My Blog

July 11, 2008

FRI 11 JUL

Money is way too loose, not too tight By Michael Pettis

The Shanghai stock market capped yesterday’s 1.5% decline with a further decline today of 0.7%.  It’s still been a great week, up nearly 8%, but the party, at least for a while, seems to have ended.

 

At least one government official is, alarmingly enough, wondering if there are ways to manage the process better.  According to an article in today’s China Daily:

 

It's necessary and urgent to set up buffer funds to confront big speculators and stabilize the mainland market, a senior official said.  Jiang Lianhai, head of Jilin provincial securities regulatory bureau, published an article in Shanghai Securities News yesterday, which pointed to the necessities, functions and capital resources of launching a buffer fund. Later, an official from China Securities Regulatory Commission reiterated the view in an interview with China Daily.

 

In the article, titled "The capital market with Chinese characteristic calls for a buffer fund", Jiang said that in recent years, international hot money has flooded into China's stock market and real estate sectors. Some international speculators are planning to buy cheap stock when the market is sluggish and close out in a high price. "If the government does not have an effective tool in hand, it will be dangerous."

 

One of my Peking University students sent me the article, highlighting the last two sentences.  His sardonic comment: “Nothing can be worse for China than to allow foreigners to make money.”  

 

He was being sarcastic, of course, and I am glad to see that my students are sophisticated enough to laugh at this kind of comment (a very widely held view here, by the way), but it is a little dismaying that a senior government official would say something that even an undergraduate would find so silly.  There is plenty of evidence that hot money inflows are driven mainly by Chinese at home and abroad, but even if that weren’t the case, foreign buyers during a time of market collapse are a force for stability, and the fact that they may profit shouldn’t be a driving factor in determining policy.

 

But I digress.  Here is what today’s South China Morning Post says about the article:

 

A senior official at the mainland's securities regulator has come out in favour of setting up a fund to help stabilise the volatile stock market, the first time a government official has openly advocated the controversial idea.  In an unusual and bold move that may press top decision makers to consider the issue, Jiang Lianhai, the head of the China Securities Regulatory Commission's Jilin branch, wrote an article in Modern Bankers magazine calling for the launch of a non-profit-making fund.

 

The government had no reason to stay on the sidelines of the troubled stock market, and its intervention could help stem destabilisation of investments, Mr Jiang said.  Unlike their more outspoken counterparts in the west, mainland securities officials rarely comment on policies, to avoid media attention that might not sit well with leaders.

 

We have heard these rumors before, in 2006 I think, before the market took off, but this is the first time a government official has made the point.  It may be a good short-term political move to bail out middle class investors, but these kinds of comments only reinforce the pessimism of those of us who do not expect to see a well-functioning capital market in China for many more years.

 

On a separate note, Paul Cavey of Macquarie has an excellent new research piece out on China called “China’s great Monetary Con” in which, among other things, he torpedoes the idea that Chinese monetary policy is tight.  His piece starts out:

 

Macquarie analysts. Global investors. Ordinary people. Everybody believes China’s monetary policy is tight. As a result, the market has sold off, and savings rushed into the banks. But why? Rates have fallen further behind inflation. The stronger currency has been offset by bigger capital inflows. Reserve requirements have been hiked, but credit growth has hardly slowed.

 

The only thing that has really changed is rhetoric, notably the announcement of a “tight” monetary policy. The impact of what has been purely a rhetorical shift suggests Beijing has more credibility than the Fed. Neither the US nor China has much ability to raise rates, but while attempts to talk up the USD have floundered, verbal threats in China have bought money back to banks.

 

With rhetoric a lot less disruptive than real policy changes, conning investors – more politely, the guiding of expectations – is a key central bank tool. As an example, China’s talking down of CPI will probably work. With households putting their money away, domestic inflation will indeed likely ease.

 

I have often referred in my blog to “tight” (quotations included) monetary policy in China, but after reading Paul’s piece I wonder if I may have been a little aggressive in assuming that everyone would know that what I meant by those quotation marks is that I don’t believe monetary policy in China is tight at all, or for that matter has been tight during any of the nearly seven years I have lived here.  China has a very loose monetary policy, and this was an inevitable consequence of the combination of ample global liquidity, an undervalued currency, and the country’s ongoing decision to manage the dollar value of the RMB, which almost automatically precluded its ability to manage domestic monetary policy.

 

How can I say that money is loose, not tight?  Except for the assurances of the central bank there is no other good evidence that money is tight:  Interest rates are negative, inflation is rising, and credit growth is actually very high and growing from a high base.  Remember that officially credit growth is supposed to be limited to 16% this year (from 18% last year), which already doesn’t seem particularly tight, especially given the high base, but this growth limit doesn’t apply to the policy banks, the informal banks, and to dollar loans, and all of these, to the extent that we can measure, have surged.

 

Even the growth of monetary aggregates, which in yesterday’s entry I explain why I don’t consider too seriously, is high, again especially considering they are also growing from very high bases.  My student undergraduate Liu Bing kindly interrupted his internship at Van Eck in New York to send me the following data.  In May the year-on-year growth in M_O, M₁, and M₂ were, respectively, 13%, 18% and 18%.  For reference purposes, according to Deutsche Bank, M₂ is expected to be 164.0% of GDP this year, up from 156.3% last year.  That is a pretty high base from which to grow.  The growth in PBoC liabilities, by the way (and this is the indicator that most impresses me), was 31% in May, from an already astonishingly high base.

