My Blog

December 1, 2007

SAT 1 DEC 2007

More monetary headaches (2) By Michael Pettis

Wright adds up all this liquidity and says the PBoC may be dealing with an increase of RMB 2 trillion ($270 billion) in the next two months alone, and I think he may be underestimating reserve inflows, which he projects at $20 billion a month. How will the PBoC do so? The central bank pays 1.89% on required reserves and has been paying 3.99% on 1-year paper so, aside from the fact that it would be very difficult for the PBoC to sell so much paper at the rate at which current paper trades, it is far more cost effective to sterilize by raising reserve requirements than by selling central bank bills.  This is what Wright suggests will happen – and he predicts that minimum reserve requirements will rise 1.5%, to 15%, by the end of the first quarter.

 

My assistant, Oliver Shang, coincidently sent me a note yesterday saying new MoF 3-year and 5-year bonds will be sold next Wednesday, and at far higher rates than they have been sold in the past. I searched for the information and found that in fact the MoF will be selling to retail investors RMB 34 billion of 3-year bonds with a coupon of 5.74% and RMB 6 billion of 5-year bonds with a 6.34% coupon.

 

These will be part of RMB 110 billion of bonds expected to be sold next week – mostly by government agencies, departments or SOEs.  For example the Ministry of Railway will be selling RMB 45 billion of 7- to 15-year maturities, of which more than half will be 10-year bonds with a 5.60% coupon, up from 3.75% last year.  During the first ten months of 2007 Chinese bond markets saw RMB 6.3 trillion ($85 billion) of issuance, which exceeded last year’s total of RMB 5.7 trillion.

 

It’s great that so many bonds are being issued – the growth of a domestic bond market is over the medium term one of the best risk-management developments that can take place in the Chinese markets. Chinese companies are turning to the bond markets because their issuance has become more flexible than bank borrowings, especially with the government indicating a very strong determination to slow credit growth.  This determination hasn’t had much impact in the past, but it seems that this time around they may be a little more determined than usual.

 

Borrowing costs in the bond markets are also lower – 10-year corporate bonds in recent months have come out at under 6%, whereas the 5-year loan benchmark is much higher – currently 7.83%.  For these two reasons I expect that over 2008 we will see ever more activity in the mainland bond markets

 

But in the short term rapid growth in the bond market brings its own problems.  First of all, so much new issuance by the government, SOEs, banks and corporates is not going to make it easier for the PBoC to sell anywhere near the amount of bills it needs to sell to sterilize the liquidity expected to flood into the system over the next few months. Secondly, if bond financing grows too quickly, it may seriously reduce the impact of administrative measures aimed at slowing credit growth. A lot of credit growth will simply occur outside the formal banking sector (and I wonder if the business of informal banks has been growing rapidly during the past few months, as I suspect it might), so undermining the goal of restraining fixed asset investment by restraining loan growth.

 

By the way, with all this money pouring into the markets over the next four months, what are the likely impacts on asset prices? I wonder if we will see the equity bubble shake off its doldrums (Shanghai was down 18% in November) and get back to being a bubble.

 

SAT 1 DEC 2007

More monetary headaches (1) By Michael Pettis

Logan Wright, of Stone & McCarthy has been trying to count the amount of money likely to be sloshing through the system over the next few months and comes up with some very interesting numbers. In a note he sent me yesterday (“We’re going to need a bigger boat”) he points out that the next four months may be very trying times for PBoC money management.

 

First off, an awful lot of PBoC paper is maturing during this time.  About RMB 1.5 trillion is coming due between December and March, with a peak of RMB 586 billion in January alone. This is, according to Wright, “the largest four-month volume of paper redemptions in the history of PBOC sterilization operations.”

 

In itself the fact that we are record levels doesn’t surprise me. With foreign currency inflows and concomitant reserve growth accelerating over the past three years, it is not surprising that every few months we hit a new record – whether we’re measuring industrial production, credit growth, the trade surplus, or, why not, maturing central bank bills.  By the way yesterday we saw that the Purchasing Managers’ Index rose from 53.2 to 55.43 in November, suggesting that industrial production is going to surge. This is not surprising given recent high fixed asset investment levels. With surging industrial production will come, as I have argued many times before, a rising trade surplus and, along with it, more foreign currency inflows.  This is a hard trap from which to escape.

 

But to get back to Wright’s piece, RMB 1.5 trillion of maturing bills in four months is a big number, about $50 billion a month on average, comparable with and even larger than the monthly increase in reserves. Basically the PBoC has not only to mop up an expected $30-40 billion of foreign currency inflows every month, a Herculean task as it is (October’s reserve increase was $21 billion, probably low because of transfers to the CIC, but it has averaged $39 billion a month in 2007), but it must add to the mop-up the maturing of a substantially larger amount of maturing central bank bills during the next four months.

 

But there’s more. Wright argues that the maturing of repurchase agreements will add another RMB 250 billion over the four months, bringing the total amount of money entering the system to nearly $60 billion a month, not counting the PBoC purchase of net foreign currency inflows, which could mean managing $80-100 billion a month of new liquidity. In addition the recent amount and structure of fiscal revenues will add to the liquidity far more than it normally does. Wright explains:

 

Fiscal revenue is sky-high this year, up from last year's total of 3.87 trillion yuan to an estimated 5 trillion yuan this year, according to a report from Yao Jingyuan, chief economist of the National Bureau of Statistics, cited in the Shanghai Securities News on November 26. The targeted revenue level was 4.4 trillion yuan. Fiscal deposits have continued to grow in the central bank throughout the year; as of the end of July, they had risen by 1.036 trillion yuan since the end of 2006. Usually, government departments spend their budgets toward the end of the year in order to justify higher budgets in the following year. Typically, in December, money flows rapidly out of government deposits at the central bank; last year, the month-on-month decline in December was 557 billion yuan.

 

This year, with revenues even higher, the outflow could be higher as well. A report from the State Information Center on November 12 warned about precisely that outcome, stating, "If we were to stick to the fiscal deficit target set at the beginning of the year, fourth quarter (government) spending would have to be very large to achieve that deficit, which could significantly boost aggregate demand in the economy." The report cited spending levels as high as one trillion yuan in the fourth quarter were possible, and warned against that level of spending.

 

Will the PBoC be able to sterilize this flood of money?  Unless they are willing to see interest rates rise much higher, it is pretty unlikely, and the several spikes we have seen in pre-IPO repo rates (see my November 8 entry “Small banks getting squeezed by IPOs”) have made banks less willing than ever to tie up money in anything except the shortest maturities. This will make selling PBoC bills a very difficult task unless they are willing to pay up.

 

Remember, by the way, that high interest rates only increase the attractiveness of domestic markets to foreign money, and are likely to encourage even more speculative inflows into the country. Allowing rates to rise in order to accommodate a higher volume of sales may only increase the amount of paper that needs to be sold. PBoC money management is not easy.