It seemed the information had been merged into the “other items” category, whose January figure was US$243.9 billion – a surge from US$20.4 billion the previous month.
Another key item of potentially sensitive financial data was altered in the latest report. The central bank also regularly publishes data on the forex purchase position in renminbi, which covers all financial institutions including the central bank. The December reading was 26.6 trillion yuan (HK$31.7 trillion). But the January data gave information on forex purchases made only by the central bank, detailing the lower figure of 24.2 trillion yuan.
It is not clear exactly why the PBoC made these changes, but it is not obvious either that these changes were made in order to disguise the data. Unfortunately the great confidence in Beijing foreign investors used to have has dissipated completely in the past 2-3 years, to be replaced by a tremendous lack of confidence.
My skepticism about the validity of the IMF’s minimum required reserves formula does not mean that I am skeptical about everything in the letter Kyle Bass sent out to Hayman Capital clients. He addresses important issues, including its large and rising debt burden, but for the reasons discussed above I think China will be able to withstand net capital outflows longer than he and the market might currently believe. If I am right, however, it doesn’t mean that we can simply ignore the extent of the net outflows. And clearly the PBoC isn’t ignoring it. For reasons I can’t publicly disclose I am quite certain that Beijing and its policy advisors have been watching the large net monthly outflows with as much concern as anyone in the market.