I don’t know if I was the first one to use the word “stagflation” in discussing one of the potential scenarios for China in 2008, but I think it is a word that is going to come up again and again in the following months.I first discussed the possibility in November in my class at Peking University and at various conferences, and I wrote about it recently in my blog (January 17, “Can stagflation hit China?”). At the time a number of friends and associates thought I was being even more alarmist than usual – and one bank researcher was a little brusque in dismissing the idea – but I although I don’t think it is inevitable I do think more than ever it is worth pondering.
My basic worry is that inflation will persist because it is driven by three or more years of out-of-control monetary expansion, whereas the heavy-handed attempts to cool the economy could take effect just as a slowdown in the US dampens export growth, and if all the accompanying worry – not to mention the impact of the recent snow storm and its role in undermining faith in the government – causes consumption growth to slow, we could see a much sharper slowing down of the economy than expected. One caveat, as I pointed out in the January 17 entry:
In China a “stagnant” economy is not necessarily one that is recession. It is one in which employment growth fails to keep up with the growth of the labor population, which when I first came to China six years ago everyone assumed to be GDP growth below 7-8%. Given the much higher growth we have seen in recent years and the still-upward pressure on unemployment, especially among university graduates, I suspect that the minimum level of GDP growth is probably much higher.
So why doesn’t the government quickly move to support the economy and prevent this slowing down?The problem is that no one is really sure what is going on.In the October Economic Conference the government made it very clear that it considers overheating to be one of its top two concerns (the other is inflation).Now there are increasing rumors that the leaders are so worried about a potential slowing down that the government and the PBoC may move to a more accommodative stance.
Last week Premier Wen worried publicly that 2008 was going to be a very difficult year for China, and just two days ago President Hu said “We should correctly realize the global economic situation and its influence on China, fully recognize the complexity and variableness of the external economic environment, scientifically manage the pace and intensity of macroeconomic controls, and make efforts to maintain stable and relatively fast economic growth as prolonged as possible.”That’s a bit of a mouthful, but it sounds like he is saying “Forget those old-fashioned fears of overheating, we are not going to risk sacrificing growth”.The always-interesting Xinxin Li of the Observatory Group has this to say in his report today:
This shift in the attitudes of top leaders is also good news for the PBoC, which is reluctant to tighten further. Now, the central bank will feel more comfortable keeping interest rates on hold, and rely more on the RMB appreciation to curb inflation. In addition, the government will likely utilize more fiscal measures to subsidize food and energy production, and fix the infrastructure damaged in the bad weather. Overall, we expect China’s economic policies to be less hawkish in coming months; the risk of an over-tightening is dropping significantly.
But how aggressively can they move? If they lighten up on tightening policies this could seriously backfire if domestic investment and industrial production continue to surge and the US slowdown turns out not to be as bad as expected, or if its impact on the Chinese economy is less than expected or (far more likely in my opinion) delayed. So, to use a metaphor I have probably overused, China may be like the man in the old-fashioned shower who jerks the faucet back and forth between scalding and freezing several times before he can find the right level. Growth may be paramount, but it isn’t clear how quick they should be to dismiss the concerns about overheating, and this lack of clarity is going to make it easy for them to what they have recently done best – do too little.
If the Chinese economy slows down won’t that at least put paid to inflation? Maybe. It depends on what model you use to explain inflation in China. If you think inflation is caused by food supply shortages relative to growing demand, a slowing economy might very well reduce demand sufficiently to cool inflation, especially if there is a lag between slowing consumption and production that allows inventory levels to build. If you believe as I do, however, that inflation is caused by several years of excess monetary expansion, inflation is almost certainly going to persist, even with a slowdown in the economy.
I have already mentioned one economist John Tamny,, who claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.”I bring all this up because I see that the very wise Charles Goodhart, former Bank of England policy maker and now a professor at LSE, said in a speech yesterday that “We're going into a sort of a minor replay of the stagflation we had in the 1970s. Growth has been declining, productivity has been falling awkwardly, and there have been supply shocks on the inflationary side.” He claims that we will need “a great deal of luck” to avoid it.
More alarmingly, given my contention that China’s economy is like the rest of the world’s but only more hopped-up on amphetamines, “Whether stagflation becomes entrenched is not at all certain. For us it may be a minor replay in the West, but in emerging economies it's a different story. If anyone's going to suffer, it's them.”I hope he is dead wrong.
By the way, in totally unrelated news, China Coal Energy, whose $3.6 billion IPO drew $433 billion in bids, traded up 43% on its opening day before falling back about 10% from its high. This was considered a hugely disappointing first day, but with such difficult markets (Shanghai was down nearly 1.5% today) maybe it wasn’t so bad. Normally 30% may seem like a good one-day return, but remember that for every dollar of shares you got allocated, you had to put up bids for about $120, which according to Chinese regulations must be 100% cash-backed.You risked $120 dollars (if the deal turned out to be a failure you would probably get all or nearly all your bid), but only made a profit of $0.30 – not so good.I think we may start to see a decline in oversubscription.
So will they or won’t they? One worry making the rounds is that on the economic front the government will overreact to the weather crisis in the same way it did during and after the SARS crisis, when it expanded monetary and credit growth much too quickly to make up for a supposed slack in employment growth.Given the level of unhappiness caused by the storms – not altogether the fault of the government although they have been criticized for being unprepared and for sugarcoating accounts of the crisis (no big surprise on the latter charge) – the government may be biased towards over-stimulating rather than under-stimulating employment growth in the near term. When in doubt, step on the gas.
Not everyone agrees.At a conference in Beijing today former Central Bank Deputy Governor Wu Xiaoling said that China would continue tightening economic conditions in order to moderate economic growth and rein in inflation.She also suggested that the government would allow more flexibility in the currency regime, especially since “the U.S. rate cuts have limited the room for the central bank to use interest rate as a leverage tool to adjust domestic demand.”I guess there are some rather tantalizing ways to interpret that comment, but I guess I shouldn’t read too much into it.
