My Blog

September 21, 2008

As everyone by now knows, a massive intervention Thursday by the Fed and the US Treasury, which the Financial Times calls “the most extensive peacetime expansion of the role of government in the financial system since the Great Depression,” and seemingly coordinated world-wide, caused a huge rally in global stock markets.  Chinese markets were no exception. 

Thursday night, the night before the intervention, the government had independently signaled its own worries about the markets by dropping the 0.1% stamp duty on stock purchases (the duty remains on stock sales) and announcing to the media that Central Huijin, an arm of the CIC, would buy shares in three of the Big Four banks (all except Agricultural Bank, which has not yet had its IPO).  Why only banks, if the goal was to support the broad market?  Perhaps in part because banks are a large part of the index and because the mechanism (Central Huijin) was already in place, but I suspect that at least part of the reason had to do with concerns about the self-reinforcing positive feedback loop between stock prices and perception of creditworthiness that was such an important part of the banking crisis story in the US.

I don’t think the reduction in stamp tax had much impact, but coming as it did with the stock purchase plan and the huge global rally, China’s stock markets flew on Friday.  The SSE Composite immediately shot up on opening, wobbled a bit for a few minutes, and then recovered so that within the first 30 minutes it was up 9.5%, to trade flat the rest of the day, closing at 2075.  For those wondering why it traded so flat for most of the day, remember that the Chinese markets have a 10% rule, which causes trading to stop when a stock is up or down by 10% within the trading day.  Normally, when the market trades at its limit for most of the day, the momentum is carried forward onto the next day.

Will it maintain the momentum beyond a few days?  I doubt it.  If Chinese share had declined because of liquidity issues affecting the US and global markets, I would argue that the various interventions might be enough to resolve what was, after all, “just” a technical liquidity problem.  However because of fairly strict capital and investment restrictions there is very little connection between China’s financial markets and global financial markets, so it seems to me that nothing fundamentally has changed.  In addition I don’t think the full extent of the international crisis has yet hit China – there are transmission lags in both the capital account and in real economic links – and so we are likely to see more problems before the crisis is safely behind us. 

At any rate my Peking University graduate student Shang Ning, being very curious, immediately decided to see what has typically happened when the Shanghai market has moved up by 8% or more in one day.  He found five cases during the decade, two of them this year, and emailed his findings to me.  His numbers suggest that sharp upward movements are no more likely to presage future gains than to presage future reversals:   

This table proves nothing, of course, except that big upward price movements are not as rare as we might expect, and that in the past they have not been particularly good at predicting the future, but they do show how noisy very speculative markets are.  The only bullish indicator I can find is that from what I gather most analysts and fund managers are warning that the price rally is not likely to be sustained.

For all the fear and panic abroad, and the attendant urge to regulate markets more strictly, it is refreshing and a hopeful sign that in China, in appearance at least, the regulators are still determined to liberalize the financial markets.  According to an article in Friday’s People’s Daily, a number of regulators were pretty clear about this in a forum held in Beijing:

Undaunted by the worsening US financial crisis, partly blamed on regulatory shortcomings, Chinese regulators are pushing for more reform and speedy development of the nation's financial sector.  “It is time to lift excessive regulatory restrictions on private sector financing, which could help boost the dynamics of enterprises as well as improve the capital efficiency of the financial industry as a whole,” said Wu Xiaoling, vice-chairwoman of the Financial and Economic Committee of the National People's Congress, at a financial forum in Beijing yesterday.

Wu said encouraging private companies to raise money directly from investors could also help reduce pressure on the government to relax its monetary policy, which is central to the fight against inflation.

The problems facing the Chinese financial system are very different than the problems facing the US, and Fan Gang, director of the National Economic Research Institute, made the distinction very explicit at the forum:

“Much of the problem behind the US financial crisis stemmed from the excessive complexity of financial derivatives,” Fan said. But China is facing challenges of an entirely different nature, he said. “The Chinese financial market, still at the initial stage of development, lacks effective financial tools, which has hampered the sustainable development of the market,” he said.

