My Blog

April 28, 2008

Bad earnings were blamed for the poor start to the trading week, with the SSE Composite down 2.33% today.  Even Jim Rogers, who said over the weekend that he was scooping up Chinese stocks now that they were cheap again, was not able to psych the market up, and he is much quoted and admired among small investors here in China.  Rumors continue to swirl about additional measures to help prop up the market, but I suspect the failure of Wednesday’s cut in the stamp tax to sustain a rally will have seriously dampened the credibility of future administrative moves to strengthen the market.

There is not a whole lot of interesting news today, as far as I can see, and I have been too busy recently to write about an analysis my assistant Shang Ning did on debt levels among Chinese corporates, but I do plan to do so soon.  What small thing worth noting: China Daily has an article today (“Yuan appreciation dampens textile export”) that discusses how the rise of the RMB has hurt textile exporters, at least according to preliminary reports from textile firms wooing foreign buyers at the 2008 International Textile, Fabrics and Accessories Exhibition held recently in Zhejiang Province.  The article blames the rising RMB for the lack of orders, although given that they quote an Austrian businessman who complains about rising material and labor cost – and of course as a Eurozone country Austria has not seen any RMB appreciation at all – I would argue that the article confuses the impact of rising labor costs in China with the RMB’s appreciation against the dollar.  I suspect that this article is part of the internecine fighting among the growth and monetary guys vying over an explanation of what ails China.

Speaking about exports, I am increasingly concerned that the trade surplus in China is actually beginning to decline, and much faster than people think.  My reasoning is simple and completely intuitive – i.e. there is not a shred of hard evidence to back it up – but I nonetheless think it highly plausible.  I contributed the following (somewhat edited) comment to today’s discussion on Chinese reserves on Brad Setser’s blog (http://www.rgemonitor.com/blog/setser):

Given the rapid increase in various proxies for hot money inflow, it is probably pretty safe to assume that hot money disguised as FDI and/or trade is also growing quickly. Certainly the nearly 70% growth in FDI during the first quarter suggests that there has been an increase in speculative inflows disguised as FDI. After all there was no very good fundamental reason for this growth – in fact it is not hard to argue that FDI in China is less, not more attractive today than in the past few years.  If this is true and a big chunk of FDI is simply hot money, it is probably also plausible to argue that hot money disguised as trade has also increased significantly.

From that it follows that export growth and the trade surplus have probably declined much faster than the small decline in headline numbers suggest.  If true, this complicates matters.  Thanks to deteriorating global conditions China may actually already be running a narrow trade surplus or even a small trade deficit, which could make the authorities all the more afraid of a maxi-revaluation, and yet for the reasons we have been discussing over the past fifteen months the maxi-revaluation is probably inevitable because of the crazy monetary consequences of hot money inflow.  The cost of a maxi-revaluation may be rising even as the cost of steady appreciation is.  The longer they wait the worse the options become.

In other words, if we are starting to see Chinese monetary growth powered exclusively by hot money inflows, instead of by the trade surplus as it was in the past, we are entering into a far more volatile stage of the game, where the consequence of a policy misjudgment may be higher than it has been in the past because the outcome is likely to be much more heavily determined by very volatile and hard-to-control and hard-to-judge hot money flows.  The risk associated with an adjustment is rising, in other words, even as the cost of not adjusting is too.  I worry that another quarter or two of $200 billion plus increases in reserves is going to make the adjustment process for China much more difficult.  It is increasingly important that the recession in Europe and the US be as brief as possible if China is going to have room to adjust.  If we see additional weakness in the global environment, I think China’s room for maneuvering declines substantially.

Speaking of Brad Setser, his blog alerted me to an article published last week in Caijing, China’s most influential business and economics magazine, and written by Wang Tao, head of Bank of America’s Economics and Strategy for Greater China.  You can find Wang Tao's article here.  He argues that given the hot money inflows that we have been seeing Chinas’s best option is a maxi-revaluation.

More drastic measures may be necessary to reduce liquidity-generating FX inflows and loosen the close link with the accommodative U.S. monetary policy. The answer may be a combination of a one-off revaluation and tightened capital controls, accompanied by structural measures…[T]he current and steady appreciation of the yuan has entrenched expectations and helped fuel speculative inflows. A one-off revaluation could help break the expectation in the near term if it is combined with tightened capital controls.

Two issues would immediately arise from the above approach: the difficulties in determining the appropriate size of the revaluation, and the questionable effectiveness of capital controls. On the first, we doubt anyone would be able to make an accurate estimate of the yuan’s fair value or degree of undervaluation. However, that may not be necessary. A sizable revaluation that is significant enough to have an impact on the trade surplus yet deemed acceptable by the government over a one-year period (say 10 percent) could be picked. An unexpected revaluation, combined with the right statement and other policies, could send a clear signal to the market that this round of yuan appreciation has ended, thus staving off speculative inflows.

I agree with much of his analysis, although I think 10% might be too little.  Still, it seems that more and more commentators are coming around to the view that China is being forced inexorably into a one-off revaluation.  I predicted in early 2007 that by the summer of 2008 this once-crazy proposal would become conventional opinion.  I think the sheer size of the problem and the weight of the numbers will eventually drive away all the objections.  It will be a difficult choice to make, but I can’t see the alternatives.

Comments (10) for "The market isn't too happy, ...

