Our final theme is an important development. Fears of capital outflows from China have led to expectations of yuan currency depreciation. Surprisingly, those expectations may have contributed to downward moves in December in both gold and the euro. Whether such trends will persist in 2012 remains in doubt: before the leadership transition in October, China policy makers will likely take steps to arrest any concerns over capital outflows. However, any reduction in the flow of dollars back to the US would have significant consequences most notably in the form of rapidly rising US interest rates. This dynamic bears close attention given the significant global impact of China as any change in the market consensus viewpoints of expected currency appreciation and continued accumulation of reserves would have significant market impact.
Away from Europe, risks have been rising in another corner of the world: China. We focus our attention on two key elements of the Chinese economy: exports and investments, and argue that these components could ultimately affect the financial markets. China's policy of capital controls highlights a significant concern: were capital to move out of the country in sufficient size and speed, it could destabilize the country's finances, as well as global markets. While such a scenario remains remote, recent shifts in market expectations for the Chinese yuan highlights important changes worth carefully monitoring in 2012.
China's impossible triangle
China exports significantly more goods than it imports resulting in a substantial net inflow of mainly dollars. These trade surpluses have averaged $100bn per year over the past ten years. Under a system of floating exchange rates, over time these surpluses would be reflected through a rise in the yuan against the dollar as the excess of global demand for Chinese goods lead to an increase in the value of the currency. However, under the Chinese currency system, the level of the yuan does not "float," rather it is "set" by Chinese policy makers. The level of exchange officially is set as a "band" or range against an undisclosed "basket of currencies," and is determined not by the market but by Chinese officials. Since heightened US political pressure accelerated as the financial crisis of 2008 ebbed, beginning in June 2010, China has allowed a gradual appreciation of its currency against the dollar on the order of 4-5% per year.
How does China manage its currency value in the face of large and persistent surpluses in both trade and investment? It prints the yuan needed to meet global demand. Look at Figure 12 below. The accumulated amounts of China's trade and investment surpluses represent China's holdings of dollars (and other foreign currency). These are held in a portfolio called "foreign exchange reserves." The dark grey bars indicate average annual growth rates of these reserves of nearly 30% (indicated by "FX Reserves" in the figure). "Reserve Money" (indicated by the solid blue line in Figure 12) indicates the expansion of the domestic money supply necessary to meet this global demand. As can be seen in the chart, expansion of the domestic money supply by nearly 20% per year over the past decade has been required to manage the value of the Chinese currency.
Figure 12: Components of China's Money Growth
Source: People's Bank of China
Left unchecked, this large growth rate in domestic money might create rising prices. China employs two countermeasures to address the potential domestic inflationary consequences of the currency policy. A policy of "sterilization" attempts to limit the inflationary consequences of an expanded money supply. It does so by removing the money supply from the banking system, thereby preventing it from being extended into the economy. The government accomplishes this by issuing short term debt and receiving yuan. By holding the yuan received, it effectively "removes" it from circulation. This process is indicated in Figure 12 in negative net domestic credit growth rates (the light grey bars). Figure 12 also highlights how beginning in 2007, China policy shifted away from sterilization towards increasing required reserves as the main tool of sterilization. A policy of increasing required reserves of the banking system limits the ability of the banking system to expand the money supply through further credit creation. This policy was further augmented by direct curbs on lending through the imposition of lending quotas.
The Impossible Triangle
The "impossible triangle" describes the required tradeoffs in macroeconomic policies between a fixed currency, an open capital account, and control over domestic monetary policy. Each policy choice represents one leg of the "triangle." Only two of the three can be chosen. The third policy will be "imposed" by the choice of the other two. Hence, out of the three policy choices, it is impossible to choose all three simultaneously. For example, a country that chooses a fixed currency and management of its domestic monetary policy cannot also choose to have an open capital account. Otherwise, global capital flows would overwhelm its ability to maintain the fixed currency level. This occurs when domestic monetary policy differs from the rest of the world. If the country instead sought to have a fixed currency and an open capital account, management of its domestic monetary policy would become subjugated to the needs of maintaining the fixed currency value.
