By Jeffrey P. Snider, Alhambra Investment Partners
On April 12, Muhammadu Buhari, President of Nigeria, was in Beijing to negotiate Chinese aid for his ailing country. At home, the government faces an enormous budget deficit largely on the price of oil. The more immediate threat, however, is that Nigeria in large part due to oil prices is being squeezed by monetary shortage. The country is an import-heavy nation and is thus dependent upon dollar availability for that trade. That includes China, Nigeria’s largest single source of imported products, so it makes sense that Buhari would reach for currency relief from the Chinese.
It came in the form of an announced currency swap. Details are still a little short (pun intended), but in some ways, especially intermediate and longer term, the arrangement is all that matters. For Nigeria, the nation’s companies will be able to buy from China in yuan, as Industrial and Commercial Bank of China, the largest Chinese bank and state “owned”, provided both the swap basis and another loan offer. In other words, the Nigerian central bank now has an account with ICB with likely tens of billions of yuan in it.
Most commentary surrounding the swap has indicated an expectation that it will help with Nigeria’s exchange problem, lessening the need for dollars in trade. That might be true in the very short run, but I strongly suspect there is much more here and that it tells us a lot about China and the dollar perhaps far more than Nigeria.
The problem of perceptions about these sorts of arrangements starts with misperceptions about the structural nature of these sorts of arrangements. Viewed from the traditional format of foreign exchange and banking, these appear to be solid commitments of more “flexible capital” flow. From the wholesale perspective of the eurodollar ground, territory that China is not only familiar with but it may even now spin its central axis, the entire story changes.
We see this a lot within other factors related to wholesale eurodollars and specifically the “global dollar short.” For example, when swap spreads first turned negative last year it was thought a benign issue of corporate issuance; when spreads compressed even more negative and showed that they would stay that way, the corporate issuance theory remained as a limp excuse but mainstream commentary was forced to at least acknowledge some of the more obvious correlations (even though they thoroughly refuted the corporate issuance theory).
In an article published by Bloomberg in January under the title Swap Spreads Are Falling Again, And Analysts Are Blaming China, the authors make the connection in general terms without understanding exactly what it meant or how it was.
While new sales of corporate bonds tend to be a driver of swap-spread tightening in January—traditionally among the year’s busiest months for new investment-grade deals—investors have also pointed to foreign central banks’ selling of U.S. Treasuries as a catalyst for the recent fall. The speculation comes as data released on Thursday showed China’s stockpile of foreign reserves shrank by a record $108 billion as the country fought to stem a decline in the yuan.
That was about as much as the article offered in terms of explanation and that is likely all that the authors received from “analysts.” In other words, they noticed both sides of the same coin (pun intended) without connecting the distinction of them. We have China “selling UST’s” while swap spreads are “unexpectedly” negative, providing both an indication of “dollar” demand and supply, the missing pieces in the traditional format. The PBOC “selling UST’s” is the bright, shining signal of desperate demand for wholesale “dollars” and the negative swap spreads the same flashing warning about the troubling reluctance of global eurodollar banks to supply them. That all of this occurred when global markets were surrendered to persistent and steady liquidation is the delivery of the consequences of this wholesale disarrangement.
In many ways, the Bloomberg article is written from the perspective of shocked almost disbelief that is only considering these other whispers because there are no other explanations left – the worst of which was Janet Yellen’s idea of plentiful dollars through Fed balance sheet expansion and a continued expectation for a healthy recovery globally. A full part of that suspicion stems from the still-unknown nature of China’s “dollar” connections, including its own participation in the eurodollar system via a synthetic short position.
Even when the idea of China’s short is allowed, it is still mistaken under traditional terms (such as “hot money”) that imply again “capital flows.” The wholesale version is far more nuanced and presents not just difficulties in perceptions but alterations in function and thus provides very different implications. For example, in the years just after the Great Recession, financial disparities and structural changes in China led to the growing use of currency swaps to fund international activities inside the country. As Reuters noted in July 2013:
Multinational companies said that they could raise more money, more quickly and more cheaply by borrowing in dollars and swapping the money into yuan than if they borrowed directly in yuan through the offshore yuan-denominated bond (Dim Sum) market in Hong Kong.
