Sunday, October 28, 2018

The Most Disturbing Statement...

The following is the most disturbing statement in the most disturbing report, prepared by the (2nd) most disturbing group of bureaucrats America has ever known.  (The SEC crew that approved the BABA F-1/424(b)4/IPO filings being, by far, the most disturbing group).   Here's the statement:

Treasury is deeply disappointed that China continues to refrain from disclosing its foreign exchange intervention. (Page 4 of the Report)

MORE BREAKING NEWS: Generalissimo Francisco Franco is still dead....




There really hasn't been much serious, mainstream discussion about the recent "Don't Worry....Everything is Fine.... China is NOT a Currency Manipulator" US Treasury Report to Congress, although, from my vantage, it's the most important issue facing the world today.  (No bullshit....it really is.)

https://home.treasury.gov/system/files/206/2018-10-17-%28Fall-2018-FX%20Report%29.pdf

Sadly, the Treasury report discussed herein should have begun with "Once upon a time" as its opening line.  It truly is a fairy tale.  It's now clearer to me than ever that the boys and girls at Treasury need a little help here, so I'll be happy, as always, to step in and lend a hand.  After all, it's my duty as an American citizen.  Consider this the first installment of my brand new, annual "World Trends in Finance" (WTF) Report.  I'll publish it every October....that is, of course, providing that our financial markets are still functioning in October of 2019....if not, I won't bother since I'll be too busy trying to locate food and shelter for my family.

But First....a Little Commentary on How These Things Happen....

Economists, bureaucrats and regulators are unfortunately, for lack of a better term, "odd ducks".....we are "rule followers".  We are machines.  Our personalities are devoid of imagination and creativity.  We see only what's in front of us, put our blinders on and get the job done. We parse and crunch absurd data without even considering the source, accuracy, veracity or potential impact of the (potentially nefarious) issuer's decision making and disclosure motivations.  (The PBOC Financial Stability Report describing the US$25 Trillion of "newly discovered....Oooppssss" Shadow Bank assets and the subsequent elimination of the report that disclosed same, is an incredible piece of evidence....but I digress.)

Economics is the only profession where we bring together all sorts of conflicting, contradictory data sources, produced and collected by all sorts of self interested governments, agencies and businesses, carefully throw it all into a pot and after much consternation, throw up our hands because nothing makes sense.  But that doesn't stop us.  As seasoned Economists, we forge ahead and give an opinion anyway, or worse, advise people to go full speed ahead and bet the farm on our analysis. (That's how economists get paid).  I, for one, am glad we don't design (and build) buildings, bridges and airplanes that way.

On the other hand, economists also become frustrated without "perfect data"....we continue the crunching, iterating and parsing, angered that we don't know the precise weight and speed of the (out of control) train hurtling toward us....therefore, we can't calculate the exact arrival time or the amount of destruction it will cause when it smashes into our train station.  We can't come up with data indicating that there's anything amiss, so by default, the train must be running just fine...... ..unfortunately, we are forced to make these errant, incomplete calculations and recommendations while standing on the tracks.   

The Treasury folks, financial people, regulators and economists all seem to be analyzing today's economic reports/data as though it's just another day at the train station......when, and we'll see this very clearly in hindsight (we always do) that they should, instead, be examining the financial environment as if it were a crime scene....because it is.

Ok....enough picking on Economists...we all have our shortcomings.  Time to dig into the report.

Here's What the Treasury Department Came Up WIth...

I've listed a few of the more entertaining quotes from the Report below, along with a translation provided by my patented Dick Fuld Banker Speak Translator (BST):

Page 11
At the end of the second quarter of 2018, the U.S. net international investment position stood at a deficit of $8.6 trillion (42.3 percent of GDP), a deterioration of more than $900 billion compared to end-2017. The value of U.S.-owned foreign assets was $27.1 trillion, while the value of foreign-owned U.S. assets stood at $35.7 trillion. Recent deterioration in the net position has been due in part to valuation effects from an appreciating dollar that lowered the dollar value of U.S. assets held abroad, as well as the relative underperformance of foreign equity markets compared to U.S. stock markets in 2018

BST Translation: - Remember in my last post "When Will Xi Click the SELL Button?" A breakdown of what's included in the $35.7 Trillion would have been helpful.....Stocks?  Bonds? Real Estate?  By country?  China?  Tax Havens?  Who owns it and why?