The macroeconomic policies of China and the US in the post credit crisis world stand in even greater conflict than they arguably did before the crisis. The US dollar plays the role of the world's reserve currency: the primary store of value and means of exchange. The United States benefits from the historical fact that the majority of the world's trade is denominated in dollars. A criticism of the Fed is that in the post crisis world, its monetary policy is run purely for domestic purposes. Those policies are thought to neglect the role of the dollar as a reserve currency and deny the impact of its policies on current account surplus countries1. For countries operating with more open capital accounts than China, this issue has an even greater impact. These countries have been forced to adopt more closed capital account policies through for example the imposition of constraints such as taxes on foreign investment. The Fed has answered these criticisms by pointing to the rigidity of these surplus countries' currency policies (a diplomatic way of referring to China) and the risks those policies pose to the global financial markets 2. These issues will need to be resolved one way or another. Global policymakers' failure to properly address these issues before the pressures boil over into financial markets stands as a key investment risk.
How effective are capital controls?
Such macroeconomic policies are neither without their costs nor risks. As the nearby box describes in more detail, China faces the "impossible triangle." That is, it can choose only two of three macro policy objectives: a fixed currency, an open capital account, and control of domestic monetary policy. China chooses to have a (relatively) fixed currency and attempts to maintain control of domestic monetary policy. To do so, a closed capital account, meaning restrictions on the free movement of capital in and out of the country is required. However, it is unclear in today's modern globally integrated economy how effective capital controls are. Many forms exist for circumventing capital controls, potentially rendering them ineffective. As a result, we do not know the true state of China's closed capital account. If capital controls are not as effective as thought, China's policy to maintain a relatively fixed currency against the value of the dollar means that Ben Bernanke effectively sets Chinese domestic monetary policy. While China's policymakers can take action to deal with the short-term consequences of the expansion of money domestically (reflecting the Fed's expansionary monetary policies), eventually this expansion of domestic money supply beyond the level of growth rate the Chinese economy requires will make its way into domestic inflation.
China's "Vendor Financing Model"
The accumulated amounts of China's trade and investment surpluses, that is, its portfolio of foreign exchange reserve holdings, have increased dramatically totaling $3.2 Trillion as of September 2011. (Figure 13). China takes these accumulated dollars and "recycles" them back into the US through buying treasuries. Indirectly, this is a form of vendor financing, as by purchasing US Treasuries, China helps to hold down interest rates (particularly out the yield curve) helping to keep interest rates for US consumers — China's main customer — low, a process we like to call China's "Vendor Financing" model. China's holdings of US Treasuries totaled $1.1Trillion as of October 2011. Concerned with the concentration of risk in both dollars and US Treasuries, China diversifies its holdings and these actions (or equally the perception of these actions) can greatly influence financial market prices, some examples of which we will examine below. But first we will look at the other main aspect of the Chinese economy: investment.
The investment-led growth model
The link between China's currency policy and its domestic economy flows through the rapid expansion of the domestic money supply. That rapid expansion, initially designed to benefit an export-led growth model, now fuels an investment-led growth model. Since 2000, and rapidly expanding during the financial crisis of 2008, domestic economic growth in China became primarily fueled by investment spending, accounting in 2011 for nearly half of all growth (Figure 14). This level of growth supported by investment and funded mainly by debt is unprecedented in any modern economic experience.
Much of the financing of this investment is either directly or indirectly supported through the prospect of rising asset values, particularly in real estate. One manner in which this occurs is that local government investments are frequently financed through land sales to developers. Land "owned" by the local government sold to developers for housing provides a key source of borrowing capacity for local governments who can then channel these funds into other development projects such as transportation, industrial park or other infrastructure development. Think of this policy as a more permanent form of "stimulus spending" as temporarily enacted in the US following the credit crisis of 2008.
