My Blog

January 1, 2008

TUE 1 JAN

$20 billion for China Development Bank complicates monetary policy By Michael Pettis

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.