Page 17
Treasury remains deeply concerned by this excessive trade imbalance which is exacerbated by persistent non-tariff barriers, widespread non-market mechanisms, the pervasive use of subsidies, and other unfair practices which increasingly distort China’s economic relationship with its trading partners. Treasury urges China to create a more level and reciprocal playing field for American workers and firms, implement macroeconomic reforms that support greater consumption growth, reduce the role of state intervention, and allow a greater role for market forces.

BST Translation:



Page 18
Nonetheless, the persistent presence of sizeable net errors and omissions, which have been negative for seventeen consecutive quarters, could suggest continued undocumented capital outflows....... Treasury also strongly urges China to provide greater transparency of its exchange rate and reserve management operations and goals.

BST Translation:



The Unexplainable Chart......

So given the "US$/RMB exchange rate is just fine and dandy....China is not a manipulator"  report conclusion, fully described in the "Yay us....look what a great job we're doing" Report to Congress, while fully acknowledging that the Treasury is working with China's "cooked books" I would be grateful if someone at Treasury would take the time to explain to the American people, in a way we can understand, how the relationships in the chart below could possibly exist in an environment of relatively stable exchange rates.




















The above chart describes the impossible (exchange rate adjusted) M3 relationship for the US$ (Blue Line) Yen (Green Line) Euro (Purple Line) and the RMB (Red Line) in Trillions of US$.

In open currency markets, you'd expect that as the supply of a currency increases/decreases then the exchange rate (relative value) would (generally) decrease/increase accordingly over time.  Like any commodity, the greater the "supply", the lower the value should be.  When we look at the M3 data above we see that as of 1/1/2007 all four major money supplies were within a range of between US$4 Trillion and US$8 Trillion (The RMB at the lower bound with the Euro at the higher), presumably enough currency to run the respective economies effectively.  Fast forward to 2018 and we note that Europe, Japan and the US have generally tracked.  The three (3) Money Supplies have increased to a range of US$ 9 Trillion to $14 Trillion, this time with US M3 taking the lead at the top of the range with US $14 Trillion and the EU bringing up the rear at US $9 Trillion.  Now let's take a look at China's M3, hitting a high of US$ 28 Trillion in the Spring of this year before the recent "China dip" down to US$ 26 Trillion.

Based solely on the gigantic relative increase in China's M3, you'd think that the RMB would weaken substantially.  Now let's take a look at the three exchange rates, RMB, Euro and Yen, relative to the US$.





















The exchange rate movement of both the Euro and the Yen makes some sense based on the M3 Relationship.  Both currencies have strengthened slightly compared to the dollar, as US M3 has expanded more quickly than Europe's and Japan's.  Note that the Chinese exchange rate, presumably because of the currency/capital account controls and limitations, has remained in the same managed range 6.75:1 +/- for years. 

You'd think that, based on the above schedule and the Treasury Report commentary, that the CPC/PBOC would have us believe that they've actually achieved the "Impossible Trinity".  They've been able to accomplish free capital flows, independent monetary policy and a fixed/managed exchange rate.  The "Impossible Trinity" condition has long thought to be, well, impossible....yet, at least for now, it exists.

I'd suggest, as food for thought, since no economist on the planet believes that the "Impossible Trinity" is achievable, that the relationship above is actually a ticking time bomb to the global financial system.



What if I Were a Chinese Banker?

Now, again with the aid of the Dick Fuld Banker-Speak Translator (BST), I'd like to spend a few minutes playing that hot, new party game that's taking Chinese living rooms by storm.  I'm of course referring to "What would I do if I were a Chinese Banker?"  It's all the rage.

Here are the rules: The party host asks his guests "If you were a Chinese Banker and your book was comprised of 40% dog-shit, non-performing loans; and you knew the RMB was imploding; and you had hundreds of party bosses breathing down your neck, forcing you to help them get their stolen funds offshore, what would you do?  (A Xinjiang prison camp is, of course, always an option.)

The guests take turns and imagine stepping into the poor beleaguered bankers shoes, giving their opinion on how they'd handle the situation.  The best answers are submitted to the party for implementation.  The CPC has always been big on focus groups.

