After the October Economic Conference it was pretty clear that the monetary alarmists, who worry that Chinese monetary policy has forced excessive investment and the threat of rising inflation, had gained the upper hand over the pro-growth members of the government, who were determined to maintain employment growth and more willing to accept the risk of overheating.Premier Wen Jiabao, who is responsible for China’s economic and monetary policy, finally seemed convinced that China needed to address the rising imbalances caused by excessively loose monetary conditions.
Last month, however, things seemed a little less clear.The gloomy outlook for the US economy and the freak snow storms in China last January re-opened the debate on China’s economic outlook and we heard a lot of warnings about the dangers of pressing too firmly on the brakes.A PBoC-engineered slowdown timed with a US-led slowdown and a domestic weather crisis might push China too far.It was unclear how these warnings were affecting the policy debate, but I was worried that concerns about slowing growth might cause the government to delay even further their need to address China’s serious monetary imbalances.
Now I am increasingly getting the impression that the monetary alarmists are back in control, if they ever were out.January CPI inflation came in at 7.1% and I have been hearing rumors that February’s numbers are not going to look good, and perhaps that is the reason for anxiety levels to have risen again.
In the special red-tinged “2008 NPC & CPPCC Session” pages of the major newspapers announcing the beginning of National People’s Congress on Wednesday, the lead story is “Inflation major concern of lawmakers, advisors”.It is part of a whole series of recent articles and announcements I have seen recently discussing the dangers of inflation, the limited impact on China of the US sub-prime crisis, and rising inflationary expectations.As the official news agency Xinhua pointed out today,
The central bank had taken a series of measures such as raising the reserve requirement ratio 11 times and the benchmark interest rates six times since last year to absorb excess liquidity and the measures had played an active role in slowing down the inflation growth.Political advisors and lawmakers, however, have voiced their calls urging the government to take measures to protect the interests of low-income earners, who are affected most by the growing inflation.
They quote one of my Peking University colleagues, Song Guoqing, as saying “Even worse than the inflation itself is the anticipation of further price hikes by the public.”
In Friday’s China Daily there was a similar warning.Despite the perfunctory “Domestically, there is a long way to go before the effects of inflation undermine the overall rise in the standard of living”, followed with the not-very-helpful observation by an 84-year-old resident of Pingyao that for all the problems caused by inflation he nonetheless eats better today than he did thirty years ago, the article’s title proclaims that “Inflation threatens economic miracle.” They cite Ding Jianchen, professor at Beijing's University of International Business and Economics, who says "[Inflation’s] impact on low-income families will be beyond government's imagination."
It seems that those who worry about inflation and excess money growth are making very clear the political implications of allowing things to continue as they are.So what will the government do now?Obviously a lot of the focus is on the traditional methods for monetary tightening – raising reserve requirements, raising interest rates, putting caps on loan growth, etc – and the fact that they have had so little impact in the past does not seem to have diminished their appeal.
But I don’t think this will have much impact in the future either and clearly I am not the only one who thinks this way.I am convinced, as I have said many times before, that the fundamental economic problem in China is the country’s currency regime and I am not terribly hopeful that anything substantial can be done about overheating without addressing the furious inflows through the country’s trade and investment accounts.That is why I was interested to see the following in another story in the China Daily:
The central bank has admitted in a monetary policy report that there is an increasing risk of rising inflation. It said it will "further" use the exchange rate policy to balance the economy, which, analysts said, indicated that policymakers may consider allowing accelerated yuan revaluation to reduce prices of imported products.
But no definite correlation has been found between faster yuan appreciation and lower inflation, said Dong Yuping, an economist with the Chinese Academy of Social Sciences. Faster yuan appreciation could reduce prices of imported products, but it may also attract more foreign capital, which may intensify liquidity-induced inflation. "It is hard to conclude that there is a positive correlation between the two."
I am not sure exactly what Mr. Dong was implying for policy-making, but I agree with the facts in his statement, and for me the most plausible conclusion is that China needs to find a way to get the benefits of appreciation without risking the increase in hot money inflows, which only exacerbate the problem.Regular readers know where I believe that leaves us – only a one-off maxi-revaluation can get us there.I don’t want to read too much into this little quote and the various informal conversations I have had, of course, but more and more people I talk to seem to agree with this conclusion (which of course may only say more about what kinds of people I talk to then how the consensus is developing).At any rate I think it is noteworthy if people in CASS, one of China’s most important think tanks, are arriving at a similar conclusion.
