Twins!
If you want to know why I haven’t been writing much recently, here’s the reason:
This Tuesday, January 29, at 6:45am, my wife Frances gave birth to twin baby girls. Alice Chovanec (Chinese name Cheng Yilan) was born first, weighed 2.82kg (6 lbs, 4 ounces), and was 46cm long. Rachel Chovanec (Chinese name Cheng Xinlan) came next, weighing 2.55kg (5 lbs, 10 ounces), and was 44cm long.
Within hours, it became evident they have quite distinct personalities. Alice (pictured right) squints and grunts at the world around her, and cries loudly whenever she needs our attention — she also bears an unmistakable likeness to her older brother William (now 3 years old) as a newborn baby. Rachel (pictured left) hardly makes a sound, but is always opening her eyes and quietly looking around, just like she is doing in the photograph below.
William, who until now has been enjoying life as an only child, got to meet his new sisters today and gave each of them a kiss — and then attempted to pinch Alice to see if she would cry. Actually, besides this one instance of rather innocent curiosity, William proved to be on his very best behavior, and — like all of us — is looking forward to getting to know these new members of our family much better in the days to come.
What Causes Revolutions?
A surprising number of people in China have been writing and talking about “revolution”. First came word, in November, that China’s new leaders have been advising their colleagues to read Alexis de Tocqueville’s classic book on the French Revolution, L’Ancien Régime et la Révolution (The Old Regime and the Revolution), which subsequently has shot to the top of China’s best seller lists. Just this past week, Chinese scholar Zhao Dinxing, a sociology professor at the University of Chicago, felt the need to publish an article (in Chinese) laying out the reasons China won’t have a revolution (you can read an English summary here). Minxin Pei, on the other hand, thinks it will.
In the midst of this debate, I happened across an interesting set of passages in retired Harvard professor Richard Pipes’ slender volume Three “Whys” of the Russian Revolution. The first “why” he asks is “Why did Tsarism fall?”, an event that few saw coming:
If you read the Russian and foreign press before 1917, or memoirs of the time, you find that hardly anyone expected the downfall of tsarism either. On the contrary, people believed that tsarism would survive for a long time to come … For had not tsarism weathered all onslaughts and all crises [including the 1905 uprising], and emerged from them intact?
The answer, he argues, lies in the fact that Russian society changed dramatically, but its political system did not, leading to an explosive disconnect between the two:
So, around 1900, we have a mechanically rather than organically structured state that denies the population any voice in government, and yet, at the same time, aspires to the status of a global power. This aspiration compels it to promote industrial development and higher education, which has the inevitable effect of shifting much opinion and the power to make decisions to private citizens. Pre-1905 tsarism thus suffered from an irreconcilable contradiction. A not-insignificant segment of the population received secondary and higher education, acquiring, in the process, Western attitudes, and yet it was treated as being on the same level with the illiterate peasantry, that is, unfit to participate in the affairs of state. Capitalist industrialists and bankers made major decisions affecting the country’s economy and employment, yet had no say in that country’s politics because politics was the monopoly of the bureaucracy …
The result was a situation which Marx had rightly predicted had to arise when the political form — in this case, heavily centralized and static — no longer corresponded to the socio-economic context — increasingly dispersed and dynamic. Such a situation is by its very nature fraught with explosive potential. In 1982 [Pipes writes], when I worked in the National Security Council, I was asked to contribute ideas to a major speech that President Reagan was scheduled to deliver in London. My contribution consisted of a reference to Marx’s dictum that, when there develops a significant disparity between the political form and the socio-economic context, the prospect is revolution. This disparity, however, had now developed in the Soviet Union, not in the capitalist West. President Reagan inserted this thought into his speech, and the reaction in Moscow was one of uncontrolled fury: this, of course, was a language they well understood and interpreted to mean a declaration of political war against the Communist Bloc. Their anger was enhanced by the awareness that the statement was correct, that they were ruling in a manner that did not correspond to either the economic or the cultural level of their population.
Read that again carefully, line by line, with present-day China in mind, and I think you’ll find some fascinating food for thought. I have often observed that I know of no country that has changed as much in the past 30 years as China has, in terms of the kind of practical freedom people experience in their day-to-day lives. The greatest challenge facing China’s leaders is how — or whether — a fundamentally closed political system (rule by an elite) can cope with the dramatically more open economy and society that present-day China has become. That’s why they’re reading Tocqueville.
Enter the New Year
I took a bit of a blogging break for the holidays, so this is a catch-up post.
Just before Christmas I appeared on another edition of Sinica Podcast, this one focused on the looming clash between the U.S. and China over accounting standards for US-listed Chinese companies. My fellow guest was Professor Paul Gillis from Peking University, whose blog I highly recommend for anyone following this subject. You can listen to the podcast discussion here.
On New Year’s Day, I took part in a special 2-hour “year in review” episode of the Today Show on China Radio International, where we covered everything from Syria’s civil war to the Greek debt crisis to the London Olympics. My suggestion for the “top story” of the year: China’s netizens, and how they’re changing the terms of China’s social and political climate. You can listen to the program here.