On the other hand, according to today’s Financial Times, “China has ordered financial institutions to provide emergency loans to businesses and individuals hit by the snow storms and power cuts that have paralyzed swathes of central and southern China.” They then go on to say that the directive, issued by the PBoC late Thursday night, “could bring a speedier than expected end to the credit squeeze instituted in recent months to fight inflation and cool a number of sectors of the economy, especially the property market.”Already, as I have mentioned several times before on this blog, there seems to be evidence that the weather crisis has tilted the balance of policy activity away from the monetary alarmists, who only seemed to gain the upper hand just a few months ago, back to the growth camp. As a card-carrying monetary alarmist I find that worrisome. How long the growth camp remains in control depends partly, I guess, on the duration of the weather crisis and the evolving evaluation of its economic, social and political impact.
Meanwhile weather conditions are not getting a lot better. Tthe China Daily today gives us the slightly awkward but soothing headline “Power could resume shortly in worst-hit area by snow”, but the story itself is not particularly optimistic. Conditions are grim.Other accounts of what China still has in store are even more alarming.Yesterday apparently Premier Wen speaking at a State council meeting warned the country that things were going to get worse, and today’s South China Morning Post has the headline “Another 10 days of misery forecast for a city living in fear,” which quotes Yu Jianhua, an operator for China Telecom’s information service in the city of Chenzhou, the subject of the headline, as saying "We know external help has been largely cut off. We know we must rely on ourselves and help each other. We cannot depend on the government.”
Most commentators see the weather crisis as an unambiguous political negative for the government, with the effect perhaps of increasing discontent and reducing credibility, unless the government succeeds in convincing people living in the affected areas that it has been sympathetic and effective in assisting them. The may well succeed in doing so since the leadership, perhaps a little belatedly, has nonetheless been firing all pistons to bring relief. Still, there is another, perhaps more positive, interpretation of the impact of the crisis making the rounds, at least among elite university students. Two different students (one from Tsinghua and one from Peking University) assured me yesterday that the weather crisis has provided a great excuse for the government to adjust CPI numbers that should have been adjusted earlier (I am trying to be polite here). I don’t know where they heard this and I have absolutely no idea if these statements have any basis or are completely groundless – and I am not trying to imply anything by repeating them – but I present them as, at the very least, evidence that there is a lot of cynicism out there.
In 16 and 17 days we will get PPI and CPI numbers for January.I think the consensus is moving towards 7% very quickly.
I’ve just seen one piece of good news and one favorable prediction about January inflation. The good news is that the State Administration of Grain said in a statement posted on Xinhua News Agency's Web Site today that in spite of the recent disastrous weather, China still expects to meet its grain harvest target this year.I did not realize that China is the world’s biggest wheat grower, but last year it harvested 501.5 million metric tons and this year it is on target to harvest around 500 million metric tons.
I hope this is true. The favorable prediction comes from Chen Xiwen, director of the Office of the Central Leading Group on Rural Work, according to today’s China Daily.“Given that prices of grain, pork and edible oil have seen no apparent rises, January CPI will remain stable,” Chen told the briefing held by the State Council Information Office.He predicted that January CPI inflation would be 6.5%.
This is not stable, by any means, but a lot of other analysts, including me, are predicting that CPI’s rise will be closer to 7%. Is 6.5% achievable?Perhaps, but not without some fudging.The government has been aggressively selling and/or delivering food reserves.Given the weather-related chaos in the food markets, this is not at all an unreasonable policy, but it does tend to put temporary downward pressure on prices, and that pressure will be reversed when the government replenishes its stocks. According to other reports farmers are complaining that food price freezes – another way of containing headline CPI inflation – are hurting them because they are being squeezed by higher fertilizer and energy prices.Finally according to the China Daily article, “To help keep prices down, the government has ordered all highway and expressway operators to exempt trucks carrying vegetables from toll fees.”Both price freezes and toll-road-fee exemptions reduce nominal food-related inflation, but they do so simply by a sort of accounting trick – what should have been called “higher food prices” will now be called something like “extraordinary loss” on the farmers’ and toll road companies’ income statements (I don’t mean that literally – the inflationary cost will simply show up as lower revenues or higher taxes).
I would have thought that it would have been smarter to let the full rise in food costs pass through into CPI numbers in January, because then inflation could be blamed on extraordinary circumstances.They can continue to subsidize the food costs to the worst-affected consumers, since this is politically and humanitarianly necessary, but the subsidies should be segregated and made explicit, although perhaps this would be administratively too complicated. Still, as it is, the net effect is to reduce upward pressure on prices in January and postpone that pressure into the next few months.This is surely more likely to cause inflationary expectations to rise than are price increases concentrated in January.
The government has spoken, I guess. At any rate the stock market certainly thinks it has. As a side project I run a small investment club, with money supplied by me and some friends, that is invested in a diversified portfolio of Shanghai-Stock-Exchange-listed B-shares (which foreigners are permitted to own, unlike shares in the much larger A-share market), so I can’t say I was disappointed when I clicked onto the SSE website and found that the B-share index was up 7.94% today (A-shares are up 8.13%). Although I am a little surprised at the extent of my gains, I am not at all surprised that my shares, and the market more generally, is up significantly today.
In fact I knew all weekend that my shares would be up today. How did I know?Easy.Everybody knew the market would be up today because the government very cleared signaled over the weekend that it wanted the market to go up. It was as simple as that.An article in today’s China Daily explains: “Monday's rally came after the China Securities Regulatory Commission (CSRC) gave the green light to CCB Principal Asset Management Co. and China Southern Fund Management Co to launch two funds expected to raise 14 billion yuan for equity investment.”
About four months ago, as a sign that it was very unhappy with the excess rise in the stock market and wanted it to come down, the government embarked on a series of measures to bring prices down.One of these measures was to prevent the launch of new mutual funds – always an important sign here of the government’s intentions.The market duly collapsed. At its peak in mid-October the Shanghai CSI hit 5885, before dropping to 4318 on Friday (a decline of nearly 27%).But now, by approving the application of two of these funds, the government made it clear that it believed the decline in the markets of the last three months has been excessive and may begin to have adverse effects on public sentiment. It was time for the market to go up.
