My Blog

January 1, 2008

I spent the last week at my family’s home in Spain for the holidays, but spent most of the time in bed with a flu that I brought with me from Beijing, so I haven’t posted anything in several days, even thought there has been a lot to write about.  Now I am back in Beijing, recovering from last night’s party at D22. 

While gingerly reading the newspapers today, a little surprised that the world hadn’t stopped turning during a day in which most people I know stopped doing useful things altogether, I see that yesterday Central Huijin Investment, an arm of the China Investment Corp (CIC), signed a formal agreement with the China Development Bank (CDB) in which it committed to provided $20 billion to recapitalize the bank.

"The injection is a fundamental step to transform China Development Bank into a fully-fledged commercial bank," the central bank said in their comment.  "This capital injection will markedly raise CDB's capital adequacy ratio, reduce its vulnerability to risk and help its all-round commercialization."

This capital injection by the CIC seems to me evidence of some continued confusion about the role of the CIC in monetary policy.  If the CIC were simply another, more efficient or more strategic, way for the PBoC to manage its reserves, the CIC would only invest those reserves outside China and would not use them in ways that might have a domestic monetary impact.  Here, however, they do have a domestic momentary impact, and the net result will be that ultimately the PBoC is going to have to buy (and monetize) another $20 billion that it wouldn’t have needed to. This is because the “default” way for the CDB to raise capital is to issue shares domestically (whether to the government or to third parties).  By issuing shares instead to a government entity that holds dollars offshore and uses them to buy the shares, the monetary effect is as if CDB were raising money abroad and bringing it back home to China.

Let me try to explain why.  If it makes sense for the government to recapitalize the CDB as part of its “commercialization”, and I am sure it does, then the most obvious and direct way is for some government entity to raise money domestically and buy additional shares in the CDB.  Basically this makes very explicit the fact that the CDB is being recapitalized by an increase in government debt or taxes, and the increase in CDB’s cash and liquid assets would be matched by a reduction in the public’s cash (which it used to buy the bonds).  The increase in capitalization will then allow the CDB to expand its domestic loans.

Doing it via the CIC may have certain organizational advantages, mainly that Central Huijin is owned by the CIC, but it doesn’t change this basic fact.  It does, however, obscure it.  Remember that the CIC has dollars because the MoF borrowed RMB domestically, and effectively gave the RMB to the CIC, who then used them to buy dollars from the PBoC.  When they use the dollars so obtained to purchase shares in the CDB, the net effect is that the government borrowed RMB via the MoF, and used those RMB to recapitalize the CDB.

So far so good, but rather than capitalize the CDB directly with RMB, the government did it with dollars via the CIC – it effectively sold US treasuries (or whatever) and bought CDB shares.  This was done for solid organizational reasons, I realize, but it seems to me that these good organizational reasons may counteract the PBoC’s attempts to manage domestic monetary policy.  Why?  Because recapitalizing the bank will allow it to expand its domestic lending activity.  Had the CDB been recapitalized directly with RMB, say via a new bond issue by the MoF, we would see that there would have been some reduction of domestic money (the sale of MoF bonds) that corresponds with the recapitalization.  By using the CIC’s dollars, we have all of the expansionary effects of recapitalizing the CDB with none of the counteracting contractionary effects.  In a way it is like the difference between the CDB’s raising money with a foreign stock offering versus a domestic one, whether the money raises is ultimately kept in dollars or RMB.

When it was first announced that one of the roles of the CIC would be to fund domestic businesses and hold bank stocks, I mentioned that I was a little uneasy that this might be using PBoC money to complicate PBoC money management, but I think now I am pretty certain of it.  The more dollars the PBoC transfers into the CIC for use in capitalizing domestic banks, the more dollars it has to buy in the secondary market. 

Comments (6) for "$20 billion for China Develo...