“We swap from euros into renminbi for the maturity we want, which is a very straight forward treasury technique and that means we can have a fixed rate interest loan into China,” said a regional treasury head in Asia at a multinational firm who declined to be named as he was not authorized to speak to media…
Another treasurer at a multinational company with extensive operations in China said he could raise 10 times as much in international markets than he could in the offshore yuan bond market, which was another reason to borrow in dollars and swap into yuan.
From the perspective of traditional exchange accounting, these dollar loans show up as foreign direct investment or “hot money.” In wholesale terms, these are not just a “dollar short” but doubly so. The first “short” occurs when the multinational takes the loan (which is assumed to be “capital” under traditional perceptions) and the second with what happens next. In a currency swap, the multinational deposits the dollars with a Chinese bank in exchange for yuan with the exchange rate for the principle settled for both the upfront and back end (maturity). The textbook claims that this removes currency risk, and on the surface that appears to be the case. In practice, however, it is much different.
The multinational firm takes its yuan loan and does whatever it does while the Chinese bank takes its dollar loan to fund other dollar operations, a source of dollars to keep open the long ago established and existing “dollar short.” If both parties simply “invested” their end of the proceeds in single transactions, the textbook would be correct. In other words, if the multinational used the yuan loan to buy yuan-denominated corporate bonds of the same maturity, when the swap unwound it would all be as the textbooks claim. The same of the Chinese bank and its dollar end; if it invested those dollars in US treasuries or some US corporate, even Chinese Dim Sum bonds, then the unwinding of the swap is free from all complications and further decisions (it is stylized this way as to be entirely predictable, which is how these financial products are sold).
In truth, neither the multinational nor the Chinese banks have the currency upon maturity. This is where rollovers become important not just in technical terms but as a key element of actual liquidity. If a multination took at a three-year dollar loan in April 2013 and then engaged in a yuan currency swap as proposed above, it would be expiring right about now. That leads to a decision point as to whether to rollover the swap or end it; it is not a neutral proposition as there are further costs in either direction. That starts with the very first problem as to the nature of the multinational’s yuan activities; if it is true direct investment into productive capacity, then it is by definition illiquid and thus does not provide the immediate financial resources to unwind the swap. It is likely that the multinational timed the maturity of the swap to expected cash flows from the illiquid investment, but what would happen if China’s economy, for example, “unexpectedly” declined and cash flows never materialized? Thus, the multinational is forced to convert, if it decides against a rollover, the swap-based loan to an internal RMB loan (of which there are many further complications).
Primarily, however, the issue will likely revolve around currency “cost.” In April 2013, the CNY exchange was appreciating from about 6.20 to as high as 6.12 by that June (which meant that it would have made more sense to buy a 3- or even 6-month RMB forward and a related currency swaption for around that maturity, but I am getting too far ahead). If we assume that the price of the swap was 6.17 and the principle value was $100 million, that means upon maturity in April 2016 the multination is expected to deliver RMB 617 million, which is exactly the same amount as it received three years earlier. To rollover the swap, however, would require a refiguring to the current exchange, which is 6.50 to 6.46.
Therefore, to rollover the same arrangement now costs the multinational a further RMB 30 million or so (or the financial equivalent in arranged basis costs). From that view of decision-points as liquidity factors, you can see why the PBOC has a vested interest in keeping the exchange rate not just stable but actually appreciating from current levels. To not do so would mean prior swap maturities facing these very same kinds of considerations and calculations, for if the difference is too much and the multinational decides to unwind at maturity the “double short” gets actualized.
If the unwind happens, then the multinational has to find RMB for its part while the Chinese bank counterparty has to find dollars. They may have agreed to the exchange value upfront but that does not consider what the actual costs of delivery might actually be especially if funding markets in both are decidedly irregular and tight. In general terms, unwinding the swap puts liquidity pressure on both “dollars” and RMB (tighter external = tighter internal). It looks like “capital outflows” because the point of perspective is all from internal China, but at conclusion it all just disappears including the original dollar loan to the multinational (the “dollars” don’t outflow from China to somewhere else, they exit the swap and are extinguished into the long eurodollar night).