Funded through "Financial Repression"
Who provides all this debt to finance "investment" in China? The over 1 billion Chinese people do. That is, through channeling the savings of the Chinese through limiting their savings options to bank deposits with controlled interest rates (a process termed "Financial Repression" see box below), real estate and on-shore equity investments, policymakers provide the banking system with access to cheap funding that the banks can then lend out to fund the growth in investments. The difficulty arises when the marginal investment no longer exceeds in value the amount of debt used to finance it. Determining when this occurs is difficult as in the early stages of economic development in emerging economies, the asset value greatly exceeds the cost of debt. However, over time as marginal new investment opportunities with positive value (i.e. asset value created exceeds the debt) become scarcer. Determining where China stands on this development cycle is key to understanding the risks and opportunities China presents to the global financial system.
The Chinese system fits all of the characteristics of financial repression, an important concept in understanding China's financial system.
"Financial Repression" is a term used to describe several measures which governments employ to channel funds to themselves which in a deregulated market would go elsewhere. First introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon, the term was used to describe emerging market financial systems in the 1960s-80s.
A 2011 NBER working paper by Carmen Reinhart and M. Belen Sbrancia3 characterizes financial repression as consisting of the following key elements:
The pillars of "Financial Repression"
- Explicit or indirect capping or control over interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
- Creation and maintenance of a captive domestic market for government debt. This can be achieved through (i) capital account restrictions and exchange controls (ii) high reserve requirements as a tax levy on banks (iii) regulatory measures requiring domestic banks to hold government debt
- Government ownership or control of domestic banks and financial institutions and barriers to entry before other institutions seeking to enter the market.
In China, interest rates and the margin between lending and borrowing rates are strictly controlled. The "big 4" Chinese banks are all majority owned and controlled through the China Investment Corporation. Banks are limited in their asset alternatives and capital controls keeps these assets for the most part concentrated on shore.
Carmen/Sbrancia 's summary concludes that a decoupling between interest rates and risk is a common feature of financially repressed systems. Low nominal interest rates help governments reduce debt servicing costs, while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.
And "ever-growing" banks
The net impact of these policies creates an environment where the expansion of credit is necessary to further fuel the investment share of GDP. Absent the maintenance of this flow of investment, the composition of Chinese growth must evolve to make up for the loss of support from investment. That can come through either an expansion in net exports (i.e. the rest of the world makes up for this lost growth) or domestic consumption. Were investment to fall and these other aspects of growth to fail to make up the slack, Chinese growth rates would decline.
China's housing bubble trouble
Following several years of rapidly rising house prices (Figure 15), policy actions in China have been directed at reducing price appreciation in real estate while at the same time providing more affordable housing. However, by reducing the expectations for continual price increases in housing, this policy to reduce the housing bubble may have worked too well in that it may be contributing to a decrease in the attractiveness of China as a destination for portfolio investment flows and may even be contributing to capital outflows.
While it is too early to definitively link the housing market and expectations for real estate to the desired amount of capital investments in China, recent data indicate a declining rate of foreign direct investment (a 9.8% year-over-year decline in November), the first decline since 2009. Furthermore, recent strains from the European sovereign crisis have begun showing up as a decline in Chinese exports to Europe. And as exports to Europe decline, China's accumulation of foreign exchange reserves also declines. To measure this, we need to look at currency statistics. September's official currency reserve statistics highlighted the first capital outflow from China since 2008 (the latest figure available). Media reports citing a former adviser to the Chinese central bank highlighted that the reserves continued to fall through December. Combining both the decline in exports with decline in the rate of foreign direct investment, market prices now highlight expectations for currency depreciation for the first time since the 2008 credit crisis.
