My Blog

September 13, 2008

There is still no respite for the Chinese stock market (or, for that matter, of any of the other global stock markets).  On Thursday the SSE composite fell more or less in a straight line, losing 72 points, or 3.3%, rising a single point on Friday to close at 2079.  We are now less than 4% away from 2000, yet another barrier that may not prove to be much of a barrier.

There is no lack of bad news on the economy to drive the stock market down.  Thursday saw the release by the PBoC and the National Bureau of Statistics of another big batch of data, and it seems pretty clear that the economy is slowing, and perhaps very rapidly. 

Industrial output grew by 12.8% year on year in August, versus 14.7% in July, and 17.5% last August.  There was weakness in almost every sector, with iron and automobile production actually contracting versus one year ago.   Clearly the industrial sector is slowing, and this puts all the more pressure on rising consumer demand to keep the economy strong. 

At first glance consumers seemed to be doing their job.  Retail sales, the main measure of Chinese consumer spending, grew by 23.2% year on year in August, slightly less than July’s 23.3% but substantially better than last August’s 17.1%.  This growth, however, may have more to do with Olympics spending than with long-term trends, and we will probably need to see September and October numbers to get a real sense of how consumers are responding, although I suspect these will be excessively low because at least part of July and August’s robust growth in consumption probably consisted of anticipated spending for the Olympics.

Loan and M2 growth were also slightly weaker than expected.  Given the existence of the large informal lending market I am not sure what that means for total loans in the system, and given the complications imposed by a rapidly changing society and a very inefficient financial system, I am not sure how valuable M2 or any of the other monetary aggregates are in explaining money supply.  Sill, I would argue that the continued rapid growth of foreign currency reserves at the PBoC is probably being countered by the sharp fall in real estate and stock prices to represent money growth below what we would have expected (and I wonder if we will soon begin to see hot money outflows).  The fact that loans in the banking system – much cheaper than loans available in the informal sector – grew by less than they could have under the loan caps, suggests that either companies are reluctant to borrow and invest because of concerns about the slowing economy, or that banks are reluctant to lend because of credit fears. 

Neither of these explanations is very comforting.  Morgan Stanly just released a report saying the real estate sector is on the point of an imminent collapse, which suggests even that perhaps both explanations might be true.  Needless to say a collapse in the real estate sector is one of the biggest risks in China.  Not only would it cause havoc in the banks’ loan portfolios, causing a sharp rise in NPLs, but it would contract one of the main pillars of Chinese growth, real estate development.  The one piece of good news is that I have heard anecdotal evidence that developers that reduce prices have seen very strong subsequent demand for apartments and offices, so perhaps the problem is as much one of high prices (which can be fairly easily fixed) as of oversupply (which cannot).

One of the questions I have been getting a lot from my investor meetings in New York concerns the sharp split between rising PPI inflation and declining CPI inflation.  What does this indicate about inflation and financial conditions in China?

I have already indicated my puzzlement in my entry of two days ago that CPI inflation has come down so quickly, and I worry that we may not be capturing all the inflation correctly.  But aside from that, if you assume that PPI inflation is a proxy for rising input prices among corporations, and CPI inflation is a proxy for rising output prices, the tremendous gap between them suggests that corporate profits are going to be killed.  This already seems to be happening, with corporate profits down and most analysts expecting them to decline further.

How do corporations react? I think there are two ways they can react.  First, if they are able, they will raise prices, and so PPI inflation will then cause a subsequent surge in CPI inflation to bring the two back into line.  This is what I always thought would happen, but now I confess I am not so sure.  If the economy is slowing, capacity rising, and demand falling off (although we have not yet seen the third condition), companies will have great difficulty in raising prices.  In that case we may see a sharp drop in profitability and even a rise in bankruptcies, to the extent that the banking system is forced to contract.

One way or the other the system has to adjust to the tremendous monetary expansion of previous years, and there are two ways it can do so.  We can see high inflation, which brings nominal demand and nominal supply back into balance by adjusting prices.  Or we can see an equivalent contraction in the money supply because of a contraction in banking. 

Neither of these is a good outcome, but excess money expansion – as we are seeing, by the way, in the US – must eventually cause something to adjust, and the adjustment is rarely benign.  Historically it almost always consists either of rising prices inflating away the growth in money supply or of a sharply contracting banking system reversing the earlier money contraction through debt deflation.  The key determinant of which path this takes, I think, is the fragility of the banking system and the response of the central banks.

I can’t rally predict which outcome we will see in China.  On the one hand I have been notoriously bearish on the quality of the banking system for so long – and, I suspect, to the annoyance of many of my colleagues in the market – that it seems to me very reasonable to me to expect real problems in the banks that lead to loan contractions and the hoarding of liquidity.  By the way, reducing minimum reserve requirements will have little effect on lending if banks don’t want to lend, borrowers don’t want to borrow, or if informal banks have acted to undermine the impact of lending constraints, which I believe has happened in China. 