Fan called on decision-makers to further relax regulations to assist development of a multi-layered financial market.  “An overly tight regulatory system would not minimize risk, but would instead force us to passively shoulder the risks passed on from foreign markets,” Fan said.

Talking about reform in the banking sector, Fan also noted that the interest rate should be dictated by market forces to promote competition that could lead to innovation.  “We should make greater efforts to let market forces dictate the capital costs and introduce competition to China's commercial banks in the hope of strengthening their capacity to withstand risks in the global market.”

Regular readers of my blog know that I have not been overly impressed either by the pace of financial reform or by policy-makers’ understanding of balance sheet risks, and my first instinct was to assume that the global financial crisis would result in reform paralysis.  Just as, I think, a lot of policy-makers misread the lesson of the 1997 Asian crisis and put into place a Maginot Line of defense that actually increased the risk of domestic imbalances, I was worried that one misreading of the current crisis is that financial power should be even more concentrated in a few large banks under direct control of the regulators.  But perhaps not.  It seems, at least as far as the forum went, that many of China’s most influential regulators don’t think so.

For all the surface calm it is pretty clear that an awful lot of policy-makers are very, very worried.  In the property market one gets a sense of deepening gloom.  Saturday’s South China Morning Post had an article describing a funding concern that property developers are increasingly facing:

The mainland property market is expected to face an estimated capital shortfall of 673 billion yuan (HK$765.94 billion) this year as tighter controls on bank loans accelerate consolidation.  Beijing Normal University said in a research report on capital financing in the real estate industry that falling liquidity and weakening demand for housing deepened the industry's predicament in the middle of this year.

It predicted the capital gap would narrow to 492.5 billion yuan if there was a significant turnaround in the property market by the end of next year.  But the report warned that the shortfall would widen to 929 billion yuan if the market correction extended beyond next year.

With credit markets now effectively closed to property companies, yesterday's land auction in Shanghai garnered a poor response.  Three of the six sites put up for auction failed to draw any bids, which meant they would be withdrawn from sale, according to the Shanghai Municipal Housing, Land and Resources Administration Bureau.

Real estate, as everyone knows, is one of the Achilles’ heels of the financial sector and the one most likely, in most analysts’ opinions, to lead to a banking contraction.  My pessimism about financial sector strength in China is well-known enough to readers of my blog that they won’t be surprised to read that I believe there to be many others – overcapacity in the industrial sector leading to a sharp rise in inventory, sudden hot money outflows causing a shrinking in formal and informal bank funding, a renewal of inflation, rapidly declining corporate profitability, and slowing retail and export growth, to name a few (I am mangling my Achilles’ heel metaphor, I guess).

One consequence of the recent crisis is that it should put to sleep one of the most enduring myths of recent years – that financial crisis are largely currency crises.  In fact most are not, and the determination of many countries, including China, to engineer policies that reduce the risk of a currency crisis has had the paradoxical effect of actually increasing domestic imbalances and so increasing balance sheet vulnerability to crisis.  I think Russia’s example should be enough to destroy the idea that current account surpluses, limited external debt, and large reserves are a sufficient safeguard, especially if there has been rapid growth in the banking system.  

To that end there is an excellent article in last Wednesday’s Financial Times that discusses why.  It starts out:

On paper, Russia’s economy looks to be virtually bullet-proof. With a 7.5 per cent year-on-year growth rate in the second quarter, it has the third largest foreign exchange reserves in the world, low international debt, a huge resource-fuelled trade surplus and nearly $200bn (€141bn, £112bn) stashed away in sovereign wealth funds.

