Wright adds up all this liquidity and says the PBoC may be dealing with an increase of RMB 2 trillion ($270 billion) in the next two months alone, and I think he may be underestimating reserve inflows, which he projects at $20 billion a month. How will the PBoC do so? The central bank pays 1.89% on required reserves and has been paying 3.99% on 1-year paper so, aside from the fact that it would be very difficult for the PBoC to sell so much paper at the rate at which current paper trades, it is far more cost effective to sterilize by raising reserve requirements than by selling central bank bills. This is what Wright suggests will happen – and he predicts that minimum reserve requirements will rise 1.5%, to 15%, by the end of the first quarter.
My assistant, Oliver Shang, coincidently sent me a note yesterday saying new MoF 3-year and 5-year bonds will be sold next Wednesday, and at far higher rates than they have been sold in the past. I searched for the information and found that in fact the MoF will be selling to retail investors RMB 34 billion of 3-year bonds with a coupon of 5.74% and RMB 6 billion of 5-year bonds with a 6.34% coupon.
These will be part of RMB 110 billion of bonds expected to be sold next week – mostly by government agencies, departments or SOEs.For example the Ministry of Railway will be selling RMB 45 billion of 7- to 15-year maturities, of which more than half will be 10-year bonds with a 5.60% coupon, up from 3.75% last year. During the first ten months of 2007 Chinese bond markets saw RMB 6.3 trillion ($85 billion) of issuance, which exceeded last year’s total of RMB 5.7 trillion.
It’s great that so many bonds are being issued – the growth of a domestic bond market is over the medium term one of the best risk-management developments that can take place in the Chinese markets. Chinese companies are turning to the bond markets because their issuance has become more flexible than bank borrowings, especially with the government indicating a very strong determination to slow credit growth.This determination hasn’t had much impact in the past, but it seems that this time around they may be a little more determined than usual.
Borrowing costs in the bond markets are also lower – 10-year corporate bonds in recent months have come out at under 6%, whereas the 5-year loan benchmark is much higher – currently 7.83%.For these two reasons I expect that over 2008 we will see ever more activity in the mainland bond markets
But in the short term rapid growth in the bond market brings its own problems.First of all, so much new issuance by the government, SOEs, banks and corporates is not going to make it easier for the PBoC to sell anywhere near the amount of bills it needs to sell to sterilize the liquidity expected to flood into the system over the next few months. Secondly, if bond financing grows too quickly, it may seriously reduce the impact of administrative measures aimed at slowing credit growth. A lot of credit growth will simply occur outside the formal banking sector (and I wonder if the business of informal banks has been growing rapidly during the past few months, as I suspect it might), so undermining the goal of restraining fixed asset investment by restraining loan growth.
By the way, with all this money pouring into the markets over the next four months, what are the likely impacts on asset prices? I wonder if we will see the equity bubble shake off its doldrums (Shanghai was down 18% in November) and get back to being a bubble.
Logan Wright, of Stone & McCarthy has been trying to count the amount of money likely to be sloshing through the system over the next few months and comes up with some very interesting numbers. In a note he sent me yesterday (“We’re going to need a bigger boat”) he points out that the next four months may be very trying times for PBoC money management.
First off, an awful lot of PBoC paper is maturing during this time.About RMB 1.5 trillion is coming due between December and March, with a peak of RMB 586 billion in January alone. This is, according to Wright, “the largest four-month volume of paper redemptions in the history of PBOC sterilization operations.”
In itself the fact that we are record levels doesn’t surprise me. With foreign currency inflows and concomitant reserve growth accelerating over the past three years, it is not surprising that every few months we hit a new record – whether we’re measuring industrial production, credit growth, the trade surplus, or, why not, maturing central bank bills. By the way yesterday we saw that the Purchasing Managers’ Index rose from 53.2 to 55.43 in November, suggesting that industrial production is going to surge. This is not surprising given recent high fixed asset investment levels. With surging industrial production will come, as I have argued many times before, a rising trade surplus and, along with it, more foreign currency inflows.This is a hard trap from which to escape.
