The holiday week continues to limit information and policy-making, and of course the Chinese stock markets are closed, but there were nonetheless two interesting articles, one in the Chinese press and one from abroad, worth noting.The first was a very long article in today’s Xinhua called “The rise of the yuan – where now for China’s currency?” in which the author, Zhu Yifan interviewed a number of economists on prospects for the RMB.
After going through the benefits a rising RMB has had for Chinese consumers and the costs to exporters, the article shifts gears and refers to the currency regime as a structural part of China’s problem:
The reverberations of the rapid appreciation of the yuan are deep and complicated. The change was not as simple as a boost in buying power or a squeezed trade surplus. Behind it lies a shift in the country's overall economic strategy, driven by recognition that the current export structure won't support economic development the way it used to.
“China's currency had been kept in an undervalued state since the 1997 Asian Financial Crisis, and the government in effect used it to finance the imports and exports sector at the cost of its non-trading industries,” says Professor Pan Yingli, of the Shanghai Jiao Tong University management school. A large profit margin was then created between low production costs paid in undervalued yuan, and the high revenues reaped by selling these products to international clients.
This brought prosperity for the country, but took a heavy toll with high pollution and energy consumption. Too much labor-intensive industry with low-efficiency and little added value stretched supply by demanding evermore manufacturing materials, which pushed up upstream prices. The heavy reliance on overseas markets was detrimental to the establishment of an overall balanced industrial structure in China. It also created a persistent gap between the well-developed coastal east, which thrived by trading with the outside, and the poor central and western regions in China.
“The structural conflict has accumulated to a stage that demands a solution,” says Pan.“Strengthening the yuan is the rational choice as it helps stabilize inflation and leads to the optimization of industrial structure.”
The article then goes on to point out that the strategy to accelerate the RMB’s appreciation foundered, as should only have been expected, on the issue of speculative hot money inflows, which have poured into the country in the last year.It quotes Liu Yuhui, researcher with Chinese Academy of Social Sciences, as warning that losing control of capital inflows would ultimately cause policy-makers to lose control of the underlying macro-economy – something which, I believe, has already happened.
I am not sure where the article was ultimately headed – it concludes:
Given the complexity of the situation, opinion is divided over whether the appreciation will continue, or whether there will be a one-off appreciation to end the uncertainty. Guesses are made at the so-called ceiling of the yuan. Central bank governor Zhou Xiaochuan says China would gradually expand the elasticity of the exchange rate, sending out the signal that Beijing would let the yuan fluctuate rather than rise unilaterally.
The fast appreciation of the yuan in the first half might not continue, and the concern over possible fallback of foreign trade could weigh against continuous further appreciation, says Peng Xingyun, of the Chinese Academy of Social Sciences. “There are many factors in the market that affect supply and demand, which, if changed, would sway the exchange rates,” says Peng.
Still, I think this article was the strongest example of a recent spate of articles I have noticed reopening the debate over the RMB. In the past month or so we have seen a sharp decline in the rate of appreciation of the currency, and I think there is a big debate with policymakers on one hand arguing that with a slowing world economy and declining export growth this is the wrong time to be raising the value of the RMB, and on the other hand recognizing that China needs desperately to rebalance its economy away from export orientation and, just as desperately, needs to regain control of its own monetary policy.
The only thing I can add to the debate is the fear that policymakers waited way too long to resolve this debate, and I think in particular the last year of massive inflows has probably undermined the financial system to the point where it is very vulnerable to shocks. In a sense, they’re damned if they do and damned if they don’t. Maintaining the value of the currency continues the unbalance, speeding up the appreciation re-ignites speculative inflows, and even my once-favored response – a one-off revaluation – is now a very risky strategy that could provide the shock needed to cause the banking system to unravel.
