How Is Chinese Growth Imbalanced?

One of the most important external threats to the Australian economy over the next 5 years is the re-balancing of Chinese growth. The reason it is important being that: China does not need to collapse in to a pile of rubble for re-balancing to affect our country greatly. China probably won't collapse, but equally it is improbable for China to re-balance without slowing growth, and impossible for China to re-balance without changing its composition of growth - a composition of growth that the Australian economy is currently quite dependent on.

The problem is best illustrated graphically, with China's household consumption share of GDP falling from over 60% down to around 35% over the last few decades, with investment (Capital Formation) taking up the position as the dominant source of growth, rising from under 30% to almost 50% of GDP:

This has occurred because the government has pursued an investment driven growth model - that is, creating policies that favour investment in infrastructure, manufacturing capacity and real estate at the expense of household consumption. This has been driven through a number of policies (Read Michael Pettis' Books or blog for more detail), but to name a couple of the major ones:

1. An undervalued Yuan: The PBoC has offset a natural appreciation of China's currency in order to maintain a competitive advantage as an exporter, simultaneously suppressing imports and consumption (Pettis would probably say it alters the savings balance or something to that effect). As I outlined in this post, this involves purchasing a basket of foreign assets such as US treasuries in order to offset the country's twin surpluses (Current an Capital account) entirely, to hold the exchange rate to a target or crawling peg.
2. Interest rates kept too low: Particularly deposit rates, which have been kept far below the nominal growth rate and often below inflation. Because there are very few options to save in China, and because deposit rates are often negative real or growing at a pace far below national output, households are either forced in to saving through real estate - which drives investment - or saving in deposits which lose relative value over time - driving more saving to offset this and also reducing their potential consumption power. More recently the rise of Wealth Management Products has given a new outlet and higher interest rates for savers, however it is yet to be seen how beneficial these financial innovations will be. Murky securitized lending and shaky underlying assets have been famously awful for those that bought in, however with most things in finance, the extent to which they are detrimental or beneficial will be seen when monetary policy tightens, and probably not before, though this should include the end of QE in the US. As US policy tightens, liquidity will be withdrawn from riskier investments and emerging markets as systemic risk rises. In addition to this, because investment in capital is often funded by debt, excessively low interest rates favour investment in capital over labour. When interest rates are 5-15% below nominal growth in the economy, it makes a lot of sense to invest in more capital - as national output grows at a faster pace than the interest rate on debt and the real value of the debt diminishes with time.

Note below the average 1 year term deposit rate for Chinese savers - savings accounts yield even less, currently about 0.35% p/a, and the lending rate is a little higher (5-8% during the last decade), currently 6%:

Luckily for Chinese savers, this excessive over-investment and under-consumption has the effect of keeping inflation relatively contained, so it could be worse for real deposit rates. For China's economy falling inflation might be a bit more of a problem, with nominal GDP growth dropping to GFC levels recently on very low inflation levels. However as a comparison, here is how interest rates and nominal GDP track in countries like Australia and the US - consider that these are discount rates, not term deposit rates, so I am understating the difference here as term deposits are typically higher yielding:

This should hopefully give some scale to the financial repression in China compared to our own experience. For instance the US has been criticized for keeping interest rates at zero and several percent below growth and inflation, however there is no comparison to China holding rates 10-20% below nominal growth.

Imbalanced Chinese growth has become more and more dependent on investment, and less related to consumption of goods and services by households. Next I will discuss why this is an issue.

Widow-Maker Part 2: Monetary Policy

Though central banks have a lot of control over the monetary system, they suffer from what can be thought of as 'Policy Target Whack-a-Mole'.

This means that, while central banks are largely omnipotent when it comes to controlling any one variable - and they really can control one economic variable at a time completely if they like - when they use this power over that one variable to set a target rate, they have very little control over other related variables or secondary targets - which can work against their stated policy intentions. This tends to give observers the impression that central banks have little control, leading to the wrong conclusion regarding sovereign debt markets.

A case in point is one that I've talked about before - QE. The common understanding is that QE is supposed to lower both longer term yields and raise inflation to help the employment situation and recovery. One source of confusion is to think of the unemployment rate and recovery as the policy target - this is a goal of QE, but it is twice removed from the specific target, a sort of second derivative if you like.

Even yields and inflation were not the true policy targets, though they were discussed at length as intentions that would result from QE, there was no specific target for yields to fall to, and the inflation target was fairly vague. A central bank could control either one of these variables if it were truly determined, but because the Fed did not state "we will buy unlimited bonds until the yield on the 10 year is X.XX" neither of these secondary goals was really achieved.

Part of the reason is that higher inflation and lower bond yields are contradictory goals for market participants, and the Fed did not limit the functioning of a free speculative market. I discussed at length why QE actually raised yields on long term government securities while it was running. From a trader's perspective, if the central bank says it is going to try and increase inflation and support risk asset prices, a sensible trader will not fight them and sit in risk-free fixed interest, missing out on the equities/high yield rally and seeing inflation lower your real return - so portfolio allocations moved away from bonds under each QE program and yields rose despite the secondary target of lower yields. The reason Fed buying did not offset this is because the Fed is entirely a price-taker at auction, and must accept what the private sector offers - it does not have a mechanical pathway to drive yields lower under the current structure of QE.

The true policy target of QE is to purchase a quantity of assets - 85 billion per month in the latest program. The Fed achieved this target perfectly, purchasing a quantity of assets it deemed appropriate. Few question that the Fed can purchase any quantity of assets they wish, because the Fed is the monopoly issuer of reserves and can create them simply by expanding its balance sheet. QE achieved its target, but perhaps a quantity of assets was the wrong target to specify.