But to get back to Wright’s piece, RMB 1.5 trillion of maturing bills in four months is a big number, about $50 billion a month on average, comparable with and even larger than the monthly increase in reserves. Basically the PBoC has not only to mop up an expected $30-40 billion of foreign currency inflows every month, a Herculean task as it is (October’s reserve increase was $21 billion, probably low because of transfers to the CIC, but it has averaged $39 billion a month in 2007), but it must add to the mop-up the maturing of a substantially larger amount of maturing central bank bills during the next four months.
But there’s more. Wright argues that the maturing of repurchase agreements will add another RMB 250 billion over the four months, bringing the total amount of money entering the system to nearly $60 billion a month, not counting the PBoC purchase of net foreign currency inflows, which could mean managing $80-100 billion a month of new liquidity. In addition the recent amount and structure of fiscal revenues will add to the liquidity far more than it normally does. Wright explains:
Fiscal revenue is sky-high this year, up from last year's total of 3.87 trillion yuan to an estimated 5 trillion yuan this year, according to a report from Yao Jingyuan, chief economist of the National Bureau of Statistics, cited in the Shanghai Securities News on November 26. The targeted revenue level was 4.4 trillion yuan. Fiscal deposits have continued to grow in the central bank throughout the year; as of the end of July, they had risen by 1.036 trillion yuan since the end of 2006. Usually, government departments spend their budgets toward the end of the year in order to justify higher budgets in the following year. Typically, in December, money flows rapidly out of government deposits at the central bank; last year, the month-on-month decline in December was 557 billion yuan.
This year, with revenues even higher, the outflow could be higher as well. A report from the State Information Center on November 12 warned about precisely that outcome, stating, "If we were to stick to the fiscal deficit target set at the beginning of the year, fourth quarter (government) spending would have to be very large to achieve that deficit, which could significantly boost aggregate demand in the economy." The report cited spending levels as high as one trillion yuan in the fourth quarter were possible, and warned against that level of spending.
Will the PBoC be able to sterilize this flood of money?Unless they are willing to see interest rates rise much higher, it is pretty unlikely, and the several spikes we have seen in pre-IPO repo rates (see my November 8 entry “Small banks getting squeezed by IPOs”) have made banks less willing than ever to tie up money in anything except the shortest maturities. This will make selling PBoC bills a very difficult task unless they are willing to pay up.
Remember, by the way, that high interest rates only increase the attractiveness of domestic markets to foreign money, and are likely to encourage even more speculative inflows into the country. Allowing rates to rise in order to accommodate a higher volume of sales may only increase the amount of paper that needs to be sold. PBoC money management is not easy.
I think these arguments are sometimes overstated but largely correct.The direct impact of an appreciation of the RMB on foreign appetite for Chinese goods is likely to be fairly small, and so should not affect export volumes.
But while Chinese authorities and foreign supporters of the currency regime use this argument to explain why foreigners should not push China to raise the value of its clearly undervalued currency, they often justify China’s resistance to letting the currency appreciate faster by citing the adverse unemployment consequences of a subsequent collapse in exports.These two arguments cannot both be true, although of course it is unfair to discredit either argument simply because some of their proponents are inconsistent.I am convinced, however, by the first argument – an RMB appreciation is not likely to have enough of a pricing impact significantly to change foreign demand for Chinese exports, unless the appreciation were very substantial.
But that doesn’t mean that the value of the RMB not matter to China’s trade balance.It does, and a faster appreciation will reduce the trade surplus.The reason will not have to do so much with the impact of RMB appreciation on foreign appetite for Chinese goods, but rather because of the impact of a faster appreciation on China’s domestic monetary policy.
