My Blog

June 6, 2008

In a sign of how worried the authorities are about rising speculative inflows, in a report released yesterday SAFE said it would step up the monitoring of foreign capital inflows.  Yesterday I wrote about the policy paralysis that seems to be occurring as different groups within the government have some fairly radically different ideas on what are the biggest problems facing China.  Under the circumstances, I argued, it is very hard for those who are worried about inflation, overheating, stock market excesses, and speculative inflows to organize the consensus needed to take the rather more dramatic steps China needs to take.

That was not completely correct.  Where policy paralysis seems to be occurring is actually in deciding what appropriate market measures need to be taken – adjusting the currency, raising domestic interest rates, liberalizing the markets, or relaxing price freezes.  There does not seem to be a lack of consensus – or perhaps it is more appropriate to say that a wide consensus is really not needed – when it comes to administrative measures.  The government continues to use administrative measures and various forms of signaling in its attempts to address the stock market and inflation, and it seems that its first weapon of choice with which to attack hot money inflows is likely to be attempts to strengthen capital controls.  That is how I read the SAFE announcement.

Clearly greater vigilance on this front is likely to have some impact on capital inflows at the margin, but I think there are at least three problems.  First, by now it seems that speculative inflows are so large that reducing them by a little is not likely to create a whole lot more breathing room for the PBoC.  Although many commentators are only now starting to concede that hot money is a big problem, the fact is that it almost certainly was a problem even a year ago.  Given the nature of these inflows it is hard to get a real sense of how rapidly they have grown, but one Chinese commentator claims that inflows this year are running at three times last year’s pace.

I have no idea if this is true, and certainly can’t prove it one way or the other, but even if he is way off, I think few of us who have been trying to estimate the numbers would argue that hot money inflows have not increased dramatically, and we all agree that they are now a much more serious problem.  In that case, it would take a very large reduction to “fix” the problem, and I don’t think increased monitoring is going to have that impact given how complex and large China’s trading and investment networks are and how easy it is for agents to skirt the law.

Second, this increase in monitoring will necessarily raise the cost of legitimate transactions, and very tight monitoring might seriously hamper economic activity.  Trade is important to China, as is FDI, and the bureaucratic delays and frictional costs associated with a step-up in monitoring may have a significant economic cost.  Finally, most of the empirical evidence suggests that in a developing economy with weak governance an increase in monitoring will deepen illegal channels and strengthen corruption.  This can’t be in China’s interest.

So China’s fight against hot money will be like its fight against inflation and its fight against stock market volatility.  Instead of market measures it will first try a variety of administrative measures. I think this fits more comfortably within the intellectual and cultural framework with which the leaders are most familiar and it gives the sense of managing the process in a non-disruptive way.  If it ends up having no effect, as I think it won’t, the consensus will gradually build for more realistic measures.  The problem, of course, is that this may take much too long.

On a separate, but related, note, one of my former students who has spent the past three years as a trader sent me the following (edited) note:

There has been market talk that CIC is placing USD deposit with onshore banks (both local and foreign).  one-year onshore USD is quoted at L+900 bps, so it’s economically correct for CIC to do so.  This is the main reason why onshore FX swaps are bought up at -6000 to -2600.

Personally I think this is real, but I am not able to find out or even guess how much money they lent out onshore.  The onshore banks will have to place a bigger amount of USD reserve with PBOC, but I am not sure whether this will have any impact on the FX reserve number

Another thing, in reference to the rapid growth in USD loans onshore in the first quarter that you discussed on May 18, I checked with several banks, and many of them tell me that the corporates are borrowing USD and swapping the USD into CNY thru fx swaps, to get CNY funding.  (Following a query the student told me that these corporates are swapping with the banks that lend them USD.).

Let’s see if I understand.  Corporations are borrowing US dollars from local banks and then swapping into RMB.  Why?  I guess that this allows them access to RMB funding without, technically, taking out RMB loans, which would come under the lending cap.  Logan, if you’re reading this, what do you think?  Does this fit with what you are hearing?

Comments (7) for "Administrative measures trum...

