My Blog

March 26, 2008

WED 26 MAR

China's monetary trap By Michael Pettis

Scattered throughout this blog are references about the way I view China’s currency regime, why I believe monetary policy is out of control, why I have insisted since 2003 that China’s trade surplus and foreign exchange reserves could only grow, and why I claim that the authorities are increasingly going to have to consider a maxi-revaluation as the only solution to a worsening problem.  I have been asked several times to summarize this argument.  Here is a very brief summary (with apologies to readers of this blog who are tired of all my repetition):

 

1.        Since at least 2002-2003 China has been caught in a monetary trap.  By tying the value of the RMB to the dollar, and especially by setting it too low, the Chinese authorities ran the risk that in a time of excess global liquidity they would find themselves in the position of excess money inflows leading to excess domestic money expansion, which would be reinforced as domestic money expansion funded rising industrial production, which would cause an increase in the trade surplus and so increase money flows further.  Since global conditions at the time already suggested excess global liquidity, this risk was pretty high.  This is why I argued as far back as 2003-2004 that China’s then-high trade surplus could only rise, and as it rose it would necessarily feed domestic money expansion (the PBoC must create the local money with which to buy all those dollars), which would fund more investment, greater industrial production, and a rising trade surplus.  The key figure to watch is growth in foreign currency reserves.

 

2.        Because of the self-reinforcing nature of this system, this process must necessarily go on until a very sharp adjustment stops it.  The adjustment could come in the form, as it has in the past to China and other countries, of sharply rising domestic investment (“good” version: massive infrastructure spending; “bad” version: forced corporate investment via rising inventories), rapid debt deflation, a collapse of the banking system into bad debts, a breakdown of sovereign external or domestic credit (from excess fiscal expansion), or out-of-control inflation (which is, of course, one way that the currency can adjust), or it could come as a combination of these factors.  It is possible but unlikely that the adjustment will be benign, and the longer we wait the less likely it is.  This last statement is hard to prove but seems reasonable largely because of historical precedents.

 

3.        They key to stopping or slowing the process is to stop money inflows into China.  Capital controls erode over time, and after so many decades of capital controls their use is pretty limited in China, especially given the existence of China- or offshore-based transnational family business networks, and China’s size and long borders.  This means the only useful way to address capital inflows is to adjust the currency.

 

4.        Unfortunately even adjustment is problematic.  A slow adjustment , which we saw from July 2005 to roughly July 2007, means many more years of domestic monetary imbalances, which runs the risk of causing the adjustment, when it finally comes, to be all the more chaotic.

 

5.        A rapid adjustment, which we have seen since last summer, will only encourage hot money inflows, which will cause the domestic monetary problem to accelerate before it is fixed.  In addition, it is highly likely that a rapid appreciation of the RMB will overshoot whatever the “correct” exchange rate might be.

 

6.        That leaves only one option: a one-off maxi-revaluation that causes hot money inflows to subside or even reverse.  This may have an adverse impact on China’s trade account, but for reasons I have discussed often I think this impact is less than what many think it will be, and anyway it will happen one way or the other. Nonetheless with Chinese exports having risen, and still rising, so strongly even with the RMB appreciation of the past three years, it seems to me that we would need to see a huge, adverse impact on exports before it slowed export growth to zero, and much of this slowing growth would be absorbed by rising domestic consumption.

 

7.        The main argument in favor of a maxi-revaluation, however, is not that it will be painless.  The main argument is that the alternatives are much more painful.

 

8.        How much revaluation?  I leave it to smarter economists to argue about what a “reasonable” or “appropriate” exchange rate is.  My approach is much simpler.  As a former emerging-market bond trader and someone who has spent much of his career watching hot money, investment flows, and investor sentiment, I have tried to estimate what I believe to be the smallest possible revaluation that is nonetheless credible and likely to cause investors, especially speculative investors, to reconsider the direction of the RMB trade.  This wholly unscientific approach suggests to me that we will need a 15-20% revaluation of the RMB.  Notice that this means that even though between inflation and nominal appreciation the RMB has already risen substantially since I first proposed this over one year ago, I still haven’t changed my estimate.  It also means that s smaller revaluation will be a very poor policy choice.

 

This whole argument in favor of a maxi-revaluation depends crucially on the assumption that foreign exchange inflows will continue to accumulate at extraordinary levels until the adjustment is made.  This is the bet I made four years ago – I argued that reserves would surge.  Of course like everyone else I seriously underestimated just how much it would surge.  The key argument against continued rapid appreciation is of course the incentive this creates for speculative inflows. 

