Huijin’s Head-Fake
Yesterday, Central Huijin Investment, the domestic arm of China’s sovereign wealth fund China Investment Corp. (CIC), announced that it would begin buying shares in China’s “big four” state banks in order to support their share prices, which have been languishing due to growing worries over potential losses from overly aggressive lending. Today, Huijin backed up its words with action, buying 14.6 million shares in ICBC, 7.38 million shares of China Construction Bank (CCB), 3.5 million shares in Bank of China (BOC), and 39.1 million shares in Agricultural Bank of China (AgBank), at a total estimated cost of $31 million. As a result, ICBC’s stock surged by 8.9%, CCB’s by 9.1%, BOC’s by 9.8%, and AgBank’s by an all-time record of 12%.
State-owned Huijin is already the controlling shareholder of all four banks. It stands at the center of a complex web of circular money flows between China’s central bank (the PBOC), the “Big Four” banks, the Ministry of Finance (MOF), and the country’s sovereign wealth fund that would take days to unravel and explain, and serves — at least in large part — as a way of drawing on captive bank deposits to disguise and quietly socialize the losses from China’s last round of bank recapitalization. (For anyone who wants to understand this arrangement in all its dizzying and alarming detail, I suggest reading Chapter 5 of the book Red Capitalism by Carl Walter and Fraser Howie).
In the simplest sense, Huijin’s intervention is similar to a share buy-back, like last month when Warren Buffett’s Berkshire Hathaway offered to repurchase its own shares from investors (except in this case, it’s more like Warren Buffett himself is buying shares and upping his stake, in an insider purchase). The typical rationale for a buy-back or insider purchase is that the company’s stock is undervalued, and therefore a smart buy. The key question in any buy-back is whether this is indeed true, or whether it’s really just a head-fake to move (or even flat-out fool) the market. That question is even more relevant when both the buyer (Huijin) and the investee (its banks) are state-run entities pursuing policy goals that might take priority over making or losing some money. As my friend Vitaliy Katsenelson put it:
China’s sovereign wealth fund is not Warren Buffett . . . When Warren Buffett says he’s buying Berkshire Hathaway, he actually thinks it’s undervalued. China says that, but it doesn’t necessarily mean that, they’re just trying to create confidence.
There are two reasons the Chinese government wants to boost the share prices of its banks. First, it’s afraid that lagging share prices signal a growing crisis of confidence in the broader Chinese economy, which — if not halted — could take on a life of its own. Second, it knows that its banks are facing a serious bad debt problem and will need to be recapitalized. That’s why, for over a year now, Chinese regulators have been instructing the country’s banks to go out and raise capital by selling stock and issuing bonds. Some have, but many haven’t yet, and even those that have may need to raise more. But with the MSCI China Financials Index trading at just 5.6 times estimated earnings, the window to outside funding is getting smaller and smaller.
Without outside funding to replenish banks’ capital, the Chinese government will have no choice but to recapitalize the banks itself. The refrain one constantly hears is that China has plenty of money, $3 trillion in foreign currency reserves, that can be deployed for that purpose. This is incorrect. China’s central bank and sovereign wealth fund (including Huijin) do not own these reserves outright, as net worth, they hold them against liabilities, in the form of money that is already in the Chinese economy (in fact, the same money that financed the banks’ latest lending boom in the first place). The PBOC and CIC can’t give these borrowed assets away without receiving something of equal value in return, or they’ll blow a hole in their balance sheets and would themselves need to be bailed out by the central government.
That’s what the circular money flows centered on Huijin are all about: refinancing, or at least pretending to refinance, the reserve assets and other bailout funds that were injected into the banks during the last round of bailouts. Cut off the circular flows, by redirecting funds towards a new bailout, and you rip the lid off the old one and destroy the illusion that the banks are actually profitable, rather than gradually trying to dig their way out of a hole. That’s not to say that the Chinese government can’t engineer a new bailout. It can, but only by designing new and elaborate mechanisms to impose invisible taxes on captive depositors, not by deploying a “treasure trove” of foreign currency it “owns” and can use any way it pleases.
Compared to this, the $31 million Huijin spent today is a drop in the bucket. If that money — and the aura of state-led intervention — can help prop up share prices, banks can continue to tap investors for the bailout they need, rather than the government. From the government’s point of view, it’s money well spent.
So you see, Huijin is buying not because the government thinks Chinese bank stocks are undervalued, but because it knows they are overvalued. It wants to milk that overvaluation as long as it can, to minimize its own obligation to rescue the nation’s banking system from the consequences of the lending binge it orchestrated to pump up GDP.
Earlier today, on BBC, I said that China’s intervention reminded me of Japan’s decision in 1992 to inject funds from its postal savings system in order to put a floor under the stock market after its bubble economy burst — except in this case, the Chinese are trying to do it preemptively, to prevent a bubble from bursting. The more I think about it, though, the more I see important differences. The Japanese tapped into a huge pool of captive savings (thereby socializing risk) in a fairly direct and transparent way. China has huge pools of captive savings, but for the moment, it’s cheaper and easier to try and head-fake the market, suckering investors into providing the money willingly instead. When it does (eventually) tap into those pools, it will do so only in an obscure and roundabout way, as it did before.