While I yield to no one in the gratitude I feel towards anyone who can increase my wealth by several tens of thousands of dollars in a single day, I have to say that this is not as good for the development of stock markets in China.This kind of behavior will only delay by several more years the time when Chinese markets begin to fulfill their role as an efficient allocator of capital, taking money away from the least efficient and passing it on to those with the best growth prospects.I wrote about why in a January 2 posting (“The government condemns Chinese financial markets to speculation”).
A purely speculative market does not allocate capital efficiently based on reasonable estimates of future earnings prospects. Speculative investors simply try to exploit short-term price changes, usually based on changes in short-term demand or supply factors.In China the only important piece of information is about short-term changes in government and regulatory actions caused by changes in the government’s current intentions (and these change dramatically month-by-month and even day-by-day sometimes).Bloomberg quotes a grateful fund manager today as saying: “It is encouraging to investors that the government has done something to intervene in the market decline. We are probably already at a level where the regulators don't want to see a further decline.” Recent activity simply reinforces the message that in the Chinese markets the only thing that matters is the government’s intention, and the only people allowed to play are the speculators.
I am currently in Spain for a business meeting and will send the next week or so in New York, so some of my entries are going to be posted late.In China the debate about policy continues to rage, it seems, and although those of us outside the State Council can only guess at what is happening, the back-and-forth in the press gives us some hints of what the issues are likely to be.For example in China Daily Fu Jing wrote yesterday that economic policy needs a “rethink”.
The country needs to rethink its economic policy with snowstorms hitting regions and an economic slowdown in the United States, economists have said.“The economic situation has become complicated with the new factors cropping up," Wu Jinglian, one of China's top economists, told China Daily yesterday.It is imperative that the new developments are considered with measures to combat high inflation and the overheating of the economy, said Wu, from the State Council Development Research Centre, the central government's think tank.
Although the article did mention that vigilance against inflation and overheating needed to be maintained, these seemed to be fairly perfunctory acknowledgements in an article warning that China’s economy may slow down much more sharply than expected, especially if tightening measures are enforced.
The fears of people who share Mr. Fu’s views were reinforced by the poor showing in the recently-released headline PMI for December, which dropped from 55.3 to 53.0, although this is still in “expansion” territory (anything above 50).Nonetheless it does suggest that both internal factors (the weather and the credit tightening) and external factors (a slowdown in export growth) are weighing on the economy, especially given the sharp drop in the new export orders index from 54.4 to 49.0.Today Goldman Sachs made a trade recommendation that investors short the renminbi against the rupee in part, it seems, because they think the weather crisis will slow the renminbi appreciation.
On the other hand the South China Morning Post had this to say:
Zhu Hongren , deputy head of the National Development and Reform Commission's economic operations department, the nation's top economic planning body, said overall economic fundamentals remained sound. He listed several positive elements supporting economic growth, such as the Beijing Olympics in August, efforts to restore agricultural and industrial output, and some "good news" yet to be delivered. "Let's wait and see what happens. I hope we can hear some good news."
Analysts believe he was alluding to a relaxation of economic controls by Beijing. They said policymakers were quietly loosening the monetary reins after the bad weather threatened to stunt first-quarter growth. The analysts pointed out that President Hu Jintao did not mention the government's resolve to prevent overheating - a common topic - when he spoke about the economy last week. Instead, he told policymakers to "fully realize the complicated and changing economic environment and preserve as long as possible China's stable and relatively fast economic growth".
In an article I had missed, about two weeks ago the Economic Observer weighed in against using price controls to combat inflation, arguing that as a monetary problem, the only way to address inflation was by adjusting (read: tightening) monetary policy and the currency.Similarly, a researcher at the very prestigious Chinese Academy of Social Sciences published an op-ed piece in the China Daily late last week warning that it was too early to claim that adverse global conditions meant it was time for China to relax its new-found monetary hawkishness:
Many say the Chinese authorities should reconsider the tight monetary policy currently in effect.Their concern is not baseless for the economic situation in and out of China does not allow for too much optimism. Capital markets around the world are stumbling. China and the US are also seeing a narrowed difference in their interest rates.
However, these facts are far from adequate for the Chinese authorities to change the tight monetary policy.
I have seen more articles supporting than opposing continued tightening and no relaxation of monetary policy, but interpreting what this means is not easy.As I see it, my sources are more likely to be biased to the monetary camp, who are still much more worried about the consequences of rising inflation and economic overheating, then to the pro-growth camp, who do not want to see economic and employment growth drop sharply.Until recently the monetary camp seemed to be dominating the debate after having been relegated (much too long, in my opinion) to the margins, so the fact that the so many economists are arguing strongly and urgently in favor of a continuation of monetary tightening and renminbi appreciation suggests to me that they are worried that they are being once again pushed away from the center of the policy debate.
Neither I nor any other outsider knows what is really happening, and I am probably doing little more than reading tea leaves, but I am worried that we may be seeing another shift in policy.If worry about a slowdown causes the authorities to back away from their recent acknowledgement about the serious monetary bind in which China has found itself, I can only imagine that things will get worse as we approach the Olympics.
Amid all this debate, the government continues to show the people that it cares about the consequences of the weather crisis.An article in yesterday’s China Daily tells us reassuringly that “Across China, the worst winter storm in five decades has prompted governments to fight profiteering and maintain market order.”Among other things the government has told affected mobile phone operators that they cannot discontinue service for lack of payment, and they have punished railway station managers for allocating impossibly-scarce train tickets to themselves and then scalping them at many times their stated value – a popular activity this year since, during the Spring Festival, millions of Chinese overcrowd the trains as they go home to see their families for this most-important of Chinese family holidays, and the recent weather disaster has closed down many of the trains and made this year’s homecoming impossible for hundreds of thousands of workers.
It is hard to argue with punishing railway managers who withdraw scarce train tickets and re-sell them at a profit, and of course when the main reason many customers cannot pay their phone service is because of weather-related breakdowns, they should not be penalized, but some of the other inflation-busting activities reported by the media are less helpful, even if they are crowd-pleasers.In their goal to eliminate “profiteering”, hotels inundated with travelers have been prevented from raising room fees, restaurants and grocery shops running out of food and other supplies have been punished for raising prices, and everyone is required to get approval from the appropriate authorities before raising any of their prices.It seems that passing on part of the cost of the crisis to small businesses (for some reason I suspect larger businesses have more recourse) is likely to make the economy less, not more, productive.