On New Year’s Eve, the BBC ran a story on the outlook for China’s economy in 2013, which you can read here. The conventional view is that China is headed for a strong rebound, but I questioned that conclusion:
Many analysts have warned that the model is unsustainable and have called upon Beijing to boost its domestic consumption and rebalance its economy.
For his part, the new Communist Party leader Xi Jinping has pledged to deepen economic reforms and further open up China’s economy.
However, there are concerns that a shift in its growth model may hurt China’s growth in the short term.
“They must embrace real economic adjustment, which will bring real pain and likely translate to slower growth, at least for a time,” said Patrick Chovanec of the Tsinghua University in Beijing.
Analysts and observers fear that China may not be able to bear the short-term slowdown and may turn back to the traditional model of growth.
Those fears have been fanned further after Beijing approved infrastructure projects worth more than $150bn (£94bn) as its growth pace fell to a three-year low in the July to September quarter.
“In recent months, China’s economy has seen a ‘rebound’ engineered by looser lending and a renewed surge in investment,” says Mr Chovanec.
“Markets have cheered, but others worry that China’s new leaders may be shying away from the tough choices that must be made to get China’s economy back on track.”
As I tweeted the other day (@prchovanec):
“Markets should be rooting for China to embrace real economic adjustment, not to deliver yesterday’s growth targets with yesterday’s growth engine.”
I reiterated my concerns about China’s “rebound” in a Bloomberg article published this weekend:
“Lots of projects have been approved to stimulate this economy,” said Patrick Chovanec of Beijing’s Tsinghua University. “The banks are extremely reluctant to lend to them, and that says a lot about what they really know about credit risk in this country.”
(What I went on to tell the reporter is that the funding, instead, is coming from the banks selling trust and private wealth management products. The banks won’t touch the credit risk themselves, but they’re happy to take a fee for dumping it onto their clients, while promising even higher returns. Sounds like subprime mortgage origination all over again).
But I was particularly gratified to see my friend David Loevinger, the former director of the Strategic & Economic Dialogue (S&ED) at US Treasury, now a private sector analyst, make much the same point about China’s latest “rebound”:
“If China tries to sustain growth by adding debt and investing it inefficiently it will be like cotton candy: a short-term high with no lasting value,” said Loevinger, now an Asia analyst in Los Angeles at TCW Group Inc. “The U.S. got into trouble because institutions like Fannie Mae and Freddie Mac were too big to fail. … China’s financial system is full of Freddies and Fannies.”
Tomorrow morning I’ll be back on China Radio International, this time talking about the new “special zones” China is in the process of setting up to experiment with financial reform, in Wenzhou, the Pearl River Delta, and now Quanzhou. I’ll post that later tomorrow when the audio is available.
Foreign Policy: Clash of the Balance Sheets
Clash of the Balance Sheets
The most important showdown between China and the United States isn’t happening in the Pacific. It’s happening at the SEC.
BY PATRICK CHOVANEC | DECEMBER 10, 2012
China and the United States are on a collision course — over accounting. Last week, the U.S. Securities and Exchange Commission (SEC) charged the Chinese affiliates of the world’s top five accounting firms with violating securities laws for refusing to hand over information on suspect Chinese companies to investigators. The move is the latest, most dramatic step in an escalating standoff that could easily lead to a financial version of Armageddon: the forcible (and unprecedented) delisting of all Chinese shares currently traded on U.S. exchanges, including big-name stocks like Baidu, Sinopec, and China Mobile — causing losses of billions of dollars and damaging the perception that the United States is friendly to Chinese businesses.
Accounting audit practices may seem like a topic more likely to lull nations (and magazine readers) to sleep. But as anyone who lost money investing in Enron or with Bernie Madoff knows, playing fast and loose with accounting rules can have huge consequences. Accounting is the language of business, and lying about revenues or liabilities is fraud. Washington created the SEC in the wake of the Wall Street Crash of 1929 to ensure that companies that offer their shares to the public are what they claim to be.
To meet that objective, the SEC requires that all companies selling securities to the public to submit annual financial statements audited by a qualified third party. If a company doesn’t file reports that have an auditor’s stamp of approval, its stocks and bonds cannot be traded on a public exchange. After the scandal following the 2001 collapse of energy giant Enron, in which the company’s auditor, Arthur Andersen, faced criminal charges for covering up dodgy accounting practices, Congress passed the Sarbanes-Oxley Act to tighten up regulation of auditors and the audit process. The new law created the Public Company Accounting Oversight Board (PCAOB), a quasi-public entity that reports to the SEC and is responsible for policing the auditors. Now, in order to perform qualified audits, an audit firm must register with the board and submit to rigorous and regular inspections by its staff.
Over the past decade, roughly 400 Chinese companies have listed their shares on U.S. stock exchanges. A few are multi-billion dollar state-owned enterprises, such as China Life, China Telecom, and PetroChina. More than 100 were so-called backdoor-listed companies that circumvented the cost and scrutiny associated with an initial public offering by buying and merging into a U.S. firm whose stock was already listed. As U.S.-listed stocks, all of them have chosen to submit themselves to SEC regulation in order to tap U.S. and global investors for funds via U.S. markets.
Because the bulk of their operations are in China, these companies must rely on auditors licensed in China — in many cases the Chinese subsidiaries of the top global audit firms — to audit them. For the SEC to accept their audits, these China-based auditors must register and maintain good standing with the board.