Add to the mix the second article I found interesting today.John Thornhill has a piece in today’s Financial Times about the developing political and economic strains between China and Europe.I have argued for a long time that as long as China maintained its currency regime it forced a trade deficit onto the rest of the world, which for the most part meant the US. However as the dollar weakened versus the euro in response to the strains associated with the US trade deficit, it shifted China’s trade surplus from the US to Europe, something which I never believed could last very long. Europe simply doesn’t have the labor and financial flexibility and has too many “old” industries for it to be able to accept a sustained trade deficit with China.
China’s astonishing economic rise over the past three decades has unsettled many countries and regions, but perhaps nowhere more than Europe, which in some respects still regards itself as the centre of the world. For a while, Europe’s politicians and business leaders marvelled at China’s economic dynamism and applauded its successes in reducing mass poverty. Alarmed at US unilateralism at the time of the Iraq war, leaders such as Jacques Chirac of France and Gerhard Schröder of Germany even held out the prospect of a fully-fledged strategic partnership with the growing power. The European Union has been steadily developing an extensive – and largely positive – dialogue with China over a vast range of subjects spanning economics and trade, the role of the United Nations, counter-terrorism, cultural exchanges, Iran, North Korea, Darfur and Burma.
However, as the world’s centre of economic gravity slips inexorably eastwards, the perception appears to be spreading among European voters that China’s rise is as much of a curse as a blessing. As China has regained its reputation as the workshop of the world, it has seemingly sucked manufacturing plants and jobs out of Europe and flooded the EU with cheap manufactured imports. The EU’s trade deficit with China has recently been rising by an estimated €15m an hour.
The article quotes Eberhard Sandschneider, director of the German Council on Foreign Relations, as saying “Europe has switched from China hype to China angst.”He adds: “The popular view is that the Chinese are stealing our jobs.”
Anti-China feeling has been rising sharply in Europe and I think this seriously limits China’s room for maneuvering, especially on the RMB. I just saw an interview with Steve Roach, the chairman of Morgan Stanley Asia, and he is convinced that the dollar is due for more weakness against the euro. I am not sure I agree, but any dollar weakness is going to cause real problems between China and Europe since dollar weakness also means RMB weakness.
China is going to be forced somehow to adjust just its monetary policies just when everything on the external front has gone wrong. This won’t be easy.We should all hope the recession associated with the US financial crisis is very, very mild.
Earlier this week I was talking to my grad student Shang Ning about the awful markets around the world, and he suggested that maybe it was a good thing that Chinese stock markets were closed this week for National Day since this would act as an extended circuit breaker that might protect them from collapsing in sympathy with the rest of the world.We agreed, however, that whether or not next week would open with a big downward break would depend crucially on whether the rescue bill was passed by the US Congress and, if so, would cause markets around the world to soar.
Well, the bill was passed Friday, but markets continued to fall. Hong Kong’s Hang Seng Index lost 2.9% yesterday capping the fifth consecutive losing week with a loss of 5.4%.Unless the government announces some extraordinary measure over the weekend to boost stock prices I expect that next week is going to start out badly.
It would be only reasonable if it did.On Friday the US government reported that the US economy had lost 159,000 jobs in September, making it the ninth consecutive month that the US job market has contracted, and suggesting that it is going to be harder and harder for the US to avoid a slowdown in consumption. China has bet its economic future very heavily on sustained US consumption driving its economy forward, and faltering US demand – coupled, as it is almost sure to be, with faltering European demand – cannot help but slow China’s export growth.
This is, in my opinion, one of the two most likely channels by which global financial difficulties will become Chinese financial difficulties (the other is if perceptions of rising risk cause liquidity outflows from the banks). If exports slow, and domestic consumption is unable to accelerate sufficiently to replace it – and in fact I expect domestic private demand to slow – there is a good chance that domestic investment will also slow, after a lag that sees rising inventories.In that case three of the four pistons in China’s economic engine will falter.