I just got to New York yesterday and have been meeting pretty continuously with friends and investors.Not surprisingly, everyone is very interested in hearing about what is going on in China.Last time I was here, in July, a lot of people asked me about the “decoupling” thesis, and not everyone was terrible pleased (or in agreement) when I said I thought the idea was mostly nonsense, based partly on mistaken premises and partly on wishful thinking
Now, it seems, no one takes the idea of decoupling seriously at all.Everyone is convinced that a sharp slowdown in the US will be disastrous for the rest of the world. This is one idea whose death seems to have come quick and hard.In fact, the most noticeable aspect of my trip here is the sheer gloom and worry about the state of the US and world economy.It has been a while since I have seen so much pessimism and nervousness.
Actually on this trip I found myself taking the unusual but not disagreeable role of downplaying some of the risks and terrors that lurked out there.The sub-prime crisis has certainly been tough, but the resilience of the US financial system has really been impressive during the many crises of the past three or four decades, and the transmission mechanism from financial crisis to economic contraction has, in some way, been sharply weakened in the US.
More importantly, in my view, the long, globalization cycle we have been through since the 1990s won’t truly end until we start to see a sharp reduction in the combined US/Europe trade deficits if, as I believe, it has largely been Asian and (more recently) OPEC recycling of their huge current account surpluses that has underpinned the growth in underlying global liquidity.I am not saying that this can’t happen – it can and some point must – but so far this has not happened at anywhere near enough of a scale to convince me that we’ve reached the end.The main thing to watch, in my opinion, is inflation. If there is a slowdown, however mild, that is accompanied by a sharp increase in inflation, this could really spell the beginning of the end.
Talk of rising inflation and a slowing economy brings us straight back to the topic of China.Xinhua yesterday reported that the “U.S. slowdown could be opportunity, not crisis, for China.”They report that a number of Chinese economists believe that a US slowdown, by reducing the growth rate of exports, could help rebalance Chinese growth, towards a healthier mix of investment, exports and consumption and would help relieve monetary expansion.
To their credit few Chinese have taken the decoupling thesis very seriously, but if they expect a US slowdown to help resolve their domestic problems I think they are missing the point. One economist mentioned in the article, Zheng Jingping, a researcher with the National Statistics Bureau, did get focus on the key issue when he noted that “it was not export growth but the trade surplus that would be the key issue”.This is exactly right.If China’s exports decline, and Chinese imports decline also so keeping the trade surplus high, China will get hit by a double whammy. The reduction in exports will hurt economic growth but the high trade surplus will keep China’s furious money expansion going, so continuing to put upward pressure on investment and industrial production.The “rebalancing” would consist of an even greater share of investment as part of total GDP growth. This would be a worst-case outcome.
Could exports slow while causing a decline in imports?Yes, in fact it is highly likely. Remember that nearly half of Chinese exports are recycled imports, and any slowdown in the very important and lively export sector might indirectly affect Chinese overall consumption by increasing uncertainty.But even if there is a small decline in the trade surplus, that is not enough. In order to halt the money-creating monster that China’s currency regime has become, we need the trade surplus (and hot-money inflows) to decline substantially.
The problem in China is excessive monetary expansion, caused by the lack of a domestic monetary policy, and until that is resolved it is wishful thinking to talk about a healthy rebalancing.Rapid money growth will continue to fuel excess investment and industrial production, until it comes to end either after a sharp increase in unsold inventories forces companies to cut investment or after persistent and rising inflation forces the government to clamp down brutally on economic activity.
On a slightly different topic, there has been a lot of recent downgrading of expected growth rates for China (so much for decoupling). According to the New York Times in an article about a recent World Bank report:
The bank said in a quarterly update that it now expected gross domestic product in China to expand at a 9.6 percent rate in 2008, which would be the slowest growth since 2002. In its previous report in September, just as the global credit crunch was intensifying, the bank projected 10.8 percent growth for 2008.
Revising 2008 growth down from 10.8% in September to 9.6% in January is a big jump, and I expect that number will be sharply revised upward or down again.One of the things I have tried to point out about China is that there is a lot of pro-cyclicality embedded into its capital structure, which means that external events, whether adverse or positive will have exaggerated impacts on domestic growth.In spite of a recent report by UBS claiming that the old boom-and-bust of China has given way to smoother change, I continue to think that economic growth is going to be extremely volatile.
This will be reflected in bank stock prices, by the way
Yesterday’s Financial Times says that US wheat inventories fell to a sixty year low and may even force the US to import wheat this year. Apparently it had sold too much wheat last year and now will have to replenish stocks. That news drove prices for certain varieties of wheat up nearly 11% last week and 50% so far this year.There are also estimates that India, the world’s second largest wheat consumer, may have to import significantly more wheat than in the past, beginning in April this year.
One way of bringing wheat prices back down, according to analysts, is if higher prices in India and China cause farmers to allocate land away from cotton production to wheat production. Price controls in China may make that process very difficult.I am no grain expert, but the recent trend of shortages and rising grain prices is becoming monotonous and bodes poorly for China’s fight against inflation in 2008.With food prices rising so quickly, even an annual RMB appreciation of 9-10% will not bring the price of foreign food imports down in local currency terms.
Next week we will get January’s CPI and PPI inflation numbers. I doubt they will be good, but I suspect that inflation doves will insist that the distortions caused by the winter weather crisis make them useless in determining policy changes. Next month’s CPI numbers are also likely to be distorted, by the spring festival.That means it won’t be until mid-April, when we get the March numbers, that we might have sufficient evidence of persisting inflation to affect policy choices.Of course that is the time the new provincial and municipal leadership comes into power, and so there may not be a lot of appetite for economic tightening anyway.
