My Blog

January 2, 2008

WED 2 JAN

Is China sneaking in a revaluation? By Michael Pettis

The RMB keeps strengthening, to 7.2948 as of yesterday.  This has it rising at its fastest pace since the peg was broken in July, 2005.  According to my friends, some local currency traders see the burst of appreciation we have experienced recently as a sort of back-door “revaluation”.  By forcing up the currency over the past few weeks at its fastest pace (2.3% in the past two months), the PBoC is effectively engineering a revaluation over several weeks, while seeming not to violate its promise that it would not do so after the first revaluation in July 2005.

 

This may well be true.  By now I think the old argument about whether or not the RMB needed to appreciate is more or less over.  The mistake made by many was that contrary to the assumptions of many the need for China to appreciate had little to do with the direct impact of the value of the RMB on the relative prices of Chinese exports and everything to do with China’s lack of domestic monetary policy.  

 

Those of us who have been arguing sine 2003 or 2004 that the country’s currency regime had left it locked into a monetary trap that was going to lead to ever-increasing trade surpluses and ever-expanding domestic money, however, still have one big disagreement.  One side argues that China needs to adjust the currency as quickly as possible and the best way is to speed up the rate of appreciation.  The other side argues that China has forced itself into a position in which the only possible solution is a large (say 15-20%) one-off maxi-revaluation.  Over the next few months we will see whether the more-rapid-appreciation school or the one-off-revaluation school will do a better job of predicting what the government actually does, but for the record I believe that China has no choice but for a maxi-revaluation.

 

The main thing to watch, I think, is hot money inflows.  If these pick up substantially as the RMB continues appreciating, the impact of the current rate of appreciation will be at first to make monetary conditions even worse as more money floods into the country.  This will result in greater fixed asset investment, rising industrial production and, what may at first seem paradoxical, a high and even rising trade surplus.  It will also keep pressure on inflation. 

 

If we see reserves rising as fast as ever as the currency’s appreciation speeds up to 7-10% a year, this will almost certainly be an indication that the new policy is not working.  By the way, and as an aside, an important problem with the appreciation strategy, although this will not be apparent for a while, is that once the RMB has reached its targeted level there is no way for the PBoC to signal credibly to the market that the currency has reached its target and will no longer appreciate, and hot money will continue to pour in, putting more appreciation pressure on the currency.

 

At any rate if reserves continue to surge as the currency rises, the impact of currency appreciation on bringing control back to monetary policy will be negligible or even negative – and currency appreciation is the last tool the PBoC has left with which to combat inflation and overheating.  In that case the PBoC will be forced to something far more dramatic to stem capital and current account inflows, and it seems to me that only a one-off maxi-revaluation followed by a credible peg will do the trick.  The argument in favor will also seem easier to sell domestically because policy-makers will be able to see that the currency can appreciate rapidly with no real collapse in the export sector.  The argument will be faulty, of course, because this was never about relative export prices, but it will still make it easier to sell the maxi-revaluation policy to local authorities.

 

The bottom line, I think, is that if the currency continues appreciating at 1/2-1% every month, we should watch reserves growth carefully, and of course make sure we back in transactions that result in reductions in headline reserves but which will have no domestic monetary-contraction impact. If reserves still grow at their furious pace, the PBoC will be forced to shoot the last arrow it has left in its quiver

 

WED 2 JAN

The government condemns Chinese financial markets to speculation By Michael Pettis

Two weeks ago when I was being interviewed for Dialogue, a local current events show on CCTV 9, I was asked about the sophistication of Chinese investors, and I responded that China does not have a real investor base.  The whole market here is speculative, I argued, not because Chinese investors are naturally speculative but rather because the structure of the market does not permit any other form of investing.

 

The other guest on the show, the chief economist of a major Shanghai fund, disagreed, saying that Chinese investors are not speculators but are simply investing based on their perception of what the government is going to do.  In China, he explained, the only important question for an investor is “What will the government do tomorrow?”