FYI -- Wang Tao happens to be a she By bsetser - 4/28/2008 2:07 AM

Wang's point is based on the estimated large trade surplus---then revaluating is good to reduce surplus and to rebalance. If currently it is true that "Thanks to deteriorating global conditions China may actually already be running a narrow trade surplus or even a small trade deficit,", then why do they want a max-revaluation? The truth is the perception of RMB's appreciation prospects can change as abruptly as anyone can imagine. In that case, every penny of hot money, even some cool money, will run out of China in the same time, as the history of previous crisis showed. If the hot money run coincides with a largely appreciated RMB, then that will be a real desaster. By fatbrick - 4/28/2008 2:35 AM

Fatbrick, the risks associated with the currency adjustment are certainly increasing, but the fact that at some point we might see significant hot money outflows is not a reason for postponing the needed adjustment and waiting for another huge increase in reserves. If that happens, the financial system will become even more unbalanced and even more vulnerable to ho money outflows. The longer we wait the greater the risk. Brad, thanks for the correction. By Michael Pettis - 4/28/2008 11:53 AM

Lately we have seen some drastic price action in Rmb NDF and options market. Long dated Rmb NDF dropped 3-7%, bouncing back from 5.6-5.8 range in mid march and implied volatility rising. There is report some macro funds squaring very sizable Rmb long positions in NDF and options market. The strong nominal exchange rate and higher domestic inflation has already begun to constrain export and 1st quarter trade surplus dropped by 10.6% to US$41.6b, this is the first drop of trade surplus since 2004. y middle March, 2-3 year Rmb NDF has pushed Rmb /USD to 5.6-5.9 range is too aggressive. 6 Rmb/USD will imply 40% appreciation vs. US dollar and around 25-30% appreciation on real effective terms. This level imply significant appreciation and might overshoot deteriorating China macro fundamentals. 1. Inflation is approaching double digit, if persisting for a few quarters, it will limit room of nominal appreciation as exporters competitiveness and over-valued China assets losing traction. 2. Overall Growth faltering, potentially growth could falter below inflation. The slowdown is not only in export but broad based as household income, domestic consumption weakened. 3. Expensive and extensive distortion in energy prices and grain prices are difficult to adjust without major jolts. Mis-priced energy is the most important policy accommodation at Rmb600b or 2PPT GDP per year, phasing out price control risk pressuring domestic demand while sending inflation into mid-teens. 4. Asset prices are still expensive despite collapsed A share, property market remain fragile. When Rmb rose below Rmb6/USD, massive capital flow could reverse. Central bank estimate up to US$200b short term capital flowed in last five years to stock and property market. 5. Considering the challenge and slow policies responses, the risk of economy hard-landing are significant 6. Long Term Economic, Social, Political Risks premium need to be re-priced, Rmb6.000/USD is expensive and implied volatility in Rmb is low based on historical norm and China's macro uncertainties. By isaac - 4/28/2008 4:20 PM

Michael Pettis, the hot money outflow is inevitable. So it will come down to two options: a cheap RMB+outflow and an expensive RMB+outflow. Which do you prefer? By fatbrick - 4/28/2008 9:11 PM

Isac, it seems from your litany of facts that you believe that the policy adjustment is getting more, not less, difficult. If so I agree. Fatbrick, I am not sure i understand your question. Why is hot money outflow inevitable, and under what conditions? The way I see it hot money INflow is inevitable. By Michael Pettis - 4/28/2008 9:26 PM

Isaac -- I don't think there is much evidence that a stronger RMB is really pinching exports. Remember, the RMB has depreciated v the euro. The RMB has appreciated v the $ -- contributing to the slowdown there. But the main cause of the slowdown in chinese exports to the US is likely the slowdown in the US economy. The pace of growth in China's exports has slowed in % terms, but not in $ terms. Basically, the % slowdown reflects a bigger base. the fall in China's surplus in q1 has a much simpler cause: high oil prices. Look at the y/y comparison in oil prices for q1 06 v q1 07 ... this is will also be an important factor in q2. Michael -- I just learned that Yves Smith is a woman, so, well, getting the gender of line commentators right is a challenge. By bsetser - 4/28/2008 9:56 PM

Michael Pettis , One way or the other, there will eventually be a hot money outflow. Either the hot money takes profit after a mass revaluation, or the hot money run for other markets because their perception about the currency prospects changes: thin trade surplus, high unemployment, high production cost. The April food price has a small m-o-m increase from March. The biggest problem will be gas price. By fatbrick - 4/28/2008 10:26 PM

Yes, the policies are tight cornered. The most difficult one is not really exchange rate, which do have some flexibility and gradually adjusting. The biggest risk is what to do energy prices 40% off the market and risk continuous dirusption and already costing US$100b per year in subsidy, there is almost no way for smooth adjustment, more likely some kind of energy crisis will force a major shock on both growth and inflation. As for exchange rate, I just dont see further reason for revaluation or even accelerated appreciation like last two quarters, both export and trade surplus peaked, asset prices also peaked. Whether shrinking trade surplus is due to exchange rate, inflation, weaker demand or oil prices may not be that important the key is, if current pressure on balance of payment is driven mostly by repatriation inflow, the best way is not maxi reval rewarding them and potential trigger profit taking capital flight. Some form of FX control could do the job. I used to believe that Rmb appreciation need to quicken so as to curb inflation, however whether faster Rmb/ USD could help is beyond China control, this is a vicious race between Rmb and dollar/commodities Rmb could not win, unless dollar stabilized or rebound on sustainable basis, Rmb/USD move have little effect on China inflation By isaac - 4/29/2008 8:21 AM

Isac, I think the reason RMB appreciation has had no appreciable effect on inflation is because it is not the adjustment in relative price that matters but rather the slowdown in monetary expansion, and so far the form of RMB appreciation has not accomplished this. Untill we see outflows, or at least significantly smaller inflows, I don't see how the PBoC regains control of China's money supply. By Michael Pettis - 4/30/2008 5:26 PM