So what if we think through some other possibilities for QE. What if, instead of targeting a fixed quantity of assets, the Fed states an intention to purchase unlimited assets until an inflation target of 3% is achieved. There should be little doubt that the Fed can buy as many government securities as it likes, and perhaps it would be forced to purchase a very large quantity or even all of the privately held bonds. In such a circumstance, suddenly it doesn't seem like the target will be so hard to achieve. If nothing else worked, legislation can be changed for the central bank to purchase private sector securities such as the case with the BoJ or Bank of Israel - it's not unheard of. Simply put, the Fed could achieve the 3% target if it really wanted, but at what cost?

Central bank whack-a-mole is the problem. If the policy target is now an exact rate of inflation, the central bank no longer has control of the quantity of assets it needs to purchase to achieve this. If it requires purchasing too large a portion of outstanding government securities, we can start to imagine some scenarios where the economy is seriously destabilised. If a moderate QE program has pushed market participants further out on the risk spectrum, potentially causing unnatural asset valuations, a situation where the Fed takes out the majority of risk-free assets could leave the usual investors in those assets - such as pension or mutual funds - with no choice but to move in to highly speculative areas which suffer from volatility and decreasing asset quality.

Not only this, but the exchange rate under an unlimited QE policy could move very sharply, such as the Yen under Abenomics. Bond traders and investors too would demand higher yields from the government to hold Treasuries, because they firstly will want to be compensated for higher inflation, but also because the central bank would be supporting a speculative orgy in more risky assets, which bondholders would miss out on.

Many would assume that the central bank purchasing such large amounts would lower yields, however this is not a given, because the Fed purchases on the secondary market in separate auctions to auctions that the US treasury issues it's securities under. To entice bidders in to the primary funding market, yields would likely rise as dealers/investors don't usually invest charitably on purpose. Not only this, but unless the Fed sets a yield target, it is a price taker - dependent upon what yield the private sector offers at competitive auction. The Fed is only a price maker if it abandons its inflation target and targets yields instead. Banks or primary dealers can be forced to make a market for treasuries, however state controlled banking is unlikely to be an ideal choice in a capitalist economy unless things got desperate, and that is not without its own problems.

In this case, the central bank has vast power to achieve its inflation target, but the side-effects may not be great. We can extend this type of thought towards any type of central bank policy. For instance, the central bank can set the overnight interest rate at whatever level it wishes, but to set it too high can cause a recession and hardship, even outright deflation if they act recklessly - too low and they risk bubbles and high inflation.

A central bank can also control its exchange rate - if it disregards an appropriate interest rate for the domestic economy, or issues reserves to buy up foreign assets (such as China). The exception to this would be when there is a political crisis such as hyperinflation due to fraud, civil war or government collapse where there is little demand for the currency even at ludicrous interest rates - such cases are more likely in undeveloped economies however, and I'm only discussing developed nations (that are not stuck in the Euro) in regards to the widow-maker.

Whatever the chosen policy target, if it is to be achieved it normally involves losing control over other variables, but the central bank has almost unlimited powers to achieve its target if it really desires - the true limitation is political will, career risk and unwanted side effects. It sounds as if I have tried to call the Fed useless, but my real intention is to show that they can control any variable they like, as long as they deem it more important than any other consideration - the Fed could have lowered yields or raised inflation, if it was truly determined. In a round-a-bout way, we arrive at yield targeting.

Yield Targeting:

Sometimes secondary goals can align with a main policy target. Sometimes, also, an issue becomes important enough to warrant ignoring secondary issues until it is resolved - both of these apply to a country in the position to be considered for the widow-maker trade. Firstly, a central bank might need to purchase a lot of securities to hold it's yield target - further fuelling inflation - however that high inflation reduces the burden of debt in real terms, so there is an alignment between the two goals. Secondly, preventing default and rising yields can take precedence over keeping inflation low, full employment or any other goal.

The widow-maker trade is based on the idea that a country has at least these problems:

1. High and rising government debt.
2. Record low interest rates despite the high debt - so they can only go up.
3. Low or no growth to grow out of the problem.

When interest rates rise, they will be doomed as interest costs will outgrow tax revenues. If the government tries to raise taxes, they will slow growth. Austerity obviously doesn't work because fiscal multipliers can be greater than 1, so any cut in spending can shrink economic activity by a greater amount and make the debt problem worse. The government can't increase spending dramatically to speed up growth without further worsening its debt case. It's a sticky situation.

So what would make interest rates rise? Inflation is the most likely cause, since developed country debt does not carry true credit risk - the government can always force primary dealers or the banking system to make a market for its debt, so default is always a choice or poor decision making rather than a certainty. This the main reason that there have been no bond vigilantes arriving to punish Japan so far - there just isn't a serious default risk. But what if inflation actually came and interest rates started to rise?

Well, here is where the widow-maker doesn't really work, because higher inflation is exactly what the US and Japan are trying to achieve. Interest rates will almost definitely start to rise if inflation picks up in a measurable and persistent manner. But, so far the only inflation that a program like Abenomics has generated is likely to be transitory. That is, a rapid exchange rate depreciation will increase the cost of imported goods - especially for Japan who must import most of its energy needs - however without rising wages, domestic demand is unlikely to rise substantially and might even fall as more income must be allocated towards imported energy. Consumers might try harder to reduce energy consumption, offsetting price increases. Without rising wages, there is nothing to support rising prices while keeping the same level of consumption. If Japan is to create lasting inflation, the BoJ might need to abandon a fixed quantity of asset target, and move to an explicit inflation target with unlimited scope - as reckless as that sounds - because Japan's shrinking population and workforce keeps downward pressure on nominal growth and inflation, making it a different case to the US.

Still, if/when wages begin to rise, and inflation becomes persistent, then yields will rise on expectations of future inflation reducing the real income from bonds. Partially they will rise because some believe central bank cash rate rises will occur in the near future (to slow inflation), though this is probably premature. Interest expense will begin to rise on newly issued debt and roll-overs. However from the revenue side of the equation, wages rising will move incomes in to higher marginal tax brackets and consumption tax revenue will rise. Not only this, but nominal GDP will grow, making the value of the immense debt less of an issue on a relative basis.

