China’s Tough Choices

Brad Setser has an excellent post, “The PBoC’s dilemmas,” which he later admits is really China’s dilemmas. He focuses on two issues. First is that due to the loosening of the yuan peg against the dollar, the central bank is losing $4 billion a month, mainly on its Treasury holdings (note this is due to the fall in the value of the bonds; the spread over the cost of funding is still positive).

The second is that a slowdown in the US isn’t hurting China; indeed, short-term, the Chinese benefit. Why? We cut rates, that leads to a dollar decline. Even though the yuan is now being allowed to appreciate at a moderate rate against the dollar, when the dollar falls, as it has and is almost certain to continue to do, Chinese competitiveness improves versus the rest of the world. Note that Michael Pettis reads the tea leaves somewhat differently; he thinks the latest data releases point to a badly overheating economy and mismanaged monetary policy. A US slowdown and more yuan appreciation would be salutary in his view.

I hate to differ with Setser, but I take issue on his first point, that the $4 billion a month (and certain to rise) losses that China is suffering on depreciating foreign assets poses a problem. I doubt that it does.

In dealing with the Chinese, we tend not to want to see their hegemonic aims. Frankly, China believes its time is almost here. The US is now spending $20 billion a month on Iraq, and the only beneficiary is Halliburton. That exercise has strained our armed forces, damaged our finances, and hurt our global reputation. And there is no end in sight to the costs.

The question isn’t whether China can afford the FX losses (it can) but whether they derive value from them. We have long believed that China would never use the trump card that it holds by being our biggest funding source, because using it would hurt their economy as well as ours. We tend to forget that the Chinese have had a proud history of subordinating the welfare of their people to their governments’ objectives.

Japan has had this hold over us too, but not to the same degree (our current account deficit is worse now) but never would have used it because Japan is as close to a socialist society as you will see, so the idea of voluntarily inflicting economic pain on its citizenry is a no go (inflicting it out of ineptitude, however, is a different matter). It is also a military protectorate of the US and therefore in no position to push its luck.

Now the Chinese have yet to have reason to cross wills with us, and the change in government in Taiwan to one keen on closer relations with the mainland has probably removed the biggest potential source of contention (but again, closer alliance with Taiwan puts us further in Chinese thrall, since Taiwan is our biggest single source of chips). But if it were to happen, consider the example of the Saudis. The Saudis wanted concessions from Israel in the wake of the 1967 war, specifically, return of land and access to sites that were important to Muslims. The Israelis said no and we backed them. The Saudis threatened an oil embargo. We laughed and said they’d never dare, it would hurt them too.

You know how that movie turned out.

To Setser’s post:

Whatever troubles the Fed faces, at least it is still profitable. The same cannot be said for China’s central bank. And while the Fed just has to worry about economic conditions in the US, the People’s Bank of China has to worry about economic conditions in both the US and China….

Dilemma 1. China’s central bank is now losing money. At least it would be if it measured its performance like a normal financial institution.

Goldman Sachs’ Hong Liang calculates that — taking into account currency losses — the PBoC is now losing about $4b a month….$4b a month is very plausible.

Consider a bit of (very) ballpark math. Suppose the PBoC is paying an average of 1.5% on its liabilities — the low rate reflects the fact that a lot of the PBoC’s liabilities are “RMB cash” (which pays no interest). Further suppose that the PBoC gets an average of 4.5% (a fairly generous coupon given how Treasuries are trading these days) on its foreign assets. And suppose that the RMB appreciates by 7% this year against the basket of China’s reserves (The RMB appreciated by 7% against the dollar last year). The PBoC’s total return on its foreign assets, in RMB terms, would be -2.5%. Taking into account the PBoC’s funding costs, it would lose roughly $60b on its $1500b in current assets.

Even in this scenario, the PBoC’s cash flow is still positive. It would be paying about $22.5b in interest (a bit more actually, as the RMB would appreciate, increasing the dollar value of RMB payments),and it would be getting about $67.5b in interest.

But $45b in interest income is too small to offset the $105b (unrealized) currency loss on its foreign assets. As the renminbi appreciates, the PBoC’s dollars and euros will fall in value relative to the PBoC’s renminbi liabilities.

My very rough numbers are meant only to give an idea of scale.* They do though highlight the financial problem the PBoC faces as t raises domestic rates (to cool China’s economy) while US rates are falling. Raising rates increases the PBoC’s costs even as falling US rates cut into the PBoC’s interest income.

Dilemma 2. Is a US slump contractionary or expansionary?

It isn’t clear — at least not to me — whether a US slump helps or hurts China. Remember, China’s growth accelerated over the past two years even as the US slowed a bit.

Look at the graph that accompanies Andrew Batson’s article in the Wall Street Journal.

Note that domestic demand contributed less to China’s growth in 2005, 2006 and 2007 than it did in 2003 and 2004. Consumption actually contributed less to China’s growth recently than in the late 1990s. The graphs clearly show that China’s record growth over the past couple of years stems in large part from the record contribution of net exports to China’s growth.

And that contribution came even as the US slowed. See Daniel Gros over at the RGE Europe Economonitor.

A US slump obviously tends to reduce China’s exports to the US — or at least slow the pace of increase. That is obviously contractionary, both directly and indirectly. China’s trade surplus tends to lead to more rapid reserve growth, and that tends to feed into faster money and credit growth. See Mr. Pettis.

But a US slowdown also tends to weaken the dollar and also the RMB, at least so long as the RMB tracks the dollar. As Goldman’s Hong Liang notes, the RMB has depreciated against Europe and most of Asia over the past two years. That has supported China’s exports (at least if you think exchange rates matter) and China’s growth.

There is another link as well: so long as China’s currency tracks the dollar, China has difficulty pursuing a dramatically different monetary policy from the US. Yes, capital controls provide it with a measure of monetary policy autonomy. But the bigger the gap between US and Chinese rates, the stronger the incentive to move money into China — and the more money comes in, the more difficulties the PBoC faces with sterilization. Don’t listen to me; listen to Yu Yongding.

Right now, China is importing a weak currency and loose monetary policy from the US. Over the past two years, the net effect of the US slowdown has been positive — arguably too positive, as China’s economy and markets seem to have overheated.

But there is no guarantee the positive will continue to outweigh the negative, particularly is the US slowdown turns into a recession and Europe also slows.

Chine consequently has to weigh whether to continue to tighten policy — and risk slowing domestic demand growth just when net exports stop contributing as strong to Chinese growth — or whether to in effect follow the US and adopt a more stimulative policy stance and risk adding to already strong inflationary pressures in China.

That is a real dilemma.

China has been holding domestic demand growth back — whether by limiting lending or running a fairly tight fiscal policy. But policy makers can only take their foot off the brakes if they conclude that inflation is no longer a risk. And that is a hard call when inflation is still well above China’s comfort level.

Then again, it isn’t really a dilemma for the PBoC. In China, the PBoC doesn’t call the monetary policy shots. But it is a dilemma for China’s government.