The problem is that the Chinese regulator, the China Securities Regulatory Commission (CSRC), refuses to allow the board to inspect the U.S.-registered, China-based auditors, as required by Sarbanes-Oxley. It sees the idea of a U.S. regulator overseeing a Chinese auditor as a violation of China’s national sovereignty. For some time now, the board has been negotiating with the CSRC, trying to get them to accept some form of cooperative inspections, or even allow it to observe Chinese inspections. So far, these talks have gone nowhere.
It’s not unusual for the United States to get pushback from foreign countries or foreign companies on new regulations. When Sarbanes-Oxley first passed, several U.S.-listed European firms (as well as many U.S. companies) objected to a provision requiring listed firms to perform an annual audit of internal controls, in addition to the traditional audit of financial statements. They argued that this extra requirement was so costly and burdensome, they might no longer bother to maintain their stock listings in the United States, seriously undermining the position of the U.S. capital markets on the world stage. In response, the SEC temporarily suspended the rule for foreign companies, and eventually scaled down the requirement for all companies to a less onerous “top-down review.”
Recent events, however, have made it a lot harder for the SEC to show similar flexibility toward China. Since 2010, a number of short-sellers researching in China have leveled high-profile accusations of fraud against Chinese firms listed on U.S. markets. Five companies targeted by Muddy Waters, the best-known of those short-sellers, lost almost $5 billion in market value through June 2011. Several others have seen their shares rendered nearly worthless or been forced to declare bankruptcy. These firms allegedly engaged in malfeasance ranging from questionable accounting practices to inflate revenues and profits, making up numbers out of thin air (and hoping no one has the resources to prove otherwise), embezzling funds, and even being total shams.
The SEC has also raised concerns about a popular holding structure, called the Variable Interest Entity, that many U.S.-listed “China stocks” use to operate in certain industries in China, such as media and education, where foreign ownership is prohibited. The U.S.-listed company exercises operational and financial “control” via contracts, allowing it to claim the China business as its own. Virtually all Chinese Internet start-ups listed in the United States are structured this way. The SEC worries that Chinese authorities could someday invalidate the contracts as illegal, leaving U.S. investors holding completely worthless shares.
In response, the SEC has launched fraud investigations into several U.S.-listed Chinese companies and their executives, ordering their China-based auditors to hand over confidential documents to examine for potential evidence of wrongdoing. In the most visible case, the SEC in May 2011 handed lawyers for Deloitte China a federal court subpoena to turn over its audit work papers for Longtop Financial Technologies, a Hong Kong-based maker of financial software that short-seller Citron Research had accused of fraudulent accounting (prompting Deloitte to resign the account, citing “recently identified falsity” in Longtop’s financial statements).
Deloitte China fired its lawyer for accepting the subpoena, and refused to comply. In a court filing explaining why, Deloitte claimed that Chinese regulators had issued an extraordinary threat, telling auditors that handing over audit work papers would violate China’s (vague and draconian) State Secrets law, allowing China to “dissolve the firm entirely and to seek prison sentences up to life in prison for any [Deloitte] partners and employees who participated in the violation.”
The refusals come at a time when Chinese local authorities, embarrassed by the allegations, have been cracking down on short-sellers’ researchers, shutting off access to company disclosure filings and sometimes harassing and even jailing research teams conducting due diligence within China. The SEC, for its part, asked the judge in the Deloitte case for a stay until this coming January, to see if it could work out some kind of solution with its counterparts at the CSRC.
Last week’s decision to file charges against all five top global audit firms in China appears to signal an end to the SEC’s patience. In its court filing, the SEC expressed frustration, noting that since 2009, the CSRC had refused to provide any meaningful assistance on 21 information requests arising from 16 securities investigations into U.S.-listed Chinese firms. The Chinese, it has concluded, are simply stonewalling.
While the details may seem arcane, the ramifications can hardly be overstated. Chinese auditors could face financial penalties, but they could also be disqualified from conducting SEC audits. If Chinese auditors get de-registered, U.S.-listed Chinese companies won’t be able to find anyone to sign off on their audits, leading all of these firms to have their shares forcibly delisted, en masse, from U.S. markets. Shareholders would still own their shares, but those shares would be much harder to buy and sell, making them worth considerably less.
Some domestic players think China has outgrown its need to rely on U.S. capital markets. State-owned China Development Bank has put together a $1 billion war chest to help buy out U.S.-listed Chinese companies and take them private. Rather than caving in, their defenders argue, Chinese companies should come home and relist on domestic or Hong Kong stock exchanges, where they might command even higher valuations. Given that China’s Shanghai Index is down two-thirds from its peak five years ago, and with Hong Kong regulators raising similar concerns about fraud, this path may not be as easy or as promising as it sounds.
Chinese companies won’t be the only ones affected if SEC-qualified Chinese auditors go the way of the dodo. Plenty of multinationals listed on U.S. markets, many of them headquartered in the United States, have substantial parts of their business in China. Yum Brands takes in 44 percent of its revenues from the KFC and Pizza Hut outlets it has in China. Car sales in China account for 34 percent of General Motors’ profits. These numbers matter to their global bottom lines, and to sign off on their SEC filings, their lead auditors in the United States need a PBAOC-registered Chinese auditor to vouch for them. If no such auditors exist, these companies have a problem. (There may be clever workarounds, such as dividing up the work among so many auditors that none of them is vouching for a “substantial” part of the business, but it’s a costly and cumbersome solution. Nor is it clear if easy loopholes can be created for multinationals with substantial China operations without tearing a big hole in the fabric of U.S. securities regulation).
