by Keith Bradsher
HONG KONG ÃƒÂ¢Ã¢â€šÂ¬Ã¢â‚¬Â ChinaÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s central bank is in a bind.
It has been on a buying binge in the United States over the last seven years, snapping up roughly $1 trillion worth of Treasury bonds and mortgage-backed debt issued by Fannie Mae and Freddie Mac.
This was part of a ‘weak yen’ policy designed to support exports by keeping real domestic wages in check.
Those investments have been declining sharply in value when converted from dollars into the strong yuan,
Why should they care?
What matters from an investment point of view is what the USD can buy now, what the yuan can buy.
casting a spotlight on the central bankÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s tiny capital base. The bankÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s capital, just $3.2 billion, has not grown during the buying spree, despite private warnings from the International Monetary Fund.
Doesn’t matter what currency the bank’s capital is denominated in because he doesn’t know it matters.
The government has infinite yuan to spend without operational constraint; so, stated yuan capital doesn’t matter.
Now the central bank needs an infusion of capital.
Why? That’s a self-imposed constraint. Operationally central banks don’t need a local currency capital.
Central banks can, of course, print more money, but that would stoke inflation.
Operationally, this makes no sense. There is no such thing as ‘printing money’ apart from actually printing a pile of bills and leaving them on a shelf, which does nothing.
If they spend those bills, that’s government deficit spending with the same effect as any other government deficit spending.
‘Printing money’ has nothing to do with anything.
Instead, the PeopleÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.
Yes, there are self-imposed constraints imposed on various agencies of the government.
There are no operational constraints.
The central bankÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts.
The way they keep a strong currency down is by buying more USD.
A weak currency goes down on its own.
To make a weak currency rise, you have to see your USD.
This could heighten trade tensions with the United States.
The Bush administration and many Democrats in Congress have sought a stronger yuan to reduce the competitiveness of Chinese exports and trim the American trade deficit.
Yes, but if the yuan has turned fundamentally weak, the way for the US to keep it from falling is for the US Treasury to buy yuan.
The central bank has been the main advocate within China for a stronger yuan.
They want to fight inflation by keeping nominal input costs down.
But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan.
Right, they want to support exports by keeping real wages down.
As the yuan slips in value, ChinaÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s exports gain an edge over the goods of other countries.
The two bureaucracies have been ferocious rivals. Accepting an injection of capital from the finance ministry could reduce the independence of the central bank, said Eswar S. Prasad, the former division chief for China at the International Monetary Fund.
ÃƒÂ¢Ã¢â€šÂ¬Ã…â€œCentral banks hate doing that because it puts them more under the thumb of the finance ministry,ÃƒÂ¢Ã¢â€šÂ¬Ã‚Â he said.
This matters for foreign exchange policy. In the US, Japan, and others, the Treasury makes the foreign exchange decisions, not the Central Bank. And this if far more potent than interest rate policy.
Mr. Prasad said that during his trips to Beijing on behalf of the I.M.F., he had repeatedly cautioned China over the enormous scale of its holdings of American bonds, emphasizing that it left China vulnerable to losses from either a strengthening of the yuan or from a rise in American interest rates. When interest rates rise, the prices of bonds fall.
Those are not risks, as above.
Officials at the central bank declined to comment, while finance ministry officials did not respond to calls or questions via fax seeking comment. Data in a study by the Bank of International Settlements based in Basel, Switzerland, sometimes called the central bank for central banks, shows that many central banks had small capital bases relative to foreign reserves at the end of 2002,
They don’t need any capital base relative to foreign exchange holdings.
Foreign exchange holding are themselves capital.
though few were as low as the PeopleÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s Bank of China.
Given the poor performance of foreign bonds, the Chinese government could decide to shift some of its foreign exchange reserves into global stock markets.
If they shift to financial assets denominated in other currencies, this serves to shift the value of the yuan vs those currencies.
Stocks vs bonds is an investment decision only.
The central bank started making modest purchases of foreign stocks last winter, but has kept almost all of its reserves in bonds, like other central banks.