Will Huijin’s head-fake work? Zhen Wei, chief China strategist at Bank of America-Merrill Lynch, doesn’t think so:
For example, last time when Huijin announced a similar purchasing plan of bank shares on Sep 18, 2008, SHCOMP and HSCEI rose by +9.5% and +15.5% respectively the next day. However, the market fell back even more after just a week’s rally with SHCOMP and HSCEI declined by 26% and 51% respectively within a month of the short-term peak.
That time, the markets were “rescued” by the huge bank lending binge that followed, which pushed a massive amount of liquidity into speculative hands. This time, that option isn’t available — at least not at an acceptable cost.
Patrick Chovanec 
Hi Prof. Chovanec,
Thanks for yet another great posting. I just wanted to point out that in addition to your comments about the $3T in reserves, if my understanding of Pettis’s opinion is correct, another reason China can’t just import that $3T to repair their balance sheets is that, beyond the effect on price selling $3T of bonds would have, or even just not re-purchasing when they reach maturity, the result of non-sterilized transfers of that much currency would result in huge increases in liquidity, resulting in a very unhealthy increase in inflation. I’m not an economist though.
Also thanks for the book reference – it’s now at the top of my reading list.
Keep up the great work.
Dave G.
That 3T has already been exchanged for RMB as a result of China’s trade surplus. The 3T are assets on the balance sheet of the PBOC. The liabilites are the RMB currency itself, deposits that the PBOC has taken from the mainlland banks (reserve requirements) and bonds issued by the PBOC. (here’s a pretty good explanation…)
http://ineteconomics.org/blog/money-view/pboc-balance-sheet-primer
Under your scenario, you sell US Treasuries and you get US dollars. What do you do now? Go find someone who wants dollars and will give you RMB. By taking in RMB, you reduce the PBOC’s liability by the amount of dollars you converted. So if you convert all 3T (it’s not all Treasuries or even USD for that matter), you would take in a lot of RMB. Can you find people willing to do this? Give up their RMB? You could take IOUs from those sellers and let them keep their RMB. But at what exchange rate would you sell the dollars to the RMB holders? All of a sudden the peg breaks down and the RMB becomes marketized. And there are a lot of mainlanders with dollars who have little alternatives for investments given China’s controlled capital policies.
Hen ma fan!
Could someone please explain this:
” China’s central bank and sovereign wealth fund (including Huijin) do not own these reserves outright, as net worth, they hold them against liabilities, in the form of money that is already in the Chinese economy”
If I try to think about it, it’s because they can only use RMB in China and cannot recapitalize directly with foreign currency?
They print RMB to match to the reserve of foreign currency?
Well every asset is held against a liability, no?
Consider me confused.
Thank!
No, the best place to get a handle on this is the link that Hua Qiao provided: http://ineteconomics.org/blog/money-view/pboc-balance-sheet-primer
Long story short: Chinese exporter earns dollars. Chinese bank buys those dollars and gives the exporter RMB in exchange. The Chinese bank, in turn, sells the dollars to the PBOC (which then go into the PBOC’s official reserves). The PBOC pays them for the dollars by creating a reserve deposit in RMB, which is a liability of the central bank. The bank can withdraw cash from this account, and that cash (RMB notes) is also a claim on the PBOC. Or it can use its balance to buy RMB bonds issued by the PBOC, which is another form of central bank liability. All of these are reflected on the liability side of the PBOC’s balance sheet, opposite the dollars it purchased and invested in dollar-denominated assets like Treasuries. Of coures, the PBOC can never be presented with a liability that it cannot pay, because it can always create new liabilities in the form of bank reserve deposits — that is, it creates its own liquidity. But it’s equally true that it cannot simply give away assets without incurring a loss that, if total liabilities exceed the remaining assets, would render it insolvent. The PBOC would then have to be recapitalized by the Chinese government from its ordinary revenues.
The situation is a bit more complicated when it comes to sovereign wealth funds, depending on precisely how they are capitalized, but ultimately someone (either the fund itself or its parent) will hold a liability against its assets, due to the way the assets were acquired in the first place.
Huijin getting in the market may not be so unusual – recent Eurozone banning of short-selling was done with a similar intention of providing a circuit breaker in a panicky market and my recollection is that practically all Asian governments via their SWFs or state-directed pension funds were buying equities in the 1997 currency crisis, for similar reasons. What I am curious about is whether this statement reminds anyone of the Fed, QEs 1 & 2 and Op Twist :
“So you see, [Huijin] is buying not because the government thinks [Chinese bank stocks] are undervalued, but because it knows they are overvalued. It wants to milk that overvaluation as long as it can, to minimize its own obligation to rescue the nation’s banking system from the consequences of the lending binge it orchestrated to pump up GDP.”
bookmarked!!, I love your blog!