My Blog

January 23, 2008

WED 23 JAN

China's economy – a speeded-up version of the rest of the world By Michael Pettis

Zhu Xiaoliang, deputy head of the Ministry of Commerce's department of market operation regulation, said in a televised interview yesterday that inflation in China would remain high but would gradually ease.  He also promised that the ministry would ensure adequate supplies of major food products such as meat and vegetables to stabilize prices during the upcoming Spring Festival holidays. 

 

This continues to suggest to me that the main concern of the government is the impact of high food prices during the upcoming holidays, and of course I suspect that some of the measures that will be used to keep prices down – such as price controls and selling of government food stocks – will serve mainly to postpone inflationary pressures.  If numbers are good now, expect them to jump back up in March and April.  Zhu didn’t predict what tomorrow’s December CPI release would indicate, but he said he thought December CPI inflation would be in line with market expectations, which are generally 6% or slightly higher.

 

Meanwhile we are being hit again with energy shortages.  The People’s Daily reported yesterday that China now faces a 69.63 million kilowatt electricity supply shortfall, and a total of 13 provincial level power grids have been temporarily switched off to limit power usage.  National coal stocks are low – 17.7 million tons, from 20 million less than two weeks ago – and not much above what government officials say is the minimum required level (14 million tons).  I don’t know if this is mainly because of unseasonably cold weather in the central and Eastern province, which is the official explanation (and I have to say that Beijing is bitterly cold – during an outside interview with CNN earlier today I could barely move my frozen face muscles) but, more ominously, some people are being accused of hoarding.  Shortages, as we all know, are one possible consequence of price controls, and hoarding is often rational behavior by knowledgeable insiders.

 

Amid these problems the stock markets rebounded today, with the Shanghai A-share index up 3.14% following it’s nearly 13% decline in the last two days.  During times of trouble correlations among risk assets tend to rise, and perhaps this is happening in China although there are still very significant impediments to direct linkages between China’s and the rest of the world’s stock markets.  

 

Still, in my view, there should be a strong fundamental link between Chinese and global (or at least US) stock prices.  China, largely because of its currency regime and the impact of its lack of monetary policy on the banking system, and especially real estate lending, seems to me to be a very high beta version of the world economy – high GDP growth, monetary expansion, and inflation in the rest of the world is matched by even higher levels here.  

 

China is the rest of the world on amphetamines.  When the world is experiencing good growth and swimming in excess liquidity, China gets an extra dollop of both: global growth pushes Chinese growth through expansion in the export sector; global excess money feeds into explosive money growth in China because of the currency regime; and monetary growth coverts into credit growth, especially for the real estate sector.  It is primarily the booming real estate and export sectors that have driven much of China’s recent breakneck growth.

 

The problem is that this same mechanism, which can convert “good” external conditions into great domestic conditions, could also function in reverse.  That is my big fear, although I don’t think policymakers see things this way.  They are worried of course by the possibility that a US slowdown could hit them just as the recent cooling measures begin to impact the economy, but they haven’t moved decisively to break, or at least moderate, the pro-cyclical links in the economy.

 

Aside from the currency regime one of the most worrying pro-cyclical mechanisms is the two-way link between the banks and the real estate sector.  Boom times, of course, encourage bank lending, which disproportionately goes into the real estate sector in China, and real estate development is one of the prime engines of the economy.  But an export slowdown which causes a reduction in money growth would be exacerbated by the consequent reduction in bank lending to the real estate sector.  The real danger is that these might lead to sharp rises in real estate-related non-performing loans that could force real estate lending into a virtual halt.  The last thing we would need, I am sure we all agree, is for the export sector and the real estate sector to crash at the same time, but I am afraid that these two sectors are closely tied together via the country’s monetary system.  When one goes, the other will soon follow.  Thanks to the currency regime, there are not a lot of uncorrelated moving parts in the Chinese economy. 

 

The crucial factor in the link is whether or not recent real-estate-related lending is healthy and prudent.  In a speech by PBoC Deputy Governor Liu Shiyu at a Conference held on December 11, 2007 and only recently translated on the PBoC website, he lists four problems in real estate finance in the Chinese markets:

 

1. Real estate credit is growing excessively fast…

2. Competition is extremely fierce, creating huge underlying risks. At present, real estate loans, especially individual housing loans, are classified as prime assets. To take more market share, local offices of some commercial banks lower lending criteria, reduce examination steps and relax investigation through distorted practice...

3. Mortgage refinance loans and additional mortgage loans are granted without proper approval…

4. Weak loan management unveils risks associated with "fake mortgage". A few branches and sub-branches…collaborate with real estate developers and real estate agents to make up housing mortgage loan contracts in order to grant loans for real estate developments under the name of housing consumption loans, or to help developers to speculate on difficult-to-sell buildings through "fake mortgage".

 

He concludes by asking banks to continue to push forward with financial innovation while at the same time improving their risk management techniques.  I am not sure what that means, but I certainly agree with his assessment of the risks.  Unfortunately my experience in other developing countries suggests that we will only know the extent of the problems when we get into trouble, and that their extent will surprise us.

 

By the way and as an almost complete aside, in a very interesting post on his blog today Brad Setser wonders whether the decline in the US trade deficit is as healthy as we hope.   He says:

 

I am not 100% convinced, though, that all imbalances are correcting.   To me the biggest imbalance in the global economy is the gap between the current account deficit that private investors want to finance and the current account deficit the US now runs.     That imbalance – at least in my view – seems to be getting bigger, not smaller.  The deficit that private investors want to finance seems to be falling even faster far faster than the actual deficit.

 

It is a very interesting post and one which I need to think about a little – the role of central banks in financing the US deficit is rising, which among other implications also means that they are not selling dollars.  Certainly, as Brad points out, China would be a very big quantity in this equation.