The PBoC released February PMI numbers. Growth is still high (PMI at 53.5, up from 53.0 in January) but has stabilized below its earlier higher numbers in the 55 range. Input prices were very high, suggesting that price pressures are very strong.This doesn’t bode well for inflation this month or next.
Yi Xianrong, of the Institue of Finance and Banking, part of the Chinese Academy of Social Sciences, had an Op-Ed in today’s China Daily whose title, “Tight monetary policy must not be relaxed”, pretty much says it all. In the article he points out that:
The recent snowstorms that hit the southern regions of China raised fears in and out of the country about its impact on the economy.The popular opinion was that China should reconsider its monetary policy, which was tightened late last year. Admittedly, China will feel the shocks of a global economic slow down because it is a big player in international trade and an active participant in globalization.
However, these shocks will not be significant enough for the decision-makers to change the current monetary policy. After all, an imbalance in the economic structure is a more important consideration.
He concludes by arguing that “decision-makers must realize that the price rise issue is a serious and complicated one. Substantial measures must be taken to contain further price rises. More importantly, the tight monetary policy should be continued and not relaxed.”
None of this is particularly new, but by my account articles in the official media warning that this is no time to relax far outnumber articles asking for an easing of policy.The NPC starts tomorrow and I guess the great consensus machine is in high gear.
One funny note: Xing Pu, a Shanghai CPPCC delegate, put forward a proposal a few days ago that one good way for the government address the yawning income gap is for the authorities to give every citizen a “red envelope” bonus of 1,000 yuan (about $140, which for 1.3 billion people would release $180 billion into the economy). He even suggested that the rich might be encouraged to donate their red envelopes to the poor (yeah right!).This would shift income into the hands of those who need it most. Most official commentators seem to have dismissed the idea pretty quickly, but the idea has proved immensely popular and has caught the imagination of the Chinese blogosphere.There is no way that the government can do this – it would be a great way to ensure inflation takes off – but they might try to figure some way of responding.
As a complete aside the Financial Times has an interesting article about the “tsunami” of money that will be amassed by oil exporters with oil prices so high. In my model it has been the recycling of the US (and, a lot later, the European) trade surplus that has underpinned this version of the globalization cycle. For all the fear of a US slowdown I don’t think we are yet at the end of this cycle, although the last stage may be a little different. Emerging markets are likely to benefit from the investing needs of the various kinds of sovereign wealth funds with their burgeoning coffers.Remember that the last time we saw developed-country stagflation and massive petrodollar recycling was in the mid- and late-1970s, when the recycling machine fueled what was then called the “LDC” syndicated loan market. The capital flows “game” is entering a new phase, but it ain’t over yet, and a lot of risk assets, perhaps especially in Asia, are going to do very well.
There is a fairly surprising report on Reuters tonight.According to “unnamed sources”, central bank reserves at the end of January were $1,651.4 billion, which means that reserves were up by $61.6 billion during the month – nearly three times the average rate for the past few months.I called up some friends, including Logan Wright, who knows more about the PBoC’s market operations than anyone I know, and it seems that these numbers might be credible.
If this is true, I am surpprised.How is it possible that central bank reserves were up $61.6 billion?Actually, according to Logan, they might have been up substantially more than that.In January the PBoC raised minimum reserve requirements and it seems, according to traders, that the banks were required to redenominate the $22 billion of additional reserves into dollars.I have written earlier about how this reduces the headline PBoC reserve number but has no appreciable monetary impact, so if this is true it means that PBoC reserves effectively may have risen in January by an additional $22 billion, for a total of $84 billion.I am not sure about the latter because it may be that the “informed sources” were already including this $22 billion number in their calculations, but I guess we’ll know soon enough.
Whether it is $62 billion or $84 billion, how do we account for this huge increase?I wrote two weeks ago that FDI inflows for January had surged to $11.2 billion – more than twice last January’s number – and I speculated that at least part of this surge might reflect RMB appreciation expectations – investors accelerating their disbursements in order to take advantage of expected appreciation.Since then I have heard a number of other people argue that this is indeed what seems to have happened.