If these were the only actions that occurred, it is possible that it could go either way. If the bond market got the jitters, interest expense might grow more rapidly than new tax revenues - causing problems. Of course, no central bank will sit idly by while this occurs, and this is where policy goals align to prevent the widow-maker trade from working - even under rising inflation and yields.

Central Bank Intervention:

I outlined above that central banks have supreme control over the monetary system if the need to act is urgent enough. If there is a risk that by doing nothing, default risk will rise for the US Treasury or Ministry of Finance (Japan), then the central bank will disregard goals such as low stable inflation in order to preserve the functioning of the system. This can involve yield neutral bond purchases (such as the current iteration of QE in both countries) or it can involve yield targeted purchases.

In the first case, QE does not have a specific target for yields, so yields can actually rise under central bank bond purchases. This is an action that will only be taken when deflation is a threat (such as now), as yields are unlikely to rise too far. Under such actions, the central bank can end up owning a large portion of outstanding debt - this is already the case with both the Fed and BoJ, who own a large portion of their own country's debt. The profits of these central banks are remitted to their respective Treasuries, which is to say that when the treasury pays out coupons and principal on bonds held by the Fed, after some minor expenses, most of that money comes right back to the US Treasury - a sort of circular finance. The Federal reserve now holds over 10% of US debt, and the Bank of Japan 20% of its own debt - this debt can be considered mostly irrelevant from a solvency standpoint, since Treasury will effectively be paying itself.

Should there be persistent inflation, the Fed could move from a quantity target towards a yield target. The mechanics of a yield target would be very simple in the situation where a developed country like the US has amassed a huge level of debt: The Fed would offer to purchase any bonds below a certain price level so that a targeted yield was achieved. No one would have any reason to sell for a lower price than what the Fed offered to purchase for, and if they did an arbitrage profit would exist and soon disappear. This yield target would likely be below the rate of inflation, such that inflation might begin to rise - possibly even to double digits - as there would be no or minimal cash rate rises to slow it. If the private sector is discouraged from holding bonds due to fear of loss of purchasing power via inflation, the Fed would simply end up owning most of the bonds on offer - but yields would still not rise above the target.

Offsetting the inflation however, the government is able to implement higher tax rates to focus on debt repayment, and this removes some of the inflationary pressure while simultaneously lowering debt levels. Too often, arguments that say that these governments will default or the bond markets collapse tend to forget that fiscal policy will help the situation as inflation rises.

Because yields can be forced to remain below the rate of inflation, each month under this form of financial repression reduces the real value of the debt burden. During World War II and up to nearly 1950 the Federal Reserve used yield targeting to keep a cap on treasury yields of 2.5%:

After the removal of the yield cap, there was no traumatic and sudden rise in yields for a few reasons, one being that people had just witnessed the Fed hold the yield target without faltering during a turbulent period in which debt was skyrocketing. There was very likely an understanding that the Fed had a lot of control over yields, and this stopped a lot of speculative flight from those who might have otherwise been concerned about capital loss on bonds during rising rates. Furthermore people were also scarred from the crash of 1929 and many were scared out of the stock market for life, preferring to save in bonds - a similar aversion occurred in Japan after it's bubble. This was a period in which the US debt to GDP ratio rose to 120% - higher than today.

In the end, it wasn't necessary for the Fed to hold this yield cap to 2.5% after 1950. Rising nominal GDP through both growth and inflation reduced the severity of the debt, and there was little reason to expect rates to rise catastrophically, so they didn't:

The takeaway from this is that, though the Fed did not need to maintain this policy to hold yields down, it could have if it wanted to - were it faced with drastically rising yields. By doing so it could allow its debt burden to reduce over a number of years in real terms. For anybody wanting to sell or short bonds, there should be a consideration that one of the major risks to the trade is that the central bank simply implements a floor under bond prices when it gets concerned, leading to substantial losses for those traders. This is probably the nail in the coffin: If the trade starts to become too successful, the central bank will implement regime change to control yields, ruining the trade. As well as this, inflation which is anticipated to cause yields to rise, is actually how the situation is resolved from the government's perspective, so the logic isn't totally water tight.

In the end it probably isn't worth taking the risk - I can only assume most bond traders come to the same conclusion and don't bother. The other point is that we have seen this scenario before - the bond market did not collapse after the US became heavily indebted, it had no reason to when inflation offered an easier way out - even with inflation rampant, yields did not rise and there was no collapse in bond demand.

Widow-Maker Part 1: Balance Sheet Recessions

Following on from this post... It's difficult to know where to start on explaining the widow-maker trade, and what makes it unsuccessful. Having to start somewhere, I'll describe the traits of the current recession (A Balance Sheet Recession - popularised by Richard Koo), as that goes a long way to explaining why rates can stay so low, for so long - and why sometimes it is even logical to buy government debt at negative yields.

Normal Recessions:

A normal recession can go by a few definitions. For example, a common measure is 2 quarters of consecutive declines in GDP, though some people base a recession off other measures. Regardless, a recession is typically accompanied by a rising unemployment rate, falling investment, declines in retail spending, production and GDP.

Most commonly (almost invariably), recessions are precipitated by tightening of monetary policy after a period in which inflation has moved uncomfortably high for the central bank. In a typical recession, some weak businesses fail and unemployment imposes hardship upon some individuals.

During this period of economic trouble, the central bank significantly eases policy and automatic stabilisers in the form of government spending kick in, which limits the downside. In this case, for most citizens, the combination of easier policy encourages spending, risk taking and new investment to kick-start again and so the recession is short lived. Acute financial pain is common enough, but the entire population is not under duress.