So now, let's pretend that the following, possibly real life version of a hypothetical, party game discussion (over lunch) between Mr. Sun Yu, Chief Overseas Business Officer of the Bank of China, might (or might not) have  actually taken place on a Yacht, moored in Georgetown, Grand Cayman, sometime in the winter of 2015, between Mr. Yu and a group of bankers we'll refer to as Jimmy P Money, Gary Sacks and Sonny Street.  The following is a Dick Fuld - BST Translation of this totally imaginary, hypothetical discussion that, again, may or may not have taken place.
















Mr. Yu is seated at the second deck galley table.  Mr. Money, Mr. Sacks and Mr. Street enter the cabin from the starboard, aft entrance and begin the obligatory small talk.  Then, the food is served, Caribbean lobster and conch, and they get down to business.

Mr. Yu: "Ok...here's the thing.... I've got about US$2 Billion RMB I need to move. I need FOREX Swaps, forwards & Repos at my discretion.  Dollars & Euros for RMB today.  You get your Dollars and Euros back down the road.  I don't want loans.  It's gotta be OBS.  What can you guys do for me?

Mr. Money:  "Well....what the hell are we going to do with RMB?  It's toilet paper."

Mr. Yu:  "I'll give you 2% over Libor and two more points up front to do the deal."

(Silence.....they are all thinking they can find a cheaper way to hedge the RMB & lay off the FOREX risk.  They can probably swap the RMB back for Dollars or Euros in Hong Kong.)

Mr. Street: "Libor plus 2 to hold your cash?....and two points up front?  Really?  All OBS? What's the term?"  

Mr. Yu:  "Five years"

Mr. Sacks:  "I'll go one."

Mr. Money:  "I'll go six months."

Mr. Street:  "I'll go one.."

Mr. Yu:  "Three years or no deal....I've got other options."

Mr Sacks, Mr. Money and Mr. Street:  "Done....three years it is."

Mr. Yu: "Agreed.  Gentlemen, It's been a pleasure doing business.  We'll wire the RMB tomorrow & expect your return dollar wire same day.  On your way out would you mind asking the guys from CITI to come aboard?  They should be waiting on the dock.  I'm a busy man...."  

I'd suggest that variations of this hypothetical conversation have taken place on yachts, at country clubs and in offices in the Caymans, BVI, Bermuda, Luxembourg, Hong Kong, Singapore and all over the planet like they never have before.  Like our old friends, Mortgage Backed Securities (MBSs), Collateralized Debt Obligations (CDOs) and the linked Credit Default Swaps (CDSs), the OBS Forex Market and the misunderstood risk associated with these contracts will be ground zero for the (next) upcoming financial crisis.

Let's be clear.  There are only two (2) Reasons to participate in FOREX Swap/Repo/Forward transactions.
  1. Insulate other transactions from foreign currency risk.
  2. Speculation.
For those of you who need a quick refresher course on FOREX Swaps here are a couple of sentences describing same for the purpose of this post.  Mr. Yu above is willing to "Swap" the notional value (today's value) of US$2 Billion RMB for the same value in US Dollars.  In three years (by agreement) Mr. Yu will "Swap" the same dollars he held back to the Caymans Bankers in exchange for the same RMB he pledged as collateral.  In essence, the Swap is an OBS (Off Balance Sheet) loan of US Dollars, secured by the RMB he "swapped".  Mr Yu is willing to pay interest on the RMB and the Caymans Bankers are willing to pay interest on the swapped dollars at the prevailing or negotiated rates.  Mr. Yu is now able to use the dollars as collateral and lever up on other US/European Assets.  The US$2 Billion RMB (notional value) is now converted to US$2 Billion of dollar collateral sitting in the Caymans.  Depending on how aggressive Mr. Yu is, if he's operating on a capital ratio of 20% he can lever up, loan out and invest US$10 Billion.  Because the transaction is "Off Balance Sheet" the only reporting required is that the notional value (in aggregate) must be reported in the financial statement footnotes.  i.e.) He still has bank Capital of the US$ 2 Billion with levered bank assets of $10 Billion.  The expenses associated with the transaction would be:1.) Net Interest paid on the Swap.  2.) The gain/loss on the notional value of the Swap as the currency is marked to market.

For an illustration of just how significant the exposure to Swaps/Forwards/Repos/Derivatives can be, I'd refer you to the post I published three years ago entitled "Why Genius is about to fail.....Again....."   