The finance ministry, however, has pushed for investments in overseas stocks. Last year, it wrested control of the $200 billion China Investment Corporation, which had been bankrolled by the central bank. That corporationÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s most publicized move, a $3 billion investment in the Blackstone Group in May of last year, has lost more than 43 percent of its value.
The central bankÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s difficulties do not, by themselves, pose a threat to the economy, economists agree. The government has ample resources and is running a budget surplus. Most likely, the finance ministry would simply transfer bonds of other Chinese government agencies to the bank to increase its capital. But even in a country that strongly discourages criticism of its economic policies, hints of dissatisfaction are appearing over ChinaÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s foreign investments.
For instance, a Chinese blogger complained last month, ÃƒÂ¢Ã¢â€šÂ¬Ã…â€œIt is as if China has made a gift to the United States Navy of 200 brand new aircraft carriers.ÃƒÂ¢Ã¢â€šÂ¬Ã‚Â
Bankers estimate that $1 trillion of ChinaÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s total foreign exchange reserves of $1.8 trillion are in American securities. With aircraft carriers costing up to $5 billion apiece, $1 trillion would, in theory, buy 200 of them.
By buying United States bonds, the Chinese government has been investing a large chunk of the countryÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s savings in assets earning just 3 percent annually in dollars. And those low returns turn into real declines of about 10 percent a year after factoring in inflation and the yuanÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s appreciation against the dollar.
The yuan has risen 21 percent against the dollar since China stopped pegging its currency to the dollar in July 2005.
The actual declines in value of the central bankÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s various investments are a carefully guarded state secret.
Still China finds itself hemmed in. If it were to curtail its purchases of dollar-denominated securities drastically, the dollar would likely fall and American interest rates could soar.
China spent more than one-eighth of its entire economic output last year on foreign bonds, and then picked up the pace during the first half of this year. Chinese officials have suggested in recent comments that they are increasingly interested in stopping the yuanÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s rise, and thus are willing to continue buying foreign securities to support the dollar. In fact, the yuan weakened slightly against the dollar last month after 26 consecutive months of gains.
Along with Treasuries, China has invested heavily in mortgage-backed bonds from Fannie Mae and Freddie Mac, the struggling mortgage finance giants that are sponsored by the United States government. Standard & PoorÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s estimates ChinaÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s holdings at $340 billion.
Some bond traders suspect that the central bank has scaled back its purchases of these securities, as have ChinaÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s commercial banks. But the central bank trades this debt through many third parties in many countries, making its activity opaque to outside analysts.
The central bank has gone to great lengths to maintain its foreign purchases. The money to buy foreign bonds has come from the reserves required that commercial banks must deposit with the central bank. In effect, ChinaÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s commercial banks have been lending the central bank more than $1 trillion at an interest rate of less than 2 percent.
To keep the banks strong when they were getting such little interest on their reserves, the central bank has kept deposit rates low. The gap between what banks are paying on deposits and the rates they are charging ordinary customers to borrow is several percentage points. This amounts to a transfer of wealth from ordinary Chinese savers to the central bank and on to Americans who are selling their debt to the Chinese.
The central bank is now under considerable pressure to reduce the commercial banksÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢ reserve requirements to encourage growth as the Chinese economy shows signs of slowing.
Victor Shih, a specialist in Chinese central banking at Northwestern University, said that when he visited the PeopleÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s Bank of China for a series of meetings this summer, he was surprised by how many officials resented the institutionÃƒÂ¢Ã¢â€šÂ¬Ã¢â€žÂ¢s losses.
He said the officials blamed the United States and believed the controversial assertions set forth in the book ÃƒÂ¢Ã¢â€šÂ¬Ã…â€œCurrency War,ÃƒÂ¢Ã¢â€šÂ¬Ã‚Â a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.
ÃƒÂ¢Ã¢â€šÂ¬Ã…â€œA lot of policy makers in China, at least midlevel policy makers, believe this,ÃƒÂ¢Ã¢â€šÂ¬Ã‚Â Mr. Shih said.