Balance Sheet Recessions:

A different kind of recession occurs when that recession is also accompanied by a collapse of widespread investment in an asset bubble - be it a real estate or stock market, or any other bubble that has captured the attention of the entire economy and is usually debt driven. This is unlikely to occur from bubbles in Gold, Bitcoin, a particular stock, or any investment that does not involve a large portion of the public, but rather those such as real estate which are accessible to all, attractive to all, and have a strong investment narrative - with access to easy credit. Such an event might only happen once every 50-100 years or so - long enough for the next generation to have forgotten the lessons of the past.

Credit extension is an important feature, as it creates an environment where declines in asset prices can severely impair private sector balance sheets - leverage works both ways - leading to deeply negative equity with price falls. If no leverage is involved, then those involved in the bubble typically will not have deeply negative equity, even those that bought late in the bubble might not have negative equity if the purchases were not debt funded - in such a case, net worth may fall, but will not be negative. While asset prices may fluctuate with market sentiment, liabilities (debt here) tend to be fixed or at least fixed with a floating rate - bursting bubbles disproportionately affect the asset side of the balance sheet, leaving liabilities at bubble valuations, and asset values at post-bubble, depressed valuations - creating an impaired balance sheet.

When leverage is involved, even those who bought earlier in the asset bubble may find themselves facing leveraged losses, and cripplingly negative equity. It is this feature that really makes the pain widespread and can make traditional responses to recessions useless. Let's introduce an example investor in the US housing bubble, Tim. Tim's Balance sheet looks like this at the peak of the bubble:

Richard Koo described the psychology of people and corporations undergoing this kind of stressful environment, stating that their immediate goal changes from profit maximisation towards debt reduction. This is important, because a typical response to recession is to reduce short rates in an attempt to kick start consumption and investment - under a typical recession, this will probably work.

If, however, there is widespread pain inflicted by a bursting asset bubble, and those under duress have been imprudently leveraged, the first response to lower interest rates will be to pay down debt faster (debt reduction), rather than any particular increased consumption or investment. Individually this is perfectly sensible behaviour, though in aggregate it means that monetary policy is fairly handicapped to respond to this kind of crisis, and that demand for credit will remain startlingly low. If consumers did not behave in this way, it would actually be a little worrying.

Revisiting Tim for a moment to show how this is the only logical response, let's look again at his balance sheet after his area is hit by a 50% fall in housing values, also assuming he has paid down some of his mortgages and credit card debt, but the weak economy has also caused him to dip in to his cash savings:

Immediately following the fall, Tim is now worth - $154,000. Understandably, this causes discomfort. People naturally want to ease this discomfort by returning to a positive net worth. For Tim have any positive net worth, a combination of the following processes must take place:

1. House prices must rise again.
2. Tim must use income to pay down debt.
3. Tim can save his money as cash/other to offset the loss of asset value (he can also sell the houses at a loss and reinvest).

Number 1 takes a long time. While US house prices rebounded strongly following the introduction of ZIRP, they are not exceeding previous real values for the affected areas even after 8 years. It is unlikely that a person would sit on negative net worth during this time and continue to take on more debt.

Number 3 happens to an extent, but since in a balance sheet recession interest rates head to near zero, and mortgage interest should always be higher than deposit or savings rates, this does not make a very cost effective method of rebuilding net worth. If the savings were invested in shares or more housing, then this may be effective, however the psychological and financial impact of bursting asset bubbles prevents those affected from investing at an opportune time, when these assets are undervalued.

This leaves number 2, the only sensible option for an individual. Since it is more cost effective to pay down debt than to save at zero interest rates, or to wait and hope that asset values exceed the previous peak, Tim would end up putting a lot of effort in to paying down his outstanding mortgages in order to return to a normal positive net worth - even forgoing consumption in order to do so, worsening the crisis. This behaviour in aggregate explains part of why bank loan books have barely grown since the onset of the crisis - there has been little demand for new credit.

The problem extends to corporates also. Of course, many US corporations went bankrupt during the crisis, but the corporate balance sheet recession was not as extensive as that of the consumer, unlike the case in Japan's balance sheet recession. However, the effect on corporates is still very pervasive even when it is more the consumer that has been directly affected, and this feeds in to a lower demand for credit.

Because a balance sheet recession typically follows either a credit funded investment and/or consumption boom, the after-effect involves very low consumption growth and little reason for investing in greater capacity - if consumers are reducing purchases and scared of debt funded consumption, then more capacity does not make sense. Similarly, if there was an investment boom, it is likely that the country is already over invested in capacity/residential housing/supply, so that further investment after the bursting of the bubble does not make sense. In both cases, there is not great demand for new investment, and after a credit fuelled consumption boom there is also little desire to repeat imprudent purchases. The combination is that credit demand, again, remains very low. Actually, the true case post-GFC is most likely made worse by the fact that China continued investing in more capacity after Western demand collapsed, again, making it even less necessary for Western based corporations to invest domestically in more capacity. To recap why a balance sheet recession, especially, causes low rates for an extended period:

1. A balance sheet recession makes existing debt holders pay down debt to get back to positive net worth.
2. Both those indebted, and those not yet in debt are scarred by the experience of a bursting asset bubble, and are unlikely to take on debt in the immediate aftermath.
3. Monetary policy is not very potent under these conditions, so interest rates move to zero for an extended period without much fear of rampant inflation.
4. Lowered investment demand in the wake of the crisis keeps demand for credit lower than otherwise.
5. Lowered credit fuelled consumption lowers the demand for credit.
6. Lowered consumption spending reduces inflationary pressure, and excess capacity relative to demand prevents a supply side inflationary episode. Inflation is nowhere to be found, so yields will not rise substantially based on this fear.
7. The private sector has a strong demand to save in risk-free assets such as Treasuries, as they fear the stability of the banking system and are scared out of risky assets, pushing down rates on government debt. Sometimes this pushes shorter maturity bonds in to negative yields - this seems irrational at first glance. If the banking system is facing systemic threats, it is rational to pay a slight premium on safe government bonds as opposed to risking deposit loss in the banking system. Similarly, cash stored under the mattress is typically not as safe as government backed bonds might be, so a negative yield might be considered equivalent to paying for insurance.