You only transfer the net gain/loss at the end of a swap transaction. The USD they borrowed would still be USD in their pockets. Nothing change hands before the swap ends. Did I miss anything here? How did that swap exactly occur? By fatbrick - 6/6/2008 12:06 AM

Michael -- I think you have gotten the policy consensus right. No consensus on macro policy tools (exchange rates or interest rates), but consensus to make greater use of administrative measures. If I read your student right, onshore USD pays LIBOR+900 -- which is huge. I am curious what the banks do with the resulting dollars; they cannot make money buying foreign securities. Maybe local firms are so keen to borrow in $ that they are willing to pay through the nose as an exchange rate play, but that is making a big bet that the policy paralysis will break and tis better to borrow in $ at L+ 1000 than to borrow in RMB (or not borrow at all). So I do wonder what the offsetting position. The big CIC deposits could also reflect: a) a desire to support SOE's outward expansion indirectly. More $ in the banks, if lend to SOEs to invest abroad, is a means of encouraging firms to go forth ... Think of the $ lending from the CDB to support Chinalco b) lags between the CIC's purchase of FX from SAFE and the awarding of investment mandates that has led to a rise in the CIC's dollar liquidity that is expected to be temporary. I have heard that in the past the CIC handed spare cash back over to SAFE to manage. Maybe they decided to try something new? By bsetser - 6/6/2008 2:20 AM

Michael, don't leave out the obvious benefit, borrowing USD and swapping the proceeds into CNY, puts one short USD and long CNY, which is where a lot of people want to be. By bobo7874 - 6/6/2008 2:52 AM

Fatbrick and Bobo, a dollar borrowing with an RMB currency swap is no different than simply borrowing RMB. Brad, I assume that the borrowers either can't use dollars so they sell the dollars for RMB (if the dollars are being used to pay for investment, I think they have no problem getting approval for the sale) or they use the RMB to prepay imports. Technically in this case they are simply accelerating a dollar payment, but from the PBoC's point of view between the time of the transation and the time they would have normally paid this is no different from any other speculative inflow. What this amply demonstrates is how adminsitrative measures typically divert resources and management time towards ways of getting around them. The only reason I can figure out for doing this is that because of the RMB loan cap some borrowers are being turned down for normal RMB borrowings, so they use this marginally more complex route to acheive the same end. I say "margianlly more complex" because I would assume that the bank handles the loan, the swap and the exchange of dollars for RMB simultaneously. On the borrower's books there are three transactions, but they net out to one (borrow RMB). On the bank's books there is a new dollar loan and a swap, so that the bank has no net exposure either. By Michael Pettis - 6/6/2008 1:31 PM

Mr Pettis Assuming the RMB loan cap you referred to as restrictions on the banks ; does this point towards ever expanding loan capacity and therefore increasing laxity when it comes to scrutiny of borrowers? In other words, could we expect NPLs to increase? Hence, another problem potentially created by the a solution fotr another? If the loan is nominally in $, as the $ declines, the loan becomes cheaper but the bank "loses" on part of the loan/exchange mechanism, but it gets around the RMB loan cap and boosts what appears to be bank demand for the $, politically correct? By Judy Yeo - 6/6/2008 5:53 PM

Judy, if the USD loan is hedged with an RMB swap, it is really no different from an RMB loan. The loss in the RMB value of the USD loan will be exactly matched by a gain on the swap. On your first question, I definitely expect NPLs to increase. By Michael Pettis - 6/7/2008 1:58 PM

Sorry for responding to this fairly late. I've also heard rumors about the CIC placing dollar deposits with the banks, which would be consistent with the peculiar surge in foreign currency deposits in April. However, I've also been hearing that the banks approached the CIC asking for dollar funding, given the onshore dollar shortage, and were turned down, after some deliberation. It's an open question as far as I'm concerned. As far as your student's comment, I have been hearing similar things about companies borrowing USD and swapping into RMB, given the dramatic reversal in forwards prices that occurred in April and May (both onshore and offshore, which track each other, probably due to some degree of arbitrage between the markets) following the yuan's slowdown in its rise against the dollar. The lower dollar forward costs allow companies with access to the interbank market to access RMB funding outside the PBOC's quarterly quotas, which is the incentive for such loans (even though they occur at higher rates than the PBOC benchmark RMB lending rates). With the forwards markets correcting again following the RRR hikes Saturday, which increased demand for dollars (I currently see an implied appreciation in the 12M NDF of under 5%), we'll probably see more of this activity in the near future... By Logan Wright - 6/9/2008 2:33 PM