 

So far none of these numbers seem to indicate anything approaching “tight” monetary conditions.  Perhaps the reason why many people believe, according to Paul, that Chinese monetary policy is tight is conflated with concerns about an economic slowdown. 

 

These two issues are very different.  I think it is possible for China to have excessively loose monetary policy and for the economy nonetheless to be at risk of a slowdown.  In fact I think both are highly likely.  Next Monday I have been invited to speak on CCTV’s Dialogue, the country’s main current events program, on the topic of stagflation.  I have found that this program often discusses issues that are being widely debated among the country’s leadership and analyst community, and in the five shows I have done this year, stagflation has been one of the main topics of discussion (the others being inflation and the currency regime). 

 

Clearly stagflation is a problem that worries a lot of people, and with reason.  Yesterday Human Resources and Social Security Minister Yin Weimin said, according to an article in today’s South China Morning Post, that the country was facing “unprecedented pressure” on employment.  Among other things the article cites a release on the ministry’s website that claims that the record 5.6 million students graduating this year (there were 4.9 million last year) are competing for jobs with 0.7 million of last year’s graduates who still have not been able to find a job.  That means that even as the number of graduates has increased by 13% from last year to this year, nearly 15% of last year’s graduates are still unemployed, a year after graduating.  You don’t need to be a political scientist to wonder about the political implications of rising student unemployment.

 

Because of recent years of overinvestment and overproduction, with the attendant massive misallocation of capital, I think it was inevitable that China’s sizzling growth rates would have to decline, especially given a global economic slowdown.  As I’ve discussed many times this seems to be causing officials to shift focus away from monetary concerns and towards growth concerns.  I am not smart enough an economist to say what polices the government can and should implement to shore up growth and prevent rising unemployment, but I am pretty certain that monetary loosening is not the answer.  This will only postpone a slowdown slightly while increasing the riskiness of China’s balance sheet and so making the subsequent contraction more damaging.

 

Logan Wright and I have a piece in next Monday’s Financial Times that partially addresses why.  Our argument is that not only has monetary expansion continued at an alarming rate, with reserve accumulation doubling again so far this year (at the rate of nearly 30% of GDP), but, more importantly, the composition of that reserve growth has made the process much more volatile.  Logan’s numbers show that two and three years ago, the trade surplus, FDI and interest income accounted for 80-90% of reserve accumulation.  This year, even ignoring the huge amount of hot money likely to be buried in those numbers, they account for less that 40%.

 

One of the things that I have argued repeatedly, including in my book, is that it is not just aggregate debt levels or capital flows that matter to instability but, more importantly, the structure of those debt levels or flows (i.e. whether they are counter- or pro-cyclical).  For example it doesn’t make sense just to look only at raw debt levels – i.e. the ratio of debt to assets – to understand the vulnerability of a system to breaking down.  What is just as important, perhaps even more important, is whether the value of the debt is positively or inversely correlated with the value of the assets.  Argentina in the beginning of 2001, for example, had debt to GDP levels of only around 53%, which doesn’t seem high, but because the combination of its very rigid exchange rate regime (which is always highly pro-cyclical) and the fact that most of its debt was denominated in dollars, its balance sheet was too inverted to allow it to withstand any but the gentlest of shocks.

 

Unstable balance sheets, in other words, are not just balance sheets with lots of debt, but they are also balance sheets with lots of highly pro-cyclical “volatility machines” imbedded in them.  These self-reinforcing processes in the balance sheet improve good times and exacerbate bad times, and they do so in a very mechanical way that can sometimes dumbfound observers.  South Korea’s astonishing crack-up in 1997-98, for example, was almost wholly a function of the way domestic corporations were forced by their very unstable balance sheets to respond to the unexpected won depreciation. 

 

As the won depreciated and the need to hedge their dollar debt grew, they were forced to sell won assets (in a rapidly declining market) and use the proceeds buy increasingly expensive dollars, thereby exacerbating won depreciation further and putting even more balance sheet pressure on them to continue the process.  This kind of process can go on for a long time before it finally works itself out, usually in bankruptcies and enormous financial distress, leaving observers shocked at the sheer irrationality of markets that cold so far overshoot any reasonable “equilibrium”.  But the process was not one of reverting to fundamental equilibrium, but rather of unwinding imbalance in the balance sheets, and so fundamentals have nothing to do with it.  Overshooting can occur, and will occur to the extent that balance sheets are very unstable.

 

So it is not only the sheer size of capital inflows into China that are worrying, but the increasingly pro-cyclical nature of those inflows that are exacerbating the problem.  If we wait too long to repair the balance sheets, the ultimate adjustment will be far greater and more damaging than anyone expected because of forced adjustments. 

 

By the way, FDI numbers were released today.  FDI inflows for the first six months of 2008 were $52.4 billion, up 64% from last year’s $31.9 billion.  I suspect that around $20 billion of this represents either disguised hot money, or an acceleration of future expected investment, which from the PBoC money-creation point of view is not a whole lot different.