Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?

February 11th, 2010

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Everyone knows that China has US$2.4 trillion of reserves. This has led to many (including some analysts from big financial institution) to believe that such gigantic reserves are akin to ‘cash’ that China can spend its way out of any potential crisis.

Actually, this is one big misconception that this article will address.

The US$2.4 trillion of reserves is only half the picture. Looking at that alone is analogous to looking at the asset column of a company’s balance alone. What’s also important is the liability side of the picture. When you put the two together, then you will get a better idea of how much of the ‘cash’ (i.e. the reserves) that the Chinese government can really spend.

First, we will look at the liability side of China’s ‘balance sheet.’ According to this report from Pivot Capital Management,

… the size of the Government?s debt is vastly understated. Not included in the public debt figures are the liabilities of the local governments, which the Ministry of Finance estimated at $680bn as of the end of 2008. In addition to that, a large part of the loans extended this year (estimated at $350bn) went to finance public infrastructure projects guaranteed by local governments. Furthermore, when the Chinese government bailed out its banking system in 2003, it set up Asset Management Companies that issued bonds to the banks at par for the non-performing loans that were transferred to them. These bonds, worth about $260bn, are explicitly guaranteed by the Ministry of Finance and the Central Bank and sit on the balance sheets of the big four banks. The Chinese government also explicitly guarantees $400bn worth of debt of the three ?policy banks?. In total, these off-balance sheet liabilities are equal to $1.7tn, which would bring China?s public debt to GDP ratio up to 62%, a level that is comparable to the Western European average.

These debt guarantees within the off-balance sheet liabilities are what we call “contingent liabilities.” Australia’s bank deposit and wholesale funding guarantee are examples of contingent liabilities of the Australian government (see Australian government?s contingent liability to exceed AU$1 trillion).

These off-balance sheet liabilities are not the only liabilities. The Chinese currency in circulation is also a liability. Remember what we wrote in How does China ?save?? Story of the circuitous journey of a US$? In that article, we explained how a US dollar travelled from America (in the hands of an American consumer) to China, and then exchanged as RMB and then travelled back to the US as Treasury bond purchases. The crucial intermediate step to examine in this circuitous journey is when the US dollar is exchanged for RMB. As we all know, the RMB is pegged to the US dollar at a specified ratio. Currently, the ratio is at 1:6.833. To simplify matters, let us round up the number to 1:7. What happens (in a very highly simplified form) is that for every US dollar that gets presented to the PBOC, approximately 7 RMB will be issued.

One way to look at it is that the RMB in circulation are ‘backed’ by US dollars in the form of currency reserves. That was exactly the same situation that America faced in the 1920s. Back then, under the gold standard, the US dollar was pegged against gold in the ratio of approximately 1:20. In reality, not every US dollar was backed by gold. In other words, the US dollar was partially backed by gold in the same way your ‘cash’ at bank was partially backed by physical currency and your bank’s deposit on the central bank. That is, there was a theoretical possibility that there could be a run on the Federal Reserve’s gold if every citizen decided to redeem all their currencies for gold at once. In the same way, China’s RMB in circulation are partially ‘backed’ by their US currency reserve. According to the chart provided by Pivot Capital’s report, only a little over 20% of China’s total currency (plus gross external debt) are ‘backed’ by their US dollar reserves, which isn’t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

Of course, in reality, it is unlikely that there’s going to be a run on China’s US dollar reserves. But according to Pivot Capital, since 2007, there are approximately US$500 billion of “hot money” in China that can easily leave the country at a moment’s notice. That US$500 billion is money that China cannot spend and must be ready to meet the ‘redemption’ demand of the “hot money.”

So, in reality, the picture of China’s currency reserves is not as rosy as it seems.

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  • temjin

    Thanks for the explanation Ed. 🙂

    So in terms of these “off-balance sheet liabilities” in China, how likely are they be called to cover the debt? It seem most of these debt are held at the regional level and held by the central level.

    How do this compare to the situation in the US, Japan or other heavily indebted countries?

    My question is, there may be $2.4 trillion dollar worth of “assets”, but how much of them can “realistically” be spent without restriction. It could be that they can continue to increase their off-balance sheet liabilities without any serious consequences.

    Just a few more questions to make sure when the counter-argument comes, we are ready. 🙂 Thanks again.

  • @Temjin

    The answer requires more digging. China is not the most transparent country in the world, which means the it will not be easy to find the accurate answer.

    One thing to watch are the contingent liabilities. Should there be problems in the Chinese banking system, many of such liabilities will become real. That will happen when the bad debts increases as a result of mal-investments.

