My Blog

April 17, 2008

“Now, we not only have to prevent a sharp downturn of the economy, but also a rebound in investment,” Li Xiaochao, spokesperson for the National Bureau of Statistics, said in his comments yesterday.  He also said in the same release that “the top concern is still inflation.”

He’s right.  Not only were the inflation numbers pretty grim, as I see them, but fixed asset investment is up pretty substantially to RMB 2.185 trillion, for a 24.6% increase year on year, versus an already-high 23.7% increase over the same period one year ago.  Yesterday the State Council, which is chaired by Premier Wen, released a statement in which it said: "We need to closely watch the latest development of the economic situation, and strike a balance between promoting economic growth and curbing inflation.”

As regular readers know I am skeptical about the availability of policy tools that will permit a striking of this balance.  I think we have already passed the point of no return on inflation and monetary growth, and by now the only way to rein these in will almost certainly involve sacrificing employment in the short term.  The longer they wait, the greater will the needed sacrifice be.

Given attempts to cool things down what explains the jump in investment?  Credit Suisse says it is a new round of local government-driven infrastructure investment, which makes sense given that typically every five years, when the new leadership takes up their positions, their first actions tend to involve a significant jump in spending.  I am also hearing that some of the hot money inflow is showing up in the informal banking sector and being lent out.  I noted, but did not comment on, an article in the South China Morning Post five days ago that was titled “SMEs turn to underground lenders for cash.”  According to the article:

Beijing’s credit-tightening policy could have sent some cash-strapped small and medium-sized enterprises (SMEs) to seek costly funding from alternative financing channels - the underground.

“If their loan demand cannot be satisfied by the banking sector, companies will look to the non-banking financial sub-sector for funding,” said David Kiang, a vice-president for international corporate banking at Shenzhen Ping An Bank, a subsidiary of Ping An Insurance. Mr Kiang added that some hard-pressed businesses might have borrowed from mainland pawn shops, which lend sums against collaterals at high funding costs just as Hong Kong's money-lenders do.

…Beijing's policy to limit banks' loan growth also makes it harder for SMEs to borrow. Big banks traditionally prefer to lend to larger firms and have become even more selective now that the lending cap is in place.

This isn’t surprising at all and in fact several times over the past few months I have speculated that the informal banking sector would be taking up the lending slack.  I wish I knew of some way to track the sector.

At any rate, and as everyone knows (they slipped it in after I finished yesterday’s blog entry), the PBoC raised the minimum reserve requirement rate again, by 0.50% to 16%.  I expect that they are going to do this several more times this year.  Since most other “market-based” policies don’t seem to work or may even exacerbate weakness in the banking system or increase monetary inflows, this is likely to be one of their favorite solutions, although of course raising the minimum reserve does strain banking sector profitability and I think banks desperately need profits with which to help dig them out of their non-performing hole.  There are no easy solutions – every thing they give with one hand they take away with the other.

But I am not sure the raising the minimum reserve requirements will anyway make that much of a difference.  Each reserve hike drains about $20-25 billion from the system, but with currency reserves growing by about $50-90 billion a month so far this year (the wide range exists because we are not sure exactly by how much headline reserve growth needs to be adjusted to account for the full impact of net inflows, as I explained in my April 12 entry), we’re going to need a much more aggressive stance to reduce underlying liquidity, and with so much worry about excess slowing, I don’t expect we’ll get that level of aggressiveness.

By the way in today’s Wall Street Journal Asia I have an Op-Ed piece explaining why I think the low but rising inflation in the non-food part of the Chinese CPI is so worrying.  The basic argument is that if food prices were rising so quickly because of a supply problem, the fact of their rising would put so much downward pressure on the non-food sector that we would see severe deflation, or at least disinflation, in non-food prices.

In fact we are seeing low, but rising, inflation, which is inconsistent with the idea that this is just a food-supply problem.  It suggests that inflation is caused by excess money, and that the sudden partly coincidental jump in food prices has simply absorbed most of the inflationary pressure, thus keeping it from showing up in the non-food sector – until food prices stop rising.  You can find the full article at:

http://online.wsj.com/article/SB120838835562221079.html?mod=opinion_main_commentaries

Comments (12) for "Minimum reserve requirements...