The Public Sector:

The solution when the private sector will not respond to monetary policy changes is for the public sector to step in by running a deficit. This is a source of a lot of angst amongst casual observers - it appears at first glance that the country is going bankrupt as public spending spirals out of control. Strangely though, interest rates do not seem to rise (see Japan, the US now or in the great depression).

Declining rates in the face of record deficit spending indicates a line of causality that starts with the private (and foreign) sector's demand, which induces the public sector to supply - that is, the private (and foreign) sector demands the government issue more debt for holding in portfolios, foreign central banks to hold in reserve, and for fiscal stimulus and so on. The public sector then supplies this deficit spending (either automatically through unemployment benefits etc. or through stimulus packages). Because there is a revulsion to becoming indebted, the government is likely to always spend less that would be optimal in a perfect world, and so yields continue to fall for the market to clear.

Higher interest rates are always threatened, but since this does not occur, many theories and insults are directed at authorities for keeping rates too low and punishing savers. Of course, rates would be just as low without intervention, probably lower if stimulus responses were not enacted, but this gets in the way of a good bit of vitriol.

This reactionary public spending is the source of the Widow-maker, because it involves a rapidly rising debt/GDP ratio - which invokes a fearful response. But, it is different to when undeveloped, profligate governments spend freely without good reason (often due to corruption), and it is different to when emerging markets and Euro area countries have heightened default risk - in these cases shorting sovereign debt may work because there are structural failures in the monetary system that allow for default to take place under stress. The US, like Japan is a candidate for a Widow-maker trade to hurt traders because it is well developed, with a flexible monetary system and almost zero default risk.

The main risk with countries like Japan and the US is inflation, which has so far been very difficult to achieve. Were it to actually happen (which both governments and central banks would like very much), this would not automatically make the Widow-maker trade work. Unfortunately for those trying to short the debt of these countries, the central bank always has the ability to set yields across the entire curve. This is actually easier in an inflationary environment than in a deflationary one, as the central bank can place a bid under any price and offer to buy any quantity at this price to hold yields steady. No trader will fight this, because the central bank can never run out of reserves, and so the yield will most likely remain at target until the central bank changes policy. The central bank is limited mainly by how much inflation it will allow before tightening. High inflation is not optimal, but it is the lesser evil for policy makers to choose.

Should inflation move higher (say 5-10%), the central bank could hold treasury rates at 2-3% and allow inflation to reduce the severity of the public and private sector debt burden. Eventually they would be forced to raise rates and loosen restrictions in order to combat inflation, but probably not before the once scary debt burden has been sufficiently diminished - at which point, the rising rates will not immediately cause any funding issues and the higher rates will discourage further indebtedness. Though I will discuss this in more depth in another post, this vaguely describes the post-war period in which government debt was proportionally larger as a share of GDP than today. While it may sound implausible that bond vigilantes will not show up to punish the government, this inflation/yield targeting has already been enacted last century, and so we know roughly what the outcome is likely to be.

Part 2 will be drivers of interest rates, and monetary policy/central bank policy in more detail.

Reply to Pete

I've often found the 5m gives better signals than the 1m - for me, if I was trying to pick up a few ticks the red lines are where I'd be looking to enter. That said, I'm not much of a scalper. You still might have been taken out on the second trade, anyways, but since the previous low was just cleared to the left of the chart not too much reason to think the push lower is over yet if you can withstand a slightly wider stop.

That's all I've got!

Emerging Markets

Inspired by Bloomberg asking whether Australia will suffer in the same way as emerging markets - Australia Looks Like an Emerging Market - I had a fun discussion over the weekend in a comments section elsewhere. My immediate reaction is that no, Australia is not an emerging market - it is a highly developed commodity exporter with a high currency correlation to an index of raw commodities - but further, that I think people are making a mistake in equating a currency devaluation with an automatic crisis. Some of the emerging markets might not actually be having emerging market crises, depending on their monetary system/borrowing arrangements. I'll mainly use Australia in this example, because I'm less familiar with emerging markets - particularly the smaller ones - however my rudimentary knowledge of emerging markets crises tells me that Australia is in no danger.

First, it makes sense to acknowledge that a floating exchange rate is supposed to act as an automatic stabiliser – it is not in itself a cause of crisis, and there is no reason to panic if the market decides yours should move lower. In previous cases, the crisis occurred because the country was either trying to run an inflexible monetary policy or it did not control the currency its debt was issued in. The actual loss of value of the currency was not the main crisis – it was inevitable - but they either fought it and failed, or didn't realize it would hurt poorly constructed balance sheets leading to default. In essence, emerging market crises occur when exchange rate depreciation exposes an inherent flaw in that country's policy, and forces a default or a collapse of monetary policy.

In the case of a failed currency peg, the operational structure of the central bank was fragile, in that currency devaluation would force the central bank to divest itself of its foreign reserve holdings. If that attempted currency depreciation was prolonged, the central bank would eventually run out of reserves with which to defend itself, and would be forced to devalue in an uncontrolled manner, causing volatility and crisis in financial markets. This was at the heart of the Asian financial crisis in 1997, and a similar consequence befell the U.K when it was in the E.R.M:

The Thai Baht collapsed in a disorderly fashion.

Alternatively, some emerging markets borrow in a currency other than their own, as they lack the credibility to attract foreign capital in local currency denominated securities - here we might think of South America including, more recently, Argentina. This presents a huge problem, should the exchange rate move against their favour. As Eichengreen & Hausmann (2003) explain:

"... Consequently, emerging market countries that effectively make use of international debt markets by accumulating a net foreign debt will necessarily assume a balance sheet mismatch, since their external obligations will be disproportionately denominated in dollars (or yen, euros, pounds and Swiss francs), while the revenues on which they rely to service those debts are not.

