Friday, January 30, 2009

China to Obama: “Nice T-Bill Auction Ya Got There…Hate to See Anything Happen to It”

The Chinese government fired a shot across the bow of the Obama administration this week, with pointed statements by Chinese Premier Wen Jiabao at the World Economic Forum in Davos, and a coordinated backgrounder in the Wall Street Journal.

Without directly naming the United States, Wen accused you-know-who of fouling its own economic nest, endangering the world financial system, and negatively impacting China’s economy.

That’s at cross purposes with the meme the United States is struggling to get out. But Premier Wen’s message has immediate, real-world and potentially near-term consequences that the United States can’t afford to ignore.

Politics, ideology, and human nature being what they are, there is an ongoing effort to minimize U.S. culpability for the dent in China’s pocketbook, and even blame the current economic crisis on systemic abuse by the Chinese, and not a systemic failure of the free market system.

As University of Wisconsin economist Menzie Chinn noted on the blog Econbrowser, outgoing Fed Chairman Bernanke’s swan song, the last Economic Report to the President, blamed our epic economic bellyflop on the (in economic circles) notorious “savings glut” in China, the oil producing states, and other emerging countries.

The shorthand version of the “savings glut” brief is that China and other countries rolled up huge surpluses and threw them into the Western economy. This tsunami of money pushed down the cost of debt even for risky investments and sparked an orgy of injudicious lending that is now experiencing its tragic denouement.

In China’s case, as opposed to Saudi Arabia’s, the accumulation of savings is regarded as somewhat less than virtuous, coming as it did from the immense forex reserves the PRC accumulated by a) undervaluing its currency to achieve large trade surpluses and b) closing off its domestic capital markets to foreigners and buying the resultant forex surplus from its citizens to put in the People’s Bank of China vault instead of letting it roam the world freely and efficiently through the mediating genius of the world’s investment banks.

However, as Dr. Chinn points out, all these surplus savings could be sucked into the vortex of the U.S. debt tornado because the U.S. government was asleep at the regulatory switch when it came to managing the risks inherent in an environment of converging interest rates for all kinds of risk.

I would also add that, in China’s case, purchases of U.S. mortgage-backed debt were miniscule. The risk averse PRC shunned subprime investments; furthermore it struggled to find significant private sector blue-chip harbors for its US$ stash despite the heroic efforts of America’s investment banks (remember CNOOC’s abortive attempt to buy Unocal?).

Instead, the PBOC dumped its foreign exchange holdings largely into U.S. Treasury bonds, courtesy of the Bush administration’s willingness to cut taxes and run rather sizable deficits covered by issuing government debt—debt that was not purchased by American savers, who instead had become borrowers courtesy of a global debt binge and real estate bubble.

In the World Economic Summit at Davos this week, Premier Wen made these points as he implicitly scolded the U.S. for driving the world economy off a cliff:

Mr Wen made scathing comments about the "inappropriate macroeconomic policies" of some unnamed countries and the "unsustainable model of development characterised by prolonged low savings and high consumption".

He attacked financial institutions' "blind pursuit of profit" and their "lack of self-discipline".

Undoubtedly, the China-screwed-us explanation will provide aid and comfort for Republican and free-market hardheads looking for a comforting explanation/excuse for the crisis. But the Chinese aren’t going to buy it, I don’t think many economists will be comfortable accepting it as the full explanation of our woes, and the American public will probably find the Lolcats version of the theory—“Chineez made me spend there munee…Waaah!”—somewhat bewildering.

Behind Wen’s remarks was a more direct sense of anger and betrayal involving the potential loss of billions of dollars of Chinese assets in American institutions—and feelings of suspicion shading on paranoia that should be of concern to President Obama’s foreign policy and economic teams.

Economist—and China forex reserve guru—Brad Setser posted concerning a detailed backgrounder by the Wall Street Journal coinciding with Wen’s remarks at Davos.

To me, at least, the report was clearly prepared with the full assistance of a pissed-off Chinese government, and provides a behind-the-scenes account of Beijing’s exciting trip through the Wall Street meatgrinder, courtesy of Henry Paulson and the Bush administration.

The article describes in detail China’s efforts to diversify its portolio into “safe-as-houses” American instruments beyond Treasuries in recent years, including about $400 billion in Fannie Mae and Freddie Mac paper and multi-billion dollar strategic investments in some big, blue chip money market funds by China’s sovereign wealth fund, the China Investment Corporation or CIC.