Rather than paying attention to all the hand wringing over inflation and fixed asset investment by the State Council for the benefit of the press, it is far more useful to pay attention to what the political head honchos are tacitly allowing to take place. New Yuan Loans rose by 283.4 billion during March alone, or more than twice the largest single monthly expansion posted in the 4thQ of last year. This is a 40 billion yuan increase over February's figures, a single month rise of 16.4%. Jan-March's cumulative 1stQ expansion totals 1.33 trillion, up 389% relative to the three month total of 272 billion posted in the 4thQ.... a quarter-quarter growth of nearly FOUR HUNDRED PERCENT in Chinese bank lending. It would be naive to consider this an "accident." Moreover, Chinese imports are screaming higher and are on target to exceed one trillion dollars worth this year. Is it any wonder why global commodity prices are soaring? Or why Chinese inflation is soaring? Food inflation in China is guaranteed to rise even faster in the future than in the present. Bloomberg reported today that China, having zero negotiation power with fertilizer producers, just agreed to pay $576 per metric ton for potash alone....a $400 per metric ton increase over last year. Moreover, China was only allowed to buy 2 million tons for the second half of the year, a signficant reduction from last years level, to "keep China on a short leash" so they are unable to restock. These kinds of hardball negotiating tactics will be repeated again and again in the future with other agricultural components that China is not self-sufficient in. China's 1st Q GDP figures were far stronger than headlines would suggest. Primary industries growth rate expanded at a 30.6% yr-yr pace; secondary industries at a 20.3% yr-yr rate; and tertiary industries at a 23.2% rate. In other words, manufacturing, mining, construction and utilities are growing at a combined rate of over 20% versus the 1st Q of 2007 or twice the pace of growth posted in the headline "real" GDP figure. Overall Chinese GDP expanded by more than 1 trillion yuan during the 1st Q (5.03 trillion yuan 1st Q 2007 to 6.15 trillion yuan 1st Q 2008). To put this in another perspective, in terms of the nominal growth per quarter: 1st Q 2008.......1.12 trillion yuan (3 month expansion) 4th Q 2007.......0.94 trillion yuan 3rd Q 2007.......0.77 trillion yuan In six months, the growth in growth equals 45%!!! since the end of September. Another "accident"? This is one of the reasons why you have retail sales up 21.5% yr-yr.....a new record. Analyzing retail sales like the above GDP figures provides additional data: March 2008.......up 21.5% March 2007.......up 15.15% March 2006.......up 13.5% Over the last 24 months the growth in retail sales equals 59.3%! Have the politicians truly "lost control"? Or are they simply trying to insure that the U.S. doesn't succeed in dragging them into a severe recession, no matter what the cost? By kevinfischer2002 - 4/17/2008 6:36 AM

Michael, if you haven't already, please take a look at Tom Holland's column in South China Morning Post today. Basically it says that China's screwing with the numbers -- their GDP and inflation levels don't make sense mathematically. The conclusion is that either 1Q GDP or levels of inflation are higher than being reported. Would be interested in your take on that and whether the analysis presented in the column indeed holds up. By Chinawatcher - 4/17/2008 8:31 AM

Chinawatcher, it is hard to comment on the numbers because they are not very transparent and everything must be guess work. I have already written about some concerns about CPI: in spite of the 20-25% increase in food prices since the beginning of 2007, for example, the official CPI basket still assumes food to be 33% of total consumption, which implies that Chinese households have cut their real food consumption by 15-20%, an implication I find implausible. The ADB says food comprises 40% of Chinese consumption, which implies that CPI inflation understates real inflation by at least 1.5%. There are also persistent rumors coming from my Chinese colleagues and students that many companies outside of the main cities are only pretending to adhere to the price restraints or freezes, and are in fact selling illegally at higher prices while reporting sales at lower prices. In fairness, in a rapidly-changing economy and society, especially one experiencing mass migration from the country to the city, it is very difficult to establish good proxies for inflation, growth, or anything else, and weaknesses in the accounting system and the well-known tendency of local bureaucrats to exaggerate good news and downplay or hide bad news makes the process all the more difficult. Arguments about the accuracy of Chinese statistics are likely to persist for years. As an side, three days ago I was invited to speak on a well-known tv show here in Beijing and over coffee the very famous hostess, who I assume is not at all one of the poor, told me that her mother insists that inflation has been much higher than the recorded numbers for a while -- she bases this on her own purchases. I hear this often, but am in no position to evaluate. It may very well be true that the reported numbers are materially different from the reality. By Michael Pettis - 4/17/2008 1:33 PM

Good points. Yeah China stats are spongy for sure. In one of big bank's IPO prospectuses, they had a chart showing that GDP per capita grew at an annual average of 14.4% from 2000-2005 -- faster than the rate of GDP growth (11.7%) over the same period. It turned out that they had GDP per capita growing 30% between 2004 and 2005, and if you dig behind the numbers (provided by National Bureau of Statistics), it appears the bureau simply made a big population correction (GDP per capita for 2004 assumed 1.51 billion people, and in 2005 it assumed 1.33 billion). Now why they assumed 1.51 billion in 2004 when the CIA World Factbook said 1.3 billion (and everyone else seemed closer to 1.3 from what I gather) is beyond me. Always been puzzled by that mystery. By Chinawatcher - 4/17/2008 3:52 PM

Michael, As I have pointed out before, but perhaps too late for you to read, it is misguided to expect (in the absence of excess money supply growth) that if food prices are rising, non-food items in the inflation basket should be falling in price. I believe that the inflation basket is only a poor representative of the mix of transactions for which the money stock is used. In particular, the inflation basket excludes most assets. My knowledge of the Chinese economy is limited, but I believe that asset prices were generally rising rapidly before "inflation" picked up, and are now falling. By RebelEconomist - 4/17/2008 10:46 PM