Figure 13: China's Foreign Exchange Reserve Portfolio
Source: Bloomberg, China Economic Information Network
Figure 14: China Investment as a Share of GDP Growth vs. Nominal GDP
Source: CEIC/NBS, UBS estimates
Challenging two key assumptions of global financial markets
The realization that declines in Chinese exports and foreign direct investment point to the depreciation of the yuan pose a challenge to two key pillars of global financial asset pricing: (i) that China will continue to gradually appreciate its currency and (ii) that the minimum of China growth slowdown is to a 7-8% rate. Much of financial market pricing is predicated on these assumptions. Consider the impact of the recent shift in expectations for both the currency and the level of reserves on the euro and gold.
First, the euro has been a main beneficiary of China reserve currency diversification. Figure 16 nearby highlights the long term trend in global foreign exchange currency reserves. The trends highlight that since the advent of the euro, foreign exchange currency reserves increasingly moved away from dollars towards euros. As China represents over 30% of all global reserve holdings, they likely contribute significantly to this effect.
Second, as part of global central bank reserve diversification, market expectations run high for China to buy gold as part of that diversification. Whether they actually do or will in the future we do not know as China releases limited details on the management and holdings of its reserves. Most analyses of the reserve portfolio rely on educated guesses. Expectations for China to buy gold rest on two points: (i) they hold a remarkably small amount of gold in their reserves and hence could meaningfully add to the position, and (ii) they have added gold in the past. For now we will leave out the debate on the merits of either of these two points.
Rather, we focus on the idea that market expectations regardless of their basis in fact can, over short time periods, create their own dynamic. And that dynamic appears on display with the recent correlations between shifts in Chinese currency expectations from appreciation to depreciation and the euro and gold.
What's In a Name? The Contrasting Symbolism of US vs. Chinese Banks
In the US, banks historically use symbolism illustrative of strength, security and stability. The early architecture of US banking adopted the neo-classical style of government buildings in order to associate the strength of the bank with that of the US government. Such symbolism was not accidental. It was central to the marketing strategy of banks in that their core purpose was the safety and soundness of ones savings. In an irony of history, one of the greatest American banking failures, and one that precipitated the collapse of the banking system in the US leading up to the Great Depression was that of the "Bank of the United States."
In contrast, consider the symbolism and marketing strategy of a local Chinese bank. Its logo depicts the words "Constant Prosperity" inside the shape of a coin. And it translates its name in English as "Evergrowing Bank."
The contrast in symbolism between US and Chinese banks is stark. For a depositor concerned mainly with the safety of her savings, the bank represents a store of value, a safe place, the "vault," not a source of prosperity itself. Prosperity is earned; the bank is for its safekeeping. In the Western point of view, a bank that is growing too fast could indicate a bank taking on excessive risks.
"Evergrowing" for the Chinese however reflects their economic reality. In an economic growth model based on constant expansion of credit, and where the source of the credit is the banking system, banks are the source of constant prosperity. But in order to maintain that form of prosperity their balance sheets must ever expand.
Measuring expectations for future currency movements
Currency markets are beginning to tell investors that the market focus is shifting away from the euro and toward China. Anticipating currency values through financial markets can be helpful in anticipating changes in asset prices in the US and other markets. Expectations for the Chinese currency can be measured through the "NDF" or non-deliverable forward market. This market basically allows investors to speculate on the expected forward spot price of the Chinese yuan. Since the currency is pegged, i.e. its level is chosen, not set by markets, this "NDF" market amounts to market expectations as to where Chinese policy makers will chose to set their currency in the future.
Figure 17 highlights the movements between the spot currency level of the Chinese yuan and the NDF 12-month value. The market clearly is not perfect in forecasting Chinese currency policy. During the 2008 credit crisis, expectations grew for a currency depreciation that never came. Since then, for much of the period following the crisis, the NDF level trades below that of the spot. This indicates market expectations of currency appreciation (as the yuan standard of quotation is the number of yuan per $1). Notably, the far right portion of the chart indicates recent movements in market expectations for the yuan to depreciate (indicated as the NDF value at the 12 month forward contract now trades above the spot level.) This is an important shift in market expectations.
