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| 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.
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.
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:
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.
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| 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:
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| 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.
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