  • Matt

    So where to form here,,, the multi-trillion $ question.

    Will a second global slowdown lead to stimulus packages so large (and fiscal) that hyper-inflation is inevitable or will the crushing weight of a slowdown in a high leverage global environment be too much and the paper money (sorry 'pixel' money) becomes unsustainable/untrustable – as seems to be the current scenario judging by efforts in the US & UK. i suspect in the short term the later, followed in the long term by the former but im not particularly assured in my conviction.

    I have been worried about the australian economy entering this period without china at our backs but now im beginning to think that there's no where that will (comparatively) fair well, we're all going to sink together regardless. If you wanted to shift out of AUD, where exactly would you go? US short term maybe but you wouldnt want to linger. not the pound or euro, the kiwi seems roughly pegged to the AU regardless. canadian dollar? perhaps but it suffers from the same exposure as the AU with a bit less debt… i pose this question as a surragate assessment of the economies involved more than as a currency investment option. if round 2 involves china as well and the developed world seemingly on its knees, what countries will maintain a reasonale economic position?

    sorry for the ramblings, a bit off topic i know.

  • Anon

    Stocks starting to look bullish to me. I will say that tentatively because the markets can be humbling and punishing =).

    ?Although the S&P 500 is down less than 7.5% from its January high, bulls are heading for the hills. According to Investors Intelligence, bullish sentiment among newsletter writers is currently at 34.1%, which is the lowest level since March 2009. At the same time, bearish sentiment (26.1%) is the highest since November, while the percentage of newsletter writers in the correction camp has sky-rocketed all the way to 39.8%, which is a level that hasn?t been seen since 1983.?

  • Anon

    Overcrowded trades:

    Long USD

    Short EUR

    Long Gold

    Long Oil

    Short Nat gas

    *From Meryl Lynch Hedge Fund Monitor

    Remember above or any posts by me is not financial advice, all posts are just commentary 😉 See a financial advisor for adivce/decisions/info.

  • Matt

    I hear what you're saying anon. the markets have held up well despite the negative sentiments and you'll certainly be running against the crowd.

    my only concern is at what risk of a negative macro event coming through to obliterate contrarianism, trends and whatever analysis. you care to perform is that even a realistic concern?

  • @Matt

    This is a good question. Regarding China, in a recent Marc Faber interview, he posed this question to investors: is China going to crash or is it going to slow down to say 3-6%? Regardless of which outcome, it will affect the rest of Asia and Australia.

    The problem with Australia is that with such high private debt and net foreign debt, it will suffer a disproportionately great impact. Our guess is that the AUD will continue to trend down significantly in this season.

  • Matt

    Thanks for the reply.

    Im also interested in the effects of a slowdown in China on the broader Australian economy. We can assume there will be a fall in commodity prices and our stock exchange (leaving out the possibility of inflation hedge speculating in the near term). Our economic growth, which has factored in a continued resource boom will be subject to a lot of revision, although this maybe partially offset by inproved export environment through a lower AUD to USD. The RBA will drop its target interest rate and I assume the Federal Gov will reinstate the bank deposit guarantee but will that be enough to encourage continued global funding of our high-debt economy? This i think is the question for the general australian economy, will govt intervention keep the increase in funding costs domestically manageable? The RBA's target interest rate has a lot of 'down' left in it and questionably the massive quantitive easing occuring overseas should start to flow globally at some point, but would we even be a target in such an environment?

    Perhaps our high current business rates are an indication of the worlds limit to continued financing of our economy at discount rates.. but what 'better' alternatives are there?

  • Matt

    I just watched the Aussie John interview on Switzer TV which discusses a lot of my queries in regard to Australia attaining finance offshore. Basically he states that the situation is more difficult than it was but is better than mlost, and that scenario is set to continue 'barring any large scale macro events.'

  • @Matt

    The RBA will drop its target interest rate and I assume the Federal Gov will reinstate the bank deposit guarantee but will that be enough to encourage continued global funding of our high-debt economy?

    In the best case scenario, this will the case. At most the RBA will keep the interest rate steady.

    The big risk is the bursting of debt bubble in Australia, which will make our foreign debtors very nervous. That's because the Rudd government will most likely go to the bailout route, which will inflate our government debt substantially. If there's a run on the Aussie dollar as a result (given our high foreign debt), the RBA may even be forced to raise interest rates to defend the dollar i.e. the Iceland scenario.

    It is very hard to quantify the risk of such a possibility. But this is something to bear in mind for investors.