This is dangerous for the financial system, of course, because any economic slowdown will finally put the Chinese financial system to its first real test since the massive expansion of the past four years, and I am not sure it will pass the test very easily.The current issue of Caijing actually has an interesting article on the subject, indicating that quite a lot of people are becoming increasingly worried about that particular risk. The article says:
It’s the most pain China’s commercial banks have felt since a reform of the shareholding system began under fairly good economic conditions. Now, as economic growth slows, factors such as changing liquidity positions, fluctuating equity prices, loan quality downgrades and policy adjustments may bring adverse effects.All this change has given commercial banks a full-scale test, especially in terms of incentive mechanisms, risk control maintenance and income growth styles. This testing process has five key aspects.
First, the NPL ratio is likely to bounce. The overall ratio in the banking industry may rise if most economic adjustments occur in the nation’s eastern coastal area. Data show NPL ratios for loans to small- and medium-sized enterprises have been rising in this region.
Second, the loan growth rate is falling. Commercial bank income from intermediary business has expanded steadily in recent years, but interest income is still the main income source. With a guaranteed loan-deposit interest rate differential, banks rely heavily on loan growth to generate profit. In the second half of 2008, the People’s Bank of China loosened its credit control by five percent. But July and August statistics did not show a rebound for loan growth. Even if the quota were further relaxed, loan growth this year would hardly match 2007’s.
Third, the loan-deposit interest rate gap may further shrink. On inflation concerns, a loosening of monetary policy will likely be handled in an asymmetric style. That is, loan rates will be cut while deposit rates remain unchanged, which is what the central bank did September 15.
Fourth, loans to the real estate sector and local governments will become more risky. Personal mortgages and property developer loans currently account for more than 20 percent of the lending at major banks. If house prices continue falling, however, NPLs in real estate may soar.
Fifth, administrative measures may bring side-effects. Loosening credit controls and the “double cut” decision to trim loan interest rates while lowering the required reserve ratio for banks are steps aimed at encouraging banks to lend. If the government sets loan targets for commercial banks through administrative measures, banks will lower their standards for qualified borrowers, which could lead to even more NPLs.
I have often argued that the financial system (including off-balance sheet transactions, unrecorded municipal and provincial activity, and the informal banking system) has been growing much more quickly and in a much more chaotic way than most analysts realize, and its vulnerability to a slowdown may be significantly greater than we think. If three of the four pistons in China’s economic engine are faltering, fiscal expansion is left as the main driver of the economy, and although I have little doubt that we will see fiscal expansion, its impact is likely to be slow, the adjustment forced into the banks difficult, and it will only lead to greater imbalances in the economy.
On that note Standard Chartered’s Stephen Green, who regularly puts out some of the best and most interesting economic analyses of China, has a new piece out today called “The world just changed, China hasn’t.”In it he says:
We hate to be killjoys, but we have some bad news for anyone claiming that China’s transition to a new growth model – one with more consumption, less investment, more domestic demand, and less exports – is already underway. We would love to believe it too, but it just ain’t so. Worse, the US financial crisis and the coming global economic slowdown will show China’s present model to be even less sustainable than was thought before. But they also present Beijing with an opportunity to unleash new growth drivers. The world just changed, and now is the time for Beijing to change too.
Green argues that while the debate over China’s growth model suggests that policy-makers are in principle acknowledging the need for China to shift from an export-led growth model to a domestic-consumption-led one, in practice this hasn’t happened. What is worse, one consequence of the global slowdown is actually likely to be a concerted effort to reinforce the “old” model in a desperate attempt to protect the economy from the impact of a slowdown in exports.
The problem also has to do with the gulf between aspirations and actual policy choices, which are often driven by short-term concerns. To reduce the economy’s dependence upon exports, one needs to reduce exports. It sounds simple, but even with 10% real export growth at present, Beijing has apparently decided to throw incentives back to exporters by topping CNY appreciation and increasing tax rebates to textile producers, and even seems poised to increase them for electronics and machine tool exporters too.To reduce the amount of heavy industry, one needs to raise manufacturers’ cost of electricity, but there is still no effective system to prevent local governments from protecting their local steel, aluminium, and copper plants from higher power tariffs.