Separately Peter Mandelson, the EU’s trade commissioner, made some fairly aggressive claims last week in a speech at Cambridge University about rising European protectionist ire aimed at China.Mandelson has the reputation of being a hard-core free trader, but his comments suggest that he is finding it increasingly difficult politically to explain away Chinese trade policies to his European constituents.The whole shifting of Chinese trade surpluses from the US to Europe never had much chance, in my opinion, of being sustainable. Thanks to its more flexible economy and financial markets, and perhaps a different attitude towards globalization, the US is able to accept and absorb these kinds off imbalances much more easily than Europe.This means, I think, that unless the dollar rises strongly against the euro, it will be difficult for China to slow the rate of appreciation of the RMB without causing rising anger in Europe and maybe even trade-related moves.China might want to do so should it suddenly become worried about a rapid drop in exports to the US caused by a slowing US economy.
Rising global inflation, the potential US slowdown, its impact on the rest of the world, and the accompanying credit crunch are seriously complicating China’s policy options. A few years ago when former Brazilian central bank governor Arminio Fraga visited Beijing, one of the points he tried to make to government officials with whom he met, he told me, was that the best time to make difficult adjustments to the currency regime was when local and external conditions were great, as they were at the time, otherwise the financial authorities might find themselves in the position of being forced to make adjustments when conditions were much more difficult.It seems like an obvious point, but bears repeating often.
Yesterday at an investor meeting someone made the point that the lack of transparency in Chinese accounting may actually act to reduce the riskiness of the system.If this is true, it is pretty good news for investors banking on government credit.
What’s the total amount of central government debt in China and how is it structured?We don’t really know.What is the amount of municipal and provincial obligations guaranteed by the central government?We certainly don’t know.How much did banks lend against real estate?We have some figures but it is widely believed that an awful lot of real estate loans are not correctly classified as real estate loans.What is the breakdown within the banking system of new loans, and what about old non-performing loans?We have some information but not nearly enough to give us a real sense of how much bad debt there currently is and, perhaps more importantly, how vulnerable new loans are to a slowdown.There is a lot of mystery embedded in the national balance sheet.
Asking about the creditworthiness of the central government is not a trivial question.China is in a reasonably good fiscal position and government expenditures only barely exceed revenues. In addition most estimates put total current debt of the government at around 30% of GDP, which everyone agrees is fairly low and should cause little concern to anyone looking at the government’s ability to service debt.
More importantly from a financial stability point of view, most government obligations are very safe and optimally structured – they consist of medium- and long-term, fixed-rate, local currency bonds.In my book on financial vulnerability in developing countries I make a point about stressing how important this kind of debt is in protecting countries from the threat of financial crisis because of the way they dissipate the impact of adverse shocks.In a crisis anything that causes interest rates to rise substantially (say a burst of inflation) would automatically reduce the existing debt burden, thus acting to stabilize the financial system.
But still, that doesn’t mean that there is nothing to worry about.Last March the Inter-American Development Bank published Living with Debt - How to Limit the Risks of Sovereign Finance by Eduardo Borensztein, Eduardo Levi, and Ugo Panizza, and one of the most interesting points the book makes is that the surge in debt that precedes a financial crisis rarely occurs because of the accumulation of massive fiscal deficits, as we are likely to assume, but rather because of a sudden conversion of contingent liabilities onto the government’s balance sheet.
The two most likely sources of these contingent liabilities have typically been unhedged external debt, when a rapid depreciation of the currency suddenly causes the value of external debt to rise relative to the value of domestic assets, or a surge in non-performing loans on bank balance sheets that forces the government to intervene and assume the liabilities of the banking system.China, which has been vigorously fighting the 1997-Asian-Crisis war, is almost immune to the former risk, but it doesn’t take an alarmist to see that the latter risk is a real possibility, especially given the explosion in bank lending during the best-of-times period of 2003 to the present.
Right now, my best guess is that if various contingent liabilities were correctly accounted, total liabilities of the government would exceed 50% of GDP, and could be much larger – some estimates put it at 80% of GDP, which is not implausible.If there were a significant downturn the number would probably get worse – it is almost a certainty that non-performing loans in the banking system would rise in an economic downturn.How much is anyone’s guess, but it is not implausible to assume the possibility of a sharp rise in non-performing loans.
When these are combined with the non-performing loans still residing on the bank balance sheets (some correctly identified, but perhaps many of them still hidden) and the loans transferred onto the asset management companies created for that purpose, who are technically bankrupt but explicitly guaranteed by the MoF, total debt of the government may jump substantially, and this debt is not nearly as well structured as the existing bond obligations of the government.In fact, as I explain in my book and elsewhere, these types of debt exacerbate external shocks and so can be as toxic for the government as external debt, or Mexico’s famous Tesobons, in case of a domestic crisis, because like external debt their value tends to expand just when the country can least afford it.
I brought this up yesterday at an investor meeting and received a comment, in the form of a question, that I have heard many, many times before – and from some fairly sophisticated sources.Since the government has been able to hide the true extent of its liabilities quite well, why should we assume that in a contraction we will suddenly get access to this information and, if we don’t ever know, why should it matter?The hole on a borrower’s balance sheet is only a problem if we know it is there.China’s lack of transparency actually reduces the risk of bad information spooking investors.
It is always frustrating to get this kind of comment, especially now when the sub-prime crisis has made it very obvious that sometimes the lack of information is worse than unhappy information.After all it wasn’t the extent of the potential sub-prime losses, even assuming the worst possible case, that scared the market but the fact that no one knew where these losses were hiding.
Information does matter, especially when we need it most.Based on many years of trading, I can say one of the few rules of financial markets I know is that when markets are buoyant and liquidity plentiful, transparency and high-quality information is of little use – in fact since we tend to assume the best, no information just means no bad information, so buy, buy, buy.However when things go badly, investors change tack suddenly and begin to assume the worst.In this case no information means nothing but bad information.
It’s always dangerous to make predictions but one thing I will predict with great confidence is that when things turn badly in China – when economic or monetary conditions are contracting – the lack of information that emboldens investors today will force them into panic selling.Lack of transparency is only a blessing in the irrational state of a bull market.However it becomes a source of new irrationality in a declining market.
This, by the way, is not a new observation at all.On my flight to New York I was reading Russell Napier’s Anatomy of the Bear and came across this June 15, 1932 quote from the Wall Street Journal: “During the roaring days of the bull market, lack of full information about a company gave its securities a certain mystery value. The long depression has done a good deal to eliminate mystery value from consideration of the worth of a security.”