The SEC, though, may feel it has no other option. China’s constraints effectively place Chinese companies completely beyond the reach of U.S. securities laws. If this were just a theoretical concern, there might be room to maneuver. But with dozens of Chinese stocks traded on U.S. exchanges dragged down by fraud allegations, costing investors billions of dollars in losses, the SEC has to act. And each action it takes brings the United States and China one step closer to an ugly financial divorce.
Bloomberg: Challenges China’s New Leadership Faces
On Friday, I was on Bloomberg TV talking about China’s latest economic data for October (at the time of my interview, only the inflation figures had been announced), and some of the key challenges facing China’s ruling party as it begins its once-in-a-decade leadership transition. I took a distinctly contrarian view on the latest inflation numbers, arguing they do not create room for monetary loosening to give the economy a quick and easy boost, because the issue isn’t just how much money is sloshing around China’s economy, but where that money is going. To the extent that prices in certain key sectors like steel and coal — and I would add real estate, despite the official statistics saying otherwise — are falling, it reflects real overcapacity compared to real demand, and the absence of real value being created. The PBOC is right to resist pumping in more money and reflating bloated investment sectors, which would only reinforce the imbalances in China’s economy and prevent the kind of adjustment China needs towards more meaningful growth. You can watch my interview here.
I also discussed aspects of President Hu Jintao’s big address to the 18th Party Congress. Let me just highlight four key points of the speech that caught my attention:
1) Hu promised to double China’s 2010 GDP by 2020. That sounds really impressive, but it actually equates to just 7% growth going forward — and I’m assuming here that he meant double real, not just nominal GDP, because otherwise the real growth rate would be even lower. So really, he’s lowering the bar in a pretty significant way. Hu also set the goal of doubling per capita income by 2020. The problem is, if GDP and per capita income both double, China won’t see any meaningful rebalancing towards consumption, because household income won’t grow as a portion of GDP — and again, that’s assuming he’s talking about real income growth, because if income only doubles in nominal terms, it will decline relative to real GDP. To rebalance its economy China needs to grow income faster than GDP — which could either mean faster growth in income, or slower growth in GDP.
2) Hu spoke forcefully about how corruption seriously threatens to undermine the Party’s rule. I agree, and talked in my Bloomberg interview about why it’s so hard to deal with this problem. I should also add that inflation — driving investment growth by pumping more and more money into the economy — is one of the major factors contributing to corruption, because it drives a widening gap between those who have pricing power and those who don’t, and those who have access to credit and those who don’t. Inflation (from a big lending boom), and inflation-driven corruption, were two of the main grievances that fueled the Tiananmen protests in 1989.
3) Hu also spoke of the need to “resolutely safeguard China’s maritime rights and interests” and called on China to become a “maritime power.” Given recent confrontations in the South China Sea (with the Philippines and Vietnam) and the East China Sea (with Japan and South Korea), as well as the launch of China’s first aircraft carrier, these lines surely caught the attention of China’s neighbors (as this FT article suggests).
4) Hu also appeared to push back against reformers’ calls to reduce the role of the state sector in China’s economy. Instead, he insisted China would “unswervingly” adhere to “the basic economic system in which public ownership is the mainstay and economic entities of diverse ownership develop together,” and said the party and government “should steadily enhance the vitality of the state-owned sector of the economy and its capacity to leverage and influence the economy.” His stance appeared to run contrary to the prescriptions in the World Bank report issued earlier this year in conjunction with top Chinese policy makers, which appeared to have the support of Hu’s protegé, Premier-in-waiting Li Keqiang, and had raised hopes that positive reforms might take place after the leadership transition. We’ll have to wait to see what, if anything, the new rhetoric means for actual policy.
Sinica Podcast: Party Congress Preview
You know you’ve hit the big time in China when you’re invited as a guest on Kaiser Kuo’s Sinica Podcast. This week, I joined Kaiser’s co-host Jeremy Goldkorn of danwei.com for a discussion about China’s upcoming leadership transition. I really recommend listening to the 45-minute session, not so much for my own comments — which will be familiar to anyone who regularly reads this blog — but for the great stories and insights from my two fellow guests, John Garnaut of the Sydney Morning Herald and Jamil Anderlini of the Financial Times, both of whom have just published brand new books on the Bo Xilai scandal. You can listen to the podcast here or download it here.
While you are listening, I highly suggest you check out the provided links, including the China Economic Review article I wrote in 2010 (and mentioned in the podcast) on why China needs a new “Southern Tour,” as well as the “primer” on China’s leadership transition I wrote last year, which Kaiser was kind enough to plug as his “reading recommendation” for the week. You can also listen to (and link to) my own recommendations, which focus on the impact the receding Arctic ice cap and cheap U.S. natural gas could have on China (and the world).