Figure 15: China House Price Trends
Source: National Development and Reform Commission
Figure 16: Foreign Reserve Diversification
As China goes, so goes...
Now, lets look at an example. Consider how this recent shift in currency expectations relates to both gold and the euro. Figures 18 and 19 show the difference between the NDF and the spot level against gold and the euro, respectively. As described above this difference measures market expectations for future movements in the currency. A negative value (where the NDF is below spot) indicates market expectations for yuan appreciation relative to the dollar while a positive value indicates expectations for depreciation against the dollar.
A notable shift in market pricing relationships occurred beginning last August. As the market shifted first towards a smaller amount of appreciation in the Chinese yuan and towards outright depreciation first in October and again recently in December (indicated on the figures as positive values of the NDF — spot rate; note the axis on the chart is inverted), correlations between gold and yuan have turned on their head: expectations for currency depreciation in China is now associated with falling gold prices where importantly the gold price follows the currency.4
Similarly, Figure 19 highlights the relationship between expectations for the yuan and the level of the euro. While over the entire period, yuan currency moves tended to track those of the euro, prior to December it was euro movements that appeared to preceed those of the yuan. This makes sense as the main source of market risk was emanating out of Europe. Notably however, since the beginning of December, it appears that Chinese yuan currency movements now appear to procede those of the euro. That suggests that the focal point of market risk is moving away from Europe and towards China.
Figure 17: Spot Chinese Currency Level vs. Non-Deliverable Forward Value
Figure 18: Expectations for China Currency Level vs. Gold
China policy likely postpones the risks...for now
Whether such trends of rising risk emanating out of China will persist in 2012 remains a key question. We have doubts that such trends will persist in 2012 as policy makers likely take steps to intervene to arrest any spread of concerns over capital outflows in China. Such intervention would be warranted. Given relative political instability at home, combined with weak protections on private property and growing wealth, capital outflow is typical stage of emerging market development. China's capital account however is on the surface closed. That means that individuals cannot freely move capital in and out of the country. Limited "official" means for doing so exist, but means for circumventing capital controls are another hallmark of developing economies. China's recent moves to secure against such unlawful movement of capital highlight the government and market's concerns: were capital to attempt to move out of the country in sufficient size and efficacy, it could destabilize the country's finances.
While such an outcome remains remote, the mere sign of such movement has already had notable impact on financial asset pricing. And the largest of these impacts we have yet to discuss: US Treasuries. Expectations for continued reserve recycling — what we like to call the "Vendor Financing" model — help to hold down US Treasury rates. Any disruption in this flow of dollars back to the US would have significant consequences in the form of rapidly rising longer-term US interest rates (Figure 20). While such a scenario remains far off, given the potential global impact of any violation of the market's consensus viewpoints on China — whether of currency appreciation or reserve accumulation — bears careful watching.
Figure 19: Expectations for China Currency Level vs. Euro
Figure 20: China Holdings of US Treasuries
1 A good example reflecting such criticism can be found in "Reform the International Monetary System", Zhou Xiaochuan, Governor of the Peoples Bank of China, March 23rd, 2009. http://www.bis.org/review/r090402c.pdf
2 For a good example, see Ben Bernanke's speech "Rebalancing the Global Recovery", November 19, 2010. http://www.federalreserve.gov/newsevents/speech/bernanke20101119a.htm
3 The Liquidation of Government Debt, NBER Working Paper No. 16893, March 2011.
4 Simply, you can see in the figure it "looks" that way. But we can test that "gut feel" more rigorously through the statistical analysis of financial time series data. These tests, called Granger Causality tests show that since August 2011, precedence in information most likely flows from the NDF to Gold rather than the other way round.
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