from CItibank ... 10% of China's reserves now tied up in shoring up 2 Chinese State Banks. Final solution or band-aid??
Subject: China FX and Fixed Income Implications of China's latest bank recap on FX/bond markets
* Chinese state media today confirmed remarks first made by a World Bank official that foreign exchange reserves (US$45bn in all according to wire reports) would be used to recapitalize the Bank of China and China Construction Bank (two of China's four big banks); wire reports said the monies would be evenly split between BOC and CCB
* Short-term, we do not see the CNY NDF curve steepening because China will now somehow accelerate buying of USD to fund further recaps, thereby narrowing the discounts along the NDF. Longer-term, this policy change marginally improves the structural backdrop for an eventual band-widening (in line with our longstanding arguments), but the real question is whether the flow creation of banking bad debt in China has been stemmed
* As China is on a fixed exchange rate regime, reserve accumulation largely depends upon the pace of capital inflows. China cannot purposefully accumulate reserves without affecting the traded value of its fixed currency. What China accumulates in reserves in 2004 will largely reflect net flows of capital in and out of the country, so it seem inaccurate to describe the country as purposefully building up more reserves
* Plans had been afoot in the last year for a major revamp of the four big banks in China. Equity market participants appeared to have been expecting help to come first for BOC and CCB, en route to an initial equity listing possibly this year. The recap is a major policy decision.
Having been made, the next recap should not follow quickly. But in any event, further recaps should occur ahead of the 2006 full opening to foreign competition in the banking sector. Should capital flows continue streaming into China this year at last year's pace, we cannot rule out another recap that uses foreign reserves (in a sense to be define below)
* Somewhat curiously, having announced the decision Chinese state media was mum today about details of the actual recap (unlike a number of other cases in Asia dating from the 1997-98 financial crisis). In fact, some officials in Beijing sounded uncertain whether the recap had actually taken place yet (although wire services said the recap occurred at year-end 2003)
* Nonetheless, discussions with close observers in Beijing suggested that the recap mechanism should be fairly standard, and may involve the use of US$45bn of Chinese foreign reserves as backing only for an amount of MOF-issued government debt that will be injected into BOC and CCB, to shore up balance sheets and provide for potential future losses
* The US$45bn of foreign reserves will continue to show up as foreign reserves in central bank reporting; what has possibly changed is a future reduction in the central bank's net worth as it takes on a large contingent liability
* Monetary conditions locally should not be affected, and hence local interest rates will remain unchanged. The sensitivity of local authorities to any observable hike in interest rates have intensified anyhow in recent weeks, to the extent that onshore banks bidding for central bank bills are no longer allowed to bid rates only volumes (ie, the central bank gives the onshore market a fill-or-kill supply of paper each week). Interest rates are set by the central bank, and details of PBOC's weekly auctions have not been published for several weeks
* As to whether this policy move accelerates an exchange rate regime change in China, recall the CNY270bn recap done in 1998. That policy move never shored up the banking sector sufficiently that China was prepared to move on the exchange rate issue. Clearly now with a subsequent recap and hindsight, the 1998 recap did not stem the flow creation of bad debt in China's banking system, which continued beyond 1998 and kept the system from ever being stable enough to allow for more aggressive opening in the capital account. Whether the latest recap will do the trick this time round depends largely on whether the flow problem is corrected
* One can also ask whether this reflects good management of China's foreign reserves. Since the reserve backing remains on PBOC's books it will continue to earn a blended yield of global government and agency bond returns. What China has done is to pre-commit a little more than 10 percent of the US$403bn of foreign reserves it had on hand at the end of 2003, and the interest earnings thereof, to help fund potential future losses in the banking system. To the extent that such losses eventually occur, clearly the ex post return on holding these US$45bn of reserves will be lower |
