Monday, September 26, 2011

Michael Pettis on the Euro, Swiss Franc. RMB trading, and Chinese Debt

In a very long private newsletter received on September 13th, Michael Pettis began with "Slow growth is embedding itself solidly into the US economy and the bond mayhem in Europe continues. The external environment for China is getting worse. This will almost certainly make China’s adjustment – when Beijing finally gets serious about it – all the more difficult. With still weak domestic consumption growth, and little chance of this changing any time soon, weaker foreign demand for Chinese exports will cause greater reliance than ever on investment growth to generate GDP growth.

"Europe’s travails in particular can’t be good for exports. What’s worse, it’s now pretty much official that the euro will fail soon enough."  Pettis saw Merkel's assertion that the euro will not fail as an official government denial confirming that it could fail as in the political maxim, "The first rule of politics is never believe anything until it is officially denied."  Pettis then proceeds to discuss in depth Otto Henkel's proposal ( "A Sceptic's Solution - A Breakaway Currency") for a two currency euro.  Although Pettis thinks there is little likelihood of the creation of two euro currencies dividing the deficit and surplus eurozone countries, he likes the idea, because all the deficit countries will not adjust fast enough as long as they maintain the euro and their economies will continue to contract and debt grow until their electorate rebels.  If those countries will then leave the euro and default and the surplus countries will eat the losses, why shouldn't the surplus countries force the deficit countries to leave the euro now?  Pettis answers his own question.

If a deficit euro country leaves the eurozone and adopts its own fiat currency, Pettis believes it would be caught in a downward currency spiral such as Mexico in 1982 and 1994 and Korea in 1997 suffered, because a substantial portion of Mexican and Korean debt was denominated in foreign currency.  A deficit euro country leaving the eurozone would have its debt denominated in euro.  This would be a foreign currency.

My comment in response to Pettis on the above scenarios is the High euro and Low euro bifurcation would merely create to stage productions of the very same play; one with a short and the other a longer audience length of the play.  Both would suffer the same, inevitable fate of the exporting country economically subjugating the importing countries with no fiscal transfer mechanism to resolve the current account imbalances creating an inevitable currency crisis as the deficit countries are challenged by the bond market one by one since they cannot guarantee payment under such a system.  Any eurozone country which withdraws from the euro must default on all euro debt and immediately redenominate all public and private debt at a fixed conversion to the new fiat currency on a take it or leave it basis and then let the new fiat currency trade freely with the market deciding the devaluation, which must occur.  The euro is a foreign currency to all eurozone countries and it would be irresponsible to leave debt in euro when exiting to a fiat currency; yet, almost all scenarios of such exits assume the debt would remain in euro.  That would be a fatal economic error.

As Pettis well knows, as he continues, to leave debt in a foreign currency means the devaluation may well not be in line with estimates of overvaluation.  It could cause a devaluation of 50% or more, when the overestimate might be only 15-20%.  The external debt would rise as its fiat currency devalues, because it would remain denominated in an appreciating foreign currency.  The credibility question of bond payment would rear its ugly head again and financial distress cost would rise just as they are now.  As domestic borrowers try to hedge the currency risk, investors would flee the new fiat currency in a self-defeating currency crisis involving foreign currency debt.  Default would be unavoidable.

For Pettis, this is not an argument for a deficit country to stay in the eurozone, because, if the deficit country "stays in the euro, we will still arrive at default, but much more slowly, and mainly at first through a grinding away of wages and economic growth over many, many years and a gradual building up of debt as Germany refinances Spanish debt at interest rates that exceed GDP growth rates. The default will occur anyway, but only after years of high unemployment."  He leaves unstated the likelihood of growing social unrest and intra eurozone national distrust of the surplus eurozone countries.

This is why he likes Henkel's two euro currency idea, but with the surplus country (such as Germany) leaving the euro as Marshall Auerback has repeatedly suggested.  The new fiat German currency would immediately appreciate while the euro depreciates, but their banks would still have loans in euro which would cause them significant losses.  Pettis thinks the losses would be less and more orderly than a deficit country leaving the euro.  Either way the surplus country leaving the euro would take a big hit and it is a waste of time trying to avoid it and it is better to face it and deal with it and "as any good Minskyite would tell you, that means we have to pay special attention to the balance sheet dynamics."  Pettis also believes this would set up a two entity Europe of Germany and its associated countries and France and its associated countries.

With respect to the Swiss franc, Pettis believes the Swiss National Bank has decided to become very serious about currency wars.  Switzerland is enduring a large inflow of foreign currency and appreciation of the franc with significant negative impact on Swiss exports.  "The world is seriously deficient in demand compared to capacity and every country is going to try (has already tried) to capture as large a share of that demand as it can. This means every country is going to try aggressively to export capital or limit capital imports."

"But of course it doesn’t work that way. If capital-exporting countries want to increase capital exports in order to acquire a bigger share of global demand, and capital-importing countries want to limit or reverse capital imports, something has to give way. This is basically what we mean by trade and currency wars."
Switzerland has chosen to slow or eliminate foreign capital inflow by capping the rise of the franc.  Pettis believes it cannot work and there will be massive speculative inflows in the Swiss franc on the expectation the inflows will cause the Swiss National Bank to revalue.  In a few months the SNB will have to take even more forceful measures.  When countries continue to desperately export capital to each other while continually crying foul at attempts to import capital, currency wars will roll on as he explain in his recent Foreign Policy article

This also means we should not get too excited about news London may become an offshore trading center for the Chinese RNB currency.  Every time the suggestion is made that the renminbi will become more international, excitement sweeps the world, although nothing ever really happens.  One only has to look at the developing currency wars and understand everyone wants to export capital and no one wants to import it so why would China want its currency to evolve into a reserve currency by trading internationally.

