Do China’s fast growing dollar reserves guarantee a sound banking system?

One common argument about China that I never have fully understood is that China’s banks are OK because China has tons of dollar reserves.

It is implicit in this statement by the (very good) Richard McGregor in his FT report on the (retracted) Ernst and Young report on China’s bad loans.

China's total liabilities for non-performing loans may be as high as $900bn, dwarfing official estimates and outstripping the country's massive foreign exchange reserves, according to a study of Beijing's bad debt problem.

I don’t get it.  

Foreign exchange reserves are useful if depositors want to take their money out of the country.   But when it somes to making up a gap between Chinese banks RMB deposits and their RMB deposits, they need an RMB asset – not dollars.    Typically that asset is a government bond.  So what matters – far more than China’s dollar reserves –is the capacity of China’s government to issue and pay a bunch of RMB debt. 

I am assuming, of course, that China’s banks are not totally sound now.  No doubt, a lot of bad loans have been bought by the PBoC and shifted to the asset management companies (which will need to be bailed out) or otherwise moved off the banks' books to prepare three of the big four state commercial banks for stock market listings.  But a certain fraction of their new loans are also likely to go bad.

But the quality of the banks balance sheets is a seperate issue from how you bailout bad banks. 

When the US bailed out its savings and loans, it didn’t use its euro and yen reserves.

When Sweden bailed out its banks, it didn’t use its dollar reserves.

When Japan bailed out its banks, it added to its dollar reserves.

When Indonesia (and others in Asia) bailed out their banks, they did so in local currency.  Indonesia had no choice: it lacked sufficient dollar reserves.

If the banks deposits are in the local currency – and China’s are – the banks need a local currency asset, not foreign currency reserves.

Hell, when Argentinabailed out its banks – which held a lot of dollar deposits -- it first converted dollar deposits into peso deposits and then issued peso denominated bonds to cover the banks’ losses (this is a vast over simplification).  If the banks needed pesos, not peso-denominated bonds, they could get those from the central bank as well.  Argentina had no real choice: it didn’t have enough dollars left at the end of 2001 to back the banks dollar deposits.

Bank recapitalization is something that lots of folks don’t understand, but it is really sort of simple.

Say a bank takes in say RMB deposits.  It makes RMB loans.  Some loans go bad.  The bank has more RMB deposits than good RMB loans.  If those bad loans exceed its capital, it is technically bankrupt.  But if the bank is owned by government, the government usually will make up the difference by giving the banks a RMB bond. In a crisis, the government generally will do the same thing for a private bank.  Sometimes the government takes control of the bank as well.  Sometimes it doesn’t.

The RMB bond assures that the banks assets (a mix of bonds and performing loans) are equal to its liabilities (RMB deposits).  And since both the bank’s deposits and its assets are in RMB, the bank is matched, currency-wise.

That is the problem with giving the banks the country’s foreign exchange reserves.   It creates a currency mismatch on the banks’ balance sheet.  Potentially a big one.   RMB deposits need to be matched with RMB bonds and RMB loans.  Not dollars or Euros.   If the banks get dollars or euros, and the dollar or euro depreciates against the RMB, good banks will become bad banks quickly.  Depreciating assets are not a good thing for a bank.

I think part of the confusion stems from the fact that China has shifted $60b of reserves to three banks to help them meet their international capital adequacy standards.  That capital doesn’t directly back deposits.   And it isn’t perfect from the banks point of view, since they are left with the exchange rate risk -- though the central bank reportedly has promised it will protect the RMB value of their dollar capital. 

But it is important to remember that this transfer of reserves is only a small part of China’s bank recapitalization.   In general, when bad loans have been moved to the AMCs (or bought by the PBoC) the banks have been given RMB, whether cash or an AMC bond – not dollars or euros.   That is as it should be.

There is one set of circumstances where China’s bad banks could require China to use its dollar reserves.  It goes like this.

Chinese bank depositors lose confidence in China’s banks, and start to withdraw deposits from the banking system in mass.  That would be a big change from the very strong deposit growth we are observing right now.   But it could happen.

The banks would first draw on their stock of liquid RMB assets.  And if that wasn’t enough, they could sell their RMB recap bonds to the central bank for RMB cash.

As depositors pulled their funds out of the banks, they would end up holding a huge stash of RMB cash.   And they might want to convert that to dollars or euros.

China has capital controls, so this isn’t easy.  But let’s suppose for the sake of argument that the controls are lifted.   The central bank maintains a de facto peg – so the depositors could sell their RMB to the central bank for its dollars. 

Bingo –

Two key points:

First, the dollars are useful if Chinese citizens want to pull their funds out of China.  That is not quite the same thing as bank recapitalization -- even though concerns about the quality of the banks are one reason why Chinese citizens might want to pull their funds out.  That said, Chinese citizens had far more reason to pull their funds out of the banks in 2002 than they do now.   A lot of dud loans have been shifted to the AMCs over the past two years (particularly from ICBC).

Second, with a current account surplus of $150b (and growing) and net FDI inflows of $50b, Chinese deposits could send up to $200b a year without requiring the central bank to dip into its existing reserves at all.   Rather than financing reserve buildup, China’s enormous surplus in its basic balance of payments would just finance capital flight.

The fact that China needs a capital outflow of nearly 10% of its GDP – the kind of outflow that we saw in Argentina in the peak of its 2001 crisis -- just to keep its reserves from growing is one reason why I think the argument that “we don’t know what would happen to the RMB if China lifted its capital controls because its banks are so bad” is a bit overstated.  

We basically know that China needs an Argentine crisis level of outflow from the banks just to keep its exchange rate from appreciating, given the strong pressure for appreciation stemming from its trade surplus and FDI inflows (I'll deal with Stephen Green's argument that the Chinese data overstates China's current account surplus and understates capital flows into China at another time -- but one key point is that folks want to get into China, not get out).  Actually, China needs more than just a one-off Argentine style crisis.  It needs an ongoing Argentine-style crisis that generates a 10% of GDP capital outflow every year.  If a big capital outflow just happens in one year that isn’t enough, since the next year, Chinese exports and FDI inflows will bring in another $200b plus …

I don’t think that is likely – and I am not among those who think China’s banks are in all that good a shape.  But that is another topic.

As is the possibility that rapid reserve growth -- by leading to rapid money and credit growth and by forcing the government to rely on administrative controls rather than markets to limit lending could actually be hurting the banks long-term health.   Even if the current lending boom -- particularly with a government mandated ceiling on deposit rates and floor on lending rates -- is dramatically increasing the banks' current profitability.