The article amply describes the Chinese sense of frustration when many of these investments went south, adding the detail that China’s withdrawal from the Fannie Mae/Freddie Mac auctions in the fall of 2008 was most likely a factor in forcing the U.S. government to step in to prop up these two institutions—something the Obama administration is no doubt chewing over.

I think Mr. Setser is off the mark when he takes the Chinese to task for unreasonable command economy expectations for the risk inherent in any free market economy asset, and for selfishly pulling out of the Fannie Mae/Freddie Mac market and not lending their Treasuries to other (foreign) banks to serve as security for further lending:

China’s leaders believed that China’s investments in the US financial sector would be protected, perhaps because that is how things are done in China. They weren’t. At least not consistently.

Fair enough. China owns the Treasuries after all, and has no obligation to lend them out. But, well, its actions in both the Treasury and Agency markets weren’t exactly stabilizing.

What Mr. Setser and the WSJ miss, perhaps, is the Chinese framing of their expectation in making these investments—that they were encouraged by Treasury Secretary Hank Paulson, the fattest of Wall Street fat cats—and were not merely parking their excess dollars in some convenient slush fund. They wish to send the message they were making a strategic investment as a sovereign nation, consciously conforming to U.S. government policy, sluicing cash where President Bush, Secretary Paulson, and their Wall Street buddies wanted it, buying a let-up in China-bashing from a grateful Bush administration, and getting some of that risk insurance that the Republicans extend as a matter of course to their well-heeled buddies.

Therefore, I believe, China is making the case that it is entitled to some special consideration (for itself and its investments) now that things have gone pretty bad.

Instead, the whole process has turned into a chaotic muddle, with the Chinese angrily waiting their turn with all the other schlubs who got suckered into these collapsing investments.

Furthermore, in the Chinese reaction—encapsulated in an angry report circulated among the Chinese leadership essentially accusing naïve members of China’s financial team of happily and foolishly colluding with Mr. Paulson—I hear echoes of another source of Chinese frustration: pushback against the Bush administration concept of “responsible stakeholder” which was invented by Robert Zoellick at the State Department and invoked incessantly in an effort to get the Chinese government to subordinate its narrow national interests to the greater good, at least as it was defined by the West.

Well, now the Chinese are no doubt telling themselves that “responsible stakeholder” was the height of American hypocrisy, and a dangerous snare and delusion for China—something else the Obama administration had better note.

Mr. Setser professes himself bewildered by the statement,

One passage charged that Mr. Zhou "colluded with Henry Paulson to buy U.S. bonds, forced [Chinese yuan] appreciation, attached China's economy to the U.S. and broke China's economic independence."

presumably, because it conflates two mutually exclusive economic priorities: dumping dollars and putting pressure on the yuan to appreciate.

Politically, on the other hand the charge makes perfect sense: that people inside the Chinese economic technocracy injudiciously went along with Paulson’s policy prescriptions for smooth U.S.-China relations--allowing the yuan to appreciate and buying U.S. securities to prop up Wall Street--and the Chinese government got shafted as a result.

It’s a clear indication that the honeymoon is over for the wizards of Wall Street and their wannabe counterparts in China’s financial institutions, as far as the Chinese leadership is concerned.

A final warning for the Obama administration can be gleaned from these concluding paragraphs in the Wall Street Journal article:

Then Washington allowed Lehman Brothers Holdings Inc. to collapse, further shaking Beijing's faith. One casualty was CIC's nearly $5.4 billion investment in the Reserve Primary Fund, the money-market fund that "broke the buck" in September as a result of the Lehman collapse.

CIC had placed money in the Primary Fund because "money market funds are supposed to be very safe," said a Chinese official in an interview late last year. But on Sept. 16, the Primary Fund's managers announced that they were delaying redemptions.

CIC officials emailed Reserve asking to withdraw all of its money from the fund, and promptly received a reply agreeing to the request, says the Chinese official.

CIC officials believed the agreement meant that CIC had become a creditor to the troubled fund, and therefore was entitled to all of its money.

A Reserve spokeswoman says the company doesn't comment on individual clients.

Later in the day on Sept. 16, Reserve announced that the Primary Fund's net asset value had fallen to 97 cents a share, below the standard $1.00 level.

Reserve initially said redemption requests received before 3 p.m. that day would be honored in full, but has since said that the net asset value already was down to 99 cents a share by 11 a.m.

As Reserve further delayed payments, CIC began to fear that it might not get all of its money.

The Reserve issue "is causing a lot of concern with a lot of financial institutions in China," said the Chinese official.

Some officials expected that the U.S. and its financial institutions would better protect China from loss.

"If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system," the official said.