After declining strongly in November and December, to I think around RMB 60-70 billion a month, new lending in January soared to RMB 804 billion.This is the highest monthly figure in years and more than twice the very high monthly average for 2007 (RMB 303 billion).It also blows out the monthly average for the first quarter of 2007 (RMB 474 billion), the former record period for new lending.To make a quick back-of-the-envelope comparison, even if February and March new lending plummets to the December level, the first quarter of 2008 will still see more new loans than the average quarter last year.I think we may see a new quarterly record set.
The sudden relaxation (to put it mildly) of new lending constraints might be a panicked but limited reaction to the effect of the storm in January, or it may signal that the government has more generally reversed course and has begun easing again.Much of the lending was short term (51%).
Money supply growth also surged in January.M2 was up 18.9%, compared to the 16.5% consensus as reported by Bloomberg.M0 was up 31.2% from last January.This is not as surprising as it seems since a lot of people took out cash for the Spring Festival holidays, and of course a lot of commentators are saying just this.Still, I am still haunted by the image of the man in the old-fashioned shower jerking the faucet back and forth as he alternatively scalds himself and freezes himself.
According to today’s Bloomberg, “China's trade surplus jumped more than economists estimated in January, a sign that the world's fourth-biggest economy may keep powering global growth as a recession looms in the U.S.”Data released by the Chinese authorities yesterday showed a trade surplus of $19.5 billion for January.This is below December’s $22.7 billion (which tends to be swelled by Christmas shipments), but it is 23% higher than last January’s $15.9 billion.More importantly it was also higher than the consensus estimates, of just under $17 billion. Exports rose by a very high 26.7%, to $109.7 billion for January, while imports increased by 27.6%.
Although the number surprised substantially on the upside (yet again), a number of analysts tried to downplay or explain away the higher-than-expected surplus, and to predict (yet again) that things will improve. “Such strong export growth is unlikely to be sustained. I think it’s abnormal,” said Li Yushi, vice-director of a think-tank under the Ministry of Commerce, according to an article in today’s South China Morning Post. “Many exporters are in difficulties due to rising costs and the yuan’s appreciation, and export momentum will ease in coming months.” Analysts focused on the seemingly strong growth in imports and noted that part of the increase in exports might have been an anticipation of the early Spring Festival, which this year came eleven days earlier than last.The need to get work done before the holidays kicked in left exporters rushing to fill orders in January that might normally have been filled in February.
While this may be true of exporters anticipating the holidays, it should also be true of importers, and the net figure still should not have been so high. Anyway since the date of the Spring Festival was widely known by economists I don’t see why its impact should have been unexpected.What is more, this trade surplus, high as it is, still understates the strength of Chinese exports and overstates the rise of imports.According to Mark Williams, of Capital Economics, “the value of imports was also inflated by the high cost of oil imports last month. We estimate that this alone accounts for 12 percentage points of the growth in imports. If oil prices had remained flat, January’s surplus would have been in the region of $28bn rather than $19.5bn, not far off an all-time high in the oil price-adjusted data.”
When the trade surplus numbers started coming down at the end of last year, I wrote in my blog (January 11, “December's trade surplus declines to $22.7 billion”) not to take the decline too seriously.
Many analysts are suggesting that we may have seen a cresting of export growth and perhaps even the trade surplus.I am skeptical.I think recent export-related cooling measures, plus the surge in oil prices, may have brought the trade surplus down temporarily, but the figures are still very high and money growth is still excessive.Once the initial cooling measures on exports wear off (not to mention when the anti-inflationary cooling measures on consumption kick in) we will get back to the old dynamics of an expanding money supply leading to expanding industrial production leading to expanding exports.
My reasoning was that as long as there was excess money creation it would feed into rising industrial production via rising investments, and as long as industrial production climbs faster than consumption, China’s trade surplus must stay high or rise.I think it is going to be very hard to see a real decline in the trade surplus until we see either a sharp rise in forced domestic investment (rising inventory levels) caused by a significant falling off of foreign demand, or until the currency regime is fixed, either by a lot more appreciation or by a lot more inflation.China’s trade surplus is part of the monetary trap in which it finds itself caught.
Talking about trade, the US also reported trade figures yesterday.The US trade deficit shrank in 2007, for the first time in five years, by 6.2%.This was partly explained by a reduction in the growth rate of imports (5%) and partly because of a sharp rise in exports (12%).The lower-than-expected trade gap may cause the fourth-quarter GDP growth numbers to be revised upwards.It also underscores how risky the current strategy may be of significantly relaxing the fight against inflation and overheating because of concerns about a collapse in US demand.
So far, just as I and all the other monetary alarmists have been predicting, there hasn’t been much moderation in China’s growth numbers.In spite of the recognition in October of how flawed Chinese economic policy-making had been over the past several years in its failure to take into account out-of-control monetary policies, it seems that we have gone right back to the old days.
After all the market-related anxiety I felt during the last few days in New York, I returned to Beijing yesterday expecting a little less gloom, but nonetheless I suspect that anxiety levels in the corridors of power in Beijing are probably higher than ever.Yesterday the National Bureau of Statistics released PPI numbers for January and today it released the CPI numbers.Regular readers of my blog will not be surprised when I say the numbers weren’t good.According to the NBS release:
In January, Producers’ Price Index (PPI) for manufactured goods up by 6.1 percent from the same month last year; purchasing prices for raw material, fuels and power rose by 8.9 percent.PPI for means of production increased 6.5 percent over last January. Of the total, PPIs for mining and quarrying industry increased 20.5 percent; that for raw materials industry and manufacturing industry correspondingly up by 8.5 and 3.8 percent; that for means of consumer goods grew 4.6 percent. Of which, price for foodstuff increased 10.4 percent; that of clothing and commodities rose 2.2 and 3.0 percent respectively, while that for durable consumer goods dropped 0.6 percent.
PPI numbers rose from October to December by 3.2%, 4.6%, and 5.3%, respectively.January’s 6.1% indicates that upward price pressures continue stronger than ever.Food prices were a big part of that, but notice that mining and the raw materials industry were also up substantially.
