My Blog

June 3, 2008

TUE 3 JUN

More on speculation and Chinese monetary policy By Michael Pettis

I try not to do two consecutive blog entries on the same topic, but Kheng very kindly went through the Caijing article on the hot money survey by Deutsche Bank’s Jun Ma, which I wrote about yesterday, and translated a large part of it.  This additional information reinforces what I discussed yesterday, suggesting, among other things, that there is a fairly institutionalized process for speculative inflows (and, one must assume, outflows).

 

According to the survey, the ways enterprises bring into China what, from a monetary management point of view, is either hot money or its functional equivalent, is broken down according to the following.  52% of the money comes in the form of FDI, which I assume means an acceleration of approved FDI flows.  21% of the money, roughly evenly split, comes from under-invoicing imports or over-invoicing exports.  8% consists of “foreign donations” – I am not sure what this means.  5% comes from exchanging money with underground money exchangers and 17% comes from various other means, including paying local employees or service providers in foreign currencies, borrowing in foreign currencies, and so on.

Among individuals and households, which I assume include some of those local employees mentioned above who are sometimes paid in foreign currency, nearly half of the foreign currency funding for their purchases of RMB (49%) reportedly comes into China via the US$50,000 per year transfer from abroad permitted to local accounts, while another 20% enters via the RMB10,000 per day limit from HK banks.  15% of speculative inflows enters China via exchanges with local relatives or friends, 9% via underground money exchangers, and 7% via what I assume are legal money changers.

The article includes recommendations about what should be done to reduce hot money channels – for example improving the monitoring of FDI-financed companies’ holdings of cash, stock and bond holdings, building databases to track import and export pricing, reducing the amounts convertible per annum or per diem, and stepping up scrutiny of underground money exchangers – but I suspect that given the variety of channels, the difficulties of monitoring, and the problems with fraud and corruption, there is not a whole lot the authorities can do to deter inflows, except perhaps drive it further underground. 

 

For example, if the $50,000 that residents are permitted to bring into China every year were reduced, I suspect we would simply see a surge in the trading activity of the underground money exchangers.  At any rate just the size of the trade and FDI accounts means that a little fudging of the numbers there can lead to some fairly deep channels for inflow.  What’s more, stepping up the monitoring of trade-related and FDI-related activity comes with the inevitable corollaries – reducing real economic activity by increasing bureaucracy and frictional costs, and increasing the scope for and profitability of corruption, neither of which is good for China’s short-term or long-term growth prospects.

The survey also asked these “speculators” how much appreciation they expected for the RMB.  I am not sure how representative the survey is, and anyway I don’t think these target levels need to be taken very seriously because there is a lot of empirical evidence that suggests that our price targets are heavily affected by current price levels, and tend to change (usually in the same direction) as prices change.  Still, for what its worth, here are the target ranges.  

Expected RMB per dollar	Percent of respondents
6.0-6.5	17%
5.5-6.0	57%
5.0-5.5	26%
4.5-5.0	14%
4.0-4.5	6%

The total, mysteriously enough, adds up to 120%, but it is interesting that those sampled by Jun Ma seem to have fairly aggressive appreciation expectations, with more than one-third of them expecting the RMB to go through 5.5 to the dollar – for a total appreciation of over 25%.  The author of the article argues from this however that as the RMB approaches 6.0 China will begin to experience hot money outflows that could quickly turn into a flood, especially if the market then experiences a financial or economic crisis.  6.00 RMB per dollar represents a little more than a 15% appreciation from its current level of 6.93. 

 

I am not sure I agree that beyond that level we will see a great deal of outflow.  As the RMB steadily appreciates towards that number I suspect that arguments are going to be widely made about a higher equilibrium level, and the market will move towards higher appreciation expectations.  That is what usually happens in similar cases – rising currencies seem, at least for a while, to create expectations of continued rising, and certainly the experience of Japan in the 1980s, Germany in the 1970s, and other surplus countries is that, once it starts, appreciation can go on for a very long time.  . 

 

At any rate, given China’s huge reserves, there is no reason for speculative investors to race to the exits once their target level, whatever that is, is met, unless they expect significant depreciation pressure to follow, which I think is unlikely and can anyway be addressed by a credible peg (and nearly $2 trillion in reserves).  Their decision as to whether or not to keep their money in China will hinge on other factors – mainly the opportunity cost of holding money abroad relative to the expected returns of holding money in China.  Where I do agree with the author is that if the RMB’s trading in the 5.50 to 6.00 range coincides with a financial market collapse or a sharp economic downturn (which is likely to be the same thing), we might see sudden massive capital outflows.  But the key thing here is the condition of the market, not the level of the RMB.

 

One of his conclusions, then, is that China cannot afford a one-off revaluation of 15% or more because that brings the RMB into the capital-flight danger zone.  I would not conclude the same thing.  His data only (perhaps) suggests that China should not attempt a one-off revaluation in the midst of a financial or economic crisis, which I think is probably an obvious enough conclusion.  If anything I would argue that China needs to move quickly on the currency front precisely so as to obviate the need for a maxi-revaluation when the risk of a crisis is higher.  Every month that China has to deal with the massive inflows it is experiencing means a riskier financial system.  On that topic the May 15 edition of The Economist has this to say:

 

According to a study of previous crises by Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard, banking blow-outs lop an average of two percentage points off output growth per person. The worst crises reduce growth by five percentage points from their peak, and it takes more than three years for growth to regain pre-crisis levels.

 

A banking or financial crisis that sharply reduces economic growth (and concomitantly increases political volatility) is far more likely to lead to capital flight sufficiently large to threaten the country’s economy than a more expensive RMB, and a delay in the currency adjustment needed for the PBoC to regain control of its monetary policy is more likely to create the conditions for a banking or financial crisis than a will one-off revaluation.

 

On a related topic I missed an article in Caijing’s May 15 issue.  Among other interesting things it had this to say:

 

Hot money may have contributed to drastic fluctuations in the domestic stock market over the past year, said Bank of China analyst Tan Yaling. The Shanghai Composite Index doubled last year, soaring to more than 6,000 points in the fall, but plummeted to near 3,000 early this year. Tan noted that, while the index swung dramatically, China's macroeconomic conditions, the yuan's appreciation speed, and earnings of listed companies were generally stable.

 

Not all agree with Tan. For example, China International Capital Corp. chief economist Ha Jiming thinks the unexplained cash probably flowed into tangible sectors of the economy, such as real estate development.  Borrowers also may have attracted speculative cash. Since the government tightly controls credit, companies have had an incentive to borrow on the international market. Low interest rates globally have created “an abundant capital supply” for Chinese borrowers, Ha said. 

 

Hot money also may have been used for production projects and transactions, said Gao Shanwen, chief economist with Essence Securities. He said the central bank may be encouraging the influx by enforcing credit control targets set in late 2007 that may be obsolete. China's nominal GDP growth is more than 20 percent, Gao noted, and the capital demands of small entities are substantial.

 

I am often told that a declining stock market is inconsistent with rising hot money inflows because the hot money itself should push up the stock market, but as these various economists suggest, there are a lot of places where hot money can go, not least of which is to companies whose rising borrowing needs are hampered by caps on commercial bank loan growth.

 

Before closing, I should not that Stephen Green has an interesting Op-Ed piece in today’s Wall Street Journal about Chinese inflation.  

 

The still-dominant thinking in Beijing is that all these price hikes reflect a series of supply-side problems. But it is becoming harder to find any falling prices at all – a red flag that this inflation is a monetary phenomenon rather than an unfortunately timed series of supply shocks.

 

You can find the rest of the article here.