My Blog

February 21, 2008

THU 21 FEB

Does the PBoC think hot money is a problem? By Michael Pettis

Yesterday I quoted extensively from a UBS report that argued very strongly against the likelihood of a one-off revaluation of the RMB.  Much of my discussion concerned why I think that although I agree with some of the author’s points, I do not believe they are relevant to the case.  I had planned to write in today’s entry about one of his arguments which was in fact relevant but with which I disagreed – that there was no evidence that hot money inflows have become a problem for monetary policy.

 

When I checked Brad Setser’s blog (which I do every day and strongly recommend to anyone interested in central banks, global monetary policy, and international capital flows) I saw that he had beaten me to the punch.  In his very extensive entry he summarizes the argument proposed by UBS and others that, based on residual reserve growth (after things like the trade surplus, FDI, and other non-portfolio inflows are subtracted from the total increase in reserves), hot money inflows do not seem to be a serious problem.  He counterpoints these with the arguments of folks like Morgan Stanley’s Stephen Jen that hot money inflows have actually been very high, adding his own and Logan Wright’s calculations that suggest headline reserve growth may significantly underestimate effective reserve growth, and so underestimate the residual.

 

Brad Setser seems to come down on the aside of arguing that hot money inflows are indeed a concern for the monetary authorities and, needless to say, I strongly agree with his assessment.  Since it is an excellent post there is no need for me to belabor the point when I can simply cheat and recommend that anyone who is interested read it himself at http://www.rgemonitor.com/content/view/245201.

 

I do however want to add two things to his argument.  First, in today’s Bloomberg I read the following article:

 

Yuan Declines on Speculation China Seeking to Deter Speculators

Feb. 21 (Bloomberg) -- The yuan fell, snapping a five-day gain, on speculation China is seeking to deter speculators betting on faster gains in the currency. The central bank set a weaker foreign-exchange reference rate for trading, making it the only loser of the 10 most-active Asian currencies today outside of Japan. The People's Bank of China pledged to boost the currency's flexibility in a five-year plan released this week. China may ``flush out speculators from time to time, before allowing the yuan to appreciate again,'' said Nizam Idris, a currency strategist with UBS AG in Singapore.  

 

This is the second time in recent weeks the PBoC has suddenly reversed RMB appreciation, supposedly to “flush” out speculators. They have been doing this regularly in the past few months. 
 
Leaving aside the usefulness of their actions (if everyone knows the RMB is headed up, why should a small one- or two-day reversal worry anyone?), I would wonder why the PBoC is bothering with all this if they didn’t believe there were significant hot money inflows.  One could argue that they are trying to teach Chinese corporations about currency volatility so as to prepare them for the brave new world, but since purchase and sale contracts are usually priced forward, I doubt it would have much impact.  This action seems to be aimed at speculative inflows, and if the PBoC thinks speculative inflows are a problem, should any of us disagree?

 

Just a few minutes ago before I could post this entry I received an angry and impassioned email from one of my former Chinese students who is now an FX swap trader in Shanghai for one of the largest global investment banks (with the Subject heading “China Market SUCKS”).  I found his email very interesting and perhaps very relevant (it’s great that so many of the best young traders in the Chinese markets are my former students).  He allowed me to excerpt his email, with a few clarifications and some editing to eliminate trader’s slang:

 

Some officials from SAFE called the only two onshore money market brokers yesterday after the market closed, and told them verbally that they must stop brokering FX swap onshore immediately.  The reason they gave verbally (and only verbally, no written notice) is that FX swap is an FX instrument (because an FX forward = an FX swap + an FX spot trade, so that if the FX swap price changes, an FX forward’s price will follow – how silly this is!).  They said that the foreign exchange market is so important to China that it is highly co-related to national security, and because of the brokers’ activity, the market is too volatile and out of the control of SAFE.

 

By closing down the broker shops, they hope the onshore fx swap market will be more stable, and easier to monitor, and China’s financial market, or at least China’s FX market, will be safer!

 

Here is what we got today after this new rule, which is nothing surprising to traders.  Since banks are only allowed to trade by calling each other direct and no one really knows what is happening and where the real market is, every bank quotes very wide bid/offer spread, and during whole morning only five trades were done in the market.  If any big flow hits the market, which is very likely because no corporate is willing to hold long USD forward position, the market will be more panicked than ever as it lacks liquidity.

 

Well, at the end of day, I am surprised to find out how little they know about this market (how can a FX swap be an FX instrument?!) and that how rapid policy can be changed in China (as this verbal notice came to everyone as a surprise).  More importantly, it shows how desperate they want to control the market in their good hands, and maybe it shows they feel that they are in the threat of losing control.

 

Very honestly I am not sure why SAFE is doing this and what they expect to accomplish, but it seems they are very concerned about what is happening in the foreign exchange markets.  There have rumors for a long time (actually, much more than rumors) of corporations using the market to speculate on RMB appreciation, and maybe this is a way to try and control the market.  At any rate I welcome any of the readers of this blog, especially traders and especially my former students, to write to me either online of offline and explain what they see happening. 