 

He is right of course in his description of the motives of Chinese investors, but he is wrong in saying that this isn’t speculative.  In fact investing based on perceptions of government behavior is a classic speculative strategy, and it explains why Chinese markets are so inefficient at allocating capital and why, for all the attempts by financial authorities to make local markets more “sophisticated”, nothing is likely to improve in the near and medium term.

 

Basically speaking most investment strategies can be fit within a triangle whose three corners represent the purest form of the three main investment strategies.  In one corner, value investment or fundamental investment involves buying assets in order to earn the long-term economic value generated over the life of the investment.  In the second corner arbitrage or relative value trading involves exploiting short-term pricing inefficiencies to make low-risk profits.  In the third corner speculation takes advantage of “technical” information that will have an immediate effect on prices by affecting short-term demand or supply. 

 

Each of these investment strategies plays a different and necessary role in ensuring that a well-functioning market is able keep the cost of capital low, absorb financial risks, and allocate capital efficiently to its more productive use.  Fundamental or value investing allocates capital to its most productive use.  Speculation, because it involves frequent trading, provides the liquidity and trading volume that allows value investors and relative value traders to execute their trades cheaply.  It also ensures that information is disseminated quickly.  Arbitrage or relative value trading forces pricing consistency and improves the information value of market prices, which allows value investors to judge and interpret market information with confidence.  It also increases market liquidity by combining several different, related assets into a single market.  When buying of one asset forces its price to rise, for example, relative value traders will sell that asset and buy related assets, thus spreading the buying.

 

China does not have a well-balanced investor base.  There are almost no arbitrage or relative value traders because they require low transaction costs and the legal ability to short securities, neither of which is available in China.  There are also very few value investors because the quality of financial and macroeconomic information is poor and corporate governance and regulatory frameworks are weak and inconsistent.  If we broadly divide information into “fundamental” information, which is useful for making long-term value decisions, and “technical” information, which refers to short-term supply and demand factors, it is easy to see that the Chinese markets provide a lot of the latter and almost none of the former.  The ability to make fundamental value decisions requires a great deal of confidence in the quality of economic data and in the predictability of corporate behavior, but in China there is little such confidence.  Furthermore, regulated interest rates and pricing inefficiencies makes it nearly impossible to develop good discount rates.

 

On the other hand there is plenty of technical information, and as a consequence the vast majority of investors in China must be speculators.  Insider activity is very common in China, even when it is illegal.  Corporate governance and ownership structures are opaque, which can cause sharp and unexpected fluctuations in corporate behavior.  Markets are illiquid and fragmented, so large price movements can easily be caused by determined traders.  In addition, the single most important player in the market, the government, is able and very likely to behave in ways that are not subject to economic or value analysis.  One consequence of this is that local markets do a poor job of rewarding companies for decisions that add economic value over the medium or long term.  Another consequence is that Chinese markets are very volatile, and this raises the cost of capital for business.

 

All investors in Chinese markets must be speculators if they expect to be profitable, and if Warren Buffet moved to China he, too, would be forced to become a speculator.  As long as this is the case, investors will not behave in a way that promotes the most productive capital allocation mechanism in the markets.  In order to change this, Chinese authorities must reduce the importance of speculative trading by reducing the impact of non-economic behavior from government agencies, manipulators, and insiders.  They must also improve corporate transparency.  They must continue efforts to improve the quality of both corporate reporting and national economic data.  Finally they must deregulate interest rates and open up local markets to permit arbitragers to enforce pricing consistency and to allow better estimates of appropriate discount rates.

 

Unfortunately, Chinese financial authorities are not reducing, but are in fact increasing, the importance of technical information related to government activity.  In recent months the importance for investors of predicting government attitudes to the markets has actually increased.  The authorities are caught in a tough position, because they are worried about a bubble in the stock and real estate markets, but their inability to keep their hands off the market is actually seriously undermining the development of a balanced investor base by reinforcing the perception that only the government matters.  This will continue to be a largely speculative market for many more years.