Here is the article
http://www.debtorsprisonblog.org/journal/2010/3/4/urc-ii-the-chinese-central-bank-balance-sheet.html

Greetings Fellow Inmates:

In this second installment of Underground Reporting from China (URC) we will be looking at the backbone of Chinese finance and economy: the central bank balance sheet. As you might well expect, there are a variety of substantial differences between the Chinese banking system and that of fully "liberalized", “developed” economies. As always, the first step to any problem is to properly define all variables, systems and parameters. We will attempt to give you a succinct view of the workings of the Chinese system and when and where they differ from other notable economies, primarily the US. Again, much of this research was conducted through a thorough review of publicly available information, as well as personal data gathered through your correspondents’ travels through China. As a case in point, which we briefly touched on in URC I, you can buy an unlimited amount of gold at your local bank, regardless of the amount of money in your account. This is a very simple yet enormously important point that you would never hear about from the mainstream media in the west. Similarly, an on-the-ground view permits observing many other perspectives and exploring many nuances that contain, in and of themselves, deep repercussions, as in the gold example. Today we will begin by looking at the Chinese central bank, the People’s Bank of China; how it works, what it has been doing recently, touch upon implications for the present and future and lay down some basics for URC III: The Chinese banking system.

The Chinese banking system is, in effect, almost completely controlled by the State. While some market mechanisms and forces have been allowed to reign free, at least within a band, the banking system is the main monetary/economic tool at the government’s disposal, as in any other country really. It’s important to keep in mind that the People’s Bank of China (PBoC), is relatively infantile in its current form (as opposed to Uncle Benny and Co’s nearly 100-year old Fed). The State Council announced that the PBoC would serve as the central bank of China in 1983, and was legally confirmed 12 years later in 1995. In its first 15 years the PBoC has become the public finance institution with the most assets in the history of the world. While we have spent an inordinate amount of time dwelling on Uncle Benny’s adventures, since he is the master of the world’s reserve currency, the PBoC is an equally formidable force shaping today’s econoGaia. Perhaps even moreso given its relative obscurity and alleged lack of transparency. For that reason alone it is about time we look at some of the workings and stats of this behemoth. All the following data was obtained from the PBoC’s website itself, so it is the ultimate source. Let’s begin by looking at the PBoC balance sheet, in the last half of 2009. You can download all the following charts in XLS format here.

The first thing we notice is that at the end of 2009, PBoC’s balance sheet (PBoC BS) had a gargantuan size of 22.75Tr RMB, or 3.37Tr USD. This is 45% larger than even Uncle Benny’s greatly bloated FedBS. As we always advocate, it is important to get grounded in the Numbers first; don’t let enormous sizes fool you, record them, compare them and think! Though size is only one of many variables, we must, as a bare minimum, dedicate serious contemplation to the role the PBoC’s balance sheet currently plays in the world and some plausible deductions of the role it might play in the coming unwinding. For those of you that have yet to develop our passion for central bank balance sheets, we point out the following fact. Much of the size of the PBoC’s BS comes from the “Foreign Exchange”, which makes up about 77% of the BS, or about $2.6Tr. All those US Treasuries (USTs), Euro Bonds, Gilts, and Yen the Chinese have bought are all sitting right here. Let us say it in different words: The main monetary engine behind the industrial production of the past decade is RIGHT HERE. It is, after all, the money the Chinese earned through making “widgets” that they then turned and lent back to the developed countries so they could buy more of their widgets, ad nauseum. This one Number, the Forex reserves on the PBoC’s BS, is of fundamental importance to correctly anticipating, and then navigating, the coming Dollar Event Horizon (DEH). Once USTs become worthless, then the whole asset side of the PBoC’s BS disintegrates, making the corresponding liability side of the BS effectively worthless.

