My Blog

May 28, 2008

According to today’s China Daily Morgan Stanley is predicting that year on year inflation for May is likely to decline dramatically from 8.5% in April to 7-6-8.0% in May.  I haven’t seen the Morgan Stanley report but the article says “vegetable prices in the third week of May dropped 5.6 percent week-on-week, meat was down 0.3 percent, and eggs were up 1.7 percent.”

Morgan Stanley said inflation in China should gradually ease over the rest of this year as domestic supply improves and international prices stabilize. But it warned that the devastating earthquake in Sichuan province earlier this month could fuel more upward pressure on prices in the short-term.

"In the absence of any further major natural disasters, China inflation should ease gradually over the course of the year," it said.

If they are right it would imply that CPI declined by 0.2-0.5% month on month. 

This would be a very welcome event if true, but even if it is true (and I am not so sure it will be) I am afraid that it would only be a temporary respite that would give the financial authorities, especially those in the Ministry of Commerce and the State Council who oppose further tightening, more ammunition for their arguments.  And if prices do rise again in June and July, it would almost certainly be attributed, again, to a temporary and one-off factor – in this case the effect of the earthquake – and so a number of government officials would argue that there is little information about monetary conditions implied in the CPI price increases.

Two days ago, Ma Hongman, in a piece in the China Daily, argued yet again that any serious monetary tightening is the wrong response to current conditions because of the adverse impact it might have on economic growth.  For him, and many like him, the only proper and effective tools are those likely to increase food production:  

As a matter of fact, the traditional monetary policy tool, the interest rate or the deposit reserve requirement, could hardly work exactly upon the price-driving elements mentioned above.

Both measures could reduce the money supply in the economy, but they could do nothing in the short term to boost the supply of meat, eggs, poultry products or any other plants grown in the farm. The supply of agricultural produce cannot get free from the time span of their unique production cycle.  In this cycle, raising the interest rate would only make the agricultural production more expensive, which, in turn, would push up the price of these produces, worsening the inflation pressure.

According to this argument policy-makers should ignore inflation and focus instead of measures to boost the economy.  He goes on to say:

At a recent financial forum in Shanghai, Zhou Xiaochuan, governor of the People's Bank of China, described the dilemma of the decision-makers: to boost the economic growth, consumption should be nurtured or stimulated, while consumption needs to be curbed to ease the inflation.

He has really got the crux of the problem. The contradictory targets to maintain the economic soundness are really challenging the wisdom of the policymakers.  Therefore, they should drop the customary practice of tightening the monetary policy once the inflation indicator is lifted, but fix more flexible countermeasures according to real-time changes.

I agree and disagree.  I disagree of course with the argument that inflation is not a monetary problem, but I also don’t think most of the current monetary measures will make much difference.  The problem in China is the growth in the money supply caused by the PBoC’s forced purchases of currency inflows, and as I wrote two days ago, foreign currency inflows have grown from astounding to even-more-astounding.  The only way to address the problem is to reduce currency inflows.

On a related note it is worth noting that demand for PBoC's paper has softened over the past month.  My student Shang Ning has been keeping track of interest rates and auctions of PBoC bills, and he says recent auctions have been small and heavily weighted to the short end.  I think that is why we have seen so many increases in minimum reserve requirements, and will see still more.  The PBoC is having trouble selling paper, and so raising minimum reserve requirements is one of the only ways it can affect the domestic money supply by reining in the banks.  Whether this will work is an open question.

By the way I am hearing more and more that one of the main reasons for the irregular appreciation in the currency has been as an attempt to stop hot money inflows.  In today’s report, for example, the G7 Group says “It is likely that the PBoC will continue to induce artificial volatility in the pace of RMB appreciation to reduce speculative capital inflows.”

If this is true I think they have it completely wrong.  Inducing volatility in the exchange rate really means nothing as far as speculative inflows go – although it may help exporters learn about hedging.  Everyone pretty much knows that the RMB is a one-way bet, and even if it declines a little for one or two days that only means that it will have to run up even more in the future to make up for the decline.  This is hardly likely to cause speculators to lose any sleep, especially since anyone who thinks Chinese hot money inflow is caused by George Soros and all the other assorted evil-doers out there has it very wrong.  