On the other hand it is always easy to inflate your way out of trouble, and this tends to be the politicians’ preferred response to a banking contraction, especially in systems with limited central bank independence.  I suspect that in China we may see concerns about unemployment in the short term trump concerns about inflation in the long term.  The point is that if I am right in having argued for so long that we have seen out-of-control money growth in the past few years, we will inevitably have to see an adjustment that is as likely to be a sharp rise in inflation or a sudden debt deflation.  As Robert Frost might put it:

Some say the world will end in fire

Some say in ice

I hate to sound so apocalyptical, but this week in New York everyone around me seems to have been filled with dread, and I – no stranger to worried pessimism, as all my blog readers surely know – am also being infected by the mood.

Comments (19) for "Fire and Ice"

What are the reasons, in your opinion, for the coming slowdown in Chinese economy? Slowdown of exports market? Macro tightening of the central government? Or just plain old business cyclicity? How much does each one of these contribute to the slowdown? By Manch - 9/13/2008 3:12 AM

Prof. Pettis: Are inventories still surging? Is there a free source for one to find these composite data for China? Cheers, Matt By matt - 9/13/2008 4:29 AM

Dear Professor Pettis, Thank you for this great piece of blog entry where we have both a grasp of your thinking and your personal feelings both in clearly expressed manner. I especially liked your comments on PPI vs CPI. Is it getting to a point where the end-market is calling for deflation (massive over-capacities?)? That would certainly explain the behaviour of equity markets. Back to your "fire and ice" question, what are your feelings about Ambrose Evans-Prichard position calling for inflation in the BRIC/South and a deflationary OECDE? As long as monetary adjustments do not take place in a duly manner, that would make so much sense. Possibly the only way for trade terms to balance themselves in a BWII environment. Should your "Some say in ice" occur, aren't we heading for one of the worst scenarii? I understand that the relative weigh of private debts against public one is a key factor for a deflationary output. UK, UK, Spain and, as a small-sized lab and showcase, Ireland are possibly on their way to a persistent credit crunch. The feeling here in France - where we have extremely lively investment forums - is "deflation has started". You can certainly feel the pinch here in Paris already. But why would cash-rich China let such a process take place when they can invest and buy their way - not out of a financial crisis but deflation - through public or semi-public investment, I wonder? By François - 9/13/2008 3:15 PM

Prof. Pettis, There is a third way for corporations to tackle rising expenses without increasing their product prices: use low cost substitutes. We witnessed such case once again in last week's Sanlu baby formula debacle. This is a widespreaded problem now with raw material price so high. By vince - 9/13/2008 10:14 PM

Interesting point about PPI and CPI. But I wouldn't be surprised to see a sharp dropoff in PPI growth. For some reason, Chinese PPI tends to lag CPI, rather than the other way around. Eg the last PPI spike was at the Oct 2004, at 8.4% y/y. But CPI spiked a few months before that, in July at 5.3%. Similarly with the recent run up in prices, CPI started surging first. In August 2007 CPI was 6.5%, while PPI was still flat at 2.6%. By A Chan - 9/14/2008 9:37 AM

Leh and AIG, wow... It must be fun, until it hurts somebody... By fatbrick - 9/14/2008 10:59 AM

this just out: China cuts lending rates by 27bps and cut reserve requirement by 1% for small banks. i suspect the market will not react too much tomorrow as i suspect people just don't want to borrow and the banks dont want to lend. people will prob. just sell into an morning rally and pull down the index later in the day, will see if i'm right. By marcus - 9/14/2008 5:35 PM

Or maybe things will turn out ok in the end. If you are in a situation where if you have a disaster if you move in one direction, and the opposite disaster if you move in the other, then maybe you are actially on the right path. One thing about PPI is that oil prices have dropped very sharply in the last month, and this is going to release a lot of pressure off PPI. But as far as what the world economy is going to look like. All bets are off. By Twofish - 9/14/2008 5:37 PM

Have some more melamine with your milk, Baby! Bon Appetit! By Good4 Pet&Kids - 9/15/2008 1:04 PM

While walking on Wall Street, please mind the jumpers. By Geronimo!!! - 9/15/2008 2:06 PM

If anyone spots Richard Fuld wandering around dazed in New York, or Korea, pls just give him a good sock in the kisser to bring him back to reality. Tks. Hopefully, this guy will just go down with his ship, never to return. By Bury At Sea - 9/15/2008 4:16 PM

Kenny Lay, Kenny Lay, where in Hades are you these days. Come back from your grave, to show Lehman the errors in their ways. Oh! Kenny BOY! By MrsDamocles - 9/15/2008 11:00 PM

Michael, When reporting on the Chinese stockmarket, Bloomberg tends to quote the CSI300, whereas you usually mention the SSE composite. I would be grateful to know which you consider the most prominent index in China, and why? I ask because, as China's stock market becomes more significant, I am wondering which index the foreign media should report. By RebelEconomist - 9/15/2008 11:15 PM