In that post I focused on the fragile, opaque, insufficient capital structure of America's big banks.  When we look at the "Big Three" custodial, global banks (JPM, State Street and Citi) we see that OBS activity for all derivative classes (FOREX, Interest Rate and Equity Based Contracts) and the related exposure continues to increase geometrically.
  • JP Morgan Assets Under Custody $23.469 Trillion (12/31/17) up from $16.120 Trillion 12/31/2010 (10-K - Page 66)
  • Citi Bank - Assets Under Custody $17.4 Trillion (12/31/17) up from $12.6 Trillion 12/31/2010   (10-K - Page 24)
  • State Street - Assets Under Custody (12/31/17) $33.12 Trillion up from $21.5 Trillion 12/31/2010 (10-K - Page 2)  
The Off Balance Sheet (OBS) notional inventory/exposure for the AUC held be the three (3) banks above has increased by 50%, to US$74.02 Trillion up from US$50.2 Trillion.  Again, let me be clear, there is no detail provided whatsoever, other than the GAAP reporting requirement to disclose that the notional amount in aggregate.  Investors have no idea what the US$74 Trillion consists of.  Of course, it shouldn't have any impact on the profitability of the banks, because they are custodial assets.  The only thing we know for sure is that these assets exist, and whoever owns the assets would naturally absorb the valuation risk. 

Note that the 10-K's of JP Morgan, Citi and State Street all have very clear boiler plate language stating that they are very conservative and don't speculate on these OBS assets.  Like the casino operator, apparently they are just facilitators for someone else's speculative addiction.  So that should at least make us feel a little better about all of this.

How much of it is RMB exposure?  Of course we'll never know until it's too late.  No matter how you look at it, the activity, and hence the risk and exposure (to someone) is growing much faster than we can possibly understand.

However, as you also might suspect, unlike our friends at the Treasury, who would probably respond to a car jacking by requesting that the perpetrators "Please stop waiving that gun in our face, and, if at all possible, when you're done with my car, if you could return it with a full tank of gas I'd be grateful....no hard feelings!"...... based on just about every document prepared by the CPC, I'd suspect that the Chinese government has a great deal to do with the gigantic increase in OBS Assets. 


Holy Cats!....Forex Swaps...Would Ya Look at That!

Probably the best source for data on Off Balance Sheet Assets (Forex Swaps) is the Bank of International Settlements.  Last fall, (September 2017) the BIS published a thought provoking report entitled FX swaps and forwards: missing global debt?

The focus of the report is, as I've described, that the volume of these Off Balance Sheet transactions (and the related risk) continues grow at an unprecedented pace.  Here's my favorite chart:




















We observe, as of the end of 2016, open FOREX swaps (notional value) stood at roughly US$ 60 Trillion, nearly doubling from 2009.  About 75% of the contracts were one year term (or less).  i.e.) the contracts have to be closed out or rolled over within a year.  Roughly 60% of the contracts are written/held by non-dealer counter parties.

Now let's take a look at the most current data (12/31/17).

   
When we look at the most current data (12/31/17) we see that total Forex Swaps have increased to US$76.438 Trillion (US$50.487 Trillion + US$10.679 Trillion), up roughly US$16 Trillion in just the last year.  Eighty Five percent (85%) of these Swaps (Including Options) have the US$ as the currency on "one end" of the transaction. US$33.5 Trillion or Thirty Eight Percent (38%) of these Swaps (Including Options) have "Other Currencies" reported as a currency on the "other end" of the transaction.  Although not reported, it would be a worthwhile endeavor to determine exactly how much of this "other currency" is relevant and related to Chinese capital flight.  How much of the "Other Currencies" is RMB?

Final Thoughts

Don't get me wrong.  The Treasury (like the SEC) has an abundance of brilliant, capable, experts who have access to detailed transaction data and are fully capable of investigating this.  Our only hope is that the "Everything is Fine....China is NOT a Currency Manipulator" Treasury Report is a public head-fake intended to give confidence to naive, main street investors, while the Treasury is actually "all over" this, working behind the scenes to unwind this mess and minimize the damage. 

On the other hand, if there is actually no covert, behind the scenes effort by the Treasury to unwind this, and they really don't see any of this coming, the "Don't Worry....Everything is Fine.... China is NOT a Currency Manipulator" US Treasury Report to Congress is the equivalent of Freddie Fleet shouting from the crows nest of the Titanic.... "Hey guys....I think I see a few ice cubes floating ahead.....I sure wish I had some data on it ...nothing to worry about though....full speed ahead!"