CPI was even more alarming.A lot of debate during the last few weeks was whether we would see CPI hit 7% for January.According to the NBS release today:
In January, consumer price index (CPI) was up by 7.1 percent over the same month last year, of which, urban area and rural area rose 6.8 and 7.7 percent respectively. The price of foodstuff, non-foodstuff, consumable and services expanded 18.2, 1.5, 8.5 and 2.6 percent respectively. CPI made 1.2 percent growth over that in December 2007.
7.1% CPI inflation for January is up from 6.9% in November and 6.5% in December (although remember that for statistical reasons the price jump in December is rally equivalent to the November rise – I discussed why in an entry last month).The bulk of the increase was still caused by food inflation, but what worries me is that non-food inflation, while low (1.5%) is still rising, which it shouldn’t be if inflation were really caused primarily by a one-time food supply constraint – indeed it should be declining or even negative.It is also pretty clear that inflation is starting to spread to other areas of the economy.For those of us who have always been convinced that inflation in China is a monetary problem, and not a one-off food supply problem, the recent numbers, while not conclusive, only make us worry even more.
A lot of January inflation has been blamed on the effect of the recent weather crisis, but I believe that much of the weather-related price increases didn’t show up in January and are more likely to show up in February.I should also point out that some Chinese analysts are warning that certain industries whose prices have been frozen (or for whom price increases are subject to approval) may have concealed the true extent of price increases, so the CPI number may actually understate inflation.At any rate, according to the press, Deutsche Bank and Goldman are warning that inflation may go as high as 8-10% in February and March.I am not sure how they get to those numbers, but regular readers of my blog know that I have always been much more easily convinced by the inflation pessimists than by the optimists.
So what can the government do?Precious little, it seems to me.There is still a fast and furious debate about tightening versus non-tightening.On the one hand January’s numbers – rising inflation, the surge in bank lending, and the surprisingly high trade surplus – should argue for more tightening.The government seems to have shifted policy from pro-growth until late last year, to slow-growth after October, and now back to pro-growth.These rapid policy shifts are very damaging – they undermine credibility and, perhaps worse, they add unnecessary volatility since we never seem to wait around long enough to see what the impacts of the policy decisions have been – but there is a strong case that can be made that we need to shift once again to a slow-growth policy.
Still, it is easy to argue against a policy shift and it seems that many in China seem to be doing exactly that.The weather crisis and the possibility of a sharp US slowdown add enough uncertainty to the picture that an equally strong case can be made for taking a wait-and-see attitude before acting further.Given the government’s ideological and institutional commitment to gradualism, a good reason to do nothing would be warmly welcomed.Add to this the fact that new leadership will be announced in March, and one can imagine a lot of future newly-promoted provincial and municipal leaders eager to give their bailiwicks a big fiscal boost at the beginning of their watch.
Not surprisingly the analyst community is split on will-they-or-won’t-they.Some are expecting a rapid return to interest rate hikes, reserve hikes, and tougher lending constraints, while others think that the authorities are unlikely to move before March or April, until we can get the first set of economic numbers uncontaminated by the effects of the weather crisis and the Spring Festival, and after we have a better sense of whether or not the US economy is likely to slow enough to affect the Chinese economy in a significant way.
Either way I don’t think it will matter.I continue to believe that China’s problem is a monetary problem, and that the root cause of the problem is the massive amount of the trade and capital account surpluses that need to be monetized by the PBoC.Until these inflows are eliminated, tightening policies will be as ineffective in the future as they have been in the past.
In principle the more rapid appreciation of the RMB should be one way to affect inflows, but in practice, of course, it is not.Rapid appreciation stimulates speculative inflows, and as long as this money creation continues to feed China’s investment boom, industrial production will keep surging and the gap between production and consumption will continue to keep the trade surplus abnormally high.None of the tightening measures being discussed – even if they are implemented – will do anything to get China out of its monetary trap.
In a recent report Jonathan Anderson of UBS explains why he doesn’t think China will adjust the currency via a large one-off revaluation.As regular readers of my blog know, I have been arguing since early 2007 that there is a high probability that the financial authorities will eventually be forced into a one-off (15-20%) revaluation, although I am uncertain about the timing.
If they do revalue, they probably won’t want to do it too close to the Olympics because of their low appetite for uncertainty before such an important event, so that leaves them a very short time frame in which to do it – perhaps over the next two months.However with all the uncertainty over the US economy, and with the new leadership being approved in the next NPC (which begins March 5), I think it is unlikely that they will choose to do it then.On the other hand, the longer they wait, the worse the monetary and associated imbalances become.
Although I disagree with him, I wanted nonetheless to list Anderson’s arguments because I think his are often the strongest arguments against a revaluation.I hope I am not violating copyright laws (although if I am, my excuse is, why not? around here everyone else does…), but here are excerpts from Anderson’s piece on why a one-off revaluation does not make sense:
1. It would hurt the wrong people…As we've also discussed numerous times, the problem behind the trade surplus is not overly competitive exports per se ... but rather imports, or more specifically the sharp drop in import demand over the last few years as rising domestic heavy industrial capacity has taken over market share at home and in some cases (e.g., steel) pushed surplus production abroad. In this environment, the optimal solution for the Chinese authorities is to (i) raise costs for overinvested heavy industrial sectors in order to force out marginal players and rekindle import spending, without (ii) overly penalizing traditional labor-intensive export manufacturers, who are the single largest employer of poor rural migrants.What's the best way to achieve these aims? The short answer is to let the renminbi strengthen steadily, but not in big discrete jumps.
2. The timing is getting worse. Even if the authorities had been thinking about a one-off move before, it's unlikely they would still be considering it now on the heels of the painful weather-related disruptions in transport and power supply in January and February. Not only will Q1 2008 data point to a visible slowdown at home; most available data have also come off sharply over the past month or two, and the Chinese senior leadership has expressed public concern about the potential impact on mainland exporters. In short, this is not an environment where it would make sense to try an abrupt change of tack on currency policy.