When a country produces more than it consumes, it must run a trade surplus, and the greater the gap between production and consumption, the greater the trade surplus.Here is where China has found itself caught in a monetary trap. For many years China has been a large net recipient of foreign direct investment.Since at least the early part of the decade it has also been a net recipient of speculative inflows.When these are combined with China’s trade surplus, the net result is that in China there is a large and growing excess supply of dollars relative to RMB.
When that happens, of course, the market normally adjusts by forcing down the price of the dollar against the RMB, until demand for dollars balances supply.But China’s central bank, the PBoC, does not allow movement in the dollar value of the RMB.Every day it sets the price of the dollar (or, more correctly, it sets the narrow band within which the dollar trades).Still, supply and demand must balance, and the PBoC ensures this balance by offering to buy or sell whatever amount of RMB is necessary to force the market to clear at the desired exchange rate.
Given the growing net excess supply of dollars at desired exchange rates, the PBoC is forced to supply the domestic economy with more and more RMB in order to absorb the net dollar inflow.China’s monetary policy, in other words, is largely determined not by the needs of the domestic economy but by the net supply of dollars, and as that supply grows, China’s money base expands. In the past four years, as China dragged its heels on revaluing the RMB, the supply of excess dollars went from a river to a flood (you can measure the net supply of dollars by counting the increase in PBoC reserves).
Why does this matter for the balance of trade?Because as the PBoC flooded the market with RMB (and with central bank bills, used in a largely ineffective attempt to mop up the flood of currency), this had a number of secondary consequences.Rapid money expansion led to rapid credit expansion and rapid growth in fixed asset investment, which forced Chinese industrial production to soar.As Chinese production soared – much faster than Chinese consumption, which was hobbled by a high and rising savings rate driven in part by the social insecurities associated with China’s rapid social and economic transformation – the gap between what the country produces and what it consumes soared with it, and so China’s trade surplus grew to astonishing levels (and will grow more in the coming months).
Of course this only served to reinforce the problem.A growing trade surplus increased the supply of dollars relative to demand.It also encouraged speculative inflows from investors who had money abroad (mainly it seems from Hong Kong, Taiwan and the mainland) looking to take advantage of the asset price frenzies unleashed by money growth as well as by the certainty that China would have to increase the value of RMB, thus making any RMB investment, even something so boring as putting money in the banks and earning negative real rates of interest, very juicy by international standards.
The process is circular and highly self-reinforcing.All of this money inflow creates conditions for more money inflow, until some adjustment finally stops the process.China is caught in a monetary trap in which rising trade surpluses force an expansion in the money supply, which forces a rising trade surplus.
Until the mechanism that links the two is broken or substantially modified, there is very little China can do to slow the process down, and nothing it can do to stop it.Four years of increasingly desperate measures – raising bank reserve rates, raising interest rates, allowing a slight appreciation in the currency, enforcing or creating new administrative measures, moral suasion, jawboning, and sterilization – have done nothing to reverse money growth.In fact in the past three years the monetary process has accelerated by nearly every measure.
Ultimately China must do something that reduces and even reverses monetary inflows.One way might be to engineer a large enough revaluation of the RMB so that speculative inflows reverse themselves and imports grow.A second way might be to wait for a financial or economic crisis significantly large enough to cause capital outflows.A third way, which is currently the preferred approach, may be slowly to try to climb out of the trap by repairing the financial system and allowing the RMB to crawl upward a little faster – and pray that the country can climb faster than the trap deepens.
My own belief is that the third way brings with it a high probability of failure, and the longer we wait for the real adjustment the more likely the second way becomes – a soaring money supply increases the risks of overproduction, asset bubbles, and bad loans in the banking system. I would argue that the best solution for China is the first of the three ways I suggested, a rapid increase in the value of the RMB – in fact a one-off maxi-revaluation that would forestall speculative inflows – and although there are significant risks and costs associated with that path, they are less costly than the alternatives.
Ultimately China’s currency policy does matter to its balance of trade with the world, but perhaps not in the obvious way.