Let’s remember, as we’ve told you many times before, that the liability side of the BS is equally important as the asset side. We notice that Deposits of Financial Corporations make up the bulk of the liabilities, with approximately 45%, followed by Bond Issues (19%) and Currency in Circulation (19%). The Deposits of Financial Corporations are analogous to the Excess Reserves held by Uncle Benny. So, in this respect, the PBoC has behaved very similarly to the Fed: buying up a bunch of long-term assets, mostly US debt, and funding those purchases by electronically creating more deposits for the banks in the system. Of course, the main difference is that the Chinese are buying assets denominated NOT in their currency; so they might be excused for being “naïve”, or getting “swindled”. Uncle Benny, on the other hand, is blatantly monetizing the US debt. Now, it is not our intention to excuse either party, merely to compare and contrast them. The “Bond Issues” on the other hand are what are known as “sterilization” devices. In order to “soak up” some of that excess money China makes exporting (by buying foreign bonds), they issue RMB bonds so that the liability side grows in tandem. The reason why this is called “sterilization” is because it’s supposed to “neutralize” the inflationary effects of an influx of foreign capital by absorbing some of the extra RMB this creates through bond issuance. We have long looked askance at “sterilization” procedures for a variety of reasons, even before the crisis. The full argumentation for our skepticism will be reserved for a future post or for The Book, but for now we simply point out that a sterilization that requires exchanging one currency for another necessarily creates FX risk. Normally, this can be considered negligible, but it certainly won’t be once the enormous imbalances between the US and the RMB begin to explode. In effect, we believe that these “sterilization” mechanisms are nothing but accounting entries meant to enable the PBoC to buy up more US debt and will be largely inconsequential when SuperInflation hits worldwide.

Finally, the currency in circulation makes up only 19% of total liabilities, compared to 45% for Uncle Benny. A cursory explanation for this difference immediately offers itself. A big part of the world transacts in USD, even at the individual level when travelling for example. Rarely does anyone use RMB outside of China, if at all. Then, it seems natural that a higher-percentage of the liabilities in the FedBS would be composed of physical currency as compared to the PBoC BS. While this makes sense, it doesn’t seem like “the whole story” to us. In addition, it poses very important and interesting questions about these two currencies, the USD and the RMB, and paper currency itself. It is easy in this day and age to get bamboozled into thinking that “digital money” is exactly the same as “paper money”. Granted, they are very similar, both founded on the same rotten principles, but they are NOT the same.

From a purely “financial” perspective, we can easily say that having cash eliminates the risk of having your money “locked away” in some sort of bankruptcy, bank holiday, or any other freeze. Of course, you incur the opportunity cost of non-perceived interest, but in these zero-interest-rate days, this cost is minimal. There is also the difference between different “tiers” of the economy, where the “bottom” deals almost exclusively in cash and the “top” almost exclusively digital. So, for most events, even High Sigma Events (HSE) such as the Great Credit Catastrophe of 2007-2009, the holder of purely cash at least has a diminished financial risk from getting caught in the MoneyMatrix. Of course, it makes sense that those that make less use of the system are subject to less systemic risk. Nevertheless, in the case of an extremely HSE, as the DEH will surely be, everyone will be dragged along with it, even cash holders. This is due to the simple reason that we all participate in the fiat paper system, so once the currency unit (whatever it is) is greatly devalued versus real assets, everyone suffers.

The reason we elaborated on this difference between cash and digital reserves is because it might shed some light on how differently the DEH will be felt in China versus the US (or the other “reserve currency economies” for that matter). Both the FED and the PBoC are saturated with toxic assets, primarily composed of long term US debt. When the “assets” become greatly devalued (they are not marked-to-market, which introduces a difference to be dealt with later), the liabilities will become worthless. Only 19% of the PBoC’s liabilities are cash, as opposed to 45% for the FED, giving the former greater leeway to “play around with the computer” before killing the cash. This fact alone, would lead us to believe that the average Chinese citizen will be better protected than the average US citizen when DEH hits. Is “better” enough to survive? We don’t know, but we do like to take any reduction in risk, wherever we can.

We thus conclude this initial window into the inner working of the great Chinese economy. A simple exploration of the PBoC’s BS has revealed many interesting similarities and differences between the East and the west. The PBoC hardly seems like the conservative monetary stalwart it is made out to be. In fact, their monetary adventures even dwarf Uncle Benny’s in total size. This, in and of itself, makes us weary and distrusting of the PBoC, not to mention their participation in the Group of 30. There are however, some differences in the BS, that lead us to believe that the PBoC’s BS poses somewhat less risk for holders of RMB than the FedBS poses to the holders of USD. But in today’s world of circularly and nonlinearly interacting forces, this might end up being a moot point. Tune in to our next post, where we will be looking at the details of the banking system: how this PBoC BS eventually trickles down to the economy at large and what it does once it’s there.

May your capital be safe and your investments prosperous,

MAAA