CHINA AND ITS DEBT, FOREIGN EXCHANGE

After trying to work out how big China’s bad debt problem might be, many people still turn round and point to the country’s mammoth foreign exchange reserves as its great get-out clause.

The idea is seductive. On a deliberately gross calculation using the 20 per cent non-performing loan rate found at China’s big banks in the late 1990s, total bad debts would amount to Rmb21tn. A more sensible stab might put the level at roughly half that, or Rmb10tn. These are painfully large numbers – but hang on, China’s central bank has foreign exchange assets of $3.4tn, or Rmb20tn. Perfect – what’s the problem?

It is true that China dipped into its foreign exchange reserves in the late 1990s to help recapitalise its banks before shifting their bad debts into specially created bad banks.

However, the government cannot now go to the same well to any large extent for a number of reasons.

The first is that any large scale spending of the reserves would amount to a massive money-creation exercise by the central bank.

This is to do with mechanics of how the reserves accumulated.

To buy the dollars that China does not want sloshing around the economy, the central bank creates Renminbi. However, in order to avoid a big money-printing exercise it also issues treasury notes into the market to soak up – or sterilise – the local currency created to buy the foreign currency.

The vast majority of the foreign exchange reserve assets at the People’s Bank are matched by Renminbi liabilities in China’s banks and other financial institutions. If it tries to spend dollars without repaying these liabilities it undoes its earlier sterlisation and prints money. If China wants to print money to soak up its bad debts – and take the risks that come with this policy – its foreign reserves are really irrelevant to that decision.

The other problem with “spending” these reserves lies in the misconception that they are an asset of the country – something like its retained profits from its trade with the outside world.

China has run a current account surplus of increasing size since the late 1990s. A good chunk of this is money paid for goods and services sold – but another good chunk is foreign direct investment. This is not money handed over by outsiders never to be seen again. (Okay, so maybe it often seems like it is, but losing to money to fraud and bad investments is not the point here…)

The point is that the stock of net foreign direct investment represents a liability of the country to outsiders – it is plant, equipment, streams of future profits and so on that are owned by foreigners not by Chinese.

The interesting thing about this is how big that stock has grown, especially in recent years. Figures from the IMF (via Alicia Garcia-Herrero, chief economist for emerging markets at BBVA) show that the stock of net FDI in China was $1.66tn at the end of 2012. Over the five years from 2008, that stock grew by $927bn.

Let’s compare that to China’s foreign exchange “assets”. Between August 2008 and March 2012, these grew by $1.56tn, according to Kevin Lai at Daiwa Capital Markets in Hong Kong. In other words, China accumulated foreign exchange assets not much faster than it accumulated FDI liabilities.

Mr Lai makes a broader point about Asian foreign exchange reserves as a whole. Betweeen 2008 and 2012, the total accumulated by China, India, Korea, Taiwan, Hong Kong, Singapore, Indonesia, Malaysia, Thailand and The Philippines almost exactly matches the growth in the US federal Reserve’s balance sheet due to quantitative easing. As he says, the correlation appears very high.

What this suggests – and what is backed up by data from Hong Kong banks in particular – is that along with FDI, China has recently drawn in a lot of cheap credit from overseas. This also amounts to an external liability against the forex assets.

The final element is the effect of China’s strict capital controls and how they might create another external liability for China – the retained profits of foreign companies operating within its borders.

Western companies report dividends from operations around the world, but as Garcia-Herrero points out, just because they are reported, its doesn’t mean that headquarters actually gets the cash – especially from China.

I have not found any good estimations how big a stock of these retained profits might be. But to grasp the issue, let’s think about Apple Inc. It famously has some $50bn in cash trapped outside the US because it is unwilling to pay the taxes on repatriating profits. However, some of this may be trapped inside countries like China. The question is how much?

China is the only country, apart from the US, that accounted for more than 10 per cent of Apple’s net sales last year – it made $22.8bn worth of sales there, up from $2.8bn two years before. Its gross margins across the group were 44 per cent, but its filings tell us nothing about what profits it made in China.

It has reinvested some of the money it makes, accumulating what it calls long-lived assets in China, which trebled last year to $7.3bn – more than the long-lived assets it has in the US.

Apple may escape capital controls by making more of its profits in Hong Kong than in the mainland – we’d be very interested to see how those are split and what the cash flows from China look like.

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