And all that is really just the beginning of China’s complications, as the real pressure point is on the Chinese banking system to deliver dollars on these double shorts. In practice, as we have seen in at least three cycles now dating back to last March and April, the PBOC ends up providing some sort of “dollar” resources so that the Chinese bank can deliver dollars on swap maturity. “Selling UST’s” is really just a euphemism for various potential efforts that can actually include actual selling of UST’s – but is more likely some form of forward cover. Without getting too far into that, forward cover is really just a subsidy for Chinese banks (or whatever nationality undertaking this program to deal with an unwinding “dollar short”) to be able to borrow more “dollars”, making them even more short.
Again, this is reflected in the exchange rate as an indication of liquidity difficulty and these kinds of continued decision points. What that means is that the PBOC then absorbs some or all of the original “short”, the “dollar supply” provided by the original dollar loan to the multinational that was furnished to the Chinese banking system through the swap (or it may even be a triple short by this point). Both the Chinese bank and now the PBOC have to source “dollars.”
So when the PBOC decides that outward appearance of calm is enough verification to suggest it all worked, it begins to unwind its end of this “double short” which can only further pressure the wider eurodollar world. What happens, for instance, to Chinese banks that were more short because of the temporary subsidy? If the exchange rate or liquidity costs have normalized relative to whatever necessary baseline, then in theory it would be an orderly unwinding but still an unwinding. If, however, that is not the case and Chinese banks lose that subsidy into a more high cost or continued disruptive condition they are going to unwind as fast as practicable by bidding for “dollars” at whatever cost in CNY they have to – forcing CNY down and even more decision points on past swaps and other wholesale arrangements, which adds even more pressure to the double dollar short and so on and so on. All “capital outflows” that are not that.
It answers why “selling UST’s” and negative swap spreads might be so correlated, and includes for good measure the more obvious correlation between CNY “devaluation” and global liquidations. And it begins to answer why the Chinese might be so interested in Nigeria.
One of the primary reasons for China’s corporate/banking dollar short to begin with is oil. China had one of the largest merchandise surpluses in human history, which under traditional understanding seems to suggest that there should be no dollar short at all; the export sector brings in more than enough dollars to fund any import needs. But that ignores, again, wholesale and financial reality which is that there is no direct method between exports surplus and import payment. The very fact that it is the PBOC that ends up with foreign “reserves” is all you need to know on that count. The reason China was able to build up such a large dollar short was its reserve position, as eurodollar banks were led to believe (as one “lesson” of the Asian flu) that such huge piles of “reserves” were insurance against instability (the empirical refutation of that theory is yet another reason for what we observed last year and still this year).
If the import sector is still short the dollar no matter the export conditions, under persistent and severe “dollar” strain it makes perfect sense to undo as much of the systemic short as possible – including buying as much oil as attainable in yuan rather than dollars. Under the proposed terms of Nigeria’s swap China will be able to denominate buying of Nigerian crude in RMB. At present, the Chinese do not actually get much from Nigeria, so this appears to be an attempt to start moving in that direction.
There is also another angle to consider, one which does not even require any infrastructure commitments or expenses to move oil to China from Nigeria. The Chinese could, if pressed, purchase Nigerian oil on their own RMB terms and then immediately sell it in global markets where it already likely exists. In return for those sales, the Chinese would receive dollars, effectively converting RMB to dollars via what was really Nigerian collateral (in theory, the Chinese could just use the oil as dollar collateral, too, after having purchased it via RMB).
Nigeria, for its end, would get yuan but the country still needs more dollars and now they may have just shut off one avenue of flexibility with regard to their own dollar short (which is more of the mercantile, traditional variety).
“Buhari spent half the time he was in Beijing saying he wants closer ties with China and the other half saying Chinese firms cannot see Nigeria as a consumer market and that trade relationship is currently imbalanced,” said John Ashbourne, Africa economist at Capital Economics in London.
If the Chinese are not looking at this swap program as an opening of Nigerian consumer markets to Chinese goods (that are already there), what is their motivation? Some will say it is Chinese nationalism, to replace the dollar system with a yuan system. Maybe, but they have to survive that long first and they will need a lot more “dollars” to do it. That means navigating so many more decision points of possible greater illiquidity and potential “outflows.” It tells us, I think, a lot about China but perhaps more the state of the eurodollar world where shortage is the dominant theme. Everything is imbalanced, which means take advantage of any imbalances that might be in your favor. Nigeria is more desperate right now than China.