My Blog

April 1, 2008

Yesterday, I wondered if after their 29% decline year to date, and 3% decline that very day, the Chinese stock markets might be near a bottom.  Today they dropped again, by over 4%.  I guess my call was a tad premature.  “People are rushing to sell shares in panic,” said Wu Kan, a portfolio manager at Dazhong Insurance Co. in Shanghai, according to a Bloomberg report. “Economic fundamentals and the lack of government support measures have both contributed to the plunge.”

So the market is down; what about other financial imbalances?  In my January 24 posting I argued that although fixed asset investment and industrial production had eased a little in recent months, we shouldn’t take much comfort in those numbers as suggesting that the impetus behind the roaring trade surplus was weakening.  It seems to me that every time the numbers let up, a lot of analysts sigh in relief and suggest that at last the tightening measures are beginning to work.  But as I see it, the tightening measures cannot work as long as China retains an exchange rate policy in which rising foreign exchange inflows are tied to rising investment in the self-reinforcing mechanism I described in my March 26 entry.  A slowdown in the rate of growth of industrial production, in other words, is temporary and likely to be reversed soon enough.

But the recent release of the purchasing manager index for March suggests that both headline PMI and the new orders index are near historical highs.  According to Credit Suisse, from where I get these numbers, “this indicates a revival in economic activities, potentially fueled by the relatively looser credit control measures seen since the beginning of the year.”  They are surprised at the strength of the rebound, especially the rebound in new export orders, and wonder if it has something to do with post-storm rebuilding.  I am less surprised, and think it is largely part of the same old story we’ve seen over the last three or four years.

Where we are much more in agreement is on the indications of more inflation.  According to Dong Tao, Credit Suisse’s China analyst:

Input prices index aggravated by 4.5pp to 74.6, the highest level ever. This has reflected the seriousness of rising inflation in China, coinciding with the rampant producer and wholesale price increases seen lately. Although the worst of the snow storms has passed, expectations of higher prices did not soothe but deteriorated further.

Almost all major sub-indices have pierced the sizzling 75 mark, with metal products (92.1), general machinery (89.1), and the smelting of ferrous metals (88.3) hovering around the 90 mark. We maintain our view that margins are shifting towards upstream industries at the cost of those downstream and that non-food inflation of the CPI index will face acute upward pressures.

I think Dong Tao is right, and I think (no surprise) that March and April numbers are going to show a slowing rise in food prices and an acceleration of inflation in the non-food sector.  This would be consistent with the model of inflation I have discussed many times on this site.  By the way the April issue of Far eastern Economic Review has a piece by me explaining in some length why I think high food inflation and low non-food inflation is perfectly consistent with the idea that inflation in China is a monetary problem.  As soon as I am allowed to publish it here, I will.  By the way March CPI numbers should come out in 10 days.

I was interviewed today by a Chinese financial journal planning a big feature on RMB appreciation and the prospects for China, and in the interview I briefly discuss all these subjects.  Since the interview, which covers the range of topics I often discuss here, will be translated into Chinese and presumably read by people that don’t often read my blog (and anyway this blog is hard to access in China), I thought I would copy the questions and my answers into this blog posting.  The questions sort of summarize much of what the financial press is thinking and worrying about in China.

In the first quarter of 2008 alone, the RMB has appreciated about 4%, the fastest pace since the exchange reform in mid 2005. What do you think of the appreciation progress? From your stand of point, is this pace good or bad for China?

China should have begun the appreciation of the RMB much earlier than it did and it should have appreciated more aggressively.  Unfortunately, perhaps because of the excess global liquidity of the past few years and especially of the past few months, China is now caught in a monetary trap in which the high trade surplus forces the central bank to buy large amounts of foreign exchange, which of course causes very rapid domestic money expansion.  This money expansion feeds directly into excessively high levels of investment, which force up industrial production and so causes the trade surplus to rise or remain high.  It will be extremely difficult for China to get out of this trap.

It seems that many Chinese exporters such as textile and shoe makers can no longer bear a faster RMB appreciation. They say that the faster appreciation plus increasing costs plus decreasing demand nearly killed them. From your observation, are these exporters going to lose their competitiveness and collapse? What is the real picture of China's exporting industry?

