Tuesday, May 27, 2008
chinese financial instability
Michael Pettis gives us a very thorough report on the stunning and mystifying report from China that its FX reserves increased by $75.4 billion in the month of April alone. To put this in context, China already has the world's largest foreign exchange reserves, and unbelievably, the pace of its growth in FX reserves is accelerating. FX reserves grew $247 billion in 2006, and then the addition almost doubled in 2007 to $462 billion. And now the growth in April is nearly half the growth of the first three months of the year.
Pettis is quietly horrified. The increase is well out of proportion to changes in China's trade surplus. It appears to be in large part due to hot money inflows (from where, one might ask. The Middle East? Japan? Those seem to be the only places with large enough surpluses of their own to throw around). Dani Rodrik, Ken Rogoff, and Carmen Reinhart have all argued that high levels of international funds flows are correlated with financial instability. This announcement does not bode well for markets getting back on an even keel.
with food riots, a property crash and a stock market crash all underway, these massive hot money flows are grist for the mill of speculation regarding an incipient unstable deflationary shock in china, following hot on the heels of a massive inflationary boom that has birthed a different kind of shadow banking system within china -- one which has made a feature section of the economist this week that may soon be regarded as a magazine cover indicator. says pettis:
We have reached what I believe is the end stage of this trap in which the monetary system is forced to adjust through appreciation and inflation. The problem is that in such a case there is a huge risk that hot money inflows destabilize the adjustment process, and this seems to be exactly what is happening. Instead of reducing foreign exchange inflows, the appreciation of the RMB is causing massive hot money inflows (which is not at all surprising, but it has been made much worse by China’s bad luck of having to adjust in the middle of the sub-prime crisis) and so the adjustment must be much more dramatic and much more painful. No matter how quickly China tries to reduce monetary expansion by appreciating the currency, in other words, monetary expansion grows even faster.
pettis himself discourses at length, in the context of reinhart and rogoff's recent work, upon the likelihood of a financial crisis in china. his conclusion:
As good as the R/R paper is there are, inevitably, some things I would have liked to see discussed more. For example there has not been much discussion in the R/R paper about the role of contingent liabilities in sovereign crises. As a very interesting book published last March by the IADB (Living with Debt) notes repeatedly, very often the debt that “caused” the financial crisis was not the long-term accumulation of fiscal deficits but rather the very sudden emergence or conversion of contingent liabilities. These contingent liabilities suddenly exploded – for a variety of reasons – and were generally structured in ways that exacerbated both the previous good conditions and the current bad conditions.
The two most common forms of this have been the explosion in the relative value of debt denominated in foreign currency, following a currency crisis, and the explosion in contingent liabilities through a collapsing banking system. In my opinion these have been two of the most common causes of “unexpected” financial crisis, and it is worth considering any country’s, including China’s, risk of either event occurrence.
China, of course, is in little risk of seeing the former happen. With less than $400 billion of external debt and close to $2 trillion of foreign currency reserves, China is at no risk of a recurrence of the 1997 Asian crisis. The real threat for China is in the second set of contingent risks, that of an explosion of liabilities arising though the banking system. I am obviously not the first person to point this out – China’s massive loan growth and its stubbornly high NPL ratio in spite of what can only be described as a dream time for bankers suggests at the least that in a sharp downturn there is a very real risk of a surge in NPLs.