If only Cagney were around today to put overdue pressure on the masters of the universe, such as on Richard Fuld. How great this would be: "You're a smart boy, Fuld. But I know how to take care of smart boys. I hate your guts, you smart college guys! I've been seeing your kind around since I was ten years old... working as a busboy. "Oh busboy, it seems my friend has thrown up on the table. Clean up that mess, boy, will'ya?" And then when I went to sea as a steward... people poking at you with umbrellas. "Oh, boy!", "You, boy!", "Careful with that luggage, boy!" And I took it. I took it for years! But I don't have to take it any more. There's a war on, and I'm captain of this vessel, and now YOU can take it for a change! The worst thing I can do to you... is to keep you right here, Mister, and here is where you're going to stay. Now, GET OUT!" Now, it seems that Henry Paulson should take a card from Cagney when talking to Fuld, and others just like him! Or, better yet, maybe a Cagney figure is needed to talk to Paulson, himself, in the same manner. There is a storm a'brewin. And, it will be perfect. What is needed is a Captain Queeg to get the mess boys in our major companies, who actually did eat the strawberries, to just plain walk the plank. Good riddance to very bad worthless detritus. Let the bottom feeders feed on their bones! Oh! Kenny Boy! By NOTYET CAINEMUTINY - 9/15/2008 11:48 PM

The word hybris or hubris is popular these days. Authors use it in titles for their books. But, in many cases, the more accurate and more descriptive word would be sociopath, or, psychopath. Or, even better, the term Antisocial Personality Disorder might more aptly be used in place of hybris. Hybris, hubris, or the term Antisocial Personality Disorder, should be used to describe the basic nature and behavior of the movers and shakers at Lehman, specifically Fuld. Who can not doubt that this man is, at heart, the classic case exhibiting a mental disorder characterized by a “pervasive pattern of disregard for and violation of the rights of others” and deep down deceit and manipulation in order to benefit himself? Even more, one might make the case that Fuld is not too unlike a man such as Ted Bundy in many respects, the principle one being an utter disregard for their victims. There is nothing remotely redeeming to say about such men. One was "hanged", the other, hopefully, will suffer everlasting ignominy for his almost equally black misdeeds, and bringing down a perfectly good company which had a 158 year history. By Fellow Wallstreet Brigand - 9/16/2008 1:37 AM

Does anyone know what the threshold might be for having ones comments be censored and deleted from this blog? For example, if one says, I think that tomorrow the SSEC will completely tank before the olympics, is this cause for ones comments to be removed? Even though we all know that no one should make such statements before or after the hallowed Chinese olympics, just as the local Chicom government has instructed us, still, is it possible to make this kind of statement on this blog with no censure? Or, if one were to suggest that some of the same character traits which might be shared by both Fuld and Ted Bundy, have helped cause the crisis at Lehman, then, would such a comment be deleted and censored? Or, even going a bit further, if one were to criticize the Chinese Communist Party, then does this reach the threshold where the comment will be deleted? Or, what about if someone just made an inane statement, according to the power, the blogger, to be, then would this statement be also removed? And what about if someone were to just stand up on this blog and state unequivocally that they feel the Chinese government is basically run by a bunch of thugs, as was stated by a TV columnist at CNN recently, then would this comment also be removed from this blog? Even if the comment were directly germane to the blogging topic at hand? Blogging, by its very nature, is a public enterprise. The blogger wishes to get public exposure of his/her ideas. So, there should be no consternation when sometimes the feedback is not exactly in line with the blogger's point of view, or world view. It is perfectly reasonable to delete such things as profanity, pornography, racist remarks and hate statements, in order to protect any children who might be reading the blog. However, anything else, should be fair game. And, as an aside, as regards this blog, as anyone can plainly see, this blog does not suffer from a plethora of comments each day. Actually, one could say that this blog suffers from a dearth of comments each day. Which is NOT the fault of the blogger. Because this blog is TOP NOTCH. But, still, the more comments the better. And, why delete them if they are not profane, pornographic, racist or hate related? Finally, every week, the very few comments on this blog are written by, in William Claude Rains' words, THE USUAL SUSPECTS. For a blog with 5000 readers, it does seem suspect that there should be so very few commentors! Yeah Man! If you like this blog as much as we all do, then write something good in the comment section. The worst that can happen is that your comment will be removed. (At least, we think this is the worst that might happen. But, lets not talk about any hard labor camps at this time, pls. And, don't forget Freedom Wall, either.) By Ms. Nom de Plume - 9/16/2008 4:11 AM

From the Financial Times: "The Shanghai stock market shrugged off a cut in Chinese interest rates and succumbed to Wall Street-generated gloom on Tuesday, with its benchmark index closing below 2,000 points for the first time in two years." Just a question: What kind of a jerk off idiot would write such nonsense in a major newspaper? The degradation in the shares is so very apparent to everyone that writing this kind of tripe is just, basically, tripe. By Tripe For News - 9/16/2008 11:12 PM

Anyone care for an ice cold glass of milk? YUM! By TheMilk ManCommeth - 9/17/2008 2:41 PM

Sorry I haven't been able to respond to all the comments but my travel schedule was brutal. RE, I think the CSI300 is a better index but, like the DJIA, the SSE Composite is the most widely watched and has the most resonance among investors. By Michael Pettis - 9/17/2008 8:54 PM