Michael -- My understanding, which certainly could be off, is that the recaps are structured more like a swap, with the Huijin/ CIC obtaining shares in the recapitalized banks in exchange for some of Huijin/ CIC's fx. The fx isn't sold (which would be a capital inflow and require some offsetting sterilization) so much as transferred. This only works -- from a monetary management point of view -- if the banks in turn keep the fx rather than selling it for rmb. That implies a fx mismatch in their capital structure, though in the past this mismatch has been offset with swap contracts (hedges), and the two banks recapped in 03 -- per Logan Wright's work -- seem to have the right to swap their fx for rmb this year. (an aside -- the PBoC didn't really want the influx of fx tho, and it seems to have found new ways to force the banks to hold fx, especially in h2 2007). My understanding, limited as it is, is that the small recap in September of another bank (everbank? everbright?) wasn't accompanied by offsetting swaps to provide a long-term hedge, and it isn't clear to me that the CDB will be allowed to hedge -- or to convert the fx to rmb. what does that mean? best I can tell, it implies the CDB has a lot of fx to put to work in some way. The other banks seem to have put a lot of it into floating rate dollar debt -- most corporate debt, and possibly a lot of bank debt -- and they wanted something that paid libor plus for institutional reasons (Again best I can). I would be curious what your contacts have gleaned on this ... The Chinese banks have a growing pile of fx to manage, by all accounts. And for what it is worth, the Chinese bank data put out by the PBoC shows much smaller purchases of fx denominated securities in 07 than in 06 (When it was unusually strong) ... so isn't obvious where the money is going. By bsetser - 1/1/2008 12:21 AM

I think you may be right, Brad, but it seems to me that the CIC’s investment still works against the money management goals of the PBoC. Imagine if instead of the CIC providing the dollars, they had bought shares and paid for them with RMB, which they raised in the local debt markets, and the CDB then used the RMB to purchase dollars from the PBoC. The CDB’s balance sheet would look exactly the same as it does now. The difference would be that the CIC would have $20 billion more in US treasuries and RMB 150 billion more in local currency debt, and the PBoC would have $20 billion less in US treasuries and RMB 150 billion less in outstanding central bank bills. This would mean a monetary contraction of RMB 150 billion as PBoC bills are effectively replaced with MoF bonds. In other words there is an alternative way of getting to the same place that would have eased the PBoC’s sterilization job by $20 billion. If the CDB really needed to be recapitalized, and if it were acceptable for the CDB to hold this additional capital in the form of dollars, there would have been a real opportunity to use this to reduce money supply, but by getting the CIC to provide the dollars negates this opportunity. By Michael Pettis - 1/1/2008 3:51 PM

why Huijin was created and FX reserve was applied to recapitalize banks instead of MOF issuing Rmb gov. bonds, it might related to technicality and politics 1. The size of the recapitalization- now already closing US$100b imply Rmb 800b bond issuance. In 2004-2005 when CCB,ICBC,BOC,BCOMM need funds, it is difficult to see whether local bond market have the appetite for this size, especially institutional investor ? pushing this size bonds to retail is almost impossible. 2. Increasing public debt by such amount need to go through NPC-the Parliament approval, even the rubber stamp of NPC will risk causing PR issue and damaging to politicians and key regulators. however, those concern are no longer valid. Using US$ to recapitalize might indicate that CIC -challenged by effetive deploying US$200b in global financial market with reasonable return, CIC chose to retreat to the relatively safer waters of China asset classes rather than dumping all in US-EU financials 3. By isaac - 1/1/2008 5:54 PM

I think you are absolutely right, Isaac. It is politically and technically much easier to use CIC funds. By the way the CDB itself gets almost all of its funding from bond sales -- I think roughly one-fifth of all Chinese bonds are issued by the CDB. By Michael Pettis - 1/1/2008 7:19 PM

