My Blog

April 28, 2008

MON 28 APR

The market isn't too happy, and adjustment risks may be growing By Michael Pettis

Bad earnings were blamed for the poor start to the trading week, with the SSE Composite down 2.33% today.  Even Jim Rogers, who said over the weekend that he was scooping up Chinese stocks now that they were cheap again, was not able to psych the market up, and he is much quoted and admired among small investors here in China.  Rumors continue to swirl about additional measures to help prop up the market, but I suspect the failure of Wednesday’s cut in the stamp tax to sustain a rally will have seriously dampened the credibility of future administrative moves to strengthen the market.

 

There is not a whole lot of interesting news today, as far as I can see, and I have been too busy recently to write about an analysis my assistant Shang Ning did on debt levels among Chinese corporates, but I do plan to do so soon.  What small thing worth noting: China Daily has an article today (“Yuan appreciation dampens textile export”) that discusses how the rise of the RMB has hurt textile exporters, at least according to preliminary reports from textile firms wooing foreign buyers at the 2008 International Textile, Fabrics and Accessories Exhibition held recently in Zhejiang Province.  The article blames the rising RMB for the lack of orders, although given that they quote an Austrian businessman who complains about rising material and labor cost – and of course as a Eurozone country Austria has not seen any RMB appreciation at all – I would argue that the article confuses the impact of rising labor costs in China with the RMB’s appreciation against the dollar.  I suspect that this article is part of the internecine fighting among the growth and monetary guys vying over an explanation of what ails China.

 

Speaking about exports, I am increasingly concerned that the trade surplus in China is actually beginning to decline, and much faster than people think.  My reasoning is simple and completely intuitive – i.e. there is not a shred of hard evidence to back it up – but I nonetheless think it highly plausible.  I contributed the following (somewhat edited) comment to today’s discussion on Chinese reserves on Brad Setser’s blog (http://www.rgemonitor.com/blog/setser):

 

Given the rapid increase in various proxies for hot money inflow, it is probably pretty safe to assume that hot money disguised as FDI and/or trade is also growing quickly. Certainly the nearly 70% growth in FDI during the first quarter suggests that there has been an increase in speculative inflows disguised as FDI. After all there was no very good fundamental reason for this growth – in fact it is not hard to argue that FDI in China is less, not more attractive today than in the past few years.  If this is true and a big chunk of FDI is simply hot money, it is probably also plausible to argue that hot money disguised as trade has also increased significantly.

From that it follows that export growth and the trade surplus have probably declined much faster than the small decline in headline numbers suggest.  If true, this complicates matters.  Thanks to deteriorating global conditions China may actually already be running a narrow trade surplus or even a small trade deficit, which could make the authorities all the more afraid of a maxi-revaluation, and yet for the reasons we have been discussing over the past fifteen months the maxi-revaluation is probably inevitable because of the crazy monetary consequences of hot money inflow.  The cost of a maxi-revaluation may be rising even as the cost of steady appreciation is.  The longer they wait the worse the options become.

 

In other words, if we are starting to see Chinese monetary growth powered exclusively by hot money inflows, instead of by the trade surplus as it was in the past, we are entering into a far more volatile stage of the game, where the consequence of a policy misjudgment may be higher than it has been in the past because the outcome is likely to be much more heavily determined by very volatile and hard-to-control and hard-to-judge hot money flows.  The risk associated with an adjustment is rising, in other words, even as the cost of not adjusting is too.  I worry that another quarter or two of $200 billion plus increases in reserves is going to make the adjustment process for China much more difficult.  It is increasingly important that the recession in Europe and the US be as brief as possible if China is going to have room to adjust.  If we see additional weakness in the global environment, I think China’s room for maneuvering declines substantially.

 

Speaking of Brad Setser, his blog alerted me to an article published last week in Caijing, China’s most influential business and economics magazine, and written by Wang Tao, head of Bank of America’s Economics and Strategy for Greater China.  You can find Wang Tao's article here.  He argues that given the hot money inflows that we have been seeing Chinas’s best option is a maxi-revaluation.

 

More drastic measures may be necessary to reduce liquidity-generating FX inflows and loosen the close link with the accommodative U.S. monetary policy. The answer may be a combination of a one-off revaluation and tightened capital controls, accompanied by structural measures…[T]he current and steady appreciation of the yuan has entrenched expectations and helped fuel speculative inflows. A one-off revaluation could help break the expectation in the near term if it is combined with tightened capital controls.

 

Two issues would immediately arise from the above approach: the difficulties in determining the appropriate size of the revaluation, and the questionable effectiveness of capital controls. On the first, we doubt anyone would be able to make an accurate estimate of the yuan’s fair value or degree of undervaluation. However, that may not be necessary. A sizable revaluation that is significant enough to have an impact on the trade surplus yet deemed acceptable by the government over a one-year period (say 10 percent) could be picked. An unexpected revaluation, combined with the right statement and other policies, could send a clear signal to the market that this round of yuan appreciation has ended, thus staving off speculative inflows.

 

I agree with much of his analysis, although I think 10% might be too little.  Still, it seems that more and more commentators are coming around to the view that China is being forced inexorably into a one-off revaluation.  I predicted in early 2007 that by the summer of 2008 this once-crazy proposal would become conventional opinion.  I think the sheer size of the problem and the weight of the numbers will eventually drive away all the objections.  It will be a difficult choice to make, but I can’t see the alternatives.