My Blog

March 14, 2008

FRI 14 MAR

5% revaluation of the RMB? Are you crazy? By Michael Pettis

China’s National Bureau of Statistics released a new batch of interesting information today:  “From January to February, urban investment in fixed assets achieved 812.1 billion yuan, with a year-on-year increase of 24.3 percent.”  Last year’s increase in investment spending was 25.8%, leading some commentators to talk about evidence of a “modest slowdown”, but the numbers suggest no such thing, especially since the January storms may well have depressed spending temporarily, and more especially since investment in real estate accelerated to 32.9%.

 

Speculative investment in real estate is a good proxy in China for speculative behavior in general, and perhaps also a proxy for speculative inflows, so the high growth in real estate investment seems to indicate that China’s easy money conditions are doing all the unhealthy things one would expect them to do.  The rapid growth in real estate “investment” is particularly worrisome because most insiders worry about the impact of real estate on the banks – banking exposure to real estate is extremely high (and, from the anecdotal evidence, not always recorded as such).  In case of a sharp economic contraction that led to a steep fall in real estate prices, banks could be badly hurt, thus exacerbating the slowdown.

 

The good news is that growth industrial investment slowed (but let’s not get too excited, it is still very high), and that should show itself as reduced growth in industrial production.  I am particularly concerned about that number because high levels of industrial production force a rising trade surplus.  As long as China produces more than it consumes it must export the difference, and a rising trade surplus increases China’s monetary expansion since the PBoC is forced to buy the accumulating foreign currency.

 

To make matters worse, the fall of the dollar ($1.5580 to the euro, $2.0310 to the pound, and Y 99.77 to the dollar) is putting unbearable pressure on countries who peg their exchange rate to the dollar.  Not only does this reduce the value of their currencies in international trade (and so put increasing upward pressure on their trade surpluses), but because the Fed is dropping interest rates and pumping liquidity into the system it can only increase hot money inflows into countries like China.  Referring to Chinese Commerce Minister Chen Deming, the China Daily today said:

  

Chen's ministry, which oversees foreign trade and domestic consumption, said that during the first two months, investments from the European Union countries rose a whopping 109 percent, while investments from the United States increased 44 percent.  Wild expectations abroad that the yuan will continue to rise in value against major world currencies has led to money coming to China. 

 

"When you bring US dollars to invest in China, you need to change it into the yuan. Naturally you would like your funds to enter China at an earlier date. Because, if you are late, the same amount of dollars will turn out to be less yuan bills," Chen told reporters.

 

Sure enough.  So what to do?  The China Daily is suggesting that some economists think China should consider a one-off revaluation, “possibly 5%”, to block hot money from flooding into the country.

 

Yes and no.  As I have been arguing for over a year, a one-off revaluation is pretty much the only option available to China to regain control of its monetary policy, and they are eventually going to be forced into doing it.  The fact that China Daily is reporting it suggests to me that this “crazy” idea is becoming less and less crazy every week.

 

But 5%?  That would truly be crazy.  Not only would a 5% revaluation accomplish very little in satisfying hot money expectations of RMB revaluation – we already expect the RMB to revalue by a lot more than that just this year – but even worse it would be a huge public announcement to the world that the PBoC was forced to do what they said they would never do, and anyone with a calculator and common sense will know that a lot more revaluation would be needed to adjust the monetary imbalances.

 

You don’t have to be a shadowy, evil speculator to see that 5% revaluation as a very loud signal to bring every penny you can get your hands on into China as quickly as you can.

 

Meanwhile there is a big debate going on among economists and bank researchers about how many more interest rate hikes, how many more reserve hikes, and so on the PBoC will engineer in order to tighten monetary policy.  The debate is interesting because it does give us an idea of what is likely to happen to the stock market and of course what will happen to the cost of financing additional real estate speculation, but I do not think it is terribly useful for understanding what is likely to happen to domestic monetary conditions.  China’s problem is not which set of tools can best be used to control the domestic money supply.  It has no control over the domestic money supply.  It is the currency regime which needs to be adjusted.