My Blog

May 7, 2008

WED 7 MAY

How long will the inflation respite last? By Michael Pettis

The Chinese stock market started the day well, with the SSE Composite starting below yesterday’s close but quickly trading up to 3767 within the first hour of the morning – a hefty 2.3% jump from yesterday’s close.  But investors quickly lost heart, and the market subsequently gave up nearly 200 points from its peak today to close down at 3578, for a very ugly 4.11% loss for the day, with banks, real estate-related companies, and Olympics-related companies leading the way down.  The steepest declines took place in the last 90 minutes of trading, when a slew of selling orders ran up against a sharp decline in trading volume.  For all the talk of government support it does not seem that there is a great deal of confidence in the market. 

 

A lot of investors are still wondering what, if anything, the government can do next to stimulate the market.  I don’t doubt that there are still things government agencies can do to signal official intentions, but there doesn’t seem much they can do actually to influence real supply and demand in the market for more than a few days.  As expected, their many interventions are losing credibility.  Institutional investors seem to be using every rally as an opportunity to get out of their positions, while retail investors are filling internet bulletin boards dedicated to discussing the stock market with anxious and angry comments.

 

On the inflation front, according to a Credit Suisse report today, Dong Tao, who has had a pretty good call on Chinese inflation, is expecting the April CPI number to come in at 8%.  Like many other analysts he expects second-quarter inflation to stay high, but well below the drastic first-quarter numbers.  However he, like me I might add, is worried that as food price rises decelerate non-food inflation will soon take center stage and drive the index up higher in the send half of 2008.  In that context I should mention a piece from Capital Economics on the subject of inflation in Asia.  “Inflation has re-emerged as a unifying theme across many Asian economies in recent weeks. Driven by the continuing high international oil and food prices, persistent upside surprises to inflation have forced a rethinking of monetary policy in the region.”

 

I think this should not be a surprise.  After the 1997 Asian crisis a number of Asian economies, including China, have been so determined to protect themselves from a repeat of those events that they put into place a set of systematically mercantilist polices aimed at limiting exposure to external debt – often by managing their currencies so as to run persistent current account surpluses and burgeoning reserves.  The problem with these policies, as I have discussed often on this blog, is that they seem to have misjudged the cause of the earlier sequence of crises.

 

Financial crises do not occur because countries have currency mismatches.  They occur because they have asset-liability mismatches, of which the currency mismatch is only one form.  By managing domestic monetary policy so as to minimize the risk of a currency mismatch several Asian countries may have simply transferred the balance sheet risk into a different form.  Specifically, interventionist currency regimes have often resulted in significant monetary expansion, which create not just the risk of inflation but can also lead to domestic balance sheet imbalances, most dangerously in the banking system.  Remember that in the 1920s the US also experienced massive capital inflows on the trade and capital account, resulting in the accumulation, in John Maynard Keynes’ words, “all the gold in the world.”  The result, in the case of the US, was not a national balance sheet impregnable to disruption.  On the contrary, the US experienced the stock market crash of 1929 and the banking crisis of 1930-31 that led to the consequences with which everyone is familiar.  The lesson is that current account surpluses and massive reserve accumulation are no guarantee against financial disruption.

 

Headline food prices do seem to be moderating in China, so we will see a deceleration in CPI price rises, but I am not sure this is for all the right reasons, and I wonder if food price increases can continue to be restrained.  As a long-time trader and observer of developing countries I always get a little nervous when government officials keep repeating that they don’t have a problem in some specific area, so I guess I am getting a little nervous about yet another announcement, this time from the NDRC, that they have “ample grain to keep food prices stable”, as the prominent headline in today’s China Daily put it.

 

We are starting to get these assurances nearly every two or three days now.  “Our grain supply and demand is basically stable, our reserves are full, and we can ensure supply and stable grain prices,” the NDRC said in its statement.  The same article pointed out that customs and commerce authorities are cracking down on illegal grain exports by traders hoping to profit from surging international prices.  It points out that whereas price of rice in Thailand has soared from $300 a ton to $1000 a ton in six weeks (wow! can this possibly be true?), the price of rice in China is still frozen at $300 a ton.

 

Not surprisingly this seems to have led to wide-spread rice smuggling.  Another article in the same issue of China Daily also makes this point: “But there are concerns about how long the nation can hold its rice price at about one-fourth of that in overseas markets, given recent reports of illegal rice exports in the past months.”  Not only do we have a problem of local “businessmen” smuggling oil out of the country to take advantage of the heavily subsidized prices in China, but the smuggling problem now seems to be spreading to grains too. 

 

I suppose this was only to be expected.  With such long and complex borders, and with an endemic corruption problem, it was inevitable that the huge disparities between the subsidized prices of certain commodities in China and their equivalents in neighboring countries would lead to “arbitrage,” as the more polite among us might put it.  I have no idea of how extensive this smuggling is, but given the fact that the authorities are publicly admitting the problem (and twice in a single issue of the China Daily), I would guess that it is a big problem.  The monetarist in me would also point out that smuggling rice out of China will have a similar monetary impact as bringing foreign currency into China, so this is not just a problem for the Ministry of Finance, who has to raise taxes to pay for the subsidy going to smugglers, but also for the PBoC.

 

One final note: John Garnaut, of the Sydney Morning Herald, wrote an interesting article three days ago on unemployment in China.  As worthless as the official unemployment numbers are (the Economist recently argued that they are the least accurate of all the important economic numbers provided by the Chinese government), it may well be that unemployment in China is much lower than many in the government think.  If this is true, the social consequences of further monetary tightening may not be as grave as many government officials fear, especially given that the expected economic slowdown caused by China’s slowing export growth is likely to have been counteracted by a recent surge in infrastructure spending.  There may still be time to take the steps needed to reduce China’s out-of-control monetary growth.