It should also be crystal clear now that, like the freeze up of the credit markets back in 2009, as the CPC deleverages, there will be an ever increasing, cleverly disguised pressure on OBS assets, Forex markets and eventually credit markets.  As these Swaps fail to close and the cost to roll them over becomes prohibitive, like Lehman's plight, nobody will want to play in this sandbox, the Swaps will default and US institutions will be left holding the bag.

The RMB exchange rate will finally reset and much of the paper wealth of the world, which has been artificially created over the last half decade will be destroyed.  A significant portion of this fake wealth has already been transferred to China through this con game.  The CPC has managed to print fake currency and exchange it for hard assets, businesses, real estate, ghost cities, infrastructure, transportation, intellectual property, industrial know how on the mainland and, according to the US Treasury, some portion of the $35.7 Trillion of US Assets held by foreign owners, along with, I'd imagine a comparable proportion of European, African and South American assets.  This is the mother of all contagions building and it can't possibly end well.






Additional Reading:

Japan China Swap Agreement
https://uk.reuters.com/article/uk-china-japan-agreements-swap/china-japan-sign-three-year-forex-swap-deal-of-up-to-30-billion-idUKKCN1N00GN

State Street Assets Under Custody (9/20/18) $30.12 Trillion up from $21.5 Trillion 12/31/2010
https://www.sec.gov/Archives/edgar/data/93751/000009375118000471/exhibit992-3q18earningsrel.htm

JPM Assets Under Custody $23.469 Trillion (12/31/17) up from $16.120 Trillion 12/31/2010
https://www.sec.gov/Archives/edgar/data/19617/000001961718000057/corp10k2017.htm

Citi AUC $17.4 Trillion (12/31/17) up from $12.6 Trillion 12/31/2010
https://www.sec.gov/Archives/edgar/data/831001/000083100118000040/c-12312017x10k.htm

Swaps BIS Stats
https://stats.bis.org/statx/srs/table/d5.1?p=20172&c=

China Uses Swaps Market to slow RMB slide
https://www.wsj.com/articles/china-uses-lower-profile-swaps-market-to-slow-yuans-slide-1533654315

The first time I taked about this is in my post....
https://deep-throat-ipo.blogspot.com/2015/10/why-genius-is-about-to-failagain.html

China Japan FOREX Swap Deal
https://uk.reuters.com/article/uk-china-japan-agreements-swap/china-japan-sign-three-year-forex-swap-deal-of-up-to-30-billion-idUKKCN1N00GN

Sun Yu - BOC - Chief Overseas Business Officer
http://www.boc.cn/en/investor/ir6/201504/t20150402_4830131.html

Bank of China -  America Branches
http://www.boc.cn/en/aboutboc/ab6/200812/t20081216_494260.html

UST Report
https://home.treasury.gov/system/files/206/2018-10-17-%28Fall-2018-FX%20Report%29.pdf




7 comments:

  1. I don't understand why would banks go under as you specified that OBS activity doesn't impact profitability.

    At the same time I also don't understand why bankers in the Cayman/Luxembourg/HK...would allow Mr. Yu to lever up knowing full well that "RMB is toilet paper"

    ReplyDelete
    Replies
    1. Re: #1 someone bears the ROL on the OBS.....but the custodian doesn't.

      Re: #2 there's always a greater fool....until there isn't.

      Delete
  2. In Fed Z1, LA264104005 series, foreign borrowing has been at its max since Trump came to power, $400-500bn annualised with Q2 this year soft. If the China bank needed local funding in the US is should show up here right?

    ReplyDelete
  3. Really great analysis. I consistently enjoy your articles.

    ReplyDelete
  4. Of course China manipulates its currency. But under a 2015 law there are three conditions that must exist before Treasury can label them as such
    1) A ‘significant” bilateral trade surplus with the US that tops $20bn

    2) A “material” current account surplus that is greater than 3 per cent of GDP

    3) Persistent, one-sided intervention in its currency market, in excess of 2 per cent of GDP

    While it meets the first one, It does not meet the other two. So Treasury had no choice if it wanted to follow the 2015 law.

    ReplyDelete
  5. Thanks Paul, it sounds like you agree with my thesis/content. I'd suggest that if you and I and the US Treasury were all working to disarm a ticking bomb, that it might be counter productive to begin debate on the definition of "explosion" while trying to determine which wire to cut...

    ReplyDelete