In fact most of this massive inflow is likely to be the consequence of hundreds of thousands of much smaller transactions involving money brought in by small Chinese businesses with extended family networks abroad.  A little bit of intra-week volatility is hardly going to scare them away, and since the slower appreciation and greater volatility of April coincided with the largest one-month inflow in the history of central banking, I hope and expect it shouldn’t take too long to jettison this particular strategy for reducing inflows. I worry that the authorities here are so determined to keep the mythical speculators from profiting (they all seem to have read Currency Wars, a very silly book about the financial cabal – mostly Jews, of course – who control the world and want in particular to profit by destroying China) that they are missing the point.

At any rate I am still marveling at the size of the reported April surge in reserves.  I can’t wait to see what May brings.

Comments (17) for "Lower inflation in May?"

You raise a valid point at the end. The Chinese hate the thought that foreigners might benefit at the supposed expense of China and this no doubt clouds their judgment in many areas. By David Oliver - 5/27/2008 11:09 PM

Morgan Stanley probably has the inflation rate right. Based on day-to-day food index I saw, May's inflation number will be considerably mild. Fighting speculating is a high priority I would guess given the experience in 97 Asian Crisis, especially the experience in HK. It probably has little to do with economics. Political pressure from exporters and the unemployed will force gov's hands. Then speculators are the easist targets. I am surprised that there is no more radical legal and regulatory policy rolling out now to combat the speculation or hot money. The Author of Currency Wars has almost everything wrong, but he got one thing right. It is almost a zero sum game in short term. So there are always us vs. them. By fatbrick - 5/28/2008 2:38 AM

Everything in China changed when Deng said, "How glorious it is to be rich." No one yet knows the source of the 'hot money' pouring into China anticipating a revaluation after the Olympics, but very likely its major source is the Chinese Diaspora in Taiwan, Singapore, India, San Francisco, Vancouver, et al. The hyphenated Chinese are speculating on China's revaluation; family ties both help and mask the flow. However, if the inflation that such flows generate then grows large enough to create negative real returns, that 'hot money' will exit faster than it entered China. But if the PBoC brings down inflation, investors' expectations moving that 'hot money' could be switced to investing for the long term rather than be speculative short term. Their Diaspora is too immense and too bright for the Chinese government to control. Instead, the government should immediately start offering incentives to turn the short-term speculators into long-term investors. Deng suggested why. By a Duoist - 5/28/2008 3:44 AM

The speculative money inflows that have occurred are spilt milk. The priority of the PBoC must be to fight continued hot inflows over the longer term...I'd be surprised if they are really trying to reward/punish the speculation that has already occured, esp. as it has no real tools to do it. A sudden outflow of capital is not desired but there really are no choices other that to: (a) promote domestic consumption and growth. (b) revalue currency. If the PBoC waits too long past the opening of the Olympics, I think the problems will only get worse. By MC - 5/28/2008 3:44 AM

Oversea Chinese are the sources of hot money? A very interesting idea. There was $57 billion a month if the calculation is correct. There had to be some significant and noticeable events for all Chinese around the world to suddenly send money back home. Any evidence to back this up? I guess it is probably more about the lag reaction to U.S. volatile equity market in March: money flow to safety. By fatbrick - 5/28/2008 4:04 AM

Pettis: If this is true I think they have it completely wrong. Inducing volatility in the exchange rate really means nothing as far as speculative inflows go – although it may help exporters learn about hedging. Actually it means a great deal. If you have volatility that limits your ability to leverage, and that restricts the flow of hot money in. If I know that tomorrow the exchange rate is going to go up, I borrow vast amounts of money, change currency, wait, change it back, and profit. If you add randomness, then I go broke if the markets moves in a way other than I expect. Pettis: Everyone pretty much knows that the RMB is a one-way bet, and even if it declines a little for one or two days that only means that it will have to run up even more in the future to make up for the decline. If you borrow huge amounts of money, and it declines a little for one or two days, you will get a phone call telling you that you hit your risk limits, and you have to close your positions NOW!!!! Currency traders take very, very highly leveraged positions, and if you don't add volatility, you will end up with vast sums of borrowed money taking advantage of the shift. Pettis: This is hardly likely to cause speculators to lose any sleep, especially since anyone who thinks Chinese hot money inflow is caused by George Soros and all the other assorted evil-doers out there has it very wrong. It could cause them to lose sleep if they get a phone call in the middle of the night telling them that they have to close their position because their highly leveraged bet that the PBC would raise the rate on that day went bad. Also the people in the People's Bank of China are often recruited from investment banks and there is a lot of interaction with Hong Kong, so I'm pretty sure they know how currency markets operate. Pettis: I worry that the authorities here are so determined to keep the mythical speculators from profiting (they all seem to have read Currency Wars, a very silly book about the financial cabal – mostly Jews, of course – who control the world and want in particular to profit by destroying China) that they are missing the point. I wouldn't worry too much about the financial cabal trying to destroy China. It's not that there isn't a financial cabal, but rather that Chinese are quite well represented in it. By Twofish - 5/28/2008 10:54 AM