 Exchange rate changes will then have significant wealth effects. In particular, the currency depreciation that is the standard treatment for an economy with a deteriorating balance of payments may so diminish the country’s net worth that the adjustment of the currency is destabilizing rather than stabilizing: the dollar value of its GDP declines, while the dollar value of its debt service does not. The realization that the normal adjustment mechanism has been disabled will alarm investors, heightening the volatility of capital flows and introducing the possibility of sudden stops, current account reversals, and self-fulfilling currency and debt-sustainability crises."

In both cases, the problem isn't that emerging markets aren't to be trusted, but rather that this lack of trust inherently leads to them adopting sub-optimal borrowing patterns or central bank policy - this is why the exchange rate creates a destabilizing effect, rather than the stabilizing experience felt in developed markets. This EM problem is then exacerbated by developed market liquidity being withdrawn rapidly under monetary tightening that originates in countries such as the US - a central theme of Michael Pettis' book, The Volatility Machine, and perhaps what we are seeing currently.

Back to Australia:

Neither of these frailties is found in the makeup of Australian borrowing. Government liabilities are denominated in Australian dollars, as the country has credibility and low public debt - leading to strong demand for bond issuance. Similarly, private sector borrowings are largely either AUD denominated, or hedged, such that any fall in the currency will be largely offset by gains on hedging instruments or is not of consequence to AUD issued debt. In both cases, the RBA can control interest rates, and there is no strong possibility of external funding spiraling out of control of the domestic authorities.

But, more than this, Australia has already experienced a rout from its currency in recent history, and from this we can draw conclusions. When the GFC hit, the carry trade in the AUD unwound as the price of commodities fell drastically. The dollar fell roughly 40% over a few months. Of course, there was no currency crisis, or trouble funding debt issuance, because the debt was largely AUD denominated - in fact, yields fell with the currency. Over the next few years, the AUD should grind lower as commodity prices come under pressure. Far from creating some sort of emerging markets crisis, this will restore some competitiveness to Australian labour and manufacturing that has been lost under the commodities boom of the last decade. 

Could this cause inflation (as I saw suggested over the weekend)? Perhaps, but given that a collapse in the value of the AUD would typically occur in response to collapsing commodity demand (i.e China crisis), which is deflationary and acting on top of already very low global inflation, there is little reason for panicking about rising inflation or the RBA needing to raise rates to defend the currency.

The unwinding carry trade saw the AUD lose 40%

Australia, as a sovereign currency issuer, with its debts denominated in that currency, is unlikely to fall in to the same trap as emerging markets have in the past. It is also unlikely to experience anything similar to the Greek experience, because Greece is a currency user, not a monopoly issuer, and the Euro effectively mimics some of the effects of having borrowed in a foreign currency with a pegged exchange rate - Greece can not create Euros whenever it desires to ensure solvency, nor can it have a flexible exchange rate within the currency union. In this respect, the Euro area is far closer to emerging markets than Australia, and Euro countries are more fragile operationally than Australia, despite its correlation with some emerging market currencies.

The Widowmaker

There was a strange back and forth recently on Twitter after John Aziz pointed out Nassim Taleb's wrong call on treasury yields back in 2010, having said that every human should short US treasuries, and that it was a no-brainer. Taleb is a brilliant thinker, so how did he and other intelligent people get it wrong on sovereign debt? 

One of the hardest concepts to understand in finance is why seemingly insolvent governments can keep funding themselves almost for free. It doesn't seem right, or at least it doesn't fit with expectations. Taleb might have looked at the Euro debt crisis and subsequently painted all sovereigns with a broad brush, but I can't be sure of his process. I know I struggled for about 2 years to really understand why countries like Japan and the US had not collapsed from insolvency - looking at all the different angles, learning the basic operational and legal framework of the Federal Reserve. As counter-intuitive as it felt, in the end I couldn't see how the US would ever need to default, or any other country with its own currency (as the legal and operational constructs are similar).

The fact that this is so counter-intuitive is probably an essential feature of why government bond markets do not face the wrath of bond vigilantes. What I mean by this is that, if everyone understood that the government was not at risk of insolvency, there would be less accountability for wasteful spending - possibly even reckless spending would occur, which would itself put the government bond market at risk of losing credibility and an inflationary episode.

Because most people assume the government's finances resemble our own personal balance sheets, there is a genuine repulsion to high debt levels, and those in government normally try their best to reduce spending when possible, thereby retaining credibility enough that markets never seriously doubt the smooth functioning of this particular market.

This counter-intuitive nature is also probably responsible for so many senior analysts believing that when the Fed scales back its bond purchases, treasury yields will rise - which is of course backwards, because QE has never lowered yields in the first place. The implicit assumption is that the US government is spending beyond its means, and can only do this because the Fed is keeping rates low by buying debt - this is, funnily enough, also backwards even though it sounds correct. If the Fed were to remove its stimulus programs today, far from causing a flight out of treasuries, this would actually cause a flight in to the safety of treasuries, leading to drastically lower yields -  possibly even negative yields for shorter maturity instruments. We have seen this in action since the Fed tapered its bond purchases - yields have stopped rising and have even fallen since the announcement.

To get this backwards, one needs to assume that the natural path for interest rates is up, and that the Fed is keeping them down against what is 'natural'. This tends to play in to a lot of natural resentment felt towards central banks and private banks, so it is often unquestioned. Far more likely is that, because all the factors that caused falling long rates and inflation for decades are still in place, and there are powerful new factors since the GFC that have amplified this; de-leveraging; low demand for credit; high supply of savings; falling inflation or even deflation; Chinese investment in overcapacity - the natural path for interest rates is still down.