A CIC spokeswoman declined to comment on the current status of the dispute. [emphasis added]

Translation (to me): China wants the Obama administration to get CIC’s money in the Primary Reserve Fund to be treated as debt, not equity, thereby confirming a special, protected quasi-sovereign character for China’s large strategic investments in the U.S. financial sector.

This might simply be a hail-mary plea from the technocrats at CIC, begging their sympathizers in the U.S. financial system to save their bacon.

At the very least, the existence of this demand shows that the free-market/globalization believers in China are on the defensive.

But it also might be a warning from China’s leaders, not just the embattled bureaucrats of CIC.

If the Obama administration allows financial nature to take its course and lets CIC lose its stake, then, well maybe the Chinese government will have to let nature take its course and take its dollar-investing business elsewhere…for instance, away from the U.S. Treasuries market, let alone any shaky private or quasi-private or half-assed nationalized U.S. financial institution that’s looking for a foreign sugar daddy.

In other words: “Nice T-bill auction ya got there…hate to see anything happen to it…and, by the way—make sure that Primary Reserve Fund thing works out for us, willya?”

Beyond the world of government debt and Wall Street, the Main Street issue of the undervalued-RMB, a perennial of the U.S.-China policy debate, threatens to complicate the high-octane dispute over high finance between Washington and Beijing.

During his confirmation hearing, Treasury Secretary Geithner passed on a message that President Obama believes China was manipulating its currency. Still a step away from a formal finding of intentional manipulation for the purpose of gaining an unfair trade advantage, but at the very least an indication that the Obama team will be pounding the trade issue more than the Bush administration did.

And the Chinese will be pounding right back, painting calls for RMB revaluation as backward-looking protectionism by an Obama administration anxious to placate its union base.

As a matter of personal opinion, I do think that the RMB is undervalued.

I think the Chinese government, as a matter of practicality, has maintained a dollar peg for its currency in order to provide a stable economic environment for its exporters (instead of making them to manage their forex risk through the complicated free-market frou-frou of currency futures markets, derivatives, etc.), and that’s a legitimate national economic goal;

I think the peg was set on the high side, to give Chinese exporters a bit of a leg-up;

I think the Chinese government believes that its forex structure—the dollar peg, enabled by sale of forex to the government bank and severe limits on cross-border flows of capital—has worked pretty well, especially in light of the financial disaster sweeping the open markets of the United States and Europe;

And, given the pain that an RMB revaluation would cause China’s exporters, already battered by the global recession, and the disruption caused by speculative hot money sneaking into China to buy RMB by hook or crook in anticipation of a revaluation, I don’t see the Chinese government heeding international political pressure right now to make more than incremental adjustments to the exchange rate and the overall capital account regime.

Having said that, I think that the Chinese government is desperate to revive the world economy and get its export factories humming again, so it will be prepared to do its bit to help matters along—like pissing away its government reserves buying more U.S. Treasury debt and hope that the Obama administration’s stimulus package jumpstarts the world economy.

And I believe that the Obama administration will decide in the end that Chinese cooperation on the stimulus package will be more important than a political struggle over the exchange rate, especially as the recession causes imports from China to sag.

The question is, will China consider a de facto climbdown on RMB valuation enough? Or will they harp on the losses they suffered in U.S. securities that were implicitly government-backed?

And, will U.S. opinion cut the Obama administration any slack on accommodating China?

Despite the theoretical and practical obstacles, however, there will be continued across the board ideological enthusiasm for continuing to bash China.

Right-wing commentators, it seems, don’t like the Chinese rubbing our noses in our recession because they consider the PRC an imperfect and dishonest exploiter of the magnificent capitalistic system the West has bequeathed to the world.

Left-wing commentators, in my view, consider Chinese macroeconomic activity as an extension of the regime’s immoral policies, as the CCP tramples on the environment, Tibetans and Uighurs, Darfurians, and the world’s working poor with equal gusto in its headlong pursuit of profit.

There is a certain amount of hoping and wishing that the Chinese economy would suffer a spectacular collapse as divine punishment for its government’s malfeasance.

These expectations have been complicated and, perhaps, exacerbated by the fact that it was the advanced free market economy of the West that went into the tank first, and not the inferior Oriental model.

As to whether the inadequacies of Chinese forex regime will lead to the systemic crisis of the Communist regime that many seem to anticipate, there are, as I understand them, two major critiques:

The first is that the forex surplus produced by the undervalued RMB must be purchased by the government and will create inescapable inflationary pressure—or unsupportable levels of debt as the government sells bonds to soak up the extra cash.