Since the Fed opened the discount window to broker-dealers in mid-March, the Federal Reserve has pumped almost $250 billion in treasuries into the system, and I'm pretty sure much of it made its way to the People's Bank of China. It's absolutely extraordinary how much the financial world has changed in the last six months. Bernake is going to go down in financial history. Whether in a good way or a bad way, it's too early to say, but he will go down in history. By Twofish - 5/28/2008 11:05 AM

2-fish, again you are confusing different markets. In the US or Europe, speculators can bet on the futures market and use huge amounts of margin. In that case small downward movements, even temporary, can wipe them out. In China, hot money is not leveraged, or if it is it is not leveraged in the same way. For example, if I want to bring more money into China than I own, I can certainly borow from friends or family, and in that sense there is leverage, but if the RMB drops 1% or 2% I will not have to make margin calls and I will certainly will not have to sell out my postion. It is not a good idea to assume that the dynamics of currency market like that of China operate in the same way as the Chicago Merc -- and of course the Singapore NDFs are not relevant here. By Michael Pettis - 5/28/2008 12:01 PM

If the RMB is shielded by an inlet valve , through which inflow is made exponentially eaiser than outflow, it will be suicidal to leverage on any RMB bets. No way margin calls can be met in time. Since each person is allowed to bring in, and out, US$50,000 per calendar year, the purported hot money inflow in April is equivalent to forex transaction through 1,490,000 trusted and willing personal domestic accounts. Not an easy task to coordinate entry, and timely exit. By Kelaido - 5/28/2008 1:12 PM

Fatbrick, the evidence is the acceleration in hot money inflows. By Michael Pettis - 5/28/2008 1:33 PM

I found this nice comment by Pieter Bottelier on Victor Shihs blog. "In China’s case, it seems more likely that hot money inflows are primarily driven by large anticipated asset price increases—real estate or shares" If this is true, then the extra 1.000.000 USD or more, that flows in with each "real" business deal, is put in real estate or other assets (if so, the money won't leave so fast as one might fear). This would also mean that the PBoC was no way of controling the inflow and the non-food inflation will eventually rise. I am just thinking the inflow might not be a currency speculation thing all together. The massive privatization in the last 10 years, the security of a new property law and the extreme raise in real estate might have made the overseas Chinese and their dalu counterparts a little to sure of the good asset deal. Again this is speculation from my side. I just can't see hundreds of thousands of small transactions is with currency speculation in mind. Even if one brings in 10.000.000 USD and changes it, then you just don't show up in your local Construction Bank and change it back, there must be other ways (maybe the informal bank system you talked about last week), and it seems that currency speculation needs as few exchange stations as possible, which is not the case here using family relations or informal bank systems. It could be a trust in the almost divined raising of the real estate and assets market, that fuels this hot money inflow. By anders - 5/28/2008 7:44 PM

fwiw, I talked with a bunch of Chinese CFOs last week in NYC. The private sector consensus estimate of inflation seems to be a binomial 11-15 percent. Those who see Chinese inflation as a food phenomenon would lean towards the 11, and skeptics use 15 percent inflation in their Wall Street price guidance. By neoconservative mugged by reality - 5/28/2008 11:08 PM