Of course, we recorded our conversation before the New York Times published its taboo-shattering expose on the hidden fortune controlled by Premier Wen Jiabao’s family members, otherwise I suspect it would have ranked high among our discussion topics. Note, however, that I did mention the issue — including Mrs. Wen’s connection to the diamond trade — in my “primer” (which is just one reason I suspect that article, and now this entire blog, is blocked in China).
Boao Review: The Realities of Renminbi Internationalization
I have an article in the October 2012 issue of Boao Review, the new journal published by the Boao Forum, on what the future may hold for China’s currency, the Renminbi. I am told the article will be posted on the magazine’s website this week, and I will post a link when one is available.
The Rise of the Renminbi as an International Currency: Challenges and Solutions
By Patrick Chovanec
The rise of the Renminbi as an international currency is looked up with an almost breathless anticipation from London to Tokyo to Sydney. All this excitement has tended to eclipse a more sober assessment of the opportunities and obstacles the Chinese yuan realistically faces, as well as the benefits and burdens a larger international role for the Renminbi would pose for China. Rarely are the questions asked: Does China really want or need to manage a global currency? And if so, what price is it willing to pay?
The growing role of the Renminbi in China
The Renminbi has already come a long way. Not that long ago, the Renminbi wasn’t a fully functional currency even within China’s own borders. All imported goods, as well as services provided to foreign visitors, had to be paid for with Foreign Exchange Certificates (FEC), in exchange for hard currencies. While FEC were ostensibly denominated in the same yuan as the Renminbi used for domestic purposes, their buying power was obviously quite different, giving rise to a vibrant black market on the doorstep of every international hotel across the country.
Gradually, the yuan’s exchange rate was allowed to depreciate nearly sixfold, from 1.5 CNY/USD to 8.2, closing the trading gap and allowing China to phase out the FEC in 1995. This opened the door for China to make the Renminbi convertible for current account (i.e., trade) transactions the following year. The flow of investment funds both into and out of China via the capital account, however, continued to be strictly regulated. When China set up its two domestic stock exchanges in the early 1990s, it went so far as to create an entirely separate market in so-called “B shares,” denominated in US dollars and HK dollars respectively, in which foreigners (and until 2001, only foreigners) were allowed to invest. In effect, the inability to freely buy and sell Renminbi was used as a firewall to insulate China’s financial markets from the outside world.
In practice, convertibility on the current account meant that Chinese companies, or foreign companies operating in China, could exchange Renminbi for foreign currencies to purchase imports, as long as they presented a valid invoice. Trade itself, both imports and exports, was conducted almost entirely in foreign currencies, mainly in US dollars.
The role of the US dollar in international settlement and its effect on international trade
It’s worth pausing for a moment and asking, why US dollars? After the US de-linked the dollar from gold in 1971, demolishing the post-war Bretton Woods system, there has been no institutional framework enshrining the US dollar as the world’s preeminent currency. The dollar retains its role because market participants prefer to use it, for three main reasons:
- The dollar represents a claim on goods and services in the world’s largest economy, presuming it retains its value;
- The dollar can be freely used or exchanged for any (legal) purpose, without restriction;
- The dollar can be held in a wide range of readily traded investment instruments, and in large amounts.
The same is true of other international currencies, such as the Euro, the British pound, and the Japanese Yen, but to a lesser degree. In contrast, someone who accepts a Chinese yuan as payment – or a Nigerian naira, a Honduran lempira, or a Laotian kip – may find it a lot harder to invest or find another trader who will accept it in turn. Many of these countries find it easier – or even essential – to conduct trade in a currency that is far more widely accepted.
Using the dollar as an intermediary, however, does have costs. Take, for instance, an Argentinian exporter selling soybeans to China. Since the seller can’t use yuan, and the buyer doesn’t want pesos, they both must pay a bank commission to change their money into dollars and then back again. They may have no choice but to use a U.S. bank that has sufficient dollars available. Thus both sides run the risk that their currencies will fluctuate in value against the US dollar before the transaction is completed, creating undesired gains and losses.
The drawbacks of relying on the US dollar were driven home by the immediate aftermath of the Lehman Brothers collapse in September 2008. For several terrifying days, credit markets seized up. Exporters and importers all over the world who needed US dollars to conduct business couldn’t secure financing, and trade threatened to grind to a halt. The Federal Reserve stepped in to provide dollars via “swaps” with other central banks, but not every country found itself first in line to obtain relief. It was this crisis that provided the impetus for China to negotiate bilateral currency swap agreements with several of its largest trading partners, including Indonesia, Argentina, Australia, and Brazil.
The RMB’s increasing role in trade between China and other countries
Because few people understand what central bank currency swaps actually are, or how they function, the signing of these agreements has given rise to the misapprehension that the Renminbi has already taken on a more prominent international role that includes being held as a reserve currency. In fact, no currency reserves have been exchanged. The “swaps” are simply an emergency back-up in the event of another crisis. It is unclear how such swaps, if implemented, could be unwound except through careful stage management, since there is no global market for banks to replenish their Renminbi balances, once deployed. For now, that is a bridge nobody is too worried about having to cross.
In any event, the much-touted currency swaps that China has entered into are a tailored response to a specific set of concerns, and in no way herald the Renminbi’s arrival as a fully functional global currency.
