Trade and the RMB

Most of last week’s newsletter was dedicated to a discussion on Chinese debt, specifically on how we should think about the Chinese debt structure and on when would we know how much debt is too much debt. Every earlier example of the investment-driven growth model that China follows ran into the problem of an unsustainable increase in debt (once capital began to be misallocated) followed by a credit contraction and an economic crisis. For that reason it is important that investors, analysts and most importantly policymakers understand the way debt risks develop.

I discussed some of these issues in my July blog entry. Interestingly enough, today Reuters reported what many believe is a major new initiative in addressing what has clearly become a debt problem at the local government level:

China’s regulators plan to shift 2-3 trillion yuan ($308-463 billion) of debt off local governments, sources said, reducing the risk of a wave of defaults that would threaten the stability of the world’s second-biggest economy. As part of Beijing’s overhaul of the finances of heavily-indebted local governments, the central government will pay off some of their loans and state banks including some of the “Big Four” will be forced to take some losses on the bad debt, said the sources, both of whom have direct knowledge of the plans

Part of the debt will also be shifted to newly created companies, while private investors would be welcomed in projects previously off-limits to them, sources said. Beijing will also lift a ban on provincial and municipal governments selling bonds, a step aimed at bolstering their finances with more transparent sources of funding. Many analysts see China’s pile of local government bad debt as a major risk to the economy, especially as the economy slows, but few see widespread banking fallout as they believe cash-rich Beijing can step in to soak up losses.

I was not able to find any mention of this in the Chinese media, but I suspect we will hear more about it over the next few days. How important is this announcement? It is good that the extent of the problem is being recognized and quantified, but this announcement doesn’t do much more than that.

And I think there is a lot of confusion given what I read in the Reuters and other articles. First, this announcement, if it is true, doesn’t much change the risk profile of either the local governments or the banks because they were anyway implicitly or explicitly guaranteed. Second, the real issue here is not who gets to carry the liability, but rather who is going to foot the bill for the losses, and of course that hasn’t been addressed. As I see it there are only three sources of repayment.

1. The government can privatize land and assets and use the proceeds to pay for the losses. This might be very difficult politically right now, but ultimately I suspect that they are going to move in this direction.
2. The government can tax or confiscate wealth from SMEs and the wealthy. This is politically expedient since SMEs don’t seem to have much power as a bloc, but this could cripple long-term growth prospects if it causes SMEs to disinvest.
3. The long-suffering household sector can bear the losses once again, but of course this pretty much eliminates any hope of getting the consumption share of GDP to rise and become the driver of future GDP growth.

It is of course good that they are formalizing and recognizing the extent of the possible losses — everyone’s favorite solution of ignoring the problem is unlikely to have helped much. Perhaps these huge numbers, now that they are quantified and recognized, can push the debate forward, but in my opinion we still haven’t addressed the main issue: how will this debt be repaid and when will they slow down and reverse what has clearly become an unsustainable increase in debt?

Who trades RMB?

So much for debt. To move onto another topic, my central bank seminar at PKU had a fascinating discussion this week about the internationalization of the RMB in trade transactions. To summarize, although the amount of trade denominated in RMB is still small, it is growing at a very rapid pace. This is often given as very strong evidence that the RMB is on its way to becoming a major, if not the dominant, currency in international trade. My ever-skeptical students, however, were not wholly convinced.

They pointed out that according to PBoC data on external RMB transactions, if you exclude the services component (which they believe consists mostly of remittances), 93% of the trade transactions denominated in RMB consist of Chinese imports while only 7% consist of exports. They argued that in fact export-denominated transactions are even smaller if you exclude intercompany exports, which dominate the export numbers but not the import numbers.

When a Chinese exporter sells something to its offshore affiliate, in other words, which is then sold on to the end buyer, a foreigner, the offshore affiliate denominates the sale to the end buyer in dollars while it denominates the purchase from the onshore affiliate in RMB. In that case it is not meaningful to say that the trade took place in RMB rather than dollars, although it does show up on the PBoC books as a foreign trade transaction denominated in RMB.

So why the huge imbalance between exports and imports? If transacting in RMB were genuinely more convenient for exporters and importers, you would probably see a much more balanced split. In fact since China exports more than it imports, you could even argue that exports denominated in RMB should exceed imports.

But that isn’t the case. One possible explanation is that denominating trade in RMB is convenient only for Chinese companies, not for foreign companies. In a world of deficient demand, it is buyers who have the power to dictate terms, not sellers, so in that case Chinese buyers (importers) can force foreigners to trade in RMB while Chinese sellers (exporters) cannot. This seems plausible to me, although as one student pointed out, it suggests that there is a limit to the amount of trade that is likely to be denominated in RMB – the size of China’s imports.

But it still seems like a huge imbalance, which brings in the other explanation. As the students making the presentation pointed out, the mechanics of the trade transaction denominated in RMB requires that foreign buyers must either buy RMB or borrow RMB in Hong Kong in order to pay for Chinese exports. On the other hand foreign sellers are long RMB in Hong Kong once they conclude the sale to the Chinese importer.

With so many foreign sellers ending up with long RMB positions and so few foreign buyers ending up with short RMB positions, it should be very easy for the buyers to close their shorts in the Hong Kong RMB market. But that isn’t the case. In fact it is very hard for them to buy RMB. In spite of the disproportionate amount of long positions versus short positions, no one seems to want to sell enough RMB to the shorts.

Why would that be? Most probably it is because the sellers want to take speculative long positions in the RMB, perhaps because they expect the RMB to appreciate. Is this truly what speculators believe? Yes, and we have corroborating evidence – there is a lot of demand for RMB-denominated assets and very little supply, and most proxies for hot money inflows suggest that the hot money demand is strong.

So what did the seminar participants conclude? They claim that what is driving the increase in the RMB-denominated trade is probably not any preference to transact in RMB but rather speculative demand for RMB. That sounds pretty plausible.