There has also been speculation that a country like Nigeria would want to diversify reserves and hold renminbi, but Pettis thinks this is only a speculative idea based on the renminbi price being heavily subsidized by the PBoC and, therefore, only likely to appreciate.  China is unlikely to allow any but the financially small countries to attempt this and does not want to see it at all, since "The PBoC is required to buy up all the dollars offered in exchange for RMB in order to keep the value of the currency where it is, and any increased foreign demand for RMB bonds automatically means that the PBoC must take the other side of the trade. Its reserves will have to increase by exactly the amount of dollars that Nigeria (or any other foreigner) uses to buy the RMB. And the faster China’s reserves rise, the greater than domestic monetary mayhem and the greater the losses the PBoC will ultimately take on the negative carry and the revaluation of the RMB."  The short version of his discussion of this in his mid-May newsletter was "...that once you exclude intercompany transactions, nearly all the trade activities denominated in RMB consist of Chinese imports, and almost none of it consists of Chinese exports. Why is this important? Because Chinese imports denominated in RMB result in long RMB positions in Hong Kong, whereas exports result in short RMB positions."  Once the speculative demand dries up, there is little real demand for RNB transactions and the off shore RNB market would be very small.

Speculative demand will begin to dry up when the perceptions on the total amount of debt on the Chinese national balance sheet begin to improve.  However, debt levels continue to rise and rise very rapidly.  Most analysts have downplayed the resulting credit impact of China's spectacular growth.  Such an analysis implies China has an infinite debt capacity, which Pettis finds impossible.  What concerns Pettis now is that as analysts have caught on to this, the "horror" stories have begun to multiply out of control about " flow squeezes among SOEs and the smaller banks, about unrecorded guarantees and lending by SOEs, about highly pro-cyclical lending by banks, about a huge variety of dubious transactions in the informal banking sector, with non-transparent links to the banking sector, and so on and so on. Everyone nowadays seems to have horror stories.  For this reason, Pettis advises we remain skeptical.  We should not scare ourselves into overreacting.  Pettis does not see China reaching its "... debt capacity until one of three things has happened:

  1. Depositors flee the banking system because of uncertainty about repayment prospects. I think this is unlikely to happen unless inflation rises sharply and, because of the highly adverse cash flow impact of high nominal rates, the PBoC is unable to raise deposit rates sufficiently.

  1. Household transfers are too high. Debt servicing costs should be met out of the increased economic activity generated by the debt. If they aren’t, the balance one way or another must result in a transfer of wealth from one sector of the economy – usually the household sector. As these transfers rise, the ability of that sector to generate growth becomes smaller and smaller. At some point the transfers are too large to be managed, and investment growth must stop. Of course if the government begins to privatize assets and uses the proceeds to clean up the banks and repay loans, this problem need not happen.

  1. The private sector becomes so worried about the possibility of financial instability and rising of financial distress costs that they disinvest faster than the government can invest."
    Another way to extend debt capacity limits, according to Pettis, would be similar to Brazil in the mid 1970's when it was "saved" by massive petro-dollar recycling and a subsequent lending boom switching domestic debt to external debt, which allowed Brazil to keep investing and growing until the 1982 crisis and a lost decade.  In principle, China could do this, but it is unlikely to become a net foreign borrower as it would also have to reverse its huge current account surplus into a current account deficit.  He thinks there would institutional impediments preventing this from happening.

    Everyone knows by now that Chinese inflation is down to 6.2% in August, but he finds these numbers to be so much within expectation that he has nothing to add.  Inflation appears to have peaked, but the numbers require another month or two of observation and Pettis believes the PBoC also believes this.  There is also growing concern among economically literate policymakers about rising debt and weak consumption, because these are basically the same problem.  He expects to see comments back and forth on inflation, but a number of policymakers are reluctant to support more expansionary credit growth as a credit contraction is politically very unlikely.
    Pettis remains concerned that the Chinese consumption imbalance remains a fundamental problem despite Yukon Huang writing in the Wall Street Journal that consumption is in fact far higher than official government figures and takes issue with Huang's interpretation of the studies cited, because one study actually shows 2/3rds of hidden income accruing to the top 10% wealthiest and almost all to the top 50% and, since the wealthy a much smaller share of income than the poor, it would suggest the consumption imbalance is actually much larger.  Pettis also finds the reported size of the imbalance by Huang to be astonishing.  Just because the NBS data is awfully wrong, this would not increase China's invulnerability from crisis.  In the end, all the possible arguments against the dismissal of the fundamental consumption imbalance problem need not be made, because the balance of payments tell us it is extraordinarily low.  "... China doesn’t have either a current account deficit or a balance of zero. It has instead one of the highest current account surpluses ever recorded. This can only happen if the savings rate exceeds by a huge margin the investment rate – which, remember, was itself by 2008 the highest we had ever seen, and which has soared even further in the past few years

    "By definition, then, China’s savings rate must be extraordinarily high to allow it both a huge investment rate and a huge current account surplus. Since savings is simply the difference between total production and total consumption, China must also have an extraordinarily low level of consumption in order for the balance of payments to balance. I would argue that it almost certainly does."
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