In today’s Financial Times there is an article by Mure Dickie that describes a report by the Conference Board, a US-based research organization, on the relationship between the RMB and trade balances. I tried to get the report myself but was unable to find a place from which to download it, so I have not been able to read it, although I did see that a number of other sites made reference to this report.
Dickie summarizes the report in this way:
China’s soaring trade surplus with the US has “very little to do” with an undervalued renminbi, and faster appreciation of the currency, though welcome, would be “no panacea”, according to a new report…
“Faster currency appreciation, especially when combined with greater flexibility, would make it easier for the government to redress internal and external economic imbalances, but it is not a panacea and appropriate calibration is difficult,” the Conference Board report said.“Although an undervalued currency contributes to China’s trade surplus, it is not a primary cause of it and has very little to do with the bilateral United States-China trade deficit,” it added.
The report said that extraordinary growth in productivity had been the main driver of Chinese competitiveness, creating profits that companies pour back into investment that in turn leads to greater profits.
As Dickie points out, this report has come out in the midst of a renewed set of calls for an RMB appreciation – two days ago Japanese authorities added their voices to US and, increasingly strident, European calls for faster appreciation. This has made the report particularly topical.
Not having read the report, I don’t want to misrepresent what it says, but from the descriptions I have read in Dickie’s article in the Financial Times and elsewhere the report seems to be to making the by-now-standard argument that the an RMB appreciation will not cause a significant direct shift in trade dynamics.I think this is probably true as far as it goes, but misses the point.In fact the level of the RMB is key to the whole issue of China’s balance of trade – not because of the direct impact of the RMB on relative pricing levels, but rather because of the impact of the currency regime on domestic monetary conditions, which are at the heart of the trade balance.
Perhaps because of renewed international pressures on China I have been getting a lot of emails on the subject of the relationship between the RMB and Chinese trade, so the Conference Board’s report provides a good excuse to try to summarize why I think the level of the RMB matters a lot to the balance of trade. First of all it is worth noting that Chinese authorities and other supporters of China’s currency regime have made two conflicting arguments about the relationship between trade and the level of the RMB.
One argument points to studies, like the one I assume the Conference Board produced, that suggest that changes in the level of RMB will not significantly affect the size and direction of China’s exports, largely for three reasons: First, a significant portion of China’s exports (I think the last number I saw was between 40% and 50%) consists of the re-export of imported goods that were simply processed in China.An RMB revaluation, of course, will have very little net impact on the export prices of these goods because while it raised the dollar value of RMBs, it would reduce the RMB value of any imported good by exactly the same amount.
When we include the impact of other imported commodities, such as oil and metals (and imported food, which impacts wages), whose prices, like those of the re-exported imports, would be reduced by an appreciation of the RMB, the net direct and indirect impact of an increase in the RMB, assuming profit levels remained unchanged, is significantly less than the headline appreciation. A 10% appreciation of the RMB, in other words, would reduce the dollar value of Chinese exports by significantly less than 10%, even if all other factors remain unaffected by the appreciation.(By the way this argument is often overstated: certain commodity prices, most importantly oil, are set by the government at subsidized levels and it is extremely unlikely that these prices would drop in RMB terms with an increase in the dollar value of RMB.)
The second reason why changes in the level of RMB will not significantly affect the size and direction of China’s exports is that given recent domestic productivity growth, Chinese companies have high enough profit margins and enough pricing power domestically that the pricing impact of an appreciation could be partly mitigated by reducing profit margins and perhaps domestic input costs.In other words let’s assume, continuing with the example above, that a 10% appreciation resulted in a 5% increase in the average cost of export goods assuming no change in profit margins and domestic costs.By reducing profits and pushing costs down, Chinese corporations can ensure that the increase in the dollar cost of the products to be exported can be reduced even further.We know that in the past Chinese (and other Asian) exporters have reduced profit margins in order to keep market share, and it is reasonable to assume that they will do the same in the future – and recent rising profits may have made it all the easier to do so.
