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Streetwise Professor

August 30, 2010

When the Head of the Chinese Central Bank Makes An Airport Trade

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:17 pm

Ruh-roh.

An airport trade is when somebody puts on a trade far bigger than he can afford.  He then heads to the airport with a one way ticket to a foreign nation, preferably one without an extradition treaty.  If the trade is a winner, the guy enjoys a blowout vacation then returns as the conquering hero.  If the trade is a loser–well, welcome to Margaritaville.

There are rumors ricocheting around the internet and news that Chinese Central Bank Chairman Zhou Xiaochuan has defected to the United States.  The original version of the rumor, according to Stratfor, related to a huge loss on Chinese investments in US securities:

The rumors appear to have started following reports on Aug. 28 which cited Ming Pao, a Hong Kong-based news agency, saying that because of an approximately $430 billion loss on U.S. Treasury bonds, the Chinese government may punish some individuals within the PBC, including Zhou.

Uhm, no.  Completely implausible.  US Treasury data show that in mid-2009, China owned about $760 billion in Treasuries, and about $450 billion in agency securities.  There is no way that it could have lost $430 billion on these positions, obviously.  Especially since Treasuries have been up recently.  Indeed, people are speaking of a Treasury bubble.

To lose huge money on Treasuries in this market you’d have to be short.  Friend and frequent commentor Charles does a quick back of the envelope calculation, and figures that somebody would have to be short about $4.5 trillion in Treasuries.  Zero Hedge calculates $3.5 trillion.  Either way, no way.  Like anybody could put on such a position with nobody knowing.

But Zhou hasn’t been seen.  Internet searches on his name have been blocked in China, as have websites carrying the rumor.  The rumors of  defection are flying fast and furious.  Chinese repo rates spiked.  There’s smoke, so what’s the fire?

One story is that this is all part of a power struggle in the leadup to a transfer of power in 2012.  Given the opaque nature of Chinese politics, this is plausible.

But here’s another, more ominous possibility.   Helicopter Zhou has overseen massive injections of liquidity into the Chinese market to fight the financial crisis.  There are widespread worries about a housing bubble, and the cracking thereof, with disastrous consequences for banks.  Similarly, there are myriad reports about massive quantities of bad loans, including huge amounts to local governments.  The recent bank “recapitalization” plan, which seems to have more in common with a three card monte game than a real recapitalization, only adds to concerns.

Put all this together, and it is plausible that Zhou has realized that the whole structure is on the verge of collapse, and that he is the natural fall guy.  So, he’s getting out while the getting is good.  The biggest airport trade, ever.

This bears watching.  If the rumors are true, and his defection/departure has anything–anything–to do with a deteriorating financial and economic situation in China, we are all in for a hell of a ride.  What exactly?  Who knows?  Commodity prices would likely crash.  But beyond that, given the opacity of the Chinese economy, financial system, and political system, it’s difficult to know how they would react and what the effects of their actions would be, either in China or the larger world.

Keep your eye on this one.

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11 Comments »

  1. [...] Streetwise Professor: When the head to the Chinese Central Bank makes and airport trade [...]

    Pingback by Tuesday’s Caught On The Web - The Source - WSJ — August 31, 2010 @ 2:50 am

  2. The fact that such an amazing story has not been fully discredited makes one have to believe something is going on in the political leadership and banking sector in China. My initial reaction was that if any central bank was speculating in the markets, it would be incumbent on the G20 finance ministers to speak up and state that financial speculation is not a proper activity for a central bank. Sadly, I have such little confidence in Timmy! that I could imagine a foreign central bank could indeed be massively speculating in the U.S. treasury bond market and he would have no clue.

    The markets have certainly discredited the rumor, but something is going on over there. For some time, I have been waiting for the first cracks to show in the Chinese banking sector. China has avoided dealing with its bad loan problem way too long. China lacks a local tax structure to allow municipalities to pay for public services. This has to change. Allowing local governments to speculate in real estate development to fund public services is sheer insanity. Structural reforms are badly needed in China and it looks as if something big is going to happen before the powers that be are forced, kicking and screaming, to implement those changes.

    I simply do not believe China will be able to manage the complexities of the world’s second largest economy with a third world financial structure and without offering the transparency needed to be an integrated global player. I am quite interested in seeing what is actually going on within the Chinese central bank and how it changes China.

    Comment by Charles — August 31, 2010 @ 9:42 am

  3. I’ve seen some references to this being a loss related to Fannie and Freddie, but the articles were all related to equity investments (which makes no sense). Is it possible that these are losses in some tranches of US mortgage debt that had been insured by Fannie and Freddie. It would have to be epically horrible luck, as most tranches have rebounded from their lows. No way the PBOC would invest in that garbage though, right?

    Comment by Jack — August 31, 2010 @ 9:59 am

  4. @Charles–you and I have been waiting together, I guess. They have been papering over–literally–their fundamental financial weaknesses. That can only go on so long, and that’s the issue that I would place odds on as the real problem that stoked this kind of rumor. The substance of the rumor is for the most part immaterial. The fact that there is any viral rumor that is so critical of so important an official is what is interesting.