The trade surplus for January is expected to be just under $25 billion – itself a pretty hefty number that suggests that the trade surplus is not about to wither away, even with the faster RMB appreciation and the supposed US slowdown.Finally, there should be coupons and valuation gains in the portfolio that explain part of the increase.I estimate these to be around $15-20 billion.Add these two numbers together and we explain $51-56 billion of PBoC reserve increases in January.
That still leaves us with between $5 billion and $33 billion of January reserve increases that need explaining.This probably isn’t all hot money, but if any significant portion of it is hot money, then things may be much worse than even I expected.The combination of high Chinese interest rates and a rapidly appreciating RMB has had the expected effect of causing an unsustainable rise in hot money inflows.
I don’t want to draw any conclusions since these numbers haven’t been confirmed, but I think several of us are going to be waiting for the official release of PBoC January numbers with a great deal of nervousness.
And it’s not just the PBoC numbers that we will be waiting for.CPI numbers will be coming out soon too, and the rumors aren’t good.Another person whose work on China I value a lot is Xinxin Li, of the New-York-based Observatory Group, and in a note today he has this to say about inflation:
¨The February CPI number is expected to be extremely strong due to the impact of the severe weather, and we estimate that it will jump to around 8% y-o-y, from 7.1% of January. It is rumored to be 7.8%, although the market estimates are even higher.
¨More importantly, the CPI report will be released…in the middle of the NPC session. Inflation will certainly become a hot topic among lawmakers, as it is closely associated with social welfare and thus Hu’s political movement for a “Harmonious Society.” In other words, it is not a pure economic debate, but a sensitive political topic at the NPC.
¨Another important factor is the attitude of the new cabinet, which worries that inflation pressures may ultimately cause social instability particularly in the run-up to the Olympic Games in August. Moreover, fighting inflation is the first tough assignment for Wang Qishan, the new Vice Premier in charge of monetary and financial policies. Wang may have to “do something” to show his political correctness.
Meanwhile I read Premier Wen’s “Report on the Work of the Government” (all 45 pages) delivered today to the opening session of the 11th NPC.As most commentators reported, he seems to have emphasized the threat of rising inflation (I can’t remember how many times the subject came up, but it came up a lot).I want to stress this.Some reports suggested that inflation was simply the primus entre pares of a variety of issues, and although I suspect unemployment is one of the things that most concerns the leadership, it seemed pretty clear to me that inflation is easily the number one concern in Wen’s and the leadership’s mind, at least as far as today’s speech goes. As the Financial Times put it today:
Wen’s report was a “warning” to local officials, many newly promoted and keen to stand out with big-spending projects, that fighting inflation should be their priority, said Mao Shoulong, a public policy expert at the People’s University of China.
I agree.I think the anxiety level has moved up pretty continuously since October and I suspect that a lot of people in the leadership are terrified.But what can they do?If reports of January’s reserve increase are even vaguely credible, it will be very hard for them to use interest rates to slow the economy, and of course speeding up the RMB appreciation rate can’t work either.
Either strategy will simply cause hot money inflows to soar.Traditional measures, like selling PBoC bills and increasing minimum reserve requirements, haven’t seemed to have done much good either.I expect that price controls and administrative measures will be left in place, and perhaps even strengthened, but I also expect that within a few months they will have proven how little value they have in addressing the root problem – excess money growth.China Daily did report today that the authorities plan to combat food inflation by importing more food and by selling off domestic food reserves, but expectations of rising Chinese food imports have already sent global food prices soaring and of course selling off food reserves puts downward pressure on prices in the short term but upward pressure in the long term, when food reserves need to be replenished.After this winter’s scare, I don’t suppose the authorities want to be caught without substantial reserves.
One last note – as if we didn’t need more bad news. According to yesterday’s Bloomberg, “European finance ministers said they are ‘increasingly concerned’ that the euro’s advance to a record against the dollar risks deepening the economic slowdown in the region.”Although they spent much of the EEC session sending stern glances towards the US Treasury, there was some debate about sovereign wealth funds, which is often code for China. Weakness in the dollar is going to make China’s adjustment much more difficult because it means that China’s trade surplus shifts from the US to Europe, and I don’t see much appetite in Europe for any of this.
