Posted on 02/10/2010 8:40:24 AM PST by TigerLikesRooster
Never short a country with $2 trillion in reserves?
February 2nd, 2010 by Michael Pettis
/snip
Ok, we can argue about these things, and we can agree to disagree, but where he completely blew it was, I suspect, on the one topic are where he was absolutely certain he could not be wrong.
Too bad, because he was. Friedman proposed, yet again, a common misconception over the meaning of China’s huge accumulation of foreign reserves. He argued that thanks in part to the size of the reserves it would be impossible to make money by shorting China. “First,” he warned, “a simple rule of investing that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.”
Really? Friedman proposed the rule sarcastically – as both untestable and too obvious to need testing. It is so obvious that no country has ever had such high levels of reserves, so you can’t really test the hypothesis, but it’s also pretty obvious that a country with $2 trillion in reserves is in great shape. Anyone who wanted to short it must be pretty stupid, right?
But it turns out that reality is not as obvious as he imagines. Let us leave aside that the PBoC’s reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion. China’s foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.
But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.
The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP. My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.
The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan’s accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China’s does today.
Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.
Japan’s subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.
The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves. Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.
Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s. The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system.
These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies. And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).
In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.
It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.
We must be careful how we read history. The fact that the US and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched, and under conditions similar to those of China, does not necessarily mean that China too must have a lost decade or two. Chanos is not being crazy when he worries, but it is still an open question as to whether or not he will turn out to be right.
But the history does indicate that facile statements about central bank reserves should, at the very least, be measured against the obvious historical precedents. Chanos might still lose this debate, but Friedman has already proven himself to be hopelessly wrong.
P!
And neither the US in the 30s, nor Japan in the 90s, had the serious demographic issues that China is facing, nor did they have a one-party dictatorship.
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.