Thursday, December 29, 2011

Insane Leverage at the People's Bank of China.

Today, China is the world's great creditor nation. The Chinese produce and save, the West borrows and consumes. Or so the story goes. In a fiat currency system, money is debt. Because China has the most fiat money in the world, that means the Chinese economy also has the most debt.

The stereotype of the thrifty Chinese person is true. Very few of my Chinese friends have or use a credit card. One of them paid the downpayment on her house in cash. I don't mean through a bank transfer, I mean duffle bags and a posse. China's debt isn't coming from its households.

Chinese companies also aren't that leveraged. Companies like Baoshan Iron & Steel or Ping An Insurance in 2010 only had leverage ratios of 1.94 and 10.02, respectively.

Chinese banks have certainly leveraged themselves more, though. In January 2000, the average Chinese depository institution was leveraged 16.92 to one. That number comes from the Banking Survey. (There is no English version available, so add the first and second line together and then divide them by the fourteenth line.) Ten years later, the leverage ratio had risen to 32.02 to one. According to the FDIC, the leverage ratio of U.S. commercial banks remained between 11 and 14 since 1995. This tells us that Chinese banks are more risky, but it does not explain the enormous growth in the money supply.

If this were a case of private sector leverage and debt, reserve money would be shrinking as a portion of the total money supply. In fact, it is not. Even though Chinese M2 has increased from ¥12.1 trillion in January 2000 to ¥81.6 trillion in October 2011, reserve money as a portion of M2 is back at almost exactly the same level, 3.80 to one. The only institution that can create reserve money is the People's Bank of China.

This is what keeps me up at night. Notice the part where it went over 1,000. And then it just kept going. The People's Bank of China has been increasing its balance sheet steadily since data is available. When a central bank expands its balance sheet, it creates money out of thin air. Unfortunately, we can't just say leverage ratios don't apply to central banks and be done with it.

The leverage ratio of the E.C.B. over the same period has never gone above ten. I'm not sure which is worse, China's money supply growth, or the leverage ratio. If private sector leverage were out of control, the Renminbi would be a great investment, because eventually there would be a private sector scramble for liquidity, like there was in 2008. In this case, though, it is the central bank, the sole authority that can create money out of thin air, that has a liquidity problem.

Since the People's Bank of China's leverage ratio is 1300 to one, that means a decrease in its assets of .07% or more will wipe out its capital, and leave it insolvent. A sizable portion of its assets are foreign currency. If those currencies depreciate against the Renminbi, which is the unit of account for the P.B.C., its assets would decrease, and therefore it would become insolvent. The U.S. dollar has been depreciating against the Renminbi for a few years now, so the People's Bank of China is probably already insolvent. Why is that a problem?

Despite the Federal Reserve and the E.C.B. getting all the love from the media, the People's Bank of China is actually the largest central bank, by assets, in the world. At the end of 2010, the People's Bank of China held USD3.93 trillion (CNY25.93 trillion), the European Central Bank held USD2.74 trillion (EUR2.05 trillion), the Federal Reserve held USD2.47 trillion, and the Bank of Japan held USD1.58 trillion (JPY128.71 trillion) of assets.

In the previous post, I wrote that "The total M2 money supply, ¥72.58 trillion, is backed by ¥18.53 trillion worth of reserve money (or 25.53%)." So, the money supply is leveraged four to one. However, that reserve money is made up of liabilities from the People's Bank of China. Since the P.B.C. is leveraged 1300 to one, that means the total money supply is actually leveraged 5200 to one. Almost all of that leverage is from the monetary authority, not the banking system.

Foreign currency exchange markets should have devalued the Renminbi the whole time its money supply has been growing at unbelievable rates. The odds of it not depreciating in the future seem to be 5200 to one.