This is normal in an era that can be classified as a Balance Sheet Recession (or Great Depression/Great Recession), where the private sector is trying to repair impaired balance sheets and so demand for new loans is anemic. There have been at least 3 of these periods in recent history, and the previous 2 did not see interest rates turn around for decades. The Great Depression is particularly insightful, because even when inflation picked up during World War 2, yields still did not rise (more regarding this later on monetary policy) - again, The Widow-maker was a terrible trade, despite conditions that should have made it successful:

A long term history of interest rates and stock prices. Due to a incompelte data I've had to cobble together several data sets; 10 year UST's; Long term government bonds; High grade railway bonds; Dow Jones Industrial Index; Railway shares. Thus, this is not perfectly accurate, but the series are close enough substitutes to give a reasonable representation.

Understanding of what makes the widow-maker trade such an unrewarding trade involves, among other things:

1. Interest rate cycles.
2. Credit and savings demand.
3. Monetary policy.
4. Asset prices and bubbles.
5. Inflationary vs. dis-inflationary periods.
6. Legal framework, central bank balance sheet construction, and what separates Euro countries from other developed nations.
7. Public and private debt levels.
8. Global balance of payments imbalances (think US and China, or Germany and Greece), and the savings glut/great moderation.

I will need to break this explanation up in to parts, as it is a long one, but well worth the time as interest rates affect valuations across all asset classes. Also, yield movements make a lot more sense when you stop looking at them backwards!

China's Vast Reserves

Macroeconomics and finance suffer from huge gaps in understanding, often arising when reality is counter-intuitive, and a much simpler but incorrect interpretation exists and so is commonly accepted. Today, I'm looking at China's foreign exchange reserves and the idea that they represent accumulated wealth that can be freely spent. Most of the time (in my experience) when people consider this topic, they view China as the powerful dragon guarding vast hoards of accumulated treasure or savings, for use when the economy gets in to trouble:

Disclaimer: Not an accurate representation of China's foreign reserves. 

But this isn't really accurate. There are actually quite a few reasons why these reserves are not particularly helpful in a crisis. Today's post is sparked by a discussion over at Macrobusiness, which I identified as a misunderstanding, and I think it's one that a lot of people make, which is to consider these reserves as unburdened assets.

There is presumably an assumption that the Chinese government accumulated these savings by spending less than it receives in terms of net exports, and by generally being prudent and investing this excess cash overseas. This is an easy assumption to make given the media narrative of wealthy China and bankrupt America, but it isn't real or accurate, because China actually has been a net capital importer if we exclude the PBoC's exchange rate operations. The common understanding of the PBoC's reserve position looks like this, but this is not correct:

The best way to understand China's reserve position is to understand how the reserves got there in the first place. From there it will be easier to show that selling those reserve holdings is much less of a threat to the US than China, and that there might not actually be any accumulated wealth at all, because the heavily US dollar denominated side of the PBoC's balance sheet is offset by RMB denominated liabilities.

Accumulating Reserves:

China is unique, in that it runs a current account surplus, and a capital account surplus. Normally a current account surplus will be offset by a capital account deficit as excess income from abroad must invested in foreign countries - a capital account deficit means money is flowing out of the country. So why is this not the case in China if a balance of payments is meant to balance? By including the reserve account of the PBoC, which offsets both surpluses to prevent the currency from appreciating.

Source: Also Sprach Analyst

Because Chinese monetary policy involves a crawling peg, or a peg to a basket of currencies, the PBoC must stand ready to purchase any foreign dollars in order to defend its target rate or band. Both of the twin surpluses, in a normal world, would act to appreciate the RMB, as demand for Chinese exports should push up the currency, as should demand for investing in China. In both cases, foreigners must sell their own currency and buy RMB in order to deal in the domestic market.

The PBoC creates RMB when it buys USD, in the same way as the Fed does when it purchases assets during QE, creating reserves. Because this would be potentially inflationary, the central bank needs to sterilize this money expansion. It does this in two ways: By issuing RMB denominated bonds and by increasing reserve requirements for banks. Issuing interest bearing securities transforms the commercial bank's assets into longer term maturities that are less likely to cause inflation, while increased reserve requirements keep the reserve balances from supporting excess credit expansion.

In both cases, the PBoC's balance sheet is stacked towards USD denominated assets and RMB denominated liabilities. USD assets can be assumed to be US treasuries, or USD deposits but theoretically there can be purchases of private assets if the PBoC really wanted. I'll create an example and say that this reserve accumulation took place in the early 2000's, when the exchange rate was about 8 RMB = 1 USD. Such a balance sheet (simplified) would be a combination of asset-liability matches such as below at the time of the initial transaction:

Fast forward 10 years and the value of both sides of the balance sheet have changed due to asset appreciation and exchange rate movements. For the first balance sheet shown below, the US treasury bond has appreciated in value by say 20-30% due to roll-down and the long term trend of falling rates. This is great for the PBoC. The other side of the balance sheet offsets this though - the RMB has gained 20-30% and the exchange rate is now roughly 6 RMB = 1 USD - but this isn't too much of an issue, maybe in this simplified case the bank has not made a net gain or loss.

The RMB has been allowed to appreciate partially.

There would be an issue with the second transaction though, which represents a larger portion of the PBoC's balance sheet. Here the value of the RMB liability has appreciated by ~25% relative to the USD asset (I've used 30%). The asset being US dollars that don't benefit from the same asset appreciation as US bonds. 10 years later, the central bank's balance sheet might resemble this if marked to market:

This sounds bad, but it isn't all doom and gloom. The PBoC's liabilities didn't really cost it anything to create - central banks have unlimited power to create reserves. Technical insolvency (if this was marked to market) doesn't necessarily mean a central bank can't function, though in order to maintain trust and credibility it isn't the best place to be. We can't really say they are bankrupt, because this institution is the monopoly currency issuer, so they can't run out of money - but that money is the central banks liability, not an asset, which is a little confusing to think of. But given this, aren't these FX reserves essentially free wealth? 