    Churchill mentioned the dogs fighting under the carpet in the USSR. This is a similar sort of thing.

    The ProfessorComment by The Professor — August 31, 2010 @ 10:53 am

  5. Looks like this rumor has been resolved. STRATFOR just made a blooper ;-)

    Comment by Surya — August 31, 2010 @ 7:30 pm

  6. Are there reliable figures on bad loans in China – i.e., what % of the total?

    And, of course, compared with those in the US and Europe?

    Comment by Sublime Oblivion — August 31, 2010 @ 10:49 pm

  7. The scariest aspect is the question as to what will happen if China tries to unload its position in US securities to cover its budget deficit. This can lead to the spectacular bursting of the US securities market bubble that wojulde make the Great depression seem like fat times. Time for average Americans like myself to start thinking where to put our life savings…

    Comment by Ostap Bender — September 1, 2010 @ 7:30 pm

  8. Go on Ostap the Bender, put them in Russian bonds, I dare you.

    Put your money where your mouth is!

    Comment by Andrew — September 2, 2010 @ 8:24 am

  9. @Ostap,

    If the Chinese decided to dump their holdings of U.S. treasuries, the market would sniff it out in seconds. Once the players who were big enough to handle size as counterparties would back off the bids and the Chinese would soon be hitting bids that were at pennies on teh dollar. Once the selling ended, the market would soon return to fair value. In other words, if the Chinese wanted to dump their U.S. treasuries, it would result in a HUGE wealth transfer (hundreds of billions) from the Chinese government to large investment banks. The market would not be disrupted for long.

    Comment by Charles — September 3, 2010 @ 11:32 am

  10. @Charles,

    If the Chinese decided to dump their holdings of U.S. treasuries, the market would sniff it out in seconds. Once the players who were big enough to handle size as counterparties would back off the bids and the Chinese would soon be hitting bids that were at pennies on teh dollar.

    Exactly. That’s why the Chinese are stuck: they know that they will never be able to unload their position without losing at least 50% of the current value.

    Once the selling ended, the market would soon return to fair value.

    It’s a tautology. The fair value of a security is its current price, or equivalently the price of the latest transaction (assuming it was not bogus).

    A better question is: at what price would an intelligent investor buy US bonds today. Let’s see… The way it is now, the US government can’t repay all its debt. It’s too huge. But there is an easy solution: print the money. That’s what the US Treasury will do: print $trillions fresh new paper money. This will create a hyper-inflation, devaluing the dollar by 50% to 80% in a matter of a few years.

    The good news for US taxpayers is that this will almost wipe out the real value of the US debt to China and the rest of the World. The bad news is that such a hyper-inflation can be devastating to the economy and to those of us who keep some of their savings in banks, bonds and other fixed income.

    Once the players who were big enough to handle size as counterparties would back off the bids and the Chinese would soon be hitting bids that were at pennies on teh dollar. Once the selling ended, the market would soon return to fair value. In other words, if the Chinese wanted to dump their U.S. treasuries, it would result in a HUGE wealth transfer (hundreds of billions) from the Chinese government to large investment banks. The market would not be disrupted for long.

    So, what you are saying is that if the Chinese try to unload, say, $1 trillion worth of US bonds on September 6, 2010, they wouldn’t be able to get more than, say, 10% of their current value.

    However, in a few days, say on September 8 2010, the going price for these same bonds will be 99% of their current value, right? So, why are Wall Street moguls such idiots that they will refuse to buy these bonds at 11% of face value on September 6, but will gladly pay 98% on September 8?

    You seem to think that Wall Street is not familiar with the concept of arbitrage. Or maybe it is YOU who is not familiar with this idea?

    Comment by Ostap Bender — September 4, 2010 @ 3:20 am

  11. @Ostap

    You wrongly say “The fair value of a security is its current price, or equivalently the price of the latest transaction (assuming it was not bogus).”

    The fair value of a security of the discounted present value of its future cash flows. The market price is the price at which a security can be bought or sold at any moment in time. Understanding the difference between the fair value of a security and its market price is the essence of position trading.

    My point with respect to traders backing off bids if they know there is a dedicated seller in the market that is more concerned with unloading the position and not obtaining fair value is that traders will provide liquidity at the lowest possible price (FYI – Traders trade on govvie desks. There are no “Wall Street moguls” sitting on any govvie desks).

    Arbitrage is immaterial to the equation. Between which two markets are you asserting some trader will be arbing? The price relationship between financial centers or between the cash bonds and the futures would remain constant. Once word got out that the Chinese were dumping bonds, all traders in the marketplace would back off their bids. Its not as if traders in Singapore would be bidding 90 while the rest of the marketplace was bidding 20. Bidding 11 on Sept 6 and offering 98 on Sept 8 is not arbitrage. Its position trading. Are you sure YOU understand the concept of arbitrage?

    Comment by Charles — September 4, 2010 @ 8:23 am

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