My Blog

July 7, 2008

Today was a very good day for the Chinese stock markets and a wonderful start to the week.  The SSE Composite rose 4.6% to close at 2792, after reaching a high in the later morning of 2802.  Of course it is worth noting that in the last month we’ve seen other very good days – the market was up 5.3% on June 18, another 3.0% on June 20, and again 3.6% on June 25 – but these were always followed by sharp declines the next day that took away all of the gains.  As has often been the case in the past few weeks today’s rising prices were led by banking stocks, after two of the best Chinese banks – large but not among the Big Four – said that first half earnings were likely to more than double from the previous year.

Is the rally likely to be sustained?  Today’s Bloomberg quotes a Hong Kong fund manager justifying today’s surge in the Chinese stock market:

Liu Yang, managing director at Atlantis Investment Management Ltd., which oversees about $4 billion in assets, expects a rebound.  “Fundamentals are very strong in China compared to any other Asian nation,” said Hong Kong-based Liu. “Chinese stocks are trading at crisis valuations. Do they deserve to trade at crisis valuations? The answer is no. The market deserves a very good rebound from here.'”

I am not sure what “crisis” valuations are, but it is interesting that she says this, and for reasons which she perhaps did not intend.  To explain what I mean, I should point out that part of the reason for investor optimism was almost certainly some comments made by Premier Wen over the weekend.  According to a Reuters article carried by the South China Morning Post:

Some traders said a visit by Premier Wen Jiabao to Shanghai and Jiangsu province at the weekend, when he said fighting inflation remained his priority but the government would seek “sound and fast development”, had prompted speculation that economic policy might shift somewhat towards sustaining growth in the second half of this year.

There is a sense among a lot of businessmen and economists here that the government is planning to loosen conditions in order to ensure that Chinese growth prospects are not seriously hurt by the bad news coming from both domestic and international markets.  Wen’s visit and comments on the economy were covered widely in the Chinese press and many think he seemed to be indicating or guiding what is likely to be coming out of the meeting of the country’s top economic policy-makers to be held later this month, probably after the July 17 release by the National Bureau of Statistics of the economic figures for the first half of 2008.

According to Xinhua’s report on Wen’s comments:

Premier Wen Jiabao has said the country will maintain the fast and steady pace of economic development despite the challenges from home and abroad this year.  Wen's remarks came during his three-day trip to eastern Jiangsu province and Shanghai from Friday to yesterday, where he met with local officials, farmers and entrepreneurs. 

The country's economy is developing in the expected direction after overcoming challenges from home and abroad, he said.  Wen urged governments at all levels to improve macroeconomic controls further and optimize the economic structure to avoid serious fluctuations in the economy.

Fighting inflation is still one of the major tasks, he said, and governments should try to make price rise “acceptable” both for the industries and the public.

As recently as March and April preventing inflation was the number one policy task and one of Premier Wen’s “two prevents” (preventing overheating was the other), but now it is just “one of the major tasks”.  Fighting an economic slowdown seems to have taken priority.   

It seems pretty clear to me that we are backing away from the fight against inflation as policy-makers become increasingly worried about a possible economic slowdown.  This is not necessarily a contradiction – a slowdown itself can, in some circumstances, resolve inflation – but it does indicate what to me is a worrying policy shift.  

In that vein I already mentioned in Saturday’s posting the comments last week by Li Yining in a speech to the country’s political advisory body that

the government should not over-reach itself in fighting inflation or be misled by the concept that only a low inflation rate would be a complete success in the anti-inflation campaign.  “The inflation rate, if controlled at about 60 percent of the growth rate, would be appropriate, such as keeping the rate at around six percent for a 10-percent growth in economy,” he said.

That statement by Li, I think, was very different from much of what we had been hearing since last summer: that inflation was a scourge, one of the “two prevents”, that had to be resolutely defeated.  Mr. Li seems to be saying that 6% or 7% inflation is not so bad – and this just a few months after the government officially targeted 4.8% inflation for 2008.  

His views, of course, are not universally shared.  Last week the People’s Daily published a report by CASS (you can read about it here) in which CASS economists argued that even with tight controls on prices CPI inflation this year would exceed 7%.  They advised the government to stick to its tight monetary policy, although they did warn that more rapid RMB revaluation could cause of harm to the economy.

I think, as the CASS report indicates, policy-makers and analysts still misread the relationship between inflation and the value of the RMB, which is why the widespread comments that a rising RMB has been associated with even higher inflation is not relevant.  It is not directly via an undervalued RMB that the currency regime is importing inflation, but rather because of the role of the currency regime in domestic monetary expansion.  Inflation won’t end because a rising RMB makes imports cheaper.  It will only end when the RMB has reached a level at which China is no longer flooded by money inflow.  That is why China needs to revalue sharply, and that is why the current “rapid” appreciation strategy, which has only encouraged spectacular amounts of hot money inflow, won’t end inflation.  Only a one-off maxi-revaluation will do that, although I am worried that we have waited so long that even this “least bad” policy is going to come at a heavy cost.