No, for a couple of reasons listed below. But more strikingly, if it was this easy to achieve free wealth - just print money and buy up foreign assets - then every central bank would be getting rich. There are negative consequences for this, and it is a blade that cuts both ways - if accumulating reserves bestowed benefits, doing the opposite will bring costs. It cannot be beneficial both ways, or we have found the holy grail of policy prescriptions.

Take from this section that these aren't reserves that have been saved through hard work, but rather purchased by issuing domestic currency liabilities which still need to be honoured at some point - not so different from the way that commercial banks expand their balance sheets in order to make loans: Of course a commercial bank's assets have increased when it loans money to a customer (the loan is an asset), but so have their liabilities (a deposit or wholesale funding) - we wouldn't call a commercial bank $100,000 richer just because it makes a residential property loan for this amount, because it has also increased the other side of its balance sheet to fund this.

A central bank that issues reserves or longer term debt in order to buy US treasuries hasn't become rich, it has simply expanded it's balance sheet without necessarily creating positive equity. If it then gives away those assets (as people assume it will in a crisis), it's net liabilities increase by the same amount (as liabilities have not changed), taking it further into the region of technical insolvency. 

Is the Federal Reserve rich because it has bought trillions in US treasuries by issuing liabilities to the banking system? No, so the logic should be no different for the PBoC. Similarly, if the US Fed gave away it's treasury holdings to the private banks to help them, what would we think of the Fed's credibility? Not much! It would have no assets left and trillions in liabilities. If the PBoC gives away it's assets to recapitalize the banking system, then it's simplified balance sheet would look more like this:

So who pays for this? Well in the end, most likely the government borrows to recapitalize the central bank, meaning transferring the reserves didn't help, it just changed the mechanism of transfer. Now the government will be inclined to inject the central bank with assets - meaning liabilities of some other institution than the PBoC - such as Chinese government debt or similar.

Unwinding the Reserve Holdings:

A problem we run into in assuming the reserves are wealth is that we need to ignore the exchange rate effect of selling down this USD wealth for use in China. Accumulating reserves has only one purpose, which is to manage the exchange rate below where it otherwise would be to benefit the Chinese manufacturing and export sectors. Clearly, making the opposite transaction would involve appreciating the exchange rate and severely hurting this competitive advantage.

For instance, say China sells it's US treasury holdings - now it has an equal value of US dollars, if we ignore the poor price it would receive for unloading a large amount of bonds onto the open market. This isn't very helpful, it just changes its reserve composition towards USD deposits rather than interest bearing bonds. The PBoC already has US dollars in its reserve holdings to begin with, so it's not especially helpful. But, say they went ahead and did this anyway, what would be the effect?

Initially nothing, except a spike higher in US long rates which would probably subside. Now, they still have US dollars, not Yuan. If the banks are insolvent and need recapitalizing, this may be helpful, but it only makes the banks liquid and solvent in USD. For them to address RMB outflows and maturing RMB obligations which makes up the lions share of operations, this still needs to be converted back to the domestic currency - putting upward pressure on the Chinese exchange rate. 

However, a more likely scenario  is a liquidity crisis being the problem (rather than only solvency), as China's inter-bank market freezes up again, more dramatically than it did last year when SHIBOR moved higher. This would be a similar crisis to the sub-prime credit crunch, and it is not far fetched if defaults begin rising in the realm of WMP's, trusts and real estate loans.

In the case of a liquidity crisis, the problem is that institutions won't lend to each other in RMB. Excess USD liquidity does not help the situation unless it is converted back into RMB, again putting upward pressure on the exchange rate.  The point: if foreign reserves are to help a domestic credit crisis, doing so will reverse the currency peg's benefit. This would unfortunately happen during a time when a sharply appreciating currency would be disastrous for the country's manufacturing and exports, who would likely be already suffering some effects from a freeze in lending. I can't stress enough how unhelpful this would be.

Even still, what if they try and use the USD to save the banking system as outlined further above? As Michael Pettis notes:

"In fact there have been rumors for years that the PBoC would technically be insolvent if its assets and liabilities were correctly marked, but whether or not this is true, any transfer of foreign currency reserves to bail out Chinese banks would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities. The net liabilities of the PBoC, in other words, would rise by exactly the amount of the transfer. Because the liabilities of the PBoC are presumed to be the liabilities of the central government, the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks... "

"Bailing out the banks, it turns out, is conceptually no different than transferring debt from the banks to the central government. China can handle bad debts in the banking system, in other words, by transferring the net obligations from the banks to the central government, and the large hoard of reserves held by the PBoC does not make it any easier for China can resolve any future debt problems. In fact if anything it should remind us that when we are trying to calculate the total amount of debt the central government owes, the total should include any net liabilities of the PBoC, and that these net liabilities will increase by 1% of GDP every time the RMB strengthens against the dollar by 2%. ..."

Any central bank can create reserves and buy things, and recapitalize banks in its own currency, regardless of foreign reserve holdings - central governments can borrow money to do as well this regardless of accumulated reserves. The FX reserves are a Red Herring, that only help to the extent that foreigners have lost faith in the RMB and the PBoC needs to defend the value of the currency, or to buy international commodities during a war like situation. If the PBoC unloads its reserves in this manner it has severely reduced its credibility - it is not only now completely insolvent (to the tune of trillions of RMB), but does not have any reserves with which to defend the value of its currency... And now the central government will be forced to recapitalize the central bank rather than the commercial banks.

If in doubt, come back to the question I posed earlier: Is the Federal Reserve becoming richer and more secure by purchasing treasury bonds with newly issued liabilities (excess reserves)? This is what the PBoC does when it accumulates foreign reserves. In a sense, you could say that China has been running a Quantitative Easing program for the last decade, only because it is targeting the exchange rate rather than domestic employment and the price level, it must buy foreign bonds instead of its own.