I think they are mistaking the cause of their trouble.  If it was the rising RMB that caused them difficulties or caused them to go bankrupt, we should see China’s exports slowing sharply and unemployment, especially in the south, rising quickly.  But we see neither.  Exports continue to surge and unemployment in the major exporting regions of the economy seems to be relatively low (indeed companies complain bitterly about upward wage pressures, which is not normally consistent with high unemployment).  What is causing trouble to certain exporters is something very different.  As China’s labor force, especially in the wealthy south and southeast, move out of low value-added assembly and into higher quality manufacturing and service jobs, companies that rely on cheap, unsophisticated labor will necessarily find conditions more difficult and may even go out of business. 

Although these companies may suffer individually, their problems will have no impact on overall employment in China because it is precisely the higher wages and better employment opportunities for workers that caused them to leave.  It also does not affect China’s overall exports because the production of these exports is shifting away from highly developed areas like Guangdong to less developed areas in the interior of China.  The growing bankruptcies of these companies is not a sign that the currency is appreciating too quickly but rather a sign that policies aimed at creating a higher quality manufacturing and service base in places like Guangdong are succeeding.  As long as overall exports continue to grow it is hard to see how the rising RMB has caused trouble for Chinese exporters in general.

As you know, the CPI of China has been very high in recent months. Many say that a faster appreciation will ease inflation. But we have seen now is that China's domestic prices keep increasing. Why?

This is another common mistake in the debate.  In China, appreciation will not reduce inflationary pressures through the price impact on imported goods.  It can only really reduce inflation if it reduces the amount of foreign exchange the central bank has to buy every month, and so reduce the growth of the domestic money supply.  As long as China’s money supply keeps expanding at such a fast pace, it will be impossible to bring inflation down, and as long as the central bank is forced to purchase very high levels of foreign exchange every month, China’s money supply will keep growing too quickly.  The recent appreciation has done nothing to slow the trade surplus but it may have increased speculative inflows, so it actually causes an even further increase in the money supply.

Many economists are calling the Chinese government to rethink the appreciation mechanism. Some suggests a one-off appreciation just like 2005 to reduce import costs. What do you think of this? What is your outlook for the RMB's exchange rate by the end of the year?

When I first argued, a little more than a year ago, that the government was eventually going to be forced into a large, one-off appreciation, I made the argument because no other solution would get it out of its monetary trap.  I still believe this and I believe that recent events have actually strengthened the argument.  It is a very difficult policy choice, but the alternatives are all worse.  If China wants to reduce inflationary pressures it must move as quickly as possible to reduce foreign currency inflows, and the only way to do that is to surprise the market with a one-off revaluation large enough to slow export growth and, more importantly, to cause speculative inflows to reverse and leave the country. 

But the revaluation must be large enough to be credible.  A revaluation of less than 10-15% will almost certainly make matters worse since it will still leave the market believing that the RMB is undervalued, and it will signal how desperate the situation has become for the central bank – thus convincing everyone that the central bank will be forced to act again.  This will cause speculative monetary inflows to surge.

Comments (2) for "PMI numbers are too strong"

I have been following your analysis and blogging about it. What do you think is the maximum RMB appreciation that doesn't trigger accelerating hot money outflow if the government wants to delay or avoid the 1 time revaluation? Do you really think a 15% maxi-revaluation is really enough a shock to the system? At what levels will RMB be fairly or over-valued vs. USD? Is it fair to assess this on a PPP basis or is there some other big variable other than PPP? Thanks for your great work. We'll be following your commentary closely! By Elliott Ng - 4/2/2008 4:39 AM

Elliott, sorry, but yesterday I responded at length to your comment and thought it was published. Today I find it has disappeared. To summarize, I'm not sure I fully understand your first question but basically I don't really think about the maximum RMB appreciation so much as the minimum needed to head off further speculation – which I would propose is about 15-20%. I think this level of revaluation – and of course any larger one – is definitely enough to shock the system, but the whole point is to figure out how to create the least shock possible consistent with the desire to head off speculative inflows. I am not able to figure out what is the “fair” value of the RMB and frankly don't really try to do so. I am not sure there is even a very good theoretical explanation of what “fair” value is in this context, and even if there were, there is a lot of evidence – for example that provided by my former Columbia University professor Michael Adler – that currencies can deviate significantly from PPP for very large periods of time. Because I think of China's problem as a monetary problem, my instinct is to consider the strategy for revaluation (including the “right” amount of revaluation) primarily in terms of whether it solves the monetary problem. By Michael Pettis - 4/3/2008 6:32 PM