As far as I can see, inflation—the ultimate bugbear of China’s Communist rules, much more than an economic downturn—has not been an issue up until now. With the Chinese economy growing at a clip of about 10%, apparently there was enough productivity there to soak up the increase in the money supply.

Of course, growth is slowing to a crawl in China—if not going negative—but the trade surplus will also dwindle. Given the worldwide recession and slump in demand, I think the inflation argument is headed, at least for now, to the dustbin of history.

The second argument is that the undervalued RMB has distorted economic decision-making in China. Money pours into a) export projects for obvious reasons and b) into real estate (and the ancillary steel, cement, and construction and building material industries) and stock market bubbles as asset plays because domestic savers lack other suitable domestic and international destinations for their RMB holdings.

Certainly, sectoral imbalance is a big headache for the Chinese economy, and the government’s command economy response (throttling back on lending and materials to overheated sectors, coupled with state investment in industries and locales of dubious economic viability) isn’t pretty. And, as the economy deflates, foreign investment dries up, real estate values collapse, and major industries confront the specter of overcapacity, it will get pretty ugly.

And it could get very, very ugly if the Chinese government perversely decided to let its weak banking sector rise and (inevitably) fall on its free market merits, at the same time the West is engaged in the wholesale subsidizing and/or nationalizing of its financial sector.

However, the state-run banking system in China has so far shown itself resistant to foreclosure and immune to bankruptcy, despite perhaps a trillion dollars in non-performing loans (NPLs).
And that’s unlikely to change in the current environment.

In an eyebrow-raising development, the Chinese government reported that NPLs had declined from RMB 700 billion in 2007 to RMB 500 billion at the end of 2008, an indication either of miraculous luck in the midst of a multi-year lending binge, statistical legerdemain by the Chinese government meant to befuddle foreign analysts, a bureaucratic fiat to cook the books, a genuine sub rose injection of capital to enable the banks to lend through the recession, or All of the Above.

My bet is that the Chinese banking system, thanks to the recession and government intervention, manages to dodge the well-deserved fiscal bullet again.

I think observers who anticipate that the Chinese Communist party is going to spend itself into oblivion as the Soviet Union did (gorging on the fatal apple of shopping malls instead of armaments) will be disappointed.

Systemic financial failure--hyperinflation or the annihilation of people’s savings through the collapse of China’s state run banking system that terminally discredits the CCP regime and destroys the legitimacy of its rule--doesn’t appear likely.

The recession—and millions of impoverished Chinese returning to their villages from shuttered factories along the coast—will certainly exacerbate the simmering resentment against the Party’s serial corruption, oppression, and arrogant incompetence, especially at the local level.

However, the greatest threat to the Chinese Communist government has never been popular unrest provoked by economic suffering.

It has been the threat of fissures within the ruling elite, of the kind that nearly destroyed the CCP during the Cultural Revolution, is typified by the assisted suicide of the CPSU under Gorbachev, and provoked Deng Xiaoping’s ferocious wrath against Zhao Ziyang during the 1989 democracy movement.

Currently, the CCP ruling cadre in Beijing is riding high, coming off a decade of economic growth with a fair amount of money in the bank, reveling in its Olympic triumph, and enjoying the apparent vindication of its managed, nationalist economic model over the open-market nostrums peddled by the West. The United States, instead of representing a triumphant and destabilizing alternative, is mired in political and economic problems of its own.

If and when popular unrest does occur as a result of the recession, the Party will confront it with an effective combination of ingenuity, unity, and brutality—and the sacrifice of as many flagrantly incompetent and corrupt local officials as it takes--unhindered by the example or effective condemnation of the West.

I expect that, instead of threatening the existence of the CCP, the global financial crisis has enhanced the legitimacy and prolonged the life of the current Chinese Communist regime.

That’s not an endorsement or a value judgment, by the way. It’s just how I see it—and how I think the Obama administration might weigh economics in its China equation.


Unknown said...

There's one nagging question you fail to address: why did Asian investment favor Treasuries, and to a lesser extent, dicier securities rather than invest at home. The answer is, that the returns on American investments were too good to ignore, and better than anything investments in the domestic markets could put up. Although Wall Street fumbled, the greater sin was and is not reforming domestic financial markets and instruments.

In effect, Beijing used Wall Street to launder its money, and America didn't have the brains to return it. But then, everyone wanted the export ride to continue. Now, both American obliviousness and Asian greed have wrecked the export engine irrevocably.

America has to drain the swamp, but its financial markets can resume high-class operation. Beijing can only wish it could be so lucky.

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