To slow down the investment boom, one needs real positive interest rates (bankscurrently have negative ones), rigorous dividend payments by state firms into the budget (a reform which is still a small-scale experiment), and local officials whose performance is not measured on investment and tax revenues alone. To discourage people from investing in the domestic market, one needs a fairly priced exchange rate, but since 2005 it has been fixed and under-valued, as it still is despite the 7% gain in the effective exchange rate over the past year.
To really encourage innovation, one does not need quotas for patent applications, but a reliable civil law system which allows companies to protect their own valuable IPR. To allow people to get decent healthcare, one must allow private hospitals to participate in the state’s insurance system and regulate them. To increase the scale of the service sector, one needs to tackle the state-protected oligopolies that currently dominate – think telecommunications, parts of financial services, health and education, as well as the entertainment business. As PBoC governor Zhou Xiaochuan liked to say a couple of years ago, and everyone else asked themselves more recently with the success of Kung Fu Panda, where on earth is China’s creative film industry?
Green is fairly pessimistic, it seems to me, about the likelihood that China will take the necessary policy steps to shift its economy towards a more sustainable model. That shouldn’t come as a surprise.It is always difficult to make major necessary adjustments when external conditions are bad, and yet it seems unnecessary to do so when external conditions are good.I have mentioned before in this blog the difficult experience of the US in the early 19th Century when the US economy shifted from being driven primarily by exports to the UK, Europe and the Caribbean to being driven primarily by the development of its own internal market.
This shift did not occur in a gradual way and according to the best thought-out plans of businessmen and government leaders.The change was forced onto the US and happened mainly because beginning in 1797 the Napoleonic wars and an especially vicious spread of smallpox along the coastal cities decimated the US export business, ushering in a very long depression.It took the ensuing financial crisis and depression to reorient the economy towards its domestic market, and not without a great deal of difficulty
The “silver lining” in the current global slowdown for China may very well be that China is also forced kicking and screaming into doing what it should have done much earlier, although I suspect Green is right that in the early stages it will actually try to strengthen the export and investment orientation of its economy as a way of slowing job loss. This would be a mistake in the long run, but may be a natural reaction for a government that greatly fears the short-term political consequences of rising unemployment.
By the way and on a completely different and unrelated topic, for some reason some outfit called Forexecutor keeps trying to sneak their advertisements onto the Comments section of my blog. I checked them out to try to get them to stop.After running thought their site I have to say that in my opinion they are a scam. If you see their ads anywhere on this blog please know that I do not endorse them at all.On the contrary, you should beware of using their “products.”
As expected, yesterday saw pretty awful performances on the local stock exchanges, with the SSE Composite down 5.2%, followed by a 0.7% loss today. Given what is happening around the world this is pretty standard stuff, but it does put an effective end to the latest attempt by the government to rally markets. Unless we get some more interference from the government, or a big rally abroad, we are going to drift back down to test last month’s lows.
Yesterday in fact there was an attempt to “signal” the market into positive territory. The PBoC announced that they would once again permit companies to issue medium term bonds, and that the proceeds could be used to repurchase shares, but the market wasn’t impressed. Good.I wonder if decapitalizing companies and increasing leverage in the system is the best way to deal with upcoming volatility. I hope companies are fairly sparing in their use of this new privilege.
Tom Holland has an interesting new piece in the South China Morning Post arguing that Beijing has much less room for fiscal expansion than is widely assumed. I think this idea that fiscal expansion can get us out of the current mess needs to be much more seriously debated, and I am glad he is doing so.
His argument has two parts.First, he says, the balance sheet isn’t as clean as we might think. Problems in the banking system can have a very large impact on the government budget.
As the economy slows, the proportion of non-performing loans in the state-controlled banking sector is certain to rise, bumping up the government's contingent liabilities. That's important, because although the official ratio of bad loans at the end of June was just 5.6 per cent of banks' total loan books, the absolute amount was more than 17 times the government's budget surplus for the whole of last year. Clearly it wouldn't take much of an increase to knock a big hole in banks' capital and, ultimately, in the government's own finances.