At any rate the point I wanted to bring out was that just as we have suddenly stopped hearing about the “two prevents”, we start getting senior officials saying that a little bit of inflation is perhaps not such a bad thing.  Today’s South China Morning Post makes a very interesting observation, in the context (“Beijing planners walk tightrope on growth, inflation”):

An official source at a high-level conference last month said when it came to the priority task of the nation at the meeting, “Premier Wen Jiabao ranked inflation prevention the first, while party leader Hu Jintao put development at the top.”

I have never been an inflation hawk and I do agree that sometime a little bit of inflation is very far from being the end of the world, but as regular readers of my blog know, I think in the last few years China has been sitting on explosive and potentially very destabilizing money inflows, with the attendant money creation, and so I suspect that China does not really have “a little bit” of inflation as one of its policy options.  I think that, like the US in the early 1970s, in China we’ve had our delightful monetary party with all the attendant good things, but the party is nearly over and it is going to be very hard to keep the lid on inflation over the next few months and years.  I think by the end of this year it will get much worse.

That is why I highlighted Liu Yang’s complaint cited above that “Chinese stocks are trading at crisis valuations.”  Perhaps it is not unreasonable for stocks to be trading at crisis valuations.  On the one hand there is a potential economic slowdown that could depress earnings sharply.  On the other hand, a policy shift to combat this potential slowdown risks an even greater undermining of national balance sheets which, when combined with the huge money creation and the increasing role of very pro-cyclical hot money in that money creation, could very well lead to a crisis.

Underlying conditions are becoming more and more complex, and the risks, as nearly everyone here seems privately to acknowledge, are becoming greater.  Last week the government tried to address hot money inflow disguised as trade by increasing the regulation of export revenues, even though as I and many others have pointed out, the evidence is that most hot money comes in from other sources.  This week there are suggestions that the authorities are planning to extend the strategy.  This is from Bloomberg:

China is drafting regulations to control cross-border payments for services to curb rising inflows of “hot money” betting on gains in the yuan, according to an official at the nation's currency regulator.

Controls on international payments for consultancy or franchising fees are “relatively weak” and need to be strengthened to stop speculative capital inflows, said the official at the State Administration of Foreign Exchange, who declined to be named. The regulator is consulting with agencies including the commerce ministry on details before announcing the new rules, he said.

If this report true, the actions will simply increase costs for legitimate business without seriously hampering hot money inflows.  Because of the enormous increases in inflows away from the FDI and trade surplus accounts, many of us assume that that most of China’s speculative inflows show up in the “unexplained” parts of the published balance of payments.  

But if it is true that FDI and trade actually do conceal a very large amount of hot money, and so the new monitoring measures will matter, then all the seemingly high estimates of hot money by the likes of Stone & McCarthy’s Logan Wright will have seriously undercounted the real inflow.  That is just a very long way of saying, I guess, that if these new trade and services monitoring measures are not a waste of time, then the problem is much worse than we imagined.

On a related but different subject, one of the things I’ve been trying to figure out is how hot money inflows are affecting the headline trade surplus numbers.  If – as we all believe, and as the government seems also to believe, given Wednesday’s new regulations by SAFE in which export earnings are going to be closely monitored for evidence of over-invoicing – exporters are over-invoicing sales and importers are under-invoicing purchases in order to disguise capital inflows, then the real trade surplus, which consists of real exports minus real imports, is lower than the nominal trade surplus.

My student Shang Ning compiled for me China’s trade surplus for the first five months of 2007.  These are the figures in billions of US dollars:

On average if we assume that 1% of export proceeds are falsified, the real trade surplus is 7% lower than the nominal trade surplus.  The corresponding number for imports is 6%.  In other words if you assume that 1% of export revenues are really hot money disguised by over-invoicing exports, you should adjust the trade surplus downward by 7%.

Comments (4) for "Shanghai seems to discount t...

Crisis valuations? Give me a break! The A-shares still aren't even cheap, much less at crisis valuations! Fund managers like this (who have experienced nothing but up) are the reason that Chinese stocks got so out of whack in the first place. By Adam - 7/7/2008 8:12 AM

Ha ha I don't disagree with you there at all, Adam, which is why I tried to tiptoe around that issue By Michael Pettis - 7/7/2008 4:12 PM

Maybe 'Crisis Valuation' is an exageration, but Chinese stock PE ratio is now lower than SP500. Compare the difference in PE ratios of the two markets to their economic growth rates and Chinese stocks being 'cheaper' maybe justified. Stock prices are discounting 'severe' economic slowdown. The discounting process is never precise. However, the top 5 trading days of the past three weeks are 'UP' days. Volume counts a lot in market health. Based the trading volume these last three weeks, I have to say the market is trying to base, and possibly turn. By kelaido - 7/7/2008 6:20 PM

I think the market has a lot further to fall before it bottoms out. I feel sorry for ordinary investors like my mother in law when there are so many people with insider information manipulating the market. I told her to cut her losses and get out back at Chinese New Year, I hope she listened to me. One thing about hot money inflows, if some of that money went into the local stock market then it is losing a lot of its value as the market keeps dropping. The same could be said about money that flowed into real estate as I would predict that the Chinese real estate market is headed in the same direction as the share market - there will be a lot less of that money that can flow out again later. By David Oliver - 7/7/2008 6:31 PM