Seen from the markets, however, the situation looks anything but rosy. Stock market indices stand at less than half their May peak, billions of dollars of foreign capital has quit the country and credit has all but dried up. Efforts by the central bank to inject liquidity are having little effect. “What is happening is that no one is lending to each other,” says Garegin Tosunyan, head of the Association of Russian Banks. “This is not so much a financial crisis as a crisis of trust.”

With world markets plunging, Russia’s financial sector has been one of the hardest hit by contagion from the US credit squeeze. On Moscow’s stock exchanges and banks, global conditions have exacerbated an existing crisis whose origin was largely domestic, emerging during the Russia-Georgia war in August.

Yes, yes, I know: Russia is not China.  There are lots of differences between the two, including rules on capital transfers, but the point is not to say that China and Russia are vulnerable in exactly the same way but rather that the argument that high reserves, large current account surpluses, and low external debt are proofs against crisis is simply not true.  If anyone wants to suggest that China is safe from financial instability he will need a much more sophisticated argument than that.

This entry is getting even longer than usual so I will make two other quick points before ending.  First, I didn’t think the explosive milk scandal in China had much relevance to my blog until my friend Victor Shih made one of those comments that immediately make sense.  He wondered why the use of melamine seemed to have started so abruptly and spread so quickly.  It would have been more natural, if it was simply a “normal” case of unscrupulous manufacturers, for the contamination to have developed more slowly.  One possibility, he argues, is that the deterioration in quality is a not-unexpected outcome of recent price controls.  As the cost of inputs rose faster than the price at which retailers were allowed to sell, there was more pressure than ever for manufacturers to cut costs and engage in risky behavior.

I don’t know if this is true or not, although it sounds perfectly plausible, but since I read Victor’s comment I have seen that the idea – that there may be a connection between the imposition of price controls and the rapid expansion of the use of melamine – has become very widely discussed.  Traditionally price controls often lead to shortages and to cuts in quality, and perhaps the milk scandal is one of the unexpected costs in using administrative measures to fight inflation.

The second point I want to close with is a happier one.  Today’s Bloomberg says that “China, the world's biggest consumer of grain, may harvest a record output this year after farmers seeded more land with rice, corn and soybeans, the Ministry of Agriculture said.”  If food production grows sharply, it will limit the risk of another surge in food inflation.  I do not know enough about agricultural production and food consumption to say whether the record output is enough to keep up with demand, but it’s a start.

Comments (18) for "Markets surge, but little ha...

Nice comment on milk. Worth considering. Concerning food price control and side effects, I already pushed a question to you a couple of weeks ago. I would quite nervous about the risks related to price-control when it comes to base food. Mostly in relatively poor and remote areas. Food is definitely no ordinary stuff. It is highly critical... May I put in perspective what happened when a fast-growing and inflationary France tried to cope with the "so-called inflation" roughly 30 years ago. When strict-and-stupid price control was making bread-making profitless (yes the baguette was listed...), our boulangeries just closed in droves and people moved on changing their fooding habits. Boulangeries were of course no public services nor state-owned enterprises. They were allowed to close. The whole food chain and industry was quite efficient, flexible enough and able to cope with rough ineffective legislation and rogue price-control... But in the end bread was moved to supermarkets in a distinct packaging and format that the price-control could not tame... I have a question concerning China agriculture and its correlated industries. Should selling prices suddenly drop below production one - which part of them are rigid old-style industry with limited room for maneuver? Which one is agile private sector with ability to effectively cope with/challenge/by-pass/overcome price control? By François - 9/21/2008 1:50 AM

Regarding the melamine scandal. Please remember that last year in the US they found melamine in pet foods. It appears that adding melamine in milk products has been going on for a while. It definitely has something to do with the rising cost of cow feeds. The producers/middlemen might added smaller concentration of melamine initially without much side effects. With the increasing cost of the feeds, they added more melamine to maintain their profits. Although melamine has low toxicity (oral LD50 of >3000 mg/kg based on rat data), at high dose (concentration) melamine, like any drug, will be toxic (animals (pet foods) and kids would be the first victims due to their smaller body sizes). Furthermore, Sanlu was planning an IPO, which put more pressure on it to have good financial results. By Cirrus - 9/21/2008 7:21 AM