 

THU 21 FEB

Victor Shih on China’s credit boom By Michael Pettis

On of my favorite China experts is Victor Shih, a political science professor at Northwestern University and an expert on financial and economic policy-making within the Chinese leadership.  Yesterday the Asian Wall Street Journal published a piece by him called “China's Credit Boom”, which is well worth reading.  In case any one has missed it I am reprinting it below.

 

China's Credit Boom 

 

The rest of the global economy may be experiencing a credit crunch, but not China, where easy credit has fueled a spectacular run-up in real estate prices and stock markets. Despite a cascade of State Council decrees restricting bank lending this year and a high-profile Politburo meeting in November that focused on the risk of inflation, bank lending last month grew by over 800 billion renminbi ($112 billion) -- equivalent to 22% of the total loan quota that Beijing's technocrats meted out to state-owned banks for 2008.

 

This rate of credit expansion is similar to the rate last seen in the second quarter of last year, when China's economy grew by nearly 12% from a year earlier. And it comes just as the Party is trying to ratchet down inflation, which in January hit 7.1% year-on-year on consumer prices.

 

Technical factors don't fully explain why the monetary base grew with such fervor in January. The lunar new year holiday took place earlier this year than usual, driving up demand for cash. However, new year cash spending usually means withdrawing one's savings, not borrowing from banks. A severe winter snow storm forced the central government to release tens of billions of renminbi in funds to pay for emergency spending. But this amount would be a blip in the Chinese monetary landscape, which runs into the trillions of renminbi in a given quarter.

 

More convincingly, major borrowers are pressuring banks to lend out as much of the credit quota as possible. Companies want to take advantage of low real interest rates and lock in cheap cash for the remainder of the year. Although large firms, many of which are powerful state-owned entities, are undoubtedly exerting pressure on banks, State Council loan ceilings precisely seek to minimize the effect of firm pressure by coordinating all banks simultaneously to cut back on lending. However, bankers called the technocrats' bluff and proceeded to lend with gusto. In effect, they are daring Beijing technocrats to enforce the credit ceiling and risk a widespread liquidity shortage in the latter part of the year.

 

This is an unusual game of chicken. China's major banks, all of which are majority state-owned and run by managers appointed by the Communist Party, are simply ignoring decrees issued by the highest authorities.. In a state-dominated banking system, this is as unexpected as mid-level managers blatantly acting against the wishes of both the CEO and the board of directors. Formally the technocrats have the full backing of the ruling Communist Party and can dismiss any banker at any time. However, senior state bankers do not behave as if they take the threat of removal seriously. They've stared down such threats before, anyway -- in China, elite political discord has often compelled banks to disobey formal decrees.

 

Politics may be at work here. First, the increasingly vocal National People's Congress, China's rubber-stamp legislature, is slated to open its new session at the beginning of March. Many top technocrats, including central bank governor Zhou Xiaochuan, will receive new appointments. Others will simply be reappointed to their posts. Thus, technocrats may hesitate to enforce loan ceilings because they do not want to anger regional and industrial lobbies represented in the NPC that want easy credit. But although the NPC formally votes to appoint ministers, in reality, their appointments are decided by the Politburo Standing Committee -- the same body that voted to support retrenchment policies in November. Thus, the technocrats should not feel threatened by the NPC, even though the NPC may not prefer retrenchment.

 

There are plentiful historical precedents for these kinds of politically driven loan surges. In the 1980s and '90s, feuding elite factions cheered their provincial followers to borrow heavily from the banks. Banks, knowing that elite politicians in the Communist Party's Politburo supported loose lending, felt they had little choice but to open the monetary spigot. Likewise, because the technocrats knew that banks were lending due to elite political pressure, they could do little to punish banks. Both the technocrats and the banks served the same master -- the political elite in the Communist Party. This often led to serious inflation trouble until the faction with the most to lose from an economic crisis decided to support senior technocrats and crack down on lending, thus ending loose lending policy and stifling inflation.

 

Something similar may be happening today. When faced with rising inflation late last year, President Hu Jintao decided to support Premier Wen Jiabao's retrenchment policies. There were signs, however, that not every member of the ruling Politburo Standing Committee agreed with retrenchment policies. Days before the November meeting, for instance, Premier Wen announced on a trip to Singapore that lowering asset prices was a high priority. Yet, the Politburo meeting did not endorse this policy goal, strongly suggesting that some members of the top elite opposed it.

 

The most likely opponents of strict monetary policies are powerful "princeling" officials -- children of the Communist Party's founders -- who have close connections with economic interests in China's big coastal cities. Some of these interests, which include manufacturers and real estate developers, have suffered from the tight monetary environment. Detecting elite discord on retrenchment policies, bankers are then emboldened to disregard central decrees, betting that their elite supporters would protect them from the wrath of the technocrats.

 

The Chinese government needs to continue monetary tightening by raising interest rates and the bank's reserve requirements. Furthermore, Messrs. Hu and Wen need to overcome internal opposition and make it clear to bankers that flouting central decrees begets serious consequences, including dismissal. Otherwise, they risk allowing inflation to spiral toward dangerous levels. In the opaque Chinese political system, strong signals, in addition to decrees and laws, continue to be necessary ingredients of credible policies.

 

Mr. Shih is a professor of political science at Northwestern University and the author of "Factions and Finance in China: Elite Conflict and Inflation" (Cambridge University Press, 2008).