Governor Zhou Xiaochuan of the PBoC said in a speech today that there is still room to use interest rates increases in the fight against inflation.This was interpreted by many as suggesting that the government does not plan to increase the appreciation rate of the currency. But he also said that China should lower its savings ratio to encourage more domestic consumption.I am not sure that increasing interest rates will lower the savings rate, unless he means he will increase the lending rate without increasing the deposit rate.Good news for banks, I guess, but not for depositors struggling with inflation.
In today’s Bloomberg I saw an interesting related comment:
Li Deshui, China's former statistics chief, voiced concern over “excessive expectations” for yuan appreciation. Premier Wen said China will strengthen monitoring of cross-border capital inflows as part of a move to curb money growth.“Dollars outside of China tried all ways to come in, and hot money, via both legal and illegal channels, flew in to bet on the yuan's appreciation,” Li said in Beijing yesterday.
There is still a debate going on among banking analysts about the extent of hot money inflows into China.My read is that however you choose to interpret the numbers, the financial authorities do not act like they think there is a vigorous and legitimate debate about whether hot money inflows are a problem.They definitely seem to think the problem exists.
I have been asked to do an interview later this evening on Dialogue, on CCTV9, so my entry is very short today.If you’re interested, I think the program airs at 8 p.m. and we are expected to discuss the 11th NPC and economic policy-making.I think it is my role to be the pessimist.
Most PBoC watchers have always believed that the PBoC has been among the most vocal supporters of a stronger currency, and has argued in the past that an appreciating RMB is the best way to fight inflation. Yesterday, however, Zhou Xiaochuan, governor of the PBoC, surprised a number of people at his NPC-related press conference.He said, among other things, that “faster currency appreciation helps to rein in inflation, but not a lot. To curb inflation, we will rely more on domestic policies. There is no need to use exchange-rate reforms as a way to fight inflation.”
A lot of commentators are reading this as meaning that currency appreciation is losing its appeal as a way of attacking inflation (The Wall Street Journal Asia headline was “China's Zhou Says Strong Currency May Not Be Best Way to Fight Inflation”), while raising minimum reserve requirements and hiking interest rate will be used more aggressively. I am not sure I agree, since Zhou also commented on the difficulty or using interest rates as a tool, and admitted that the recent aggressive rate cuts in the United States are restricting his agency's ability in raising the cost of capital.He also said “We have to consider and measure the impact of interest rate changes on domestic demand,” which doesn’t sound like he is expecting to raise the deposit rates by a whole lot.
Zhou may have meant what he said about the currency, but it is also possible that he was just trying to talk down hot money inflows by downplaying the prospects of large appreciation gains. Actually I think Zhou is partly right about the limited efficacy of RMB appreciation in the fight against inflation, but not perhaps for the reasons he means.Looking at the rate of appreciation of the RMB and the CPI inflation numbers, it is hard to draw the conclusion that an increasing appreciation rate has reduced inflation.
In part this shouldn’t be a surprise since there are inevitably going to be lags between the currency and its impact on domestic inflation, especially if you believe, as I do, that the inflationary pressures have been accumulating for many years and have only just emerged.On the other hand it isn’t much easier to see the inflation-reducing impact of raising interest rates or minimum reserve requirements. None of the policy measures have worked – that is the big problem facing the authorities.
If Chinese inflation is a monetary problem, which I think it is, I it seems clear to me that the only way to reduce inflationary pressures is to reduce monetary growth, and that means of course reducing the net capital and current account inflows into China. A more rapid rise of the RMB is not only unlikely to reduce those inflows (at least until the RMB is much more expensive than it is now), but on the contrary it will actually increase net inflows by encouraging hot money faster than it reduces the trade surplus (and anyway so far the trade surplus hasn’t declined). This is what seems to be happening, and a recent report by Bloomberg, that “China will increase (QFII) quotas for overseas investments in yuan-denominated stocks and bonds this year,” seems unnecessarily to complicate things, unless they are hoping that it will boost the stock market.
The contradictory relationship between the currency regime and currency inflows forces the authorities back into the policy gridlock I have discussed so many times before. China must adjust the RMB to regain control of its careening monetary policy, but the very process of adjustment is likely to make things much worse before they can get better, and it is not clear to me that China has room for things to get much worse.That is why I think ultimately they must be forced into a much more abrupt currency adjustment.
