My Blog

June 6, 2008

FRI 6 JUN

Administrative measures trump market measures (for now) By Michael Pettis

In a sign of how worried the authorities are about rising speculative inflows, in a report released yesterday SAFE said it would step up the monitoring of foreign capital inflows.  Yesterday I wrote about the policy paralysis that seems to be occurring as different groups within the government have some fairly radically different ideas on what are the biggest problems facing China.  Under the circumstances, I argued, it is very hard for those who are worried about inflation, overheating, stock market excesses, and speculative inflows to organize the consensus needed to take the rather more dramatic steps China needs to take.

 

That was not completely correct.  Where policy paralysis seems to be occurring is actually in deciding what appropriate market measures need to be taken – adjusting the currency, raising domestic interest rates, liberalizing the markets, or relaxing price freezes.  There does not seem to be a lack of consensus – or perhaps it is more appropriate to say that a wide consensus is really not needed – when it comes to administrative measures.  The government continues to use administrative measures and various forms of signaling in its attempts to address the stock market and inflation, and it seems that its first weapon of choice with which to attack hot money inflows is likely to be attempts to strengthen capital controls.  That is how I read the SAFE announcement.

 

Clearly greater vigilance on this front is likely to have some impact on capital inflows at the margin, but I think there are at least three problems.  First, by now it seems that speculative inflows are so large that reducing them by a little is not likely to create a whole lot more breathing room for the PBoC.  Although many commentators are only now starting to concede that hot money is a big problem, the fact is that it almost certainly was a problem even a year ago.  Given the nature of these inflows it is hard to get a real sense of how rapidly they have grown, but one Chinese commentator claims that inflows this year are running at three times last year’s pace.

 

I have no idea if this is true, and certainly can’t prove it one way or the other, but even if he is way off, I think few of us who have been trying to estimate the numbers would argue that hot money inflows have not increased dramatically, and we all agree that they are now a much more serious problem.  In that case, it would take a very large reduction to “fix” the problem, and I don’t think increased monitoring is going to have that impact given how complex and large China’s trading and investment networks are and how easy it is for agents to skirt the law.

 

Second, this increase in monitoring will necessarily raise the cost of legitimate transactions, and very tight monitoring might seriously hamper economic activity.  Trade is important to China, as is FDI, and the bureaucratic delays and frictional costs associated with a step-up in monitoring may have a significant economic cost.  Finally, most of the empirical evidence suggests that in a developing economy with weak governance an increase in monitoring will deepen illegal channels and strengthen corruption.  This can’t be in China’s interest.

 

So China’s fight against hot money will be like its fight against inflation and its fight against stock market volatility.  Instead of market measures it will first try a variety of administrative measures. I think this fits more comfortably within the intellectual and cultural framework with which the leaders are most familiar and it gives the sense of managing the process in a non-disruptive way.  If it ends up having no effect, as I think it won’t, the consensus will gradually build for more realistic measures.  The problem, of course, is that this may take much too long.

 

On a separate, but related, note, one of my former students who has spent the past three years as a trader sent me the following (edited) note:

 

There has been market talk that CIC is placing USD deposit with onshore banks (both local and foreign).  one-year onshore USD is quoted at L+900 bps, so it’s economically correct for CIC to do so.  This is the main reason why onshore FX swaps are bought up at -6000 to -2600.

 

Personally I think this is real, but I am not able to find out or even guess how much money they lent out onshore.  The onshore banks will have to place a bigger amount of USD reserve with PBOC, but I am not sure whether this will have any impact on the FX reserve number

 

Another thing, in reference to the rapid growth in USD loans onshore in the first quarter that you discussed on May 18, I checked with several banks, and many of them tell me that the corporates are borrowing USD and swapping the USD into CNY thru fx swaps, to get CNY funding.  (Following a query the student told me that these corporates are swapping with the banks that lend them USD.).

 

Let’s see if I understand.  Corporations are borrowing US dollars from local banks and then swapping into RMB.  Why?  I guess that this allows them access to RMB funding without, technically, taking out RMB loans, which would come under the lending cap.  Logan, if you’re reading this, what do you think?  Does this fit with what you are hearing?