Of course, China is not Honduras, Laos, or even Argentina. China now has the second largest economy in the world, and is the world’s largest exporter. There are plenty of people around the world who want to buy Chinese goods, or make investments in China, and would be willing to acquire Renminbi to do so. Thus, the Renminbi fulfills at least the first criteria that made the US dollar a globally accepted currency: it represents a claim that many people wish to possess.
In response, China has begun to allow companies to invoice and pay for import and export transactions in Renminbi, rather than a foreign currency. Starting with a pilot program in 2009, settlement in Renminbi grew four-fold in 2011 to 2 trillion yuan ($330 billion), or 9% of China’s foreign trade, and in March 2012 was made available to all firms nationwide.
The growth in yuan-denominated settlement, and in offshore holdings of Renminbi in Hong Kong, have been hailed as a sign of the currency’s inexorable rise to global dominance. But critics, including Chinese economist Yu Yongding, have pointed out that Renminbi settlement has been heavily lopsided towards imports, resulting in a net outflow of the yuan. They argue that this currency outflow has been driven more by speculative anticipation of Renminbi appreciation, and by opportunities for exchange rate arbitrage, than by any desire to hold Renminbi as a genuinely useful currency. Beyond these immediate concerns, however, the imbalance in yuan settlement raises a more fundamental challenge to China’s long-term vision for the Renminbi.
Two undesirable scenarios in RMB’s internationalization and the solutions
In the 1960s, the economist Robert Triffin observed an interesting dilemma involving the dollar’s role as the dominant global currency. In order for the dollar to be a desirable currency to possess, it has to buy things that everyone all over the world wants. But in order to meet that need, the dollar has to be readily obtainable, which means the U.S. must run a balance of payments deficit – in other words, it has to export currency either by running a trade deficit or by channeling a very large amount of investment abroad. For the dollar to be a global currency, there has to be some way for people around the world to get their hands on dollars.
Up until very recently, China has been running surpluses on both the current and capital accounts. The result is that, far from Renminbi accumulating abroad, China has accumulated a massive stockpile of $3 trillion in foreign currency reserves. Foreign buyers can’t pay for Chinese exports in Renminbi because, in net terms at least, they’ve had little chance to earn Renminbi. And unless China starts running a trade deficit, or opens its capital account and allows a lot more investment to flow overseas, any yuan the Chinese use to pay for imports only adds to the sum of foreign currency left in China’s official reserves – heightening, rather than reducing, China’s dependence on dollars. For the Renminbi to take on a more prominent international role, much less emerge as the world’s chief reserve currency, would require a dramatic change in China’s relationship to the global economy – a change it is far from clear China either anticipates or desires.
Opening China’s capital account is the key to another obstacle facing the Renminbi: where, if investors do hold yuan, they are supposed to put them? According to McKinsey, 40% of global capital markets are denominated in US dollars, giving investors, including central banks, deep and liquid markets in which to maintain large dollar balances. China, including Hong Kong, accounts for just 4% — mostly in equities, and a large part of it barred to foreign investors. China has tried to fill the void by issuing so-called “dim sum” bonds, yuan-denominated securities sold in Hong Kong: 35.7 billion yuan’s worth in 2010, and 131 billion in 2011. But as long as the offshore market in “dim sum” bonds remains set apart in quarantined isolation from Mainland capital markets, it risks sharing the same fate as the stunted and illiquid B share market. The only viable solution is for China to finish the process it began in the 1980s and make the Renminbi fully convertible on the capital account.
Allowing free flows of capital is really the only way China can – in time – develop into the kind of global financing hub that could support a truly international currency. The problem, for China’s leaders, is that achieving that goal requires giving up a substantial amount of control over the economy. Economists call it the “trilemma,” or the “impossible trinity”: no country can allow free flows of capital, support a fixed exchange rate, and manage an independent monetary policy at the same time. One of them has to go. And as the Japanese discovered with their “big bang” in the mid-1990s, opening China’s financial system to outside market forces would make it a lot harder to hide and quietly manage any bad debt problems lurking in Chinese banks.
So the question is not just whether the Renminbi has the potential to become a truly international currency, but whether China wants to go down the path that could make it one. That path involves risks and rewards, obstacles and opportunities, but wherever it leads, it will not leave the Chinese economy unchanged.
NPR: What’s Going Wrong With China’s Solar Industry?
Yesterday, I was on National Public Radio (NPR) talking about the meltdown in China’s heavily subsidized solar industry, as a follow up to my Wall Street Journal op-ed on that topic last month. You can read the transcript below, or listen to the interview here.
Steve Inskeep talks to Beijing-based economist Patrick Chovanec about too many subsidies in China’s solar energy industry. It is resulting in money-losing companies. One company, Suntech, could soon be delisted from the New York Stock Exchange because it is performing poorly.
STEVE INSKEEP, HOST: Which brings us to our next story. As Americans try again to heat up the solar industry, let’s get an update on the competition. We reported last week on the West Coast solar power company that is trying to succeed where companies like Solyndra famously failed. American companies have struggled because they’ve been undermined by cheap imports from China. So it is meaningful to note that China’s solar power industry is a mess.
We’re going to talk about that with Beijing-based economist Patrick Chovanec. Welcome back to the program.