 

I have already argued many times that I believe speculative inflows are a serious problem.  Logan Wright, of Stone & McCarthy, has probably done the best work in trying to understand what is happening with foreign currency flows in China.  He has a new two-part paper that examines this.  I strongly urge anyone interested to read his papers (and get on his mailing list), but to summarize his newest paper, I will quote the opening paragraph:

 

Our analysis indicates that hot money inflows, which we estimate at $81-147 billion in 2007, were less volatile than the data initially indicated throughout last year and have likely increased in recent months, driven by faster appreciation of the yuan against the dollar. The implications of these findings are that current trends in foreign exchange reserve growth and foreign currency lending growth are likely to continue, even if the central bank enacts new restrictions on short-term foreign debt. In addition, some evidence points to the central bank continuing to use the daily central parity as a policy tool, rather than a channel permitting greater market influence over the yuan's value.

 

WED 26 MAR

First QDII liquidated – reversing previous money outflows By Michael Pettis

About five and six months ago there was a small controversy on my blog and on Brad Setser’s blog about the QDII process, which permits Chinese investors to invest abroad through regulated entities called QDII.  The argument was about whether QDII would be successful in helping reduce China’s net capital inflows by sparking investment outflows from Chinese savers who wanted to diversity their portfolios and buy foreign assets. 

 

The responses to the first QDII offerings were euphoric, and the offerings were vastly oversubscribed almost immediately, and supporters of the argument that QDII would help relieve monetary pressures pointed to the QDII projections of $90 billion in new offerings in 2008 as representing a significant outflow – equal to about 20% of the net expected inflow for the year.  Some of them also argued that because of the sizable H-share discount to the Shanghai markets, Chinese investors in H-shares were assured of returns high enough to overcome the headwind of RMB appreciation. 

 

Opponents, which included both Brad and me, argued that a rising RMB meant that it would be almost impossible to beat the Chinese bank deposit rate – expected at that time to be about 10-14% in US dollar terms – without taking huge risks, and that after the initial euphoria there would be very little interest in QDII.  We assumed that QDII investing would die out pretty quickly.  Here is what I wrote in my November 30 entry:

 

If QDIIs are conservatively managed they are most likely going to underperform local investment alternatives.  In that case instead of more money pouring into QDIIs next year I wonder if we won’t see disgruntled investors begin to withdraw their investments as their returns significantly underperform simple bank deposits.  We may see net redemptions next year, rather than more money going into QDIIs.

 

On the other hand If QDII managers feel compelled to beat the currency-related hurdle to keep their investors, there is the danger that they stretch a little too far for yield and take some ugly risks.  If as a manager you expect prudent investing will lead to redemptions, does that create an incentive to go out too far on a limb?  I think it might, at least in some cases, and I don’t doubt there will be some dodgy ideas peddled to fund managers.  However a nasty performance for one of these QDIIs could sour the whole market, at least in the short term. 

 

It is hard to see why investors should be taking money out of the country much longer when the best game in the world seems to be to bring money into China, especially as the pressure for RMB appreciation increases.  If QDII investors do reverse their earlier decision, the monetary benefits of the QDII program could actually reverse next year as investors bring their money back home, and with reserves expected to grow anyway by another huge amount, this reversal will only make matters worse.

 

In January the numbers came out for the various QDIIs and, not surprisingly, they were pretty bleak.  Some of them had indeed taken some big risks – when you have to beat a hurdle of 10-14% hurdle, your only option is to gamble wildly, something that I suspect many investors in QDII did not realize – and the bets turned out badly more often than not.  For those who are interested, in my January 16 posting I discuss a Credit Suisse report that QDIIs had lost an average of 12% since launch.

 

Since January it seems that things may have gotten much worse.  In today’s South China Morning Post I read the following:

 

An overseas equity-based fund operated by China Minsheng Banking Corp has been forced to liquidate after its value fell more than 50 per cent, giving mainland investors a hard lesson in the risks of overseas markets. Among the qualified domestic institutional investor funds that have made information public, Minsheng Bank's was the first to be dissolved.

 

The liquidation, which Minsheng confirmed yesterday, could be followed by similar moves by other fund managers, since mainland QDII products had suffered amid turbulent global stock markets, analysts said.

 

If I remember correctly there was about $20-30 billion of QDII money raised last year.  If we assume that every QDII fund loses half of the value of the assets under management, and then liquidates, that represents $10-15 billion of new inflows into China.  Since liquidations may take place at less than 50% loss, the inflows will probably be slightly greater.  

 

Normally $10-15 billion would be considered a large number, but we’ve been so knocked-about by large numbers recently that it seems like a piddling amount – about 2-3% of total expected 2008 net inflows.  I suppose the only good aspect about this whole thing is that having domestic investors lose money in foreign investments does reduce net capital inflows into China, even after the outflows are repatriated. Those investors who got screwed can at least sleep well knowing they have done their patriotic duty and helped the PBoC.