Mr Pettis You are doing na excellent job and helping many people understand the chinese reality. KB (from Brazil) By KB (from Brazil) - 9/21/2008 8:10 AM

The comments by Wu and Fan just convince me even more that there's a noisy debate going on behind closed doors in China right now: the old guard versus the reformers. I find it interesting and quite telling that China has been so slow to expand its corporate bond market. But I think it's clear why, and it's related to the reason they would resist private-sector financing. 1. First, private-sector financing will compete with commercial banks. Also, it will encourage greater hot money inflows, which have already exploded this year. 2. The corporate bond market will also compete with the banking sector, in a few harmful ways for fat, comfortable state banks. There will be downward pressure on lending rates (currently China has regulated a lending floor and a deposit ceiling -- minimum lending and maximum deposit rates -- ensuring a generous spread for licensed commercial banks). Also the nation's banking giants will lose business from their best borrowers; large industrial companies such as PetroChina can get money more cheaply by issuing bonds (and these companies would be the best bets to sell corporate bonds initially considering the immature credit-rating industry: you don't need to be a rocket scientist to rate the risk of big, safe PetroChina). 3. Why does the old guard in China want so badly to preserve the strength and dominance of the nation's commercial banks, beyond the obvious reason that they are a critical pillar in any financial system? I'd guess because the banks are used so heavily in the increasingly tricky task of controlling a fast-growing money supply: through sterilization bills, interest rates, hikes in reserve ratio requirements, lending limits. China’s government has used all these means to put their fingers in the monetary dyke multiple times, but it's still springing leaks. I think they're scared that financial liberalization would make their job virtually impossible -- and force the day of reckoning on how to deal with their undervalued currency. By Chinawatcher - 9/21/2008 10:22 AM

Francois, fortunately the bread in France is still wonderful. Cirrus, it is true that last year melamine was found in pet food, but I think in milk it was only this year and it spread surprisingly fast among a lot of companies. Interestingly enough from what I understand only the low-priced milk was at risk. Higher-priced milk, even from the same companies, has not been melamine-infected. Chinawatcher, you are probably right about the debate -- I suspect I was trying to put the most optimistic face possible on the forum. By Michael Pettis - 9/21/2008 11:40 AM

Michael, I understand from your Marie-Antoinette-esque answer that there is little to no information on pricing formation for food in China and price-control. I talked sideways mentioning "baguettes et croissants" in order not to be straight. But the issue can become serious with a couple of months in view of the scale. Should I understand that the government is handling price control in a very effective effective and cautious manner? Pointers on those policies welcome! By François - 9/21/2008 2:30 PM

I am not knowledegable enough about the industrial sector to answer your question intelligently. As a general rule I do not think price controls are an effective way to manage monetary pressure, so I am not sure if there is any way of handling it that I would see as useful. part of the reaosn is -- as perhaps the milk scandal suggests -- that price controls often just shift the underlying problem into some other, sometime less-easily-controlled, form. By Michael Pettis - 9/21/2008 4:03 PM

One thing to remember is that its generally not a good idea to portray debates as between an "old guard" and "reformers" since the "old guard" often want to do innovative things and the "reformers" aren't always right. It's actually not clear that "financial liberalization" is a good thing, and my assertion (which Prof. Pettis disagrees with) is that the structure of the Chinese banking system makes it far more resistant fo financial crisis than is commonly thought. Anyway, we'll see in about two to three months, and I have a suspicion that in two years, the US financial system will look a lot more like the Chinese one than it dd two weeks ago. By Twofish - 9/21/2008 8:00 PM