I think he is right and would actually go a little further. There is already more debt out there than we think. Today’s Bloomberg quotes a more optimistic Morgan Stanley analyst on the subject:
China can “afford to run multiyear fiscal deficits without running into debt sustainability problems,” because it has public debt of only 30 percent of gross domestic product, Wang said.
30% perhaps, if you ignore various contingent but very real liabilities including the obligations of the bankrupt AMCs, which are guaranteed by the MoF, or the possibility of uncollectible debt at the provincial and municipal level, which is guaranteed by the central government.About three years ago a Chinese think tank director estimated it to be about 10% of GDP, and I would guess by now that it has grown. Add all the pieces up and I suspect total debt is probably over 50% of GDP before we include the possibility that an economic slowdown might cause NPLs to rise.
Referring to charts accompanying with his article, he also makes the point that rapid growth in fiscal revenues and expenses in recent years makes projections very volatile and very sensitive to changes in assumptions:
As the first of the two charts below shows, both government revenues and spending have increased sharply in recent years. Beijing did indeed run a surplus in 2007, but only because revenue growth fractionally outstripped the rise in expenditure at the very peak of the cycle. Unfortunately for finance ministry officials, history tells us that when the economic cycle turns down, revenues tend to fall rapidly, while spending proves a lot more "sticky". As a result, fiscal positions quickly deteriorate and budget surpluses soon turn into deficits.
There are ominous signs that this is happening in China. As the second chart shows, government revenue in August was just 10 per cent higher than in the same month in 2007. That compares with a rise of 32 per cent for 2007 as a whole. And there are signals China's fiscal position will get a great deal worse before it gets better. Tax reform earlier this year has already damped corporate tax revenue from domestic companies. Now with profit growth slowing abruptly - the country's biggest listed aluminium producer warned yesterday that third-quarter profits would be down 50 per cent from last year - revenue from corporate taxes is set to fall steeply.
That's not all. The property market is cooling. Home sales in Beijing and Shanghai were down around 80 per cent in September compared with the previous year. As a result, government revenues from property taxes and land sales are also likely to head south.
Needless to say I agree with Holland’s assessment.I think we have all been a little quick to expect that fiscal expansion is the silver bullet that will kill the monster of economic contraction. Let’s see.
The market continued its losing streak with the SSE Composite dropping 64 points to close at 2093, down 3.0% for the day, with financial institutions and property developers once again leading the way.During the trading day my student Shang Ning sent me the following (slightly edited) email:
The PBoC issued 1-year bills, at 3.91%, 9bps lower than last week, and 15bps lower than the annual average 4.06%. This pushed up the market like crazy; with yields dropping some 10-20 bps for medium-term treasuries. Obviously the auction indicated that banks were eager to buy bonds.
What else it can indicate? Can it suggest a declining willingness to lend money out to corporations, since bond market and loan market are substitute goods?Or a great expectation of basis rate cut soon?
Shang Ning seems to have got it right. Seemingly as part of a concerted global effort to support markets, the PBoC announced later that it was cutting interest rates (for the second time in less than a month, after six years of raising rates), with the benchmark 1-year rate dropping from 27 bps to 6.93%.The PBoC also reduced minimum reserve requirements by 50 bps to 17%.
How effective will these measures be in spurring the economy?According to the most recent data loan growth has been slowing. I don’t have the numbers in front of me but an article last week in Caijing had this to say:
In the second half of 2008, the People’s Bank of China loosened its credit control by five percent. But July and August statistics did not show a rebound for loan growth. Even if the quota were further relaxed, loan growth this year would hardly match 2007’s.
It seems to me that at least part of the reason for slowing loan growth has been corporate reluctance to borrow. If that is the case, I doubt whether lower rates (let alone lower minimum reserves) will have much impact. After all it hasn’t been high interest rates that have constrained borrowing in the past. We will need to watch loan growth figures closely in the next few months.