Finally in many, if not most, of its markets China has become so dominant that it has significant pricing power, and in many cases actually sets global prices.This means that if Chinese companies were forced to raise their export prices because of RMB appreciation China would not suddenly see a collapse of its exports.Instead, the price of goods in Europe and America in which China had a significant market share (which corresponds to much, if not most, of its exports) would rise.In fact there might even be, paradoxically, a temporary increase in the total dollar value of Chinese exports if the increase in prices exceeded the resulting reduction in export volume.
Today’s Bloomberg article by Ying Lou quotes Ling Wen, president of China Shenhua Energy Co., the world's second-largest coal company, as saying “It's very important to use not only organic growth, but also mergers and acquisitions to make our enterprise larger, better and more profitable. We have huge room to make some acquisitions.”The article goes on to suggest that Shenhua could raise up to $80 billion by having its main owner, state-owned Shenhua Group sell enough of its shares to dilute ownership to 50%.It would use this money to fund purchases of mines, power plants and ports abroad to supply its energy needs.
I think there is clearly a rising consensus in China, driven in part by political concerns, that local companies should be increasing their presence abroad, in particular through acquisitions, as evidenced by the huge amount of interest in BHP’s bid for Rio Tinto. Many in China are concerned that a successful merger between Rio Tinto and BHP will give such pricing power to the new group that the cost of coal and iron may rise.As a big importer of commodities, a lot of Chinese feel they need to spur their own expansion abroad, and there are rumors swirling around that Chinese companies, with the help of the government, may put in their own bid for Rio Tinto.
Assuming we do see an increase in Chinese purchases abroad, funded by selling shares in the domestic markets, what are the implications?There are I think at least four points worth making.
1.First, from a monetary policy point of view this must be an unambiguously good thing for China and for the PBoC.Any increase in capital outflows due to foreign direct investment reduces the monetary growth problems facing the PBoC because these investments directly reduce the number of dollars the PBoC is forced to buy, and so directly reduces the amount of RMB the PBoC must put into circulation.
2.One word of caution, however, is that the magnitude of necessary outflows is huge – probably too big for current levels of management experience to manage successfully.How huge?In 2004 and 2005 reserves grew by $207 billion and $209 billion respectively.By then PBoC liabilities had already begun their surge and even then I was of the opinion that reserve growth was too high.By the beginning of 2008, however, China’s GDP should be around 35% bigger than it was at the end of 2004, so what was big then might not necessarily be big now, although after so many years of excess money growth, there is a lot of reversing to do.Still, let us use this very unscientific guesswork to suggest that it would be reasonable to get back to a number approximating $200-250 billion in annual reserve increases – still too high, but a lot better than now.
This year we will probably see reserve increases of over $500 billion if we include the reserves that were transferred to CIC.Next year even if there is a slowdown in the global economy I expect net current inflows and gross capital inflows to exceed that number (especially as hot money inflows pick up).Last year China had $21 billion of outward FDI, and as of September this year they had $15 billion – or roughly $20 billion outward FDI a year.Even if we multiplied outward FDI by a factor of five (which would almost certainly strain the ability of management and regulators), that only brings us to around $100 billion of capital outflow for foreign acquisitions, assuming 100% of the purchases were financed domestically, with no foreign borrowings and no share swaps (as was the case, for example, with the CITIC-Bear Stearns deal).
As an aside I should point out that if the Chinese were interested in countering the Rio Tinto acquisition, they would need to beat $134 billion, so it is possible that a few big deals could cause a lot more capital outflow than I am assuming, but until they have a few more deals under their belt I would guess that the Chinese would want to be cautious before making such large acquisitions. So, sticking with the $100 billion as the high end of estimates, if we assume that there will be another transfer of $100 billion to CIC, reserve growth will still be excessively high, at over $300 billion (and the way the CIC funds those transfers does not fully eliminate the monetary impact, as I discuss in an earlier entry).