"However because of fairly strict capital and investment restrictions there is very little connection between China’s financial markets and global financial markets, so it seems to me that nothing fundamentally has changed. " You cannot say that the capital and investment restrictions can effectively prevent the foreign money investing in Chinese stock market, but at the same time the same restrictions cannot prevent the hot money making its way into China. For Russia, it seems that hot money outflow is the main reason of the market collapse. I wonder it has anything to do with the major investment banks going BK in U.S. When M.S. faced bank run last week, it desperately wanted to sell everything to get cash...everything including the offcie buildings they owned in Shanghai as I heard. I won't be surprised that some big IBs firesold their assets in Russia to have cash to save their own butts. By fatbrick - 9/21/2008 9:12 PM

Fatbrick, I think you can reasonably make both claims. The channels that directly link institutional investors in in global markets with the Chinese markets (mostly QFII) are very different than the hot money channels, which seem to occur though mis-invoicing trade and FDI and through family business networks. The latter are much slower and less likely to react to contagion effects in the global stock markets. I think that any time the perception of risk rises, risky assets, including emerging markets, tend to see outflows, so it seems that the liquidity problems in Russia were caused first by worries about the war and then by worries about global finance. There is little doubt that global investors and banks sold assets to raise funds, and some of these assets may well have been in Russia, but my understanding is that a lot of Russian businessmen sold assets to raise liquidity, especially heavily levereaged business owners. One of the things I learned from many years as an emerging market banker is that although it is always a good idea to blame foreign speculators, the fact is that local businessmen are usually the first to take money out. It is safer to watch them than to watch the foreigners since they always have a better feel for local risks. By Michael Pettis - 9/21/2008 10:24 PM

Re: Above Milk Melamine Theory: "Up to 85000 cats and dogs in the US died in early 2007 after eating pet food contaminated by melamine. The US Food and Drug Administration found that the deaths were caused by melamine in gluten products from China. Chinese merchants had purposely mixed melamine in wheat bran to increase its nitrogen content. Later, melamine was also found in pig, chicken and fish food across the US." So, the use of melamine to pass protein testing in many foods has not been such a sudden thing. And, also, no one can say exactly when the use of melamine in milk first started. MAYBE it was gradual, and just now becoming more pervasive. WHICH I THINK IS THE CASE, and deaths/sickness in babies caused by melamine is not just a recent occurrence, in China, as you state. By Breastmilk Isbest - 9/21/2008 10:58 PM

Granted, “old guard” and “reformers” are an oversimplification for the opponents in the debate on financial policy. And “financial liberalization” is itself a somewhat loaded term. But at the least shouldn't we all be able to agree that China needs more diversification in its financial system? I was surprised once, when looking at charts for corporate bond markets, that on a weighted basis China was still very low compared with other developing countries in Asia. That leaves the commercial banks shouldering much of the load. And it seems hard to believe that the banking system would be very resistant to financial crisis considering every major Chinese bank that has sold shares in an IPO in the last three years has undergone a huge bad-loan bailout and recapitalization. As recently as 2000, more than 33% of ICBC’s loans were bad. All is fine and dandy now with the economy booming, but what happens when the music stops? By Chinawatcher - 9/22/2008 11:22 AM