On a completely separate topic, a journalist friend of mine called me earlier today to ask me what I thought about the popular discussions about whether the current crisis marked a “paradigm shift” that would see a sharp decline in the relative power of Wall Street and London and a rise in the power of one of the Asian financial centers.Aside from the fact that I am a little allergic to paradigm shifts, I thought this was an interesting question.I usually get asked where the New York or Shanghai stock markets will close Friday (for the record: I don’t know).
This is also one of those “big” questions about which I think most of the current debate is a little muddled.To begin with, I don’t think the current crisis is a paradigm shift at all.It is simply yet another in the sequence of crises that have marked the six (as I count them) globalization cycles of the past 200 years. Of course there will be big changes in the worlds of commerce, finance, and politics, but these changes won’t represent a brave new world so much as a reversion to a more standard world.
After all, during the great liquidity cycles that underlie the globalization cycles, we always see in the late stages a massive growth in financial transactions and the power of financial institutions. During these periods banks get larger and larger, often though acquisitions and expansion abroad, and financial activity expands dramatically until it seems to become the hub of all industrial, commercial and political activity.
But it is these late periods which are the anomaly, not the norm. Every end of a globalization period (which usually ends in crisis) we experience a sharp deleveraging and a massive reduction in speculative activity. Along with that inevitably banks and financial markets become less central and less active. The expected decline of Wall Street and London, in other words, is not a shocking new reality but simply a reversion to more normal times – when it is not the dream of 8 out of 10 graduates of elite colleges to become investment bankers. To tell the truth when I was graduating I didn’t even now what investment bankers did. In a few years an awful lot of young graduates will be just as ignorant as I was.That is probably not a bad thing.
I suspect that a lot of experienced bankers, academic, and students of financial history will agree with me so far, but here is where I am going to get controversial. The debate about the “paradigm shift” seems mainly to be between those who say that the current crisis marks the relative decline of Wall Street as the center of world finance and those who argue that it will maintain its relative position.
But I think the effect of the crisis will actually increase the relative position of New York and London as world financial centers.Why?I say this largely because previous global financial crises were just as brutal as the current one, or even more so (1825, 1837, 1873, and 1929 were all more brutal), and yet during the subsequent years the then-global-financial-centers became more, not less, central.
Why this happened is not hard to figure out, I think. During the liquidity booms, the great advantage of the primary financial centers – the fact that they are much more liquid than other markets – is usually sharply eroded by the huge increases in liquidity, trading volumes, and financial transactions across the world, and with them, the decline in the value of liquidity.In fact it was always during the long boom periods that secondary financial centers were able to grow in importance – just as Sao Paolo, Frankfurt, Delhi, Shanghai, Singapore, Dubai and even Hong Kong have all grown dramatically in the past 10 years.
After the booms, however, the sudden reduction in underlying liquidity and the greater value investors and issuers placed on liquid markets typically causes most of the secondary financial centers to die out as trading and issuance migrate to the deeper markets of the primary financial centers.This is simply a form of the old traders saw – “liquidity draws liquidity.”If liquidity truly dries up around the world and trading and issuance volumes collapse, the value for investors and users of capital of accessing New York or London will be greater, not smaller.
What about the argument that an Asian financial center will rise in relative importance? I think this may very well happen, but it will have little or nothing to do with the current crisis.
An Asian financial center will or will not rise depending on several factors.These include the liquidity and value of its currency for international transaction, the strength and impartiality of its legal framework, the scope for political and regulatory independence, a clear governance framework (which implies, among other things, that managers are minimally constrained by policy needs), the size of the home market, the openness to foreign markets, the importance of financial markets (as opposed to large banks) in financing, and several other obvious and not-so-obvious things. The financial center also needs to be perceived as politically (and geopolitically) safe and stable, and especially a safe haven in times of tension, which is not always an easy thing in an Asia which consists of several very large, often heavily armed countries with a long history of mutual distrust and rivalry.