3.These investments are a little more complex when seen from the PBoC’s point of view or the government’s point of view.China is using a very undervalued currency, the RMB, to buy foreign assets, and it accumulates the dollars which it will use to pay for these assets by selling goods.In effect this means that China is giving foreigners goods at low prices in order to acquire expensive foreign equity.
Of course by accumulating assets abroad, companies such as Shenhua will not be creating this bad trade for China.The trade already exists in the form of PBoC holdings of US and other foreign treasuries and bonds.What happens is that the PBoC will be able to shift a share of its overvalued holdings onto the shareholders of Shenhua (mainly the government, as of now).As I see it this means a transfer of wealth from Shenhua to the PBoC, and we will see the effects of this transfer take place in the form of foreign exchange losses for Shenhua as the RMB appreciates (the PBoC will show correspondingly lower losses).
4.From a long-term investment point of view one has to wonder about buying coal companies and other commodity related companies.Prices for most commodities are at or near highs that they have rarely exceeded except under special circumstances (war, etc.).Is this the best time to buy?Ling Wen, the president of Shenhua, seems to think so.According to Bloomberg:“In the long term, I think the coal price will keep this high level and still have room to increase further,” Ling said. “In the next five to 10 years there is no doubt the Chinese economy will keep this trend, with GDP growth of about 10 percent.”Since this seems to be a widely held opinion, I assume that the prices of coal and other commodity-related companies have already discounted these bullish expectations.
But of course we’ve seen these kinds of statements before.The basic argument is: Prices have gone up because of factor X; I predict factor X will continue; therefore prices will continue to rise.
Maybe.But although it may happen I wouldn‘t be too certain that in the next 5-10 year China will grow by 10% on average.There are many reasons why I think this is extremely implausible, and to mention only one obvious one, the demographic sweet spot in which China found itself since the mid-1970s, with the one-child policy forcing the country into a dramatically improving dependency ration, begins to turn in 2010 or 2011, and the country’s dependency ratio will begin to deteriorate sharply.Add to that so many years of excess growth and a very wobbly financial system and I would want to bet that there will be at least one or two interruptions in those exuberant growth forecasts.
But even if China confounds my expectations and it (and the US, and India, and everyone else) continues to grow like crazy, we know that persistent high prices change consumer behavior and change technological developments.Every prediction of permanently high commodity prices in the past (and there have been many, and they were asserted with every bit as much confidence) ultimately foundered because of technological changes, consumer adjustments, or failed forecasts, and I see no reason to assume that this time will be different.China may be embarking on a buying spree at or near the top of the market. Of course if this true it won’t be the first time a country suddenly flush with cash and self-confidence has done so.
5.But if a non-coal expert like me is so smart about coal prices, and wouldn’t buy coal companies today, why aren’t the executives in Shenhua, who are real experts in coal, equally smart?I am sure they are, but, ignoring the political dimensions of the decision to expand abroad, to explain why they might differ with me we might have to go back to one of the most discussed parts of finance and business theory, which we often refer to as the agency problem.As is very widely understood, managers and owners have very different incentive structures and appetite for risk (mangers are a lot more like creditors in that regard than like equity owners).I won’t go into details too much, except to say that the CEO of a state-owned company almost always benefits from increasing the size, importance and visibility of his company, and will often do so even when the reasons for doing so are economically unsound.
6.Finally, what about if Shenhua (which I am perhaps unfairly treating simply as a proxy for any acquisition-hungry Chinese company) funds foreign acquisitions by selling shares in Shanghai?As I see it, given the bubble-like conditions in the domestic market, domestic investors will be buying overvalued shares from a company which will use their money to buy overvalued foreign currency, which they will then use to buy commodity companies whose prices may be at or near a peak.Probably not a good trade in the long run – perhaps it would be better for them to keep their money in a bank, earning negative real rates in RMB.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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October, 2007
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