And they are certainly going to have to do something about inflation. During Premier Wen’s speech he announced that the inflation target for 2008 will be 4.8%, equal to 2007’s CPI inflation (the 2007 target of course was under 3%). I haven’t found a single person, Chinese or foreign, who doesn’t believe that this target is more about reining in expectations and letting the Chinese people know that the government is fighting inflation than it is a serious forecast. Everyone I have spoken to thinks inflation will come in much higher for 2008, and there are some pessimists (including me) who expect it to average above 7%, perhaps well above 7%.
So far, of course, the pessimists are right. I have mentioned in previous posts that CPI inflation for February is widely expected to come in at no less than 7.8% and perhaps even exceed 8% (we will know Tuesday – January CPI inflation was 7.1%). A very interesting report by my friend Paul Cavey at Australian investment bank Macquarie is a whole lot grimmer. He writes:
Inflation definitely is a big worry. According to the Ministry of Agriculture’s wholesale price index, food prices were about 30% higher than in the same month a year earlier. This index tends to be quite a good predictor of food CPI, suggesting overall inflation in China could make double-digits in February. Statistical quirks could bring the published number lower, but it is still likely to be high enough to be scary.
Paul also argues, based on China’s two previous bouts with inflation in the late 1980s and the early mid 1990s, that the policy responses are going to less vigorous than we might have expected because “Contrary to the popular perception of a Communist Party seeing inflation as a life or death issue for the regime, Beijing’s response to inflation has usually been late and indecisive. The reason of course is that as much as the government is worried about the social consequences of rising prices, it is also concerned about the dissatisfaction that an inflation-tackling slowdown would cause.”
Unemployment, in other words, will trump inflation as a cause of concern.Of course we might get both. Premier Wen predicted that GDP growth for 2008 will be 8%.That might seem shockingly low after the last year’s GDP growth of 11.4%, but remember that most years (including last year) the government projects next year’s GDP growth at 8%. This is not really a target but a base case.In fact I would define 8% growth as stagnation, since for me stagnation in the Chinese context means GDP growth that isn’t great enough to prevent a rise in urban unemployment. On this topic Xinxin Li at Observatory Group has some useful reminders:
The 8% GDP growth rate is only a bottom line growth rate, and the real target of Beijing's policymakers is around 10%. Note that Wen also announced an annual target of new urban job creation at 10mn. That won’t happen without stronger economic growth. (Forget the unemployment rate target of 4.5%, as the real number could be much higher, too.) In the past three years, China created 9.7 million, 11.8 million and 12.0 million new urban jobs respectively, but its annual GDP growth was steadily high at 9.9%, 11.1% and 11.4%. In other words, 10% is viewed as a minimum growth rate for Beijing to reach its employment target.
If China can’t keep its GDP growth rate above 10%, it will have great difficulty in maintaining the necessary employment growth, and with unemployment rising among the young (and among university graduates) there is a lot of pressure to keep growth effervescent.China’s conundrum is that it has too many economic policy objectives not only which are contradictory but also for which they seem to have no very efficient tools. Last year around this time Premier Wen shocked everyone by saying that the Chinese was on a clearly unsustainable path. One year later the country is still racing, faster than ever, down the same path.
Leaving China briefly and turning to the rest of the world I saw the following in today’s Financial Times:
Capital flows to emerging markets reached record levels last year as investors fled the US and other developed economies in search of higher yields and faster rates of economic growth, the Institute of International Finance said on Thursday.The IIF said total flows to emerging markets reached an estimated $782.4bn in 2007, a sharp rise from $568.2bn in 2006 and $521bn in 2005.
I am not surprised that during this time of developed-world crisis so much money is flowing to emerging markets. There is plenty of risk-loving liquidity looking for a home (see Brad Setser’s latest blog entry), and I do not believe we are at the end of the latest globalization cycle, in which rising international trade and investment flows and the always coincident “next stage” in the industrial revolution are always underpinned by a sharp rise in global liquidity.
Still, the developing-country financial historian in me finds this worrisome.In the past, massive capital flows into developing countries with their weak financial systems and inverted balance sheets often created serious imbalances in sovereign and banking capital structures. These were only resolved by financial crises that were often deep and long lasting. The “lost decade” of the 1980s was merely the most recent such period.
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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December, 2007
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