3. …The central bank still has a long way to go before it runs out of options for managing a more gradual scenario…Equally important, FX reserve pressures have been fading over the past six months following the "scare" in the first half of 2007, when inflows jumped sharply (see Chart 2 above). The trade surplus was essentially flat through all of last year on a seasonally adjusted basis and could actually begin to decline in 2008, and as we show below, the strong portfolio capital inflows of a few quarters ago seem to be drying up as domestic equity and property markets fall.
4. No need for emergency inflation fighting. One of the most common arguments in favor of a large up-front revaluation is that the PBoC now needs emergency measures to fight inflation. But this argument makes no sense to us, for the following two reasons. First, as we've stressed continually over the past months, there's no indication whatsoever from the data that current headline inflationary pressures are structural in nature. …As of end-December "core" non-food CPI is perfectly stable; all of the increase in headline CPI in 2007 has come from food, and nearly all of the pressures within food have come from meat and eggs prices alone. This is hardly a picture of widespread, spiralling inflation (the picture may change temporarily in January and February as weather-related shortages lead to price spikes, but this effect should soon fade as well).
And second, there's no rationale behind expectations that renminbi strengthening would help moderate domestic food price increases – for the simple reason that is not a significant importer of food.
5. Fading speculation worries. Another very common argument is that can't successfully pursue a gradual renminbi strategy, since letting the currency appreciate by 8% to 10% per year would bring in a flood of speculative capital and overwhelm the PBC's ability to control the money supply. And in the first half of 2007, it seemed that this was precisely the case: "hot" money was visibly returning to the mainland once again in large amounts, and the central bank was forced to slow down the pace of exchange rate appreciation so as not to encourage further speculation.
However, over the past six months those pressures have faded. As it turns out, the main driver of capital inflows was not exchange rate expectations but rather the booming equity and property markets.
I have a lot of respect for Anderson, and like reading his stuff, although I have to say that I often disagree with his predictions and this is one case where I disagree, largely because I think he misses the main point except at the very end, where he partly addresses it.Whenever people point out to me all the reasons why a one-off revaluation is a bad idea, I have no disagreement. It is a bad idea. If China is forced into a one-off revaluation, it will not be because this is a “good” policy choice that will leave the economy in better shape than it was before the policy was implemented.It is almost certainly a bad policy choice, but unfortunately the alternatives may all be worse.By waiting so long on adjusting the currency China has found itself in a trap where it must choose between the least bad options.I have discussed this often in my blog and don’t want to beat this thing to death, but I do think it is worth making a few points.
Clearly China cannot go back to the old days of a pegged exchange rate or the painfully slow appreciation it experienced until last summer.That leaves only two more options – the current strategy of much more rapid appreciation, or a one-off revaluation.There are such serious problems with the rapid appreciation option that in my opinion by a process of elimination we are left with the last one.What are the problems?At least three, I think:
1.The current appreciation strategy postpones the resolution of the monetary problem for perhaps another two years, during which time the imbalances caused by explosive money growth can only get much worse. Another two years of this kind of reserve growth is almost certainly a terrible idea.As it is, China’s monetary regime should have been altered in 2003 or 2004, and because it wasn’t, we have spent the last three years with explosive monetary growth.By October of last year all the gradualist ideology and wishful thinking in the world (and there has been a lot of both) could not prevent the economic authorities from recognizing that China had built serious imbalances thanks to its out-of-control monetary policy, and if these weren’t addressed there was a risk of a very sharp adjustment.That is why the October Economic Conference resulted in the abrupt policy shift.It is hard to imagine that another two years of this can be anything but disastrous fro China.
2.Anderson disagrees, but there is some evidences that hot money inflows are indeed high and likely to rise, although masked partly by complexities in the way the PBoC accounts for reserve accumulation and by over- and under-invoicing in the trade accounts. The trader in me finds it hard to believe, in any case, that a low-risk 10-14% return in dollars for bringing money into China will not cause large speculative inflows, even if there are capital controls.If it takes another two years to get to where we want to go, the impact could be hundreds of billions of dollars of additional monetary expansion because of speculative inflows. This is the opposite of what we need.
3.Finally, and this is a problem that almost no one to my knowledge has discussed, but there is serious a problem with the end game that needs to be addressed before we get there.A gradual appreciation, unlike a one-off revaluation, creates no credible signal that we have reached the upper limit of the appreciation path. If the RMB appreciates for two years at 8-10%, how do investors and speculators know when we have reached the "correct" level and stop speculating on additional appreciation? In past cases, sustained currency appreciation develops its own momentum, and often a currency will switch from heavily undervalued to heavily overvalued (Japan in the 1980s?). This could well happen in China, and it would cause a whole new set of problems that would be very difficult to control.
Notice that none of my reasons for a one-off revaluation are positive reasons. I came to the conclusion that China would be forced into this policy only because I was forced to conclude that every other policy would fail. In other words it is only by a process of elimination that I arrived at this conclusion.That doesn’t mean, of course, that the financial authorities will necessarily come to the same conclusion I did, but it does suggest, at least to me, that if they don’t, China’s financial system and near-term economic prospects face some very ugly adjustments. A one-off revaluation is a bad idea, but everything else is worse.
Yesterday the China Daily published an interesting editorial on inflation that may indicate what the concerns are among at least part of the leadership. Here it is in total:
Early reports of shocking price hikes in areas hardest-hit by the bitter snowstorms might have made it relatively easy for the public to swallow a 7.1-percent consumer inflation in January. Given the severity of the supply shock caused by the worst snowy weather in at least half a century, a short-term acceleration of inflation at this level, though the highest in a decade, is still an acceptable result of the Chinese government's efforts to curb overall price rises.
Had the authorities not tried hard to increase food supplies and introduced stopgap price controls on a number of daily necessities before the snowstorms, the consumer prices may have gone through the roof. On back of a 6.5-percent headline inflation in December, it took a lot of endeavors to limit growth of the consumer price index to 7.1 percent in January when both snowstorms and the coming Chinese New Year were significantly pushing food prices up.
However, while they can breathe a sigh of relief for managing to cope with short-term inflation factors, policymakers should not stop fixing their eyes on long-term inflation.Aggressive price measures that the authorities have adopted will continue to take effect and thus slow price hikes in the near future. But the country's inflation outlook may worsen in the long run if the structural imbalance in the economy cannot be properly and promptly addressed.