PATRICK CHOVANEC: Oh, it’s good to be with you.
INSKEEP: What’s going wrong with the Chinese solar industry?
CHOVANEC: Well, they have a dozen Solyndras. They basically have tried to build up an industry by pouring subsidies into trying to pick winners in that industry and right now those companies are failing badly because there’s a massive amount of overcapacity that’s been created.
INSKEEP: Well, let’s remember, because you say a dozen Solyndras. The company received hundreds of millions of dollars in U.S. government assistance and went bankrupt anyway. And one of the reasons we were given was that the price of solar power equipment has just been going down and down and down because the Chinese were producing it so cheaply, is that right so far?
CHOVANEC: Right. Prices have gone down so much that even the Chinese are not necessarily breaking even. So what you’ve got in China is a massive amount of overcapacity because all these subsidies have attracted so much investment. And you’ve got a number of very large companies, LDK Solar, which is the second-largest solar module company in the world; Suntech, which is the largest solar panel maker in the world, that are on the edge of bankruptcy right now and are really either being bailed out or there’s talk about bailing out to the tune of hundreds and millions of dollars.
INSKEEP: What are the public signs of their distress? Do they report losses? Do they fire workers?
CHOVANEC: Yes. LDK Solar has been reporting losses and they have been shedding about 10,000 jobs. And the local government, in its home province, has pledged about $315 million to try to keep it in business because they’re afraid that if LDK Solar goes down then hundreds of local companies could go under.
And Suntech, Suntech’s in kind of a unique situation. They guaranteed a loan to what is essentially a subsidiary that bought huge amounts of product from them, allowed them to report very high sales. It turns out that the collateral that was pledged, which was supposed to be German bonds to back that loan, doesn’t exist.
INSKEEP: OK. Now wait a minute. That was such a crazy story I want to make sure I understand it. You’re saying there’s a major Chinese solar company that set up another company and used borrowed money to buy solar panels – solar equipment – from itself and now is having a little trouble paying back the loan?
CHOVANEC: Yes. Not as unusual as you might think it in China – these kind of manufactured sales. Essentially what happened was there was a fund that they set up in Europe. Suntech owned about 90 percent of it, so effectively controlled it – it was essentially a subsidiary. That company bought solar panels to use in various projects in Europe. They borrowed money from China Development Bank. The parent company, Suntech guaranteed it. The total amount of the loan was $689 million, and it turns out that the collateral backing that loan just doesn’t exist. And a lot of analysts looking at that company basically say that that’s enough to push Suntech into bankruptcy.
Of course, since the Chinese government can’t allow that to happen, they’re going to have to step in and bail that company out as well.
INSKEEP: If all these cheap solar panels are being made why aren’t people just buying a lot more of them, which would save the companies?
CHOVANEC: Well, one thing that’s happening right now is the eurozone crisis and you have a lot of European countries that were giving very generous subsidies for people to buy and use solar panels. Those subsidies are now being cut severely.
INSKEEP: So what do the Chinese do now?
(LAUGHTER)
CHOVANEC: Well, what they probably do is they dig deep dig into their pockets – the pockets of the central government – and bail out these companies. Because what they’re really afraid of is, you know, we’ve seen this over the past couple of months, that even relatively small companies, when they fail in China they’re so intertwined in terms of their credit relationships and the local economy that essentially everything’s too big to fail.
INSKEEP: Patrick Chovanec is professor at Tsinghua University’s School of Economics and Management in Beijing.
Thanks as always.
CHOVANEC: You’re welcome.
[P.S. — This interview was recorded a week ago, before the New York Times published a very good article on the crisis in China’s solar sector. In particular, the article sheds some additional light on my answer to the very last question — what will China do now? It quoted one top Chinese official — the head of energy policy for the NDRC, China’s powerful economic planning agency — saying over-capacity is so severe that as many as 2/3 of China’s solar firms might have to die off for the industry to survive. In fact, it said, “he wanted banks to cut off loans to all but the strongest solar panel companies and let the rest go bankrupt.” However, banks and local governments are resisting such strong medicine and want to keep failing companies afloat by any means necessary:
But banks — which were encouraged by Beijing to make the loans — are not eager to acknowledge that the loans are bad and take large write-offs, preferring to lend more money to allow the repayment of previous loans. Many local and provincial governments also are determined to keep their hometown favorites afloat to avoid job losses and to avoid making payments on loan guarantees, he said.
Central government authorities worry, though, that trying to prop up too many companies could doom the entire industry:
“For the leading companies in the sector, if they’re not careful, the whole sector will disappear,” said Chen Huiqing, the deputy director for solar products at the China Chamber of Commerce for Import and Export of Machinery and Electronic Products.
The article also notes that China’s wind energy sector is experiencing similar problems.]
Interviews on CNN and NPR
Here are links to two interviews I did recently with major U.S. media outlets:
The first is a 5-minute interview on CNN last Monday about the mounting bad debt problem in China’s banking system and its implications for the country’s slowing economy. You can watch it by clicking here.
The second is 5-minute radio discussion on NPR about the economic transition China faces and whether its “landing” will be hard or soft. You can listen by clicking here.