Perhaps not so fine and dandy. I guess Pettis won't be too surprised but Reuters today has the following: Fitch Ratings said today that despite the strong profit figures posted by Chinese banks in H108, there are a number of strains emerging in the banking sector that point to an increasingly difficult road ahead, including rising borrower stress, escalating credit leakage, and tightening excess liquidity. In a special report on Chinese banks entitled "Chinese Banks: Signs of Strain Emerging, Despite Strong H108", the agency highlights that weakening global demand, rising inflation, and intensifying domestic economic pressures are taking a toll on borrowers and placing growing strains on banks. "Pressures within the banking system are mounting, and this carries important consequences for Chinese banks' future earnings, asset quality, and capital," said Charlene Chu, Senior Director with Fitch's Financial Institutions team in Beijing. The agency notes that despite a fall in the aggregate NPL ratio for China's listed banks at end-June 2008, there are early signs of a rise in loan delinquencies. The amount of loans recorded as overdue from one day to one year increased almost across-the-board for listed banks in H108, while at the same time the assessment rates for the amount of loan loss reserves that should be set aside for performing loans also rose. "Certain data is starting to indicate that the benign credit environment of the last few years may be turning, although it remains too early to draw solid conclusions," said Chu. The agency highlights that recent earnings growth has been primarily driven by two new noteworthy trends evolving out of the tight credit environment, including higher loan pricing and the rapid rise in the sale and re-packaging of loans into wealth management products that are then re-sold to investors. Fitch notes that although sales of these products have helped banks' fee income accelerate at a time when mutual fund sales have plummeted, this activity should be viewed with a considerable amount of caution due to extremely poor transparency and disclosure, and uncertainty about the amount of residual exposure banks retain on the underlying loans that have been sold. "If nothing else, recent international experience underscores the necessity of clear and transparent reporting by banks, and the hazards of permitting hidden risks to grow," added Chu. By MCT - 9/22/2008 12:34 PM

Cirrus and Breastmilk, I too have been hearing about connection between melamine and price controls. It is true that melamine was used in pet food last year, but the deaths from milk all seemed to occur this year, which makes me think that use of melamine in milk is recent. I have also seen other confirmation of Pettis that only cheap milk was affected, not premium brands, which is a small corroboration of the idea that use of melamine may have been in response to profit squeeze caused by price controls. Also it is not just Sanlu, so IPO was not a factor. Many milk companies have tested positive for melamine. By XuX - 9/22/2008 12:49 PM

The South China Morning Post today says that "Authorities in some provinces have warned lawyers to refuse cases tied to tainted milk out of fear litigation could lead to 'social unrest', a representative of the lawyers says." This should make us even more angry than the tainted milk. By XuX - 9/22/2008 1:17 PM

But, in addition: "It is also the second major case in recent years involving baby formula. In 2004, more than 200 Chinese infants suffered malnutrition and at least 12 died after being fed phony formula that contained no nutrients." But, basically, this problem is not just limited to milk. There is an underlying fear of substandard food products in China. And, with good reason. Also, it is now almost impossible for the Chinese government to provide any reassurances that people will actually believe. One lie after the next. One obfuscation after the next, alway hiding the truth. This was exactly the case with the Chinese SARS coverup. And this is why people can not trust their government. It will be very difficult to restore even a modicum of faith. By Breastmilk Isbest! - 9/22/2008 3:58 PM

Finally, XuX, Melamine in lower dosages will not cause visible health effects or death. What the exact level of melamine in milk needs to exceed before causing kidney stones, other health effects and death is easy to check. But, it is possible that lower levels of melamine have been used for quite some time. Levels that were high enough to pass diluted milk, but low enough not to cause a health related news story. And then, more recently, the levels of melamine were increased causing this uproar. If this is the case, we may never hear about it. Just for the same reason that China was so successful at keeping a lid on the spread of the H5N1 virus, for such a long time, when all the birds were dying at Qinghai Lake, and clusters of human H5N1 were being discovered. Either way, it is heart wrenching to watch these mothers stand in long, long lines for hours at hospitals holding their babies. A truly scary situation for them. By Breatmilk Isbest!! - 9/22/2008 4:44 PM

XuX, Speaking of "Authorities in some provinces have warned lawyers to refuse cases tied to tainted milk out of fear litigation could lead to 'social unrest', a representative of the lawyers says." It would be quite interesting if people all over China, 1 billion or so, began test messaging each other to all begin lining us at hospitals, all over China, around the clock, to demand kidney ultrasound scans. No matter what their age. Such a tactic might really show the government that China is NOT safe. By Breastmilk Isbest - 9/22/2008 7:13 PM