Pettis: In the US or Europe, speculators can bet on the futures market and use huge amounts of margin. In that case small downward movements, even temporary, can wipe them out. Currency desks and traders in Shanghai and Hong Kong work more or less in the same way as currency desks and traders in London or New York City. Pettis: For example, if I want to bring more money into China than I own, I can certainly borow from friends or family, and in that sense there is leverage, but if the RMB drops 1% or 2% I will not have to make margin calls and I will certainly will not have to sell out my postion. But there is a limit to which you can borrow/move money in this way. You might be able to make $10,000 bets on currency, but you aren't going to be making $10 million bets. The amount of money that appears to be moving into China has to go through the currency desks of the major international banks since they are far too large to move in any other way. Once you get money into the banking system, then it moves through currency traders. If you make it safe to take highly leveraged bets on the RMB, they will make those bets, and that greatly increases the amount of hot money that will be thrown into the system. Pettis: It is not a good idea to assume that the dynamics of currency market like that of China operate in the same way as the Chicago Merc -- and of course the Singapore NDFs are not relevant here. I think it is. Sure you have money changers with piles of money in the back room, and old women putting greenbacks in a coffee can. But they just aren't going to be moving $75 billion in one month. In order to move that sort of money, you have to go through someone staring in front of an Excel spreadsheet, with a cup of coffee in one hand, and with a phone in which he is either screaming or being screamed at. Singapore may not be relevant, but Hong Kong, where most of the money likely to be going through, is a world class financial center. Trying to figure out how to use massive leverage to make money off of RMB moves in light of all of the currency restrictions is tricky, but that's what currency traders get paid to do, and people can come up with some wild Rube Goldberg like convoluted schemes making money. Kelaido: If the RMB is shielded by an inlet valve , through which inflow is made exponentially eaiser than outflow, it will be suicidal to leverage on any RMB bets. When there is money to be made, people can be very, very clever, and there are some pretty obvious ways of getting around the restrictions. By Twofish - 5/29/2008 9:51 AM

Sorry 2fish, but that is absolutely wrong. It is impossible to speculate on RMB futures in mainland markets as you say. If it were possible, I and many of my very sophisticated Chinee and foreign friends in Beijing (a lot of whom are former bankers and traders, like me) would not have struggled as hard as we have to convert dollars into RMB, and capital inflows into China would be much, much larger. If you can find a way for me to buy RMB futures on margin at the current forward rate implied by interest differentials please let me know -- and please don't suggest the Singapore NDFs because they already have a large appreciation priced in and, of course, are not linked directly to mainland RMB markets. Neo, I agree that inflation is higher than the official CPI numbers suggest. If nothing else a nearly 30% increase in the price of food over the past 18 months should have increased the food share of the CPI basket, but it is apparently still 33%, where it was 18 months ago. Unless Chinese households have suddenly all gone on diets that would be a little hard to explain. The ADB said a few months ago that food is 40% of the Chinese consumption basket. Changing the weighings and using the NBSC's own data, that would suggest CPI inflation of nearly 10%. By Michael Pettis - 5/29/2008 4:29 PM

Pettis: It is impossible to speculate on RMB futures in mainland markets as you say. I don't understand why futures are involved here. You aren't trying to take advantage of deviations from interest rate parity. You are speculating on short term fluctuations on the spot rate. If you are a corporate entity with RMB funds inside the firewall and USD funds outside of the firewall, then you can leverage fluctuations in spot without moving funds across the firewall. Also corporate entities can do things that individuals cannot. In particular, corporate entities have access to large amounts of capital and also the rules about currency transactions are different. By Twofish - 5/29/2008 11:36 PM

In that case the margin requirements that can wipe out futures positions does not apply, and so, as I originally wrote, the idea that small changes in the value of the RMB can flush out speculators is absurd. At any rate the proof is in the pudding. There seems to be no slowing off of hot money inflows even with the enforced volatity. By Michael Pettis - 5/30/2008 5:44 PM

Find it highly unlikely that major brokerage houses are speculating on the RMB this way (that they would get wiped out...). If anything, these institutions are clamoring for more access inside China dn the last thing they want is to run afoul of the financial authorities. At the most, they might be issuing NDFs abroad and trying to earn a spread, but putting massive bets on currencies during periods of capital scarcity is not the business they are in. More likely that a major export house repatriates more FX than it would otherwise (possibly even more than it actually earns) with the difference coming from a network of friends-and-family. As MP suggests, not an investor class scared off by small RMB volatility. I am coming around to a point of view that not even a large one-time revaluation might be enough to dampen the spirits here. (perceived risk of owning RMB is pretty low at this point) By MC - 5/31/2008 8:28 AM