WSJ: China’s Solyndra Economy
I had a new op-ed in yesterday’s Wall Street Journal, which you can read below or view the original here. At the very last moment, one paragraph was cut from the final version, presumably due to space limitations. I have restored it here in italics, because the crisis facing Suntech (the world’s largest solar panel maker) make it clearer that what we’re seeing here is an industry-wide problem and not something restricted to a single troubled competitor.
China’s Solyndra Economy
Government subsidies to green energy and high-speed rail have led to mounting losses and costly bailouts. This is not a road the U.S. should travel.
By PATRICK CHOVANEC
On Aug. 3, the owner of Chengxing Solar Company leapt from the sixth floor of his office building in Jinhua, China. Li Fei killed himself after his company was unable to repay a $3 million bank loan it had guaranteed for another Chinese solar company that defaulted. One local financial newspaper called Li’s suicide “a sign of the imminent collapse facing the Chinese photovoltaic industry” due to overcapacity and mounting debts.
President Barack Obama has held up China’s investments in green energy and high-speed rail as examples of the kind of state-led industrial policy that America should be emulating. The real lesson is precisely the opposite. State subsidies have spawned dozens of Chinese Solyndras that are now on the verge of collapse.
Unveiled in 2010, Beijing’s 12th Five-Year Plan identified solar and wind power and electric automobiles as “strategic emerging industries” that would receive substantial state support. Investors piled into the favored sectors, confident the government’s backing would guarantee success. Barely two years later, all three industries are in dire straits.
This summer, the NYSE-listed LDK Solar, the world’s second largest polysilicon solar wafer producer, defaulted on $95 million owed to over 20 suppliers. The company lost $589 million in the fourth quarter of 2011 and another $185 million in the first quarter of 2012, and has shed nearly 10,000 jobs. The government in LDK’s home province of Jiangxi scrambled to pledge $315 million in public bailout funds, terrified that any further defaults could pull down hundreds of local companies.
Meanwhile another NYSE-listed Chinese solar company, Suntech, revealed on July 30 that the German government bonds an affiliate pledged as security for a $689 million bank loan it guaranteed never existed. Suntech, the world’s largest producer of solar panels, claims it was the victim of fraud. Considering Suntech already owed $3.6 billion (for a debt-asset ratio of 82%), and lost $149 million in the fourth quarter of 2011 and $133 million in the first quarter of 2012, many analysts believe the company could go bankrupt without a sizable government bailout.
Chinese solar companies blame many of their woes on the antidumping tariffs recently imposed by the U.S. and Europe. The real problem, however, is rampant overinvestment driven largely by subsidies. Since 2010, the price of polysilicon wafers used to make solar cells has dropped 73%, according to Maxim Group, while the price of solar cells has fallen 68% and the price of solar modules 57%. At these prices, even low-cost Chinese producers are finding it impossible to break even.
Wind power is seeing similar overcapacity. China’s top wind turbine manufacturers, Goldwind and Sinovel, saw their earnings plummet by 83% and 96% respectively in the first half of 2012, year-on-year. Domestic wind farm operators Huaneng and Datang saw profits plunge 63% and 76%, respectively, due to low capacity utilization. China’s national electricity regulator, SERC, reported that 53% of the wind power generated in Inner Mongolia province in the first half of this year was wasted. One analyst told China Securities Journal that “40-50% of wind power projects are left idle,” with many not even connected to the grid.
A few years ago, Shenzhen-based BYD (short for “Build Your Dreams”) was a media darling that brought in Warren Buffett as an investor. It was going to make China the dominant player in electric automobiles. Despite gorging on green energy subsidies, BYD sold barely 8,000 hybrids and 400 fully electric cars last year, while hemorrhaging cash on an ill-fated solar venture. Company profits for the first half of 2012 plunged 94% year-on-year.
China’s high-speed rail ambitions put the Ministry of Railways so deeply in debt that by the end of last year it was forced to halt all construction and ask Beijing for a $126 billion bailout. Central authorities agreed to give it $31.5 billion to pay its state-owned suppliers and avoid an outright default, and had to issue a blanket guarantee on its bonds to help it raise more. While a handful of high-traffic lines, such as the Shanghai-Beijing route, have some prospect of breaking even, Prof. Zhao Jian of Beijing Jiaotong University compared the rest of the network to “a 160-story luxury hotel where only 11 stories are used and the occupancy rate of those floors is below 50%.”
China’s Railway Ministry racked up $1.4 billion in losses for the first six months of this year, and an internal audit has uncovered dangerous defects due to lax construction on 12 new lines, which will have to be repaired at the cost of billions more. Minister Liu Zhijun, the architect of China’s high-speed rail system, was fired in February 2011 and will soon be prosecuted on corruption charges that reportedly include embezzling some $120 million. One of his lieutenants, the deputy chief engineer, is alleged to have funneled $2.8 billion into an offshore bank account.
Many in Washington have developed a serious case of China-envy, seeing it as an exemplar of how to run an economy. In fact, Beijing’s mandarins are no better at picking winners, and just as prone to blow money on boondoggles, as their Beltway counterparts.
In his State of the Union address earlier this year, President Obama declared, “I will not cede the wind or solar or battery industry to China . . . because we refuse to make the same commitment here.” Given what’s really happening in China, he may want to think again.
Patrick Chovanec 