There isn't much different -- apart from technicalities and politics -- of having the Finance ministry issue rmb 150b (a bit less now) to buy $20b from the PBoC and then hand that $20b over to CDB for rmb 150b in equity and having the CDB, itself owned by the CIC which in turn is owned by the Finance Ministry, issue rmb 150b in bonds and then buy $20b of dollars from the PBoC. Both lead to an increase in the bonds outstanding with the public, a fall in reserves and a rise in the CDB's fx assets. And both are different than just raising RMB (by selling bonds) and handing the RMB over to the CDB to recapitalize it (and getting shares). that avoids the fx mismatch, but also doesn't help with sterilization. That said, I support Isaac's point -- there are political and technical differences. One is when the CDB gets recaped from the CIC it can negotiate for an off balance sheet hedge to offset the financial burden associated with holding depreciating dollars (12m cny forwards now price in a 9% appreciation of the rmb/ depreciation of the $). If the CDB just issued the bonds itself it wouldn't show up as equity (tho that is in some sense just accounting) -- and if it bought the dollars itself, it also might have to go out in the market and hedge itself. That said, I am not sure recaping the domestic banks trades out with buying us/eu financials. the CIC still has $70b (ok, $62b post morgan and blackstone) to spend on us/ eu financials, and the banks have a lot of fx to put to use as well. It could equally well trade off with buying the MSCI index and taking equity market risk. Michael -- when it comes to cutting into the effectiveness of sterilization I generally agree with you that the more the CIC invests at home, the less effective the sterilization -- tho perhaps for different reasons. the CDB recap doesn't worry me so much on this front: I presume the regulators know how to keep the CDB's fx in fx and not give the CDB a chance to bring it home (and avoid the large expected loss). It gets a bit more difficult with say the CIC buys an offshore equity issue by a chinese firm to finance expansion abroad. Does it really stay abroad? Who checks? Remember, the firm itself may have strong incentives to use $ financing to invest domestically (and profit from the expected appreciation) rather than hold depreciating foreign assets ... and funds that slip back into China undercut the sterilization. The same incidentally applies is say blackstone gets approval to bring more funds into china b/c it is part owned by china. And then there is another little (or not so little) issue -- the CIC bonds generally haven't been sold to the public in exchange for cash (upfront sterilization) but have instead been sold to the PBoC, who supplies the cash to the minfin (the minfin then gives the cash back and gets fx, which it hands to the CIC). Sterilization only occurs when the PBoC sells the FinMin bonds it bought to the public. And since these bonds have a below market coupon (gotta help the MinFin/ CIC out, since they have to borrow in rmb to buy $, which isn't a sure way to make money), that isn't going to be easy. I think most of the first round of CIC bonds are still sitting with the PBoC -- neither hurting nor helping. The heavy lifting on the sterilization front seems to be all coming from higher reserve requirements. Tis a strange system, but one that so far hasn't broken down. By bsetser - 1/2/2008 2:34 PM

My personal view is that the actions of the CIC are not made with monetary policy primarily in mind. The story of the China Development Bank, as far as I can tell was that CDB was originally intended to be the primary method by which the central government would issue credit to municipalities in order to do things like build infrastructure. Chinese municipalities do not have borrowing authority, the CDB was the mechanism by which municipalities could borrow money. That central government seems to have decided to end CDB's role as policy bank and fund municipal infrastructure directly from central government funds. The policy drivers for this seems to be several. First the places that need the most infrastructure development are the places that have the least ability to borrow. Having local governments take out loans which they have to eventually pay back with taxes means that the areas that need the most investment are the least funded. Also, there seems to have been a desire for the central government to have much more control over local infrastructure projects as these projects can lead to a lot of self-dealing between local governments and property developers which then lead to riots by farmers. Now since the central government wants to fund local governments directly, this means that CDB no longer has its original mission. CDB then wants to become another commercial bank, but it has a back log of state directed loans that hinder its ability to compete against the other banks, and this is where the $20 billion going away present comes in. By Twofish - 1/3/2008 1:02 AM