I am curious which asset prices rebel economist is referring to. As China's new bank loans have spent the last year at a level exceeding a quarter of a trillion yuan per month, this can hardly be conducive to falling asset prices. Much of the credit growth appears to be flowing into real estate. The figures from the recently released Fixed Asset Investment data report that Real Estate Investment totalled 231.4 billion yuan in March, the second straight month above 230 billion and 10.2% above the 2007 average of 210 billion. The National Bureau of Statistics-Real Estate "Climate Index" has spiked back above 106, a level in the past which has been associated with a heated property market. And while there was a slight downtick in March, the Home Price Index continues to inflate at double digit rates, pegged at 10.9% yr-yr in the latest report. There has been a parabolic rise in Chinese Home Price Inflation which has more than doubled since the 1stQ of last year. By kevinfischer2002 - 4/17/2008 11:03 PM

I saw a TV show back in January on the economic CCTV channel (I think it was Economic 30 Minutes) that was showing how they determing prices. It said the National Bureau of Statistics sends people out every day to markets to find out the prices of common household items. It sounded a lot more thorough than what foreign NGOs do. Of course if NGOs send in foreigners there's a goood chance they could get higher prices in the markets. It also depends on how hard they're willing to bargain with shop owners. It really does sound hard to come up with anything near "objective." By orgulous - 4/18/2008 12:08 AM

Regarding food inflation in China: I neglected to mention that fuel and fertilizer costs make up 25-30% of farming costs. Given the meteoric rise in both (the price of oil is up 58% worldwide even if China does not pass 100% of the costs onto farmers) and the price of potash alone is up 325%, its clear that relentless food price rises are here to stay for the forseeable future. Although inflation is eroding the meagre incomes of the poor everywhere in the world, at least China is not in the same situation as India or other much poorer third world countries like Haiti. It is estimated that 70% of the population in India lives on less than 20 rupees per day. Although over 50% of the workforce is employed in agriculture, very few workers own their own land and are instead employed as field hands and migrant workers. By kevinfischer2002 - 4/18/2008 1:38 AM

kevinfischer2002, I was thinking of stocks above all. I recall reading that one reason that Chinese stocks were being bid up last year is that the return on deposits was relatively poor, which suggests that there is a link between stock prices and deposit money stock at least. Since then Chinese stocks have clearly fallen back. My main point though is that, assuming that Michael's thinking is based on the quantity theory equation MV=PT, the consumer price level is a poor proxy for the average price of transactions T. A purely relative price change that leaves T unchanged is compatible with rising consumer prices if other prices that are not included in the consumer price index are falling. By rebeleconomist - 4/18/2008 2:10 AM

Sorry; brainstorm! The average price of transactions is P of course, not T (which is the number of transactions per unit time period). By rebeleconomist - 4/18/2008 4:23 PM

Chinawatcher, I discuss Holland's piece briefly in the comments to my April 18 entry (his piece is based on research by Lombard Street, a very smart bunch of people). Their argument is plausible but hard to prove. At any rate I do think CPI inflation understates true inflation because I think the food component should be a lot higher than 33%. Orgulous, I don't think foreign NGO inflation numbers are the ones with which to compare the NBS numbers, and in fact I am not aware of any NGO numbers, foreign or Chinese. The worries about the NBS numbers are mostly anecdotal and from Chinese sources. Very few people seem to believe the CPI inflation numbers and there are persistent rumors of and stories about cheating on the price freezes. The Lombard Street exercise is not based on sampling. They are simply pointing to an arithmetical inconsistency in the government's GDP growth and inflation numbers. I don't know the process well enough either to agree with or refute them. By Michael Pettis - 4/18/2008 5:06 PM

Rebeleconomist, thanks for your comments. It is a little hard to know what is happening to asset prices in general because there is a lot of stuff we don't know, but very broadly the stock market declined until July 2006, rose until June 2007, declined until August 2007, reached a new peak in November 2007, and has been declining vertiginously since then. How important is the stock market to spending? Not sure, but total tradable stocks are less than 40% of GDP (given the alternatively soaring and crumbling prices the actual ratio depends of course on the day you do the calculation) and even much of that is locked up in the hands of ‘strategic’ investors. Real estate prices have been climbing pretty steadily during this whole period, although there have been temporary falls in some cities. This is probably much more important because it represents a larger share of household wealth in China, but even here I guess we would want to distinguish between speculative buyers and “real” buyers. Inflation started to rise in very early 2007 (perhaps even at the end of 2006) but most people didn’t notice the rising inflation because we mostly focus on the year-or-year inflation figure, which only started to show significant levels of inflation in the summer of 2007. I would suggest that for much of 2007 we have seen rising CPI, rising food prices, and rising asset values. Beginning in November stock prices turned down but the other things continued. I will admit that I may only be seeing what I am looking for. Given the tremendous and accelerating growth in money, as measured by reserve increases, I believe there has been excess money creation and perhaps because of this belief I am more impressed by evidence of monetary inflation than by other evidence. The key is if non-food prices continue to rise over the next few months. By Michael Pettis - 4/18/2008 5:09 PM