I may be wrong about whether or not New York (and London) maintain their pre-eminence, but I think I am certainly right in suggesting that any argument about what-will-happen-next that ignores the last 200 years of surging and waning global liquidity and the past several globalization cycles is likely to get very little right.What we are experiencing is dramatic, but it isn’t new.
Yesterday’s 27 bp rate cut and 50 bp reduction in minimum reserve requirements by the PBoC had the expected impact on the stock market: None.The SSE Composite declined 0.8% today to close at 2075.Another day like yesterday and we’ll be testing 2000 once again.
Of course it is unrealistic to expect that the PBoC’s actions should have had an immediate impact on either the economy or the stock market. The consequences of monetary policies are only supposed to reveal themselves over a several month period, during which time the hope here was that companies will have been given greater access to loans and consequently will more aggressively borrow and invest.The one-day market reaction was inevitably going to be colored by a lot more than just the immediate consequences on economic fundamentals of the PBoC actions, and I don’t doubt that bad markets overseas didn’t help.
But even over the medium term will the consequences be positive?I already said yesterday that I was skeptical:
It seems to me that at least part of the reason for slowing loan growth has been corporate reluctance to borrow.If that is the case, I doubt whether lower rates (let alone lower minimum reserves) will have much impact.After all it hasn’t been high interest rates that have constrained borrowing in the past.We will need to watch loan growth figures closely in the next few months.
Let me explain a little further why I worry that easier lending terms won’t cause a surge in borrowing and investing (as they didn’t either in Japan during the 1990s, by the way).For lending and investment to surge, it isn’t enough that banks make it easier to borrow.Corporations must also want to borrow. And when I say “corporations”, I should make it clear that I mean corporations who plan to borrow to invest in new facilities, plant, equipment, distribution systems, etc.I don’t mean corporations who are holding illiquid assets and who are desperate for liquidity – of which I understand that there are quite a few, especially in the property sector.
But why should these “good” corporations want to borrow and invest?Obviously enough because they believe that there are profit opportunities that justify their taking the risk of increasing debt servicing costs.The problem is that if foreign demand for Chinese goods declines with the decline in the world economy, who is going to buy the newly-produced Chinese goods?With the huge amount of fixed asset investment we have seen in recent years, industrial production in China is very high and growing. As long as the world was also growing rapidly, China could export its excess production. If the world economy slows down, however, China might not be able to rely on foreign consumers to take up its excess.
So what about Chinese consumers?After all nearly everyone agrees that it is in China’s best interest to rebalance the economy, by engineering a transition from an export-led to a domestic economy.As Chinese households get richer, they are likely to ramp up their spending. Can they take up the buying slack?
Maybe, but I am doubtful that we are going to see the necessary surge in domestic private consumption, and although we won’t get September and October numbers for a while (July and August were probably tainted by Olympics-related buying), I think the poor auto sales in September may be a harbinger. Certainly it cannot be easy for Chinese households, confronted every day by terrifying stories of declining local stock and real estate markets and of foreign financial crises, to decide that now is the best time to draw down the savings account and splurge on new consumer goods.
So if neither export growth nor growth in private consumption is going to absorb the higher industrial production, who is going to buy?The stock answer to the question, and one much beloved of research analysts, has been: The government.The Chinese government, according to this argument, is in a very strong fiscal position – it runs a more-or-less balanced account and has relatively little outstanding debt – and so has plenty of room to borrow and spend without running into credibility constraints.
In fairness there are some analysts who disagree that fiscal spending can easily take up the slack.I think Stephen Green of Standard Chartered pointed out several times that turning on fiscal spending is likely to be a lot harder and slower than simply announcing a fiscal expansion package.
I agree with Green, but in addition, as I have argued many times, I don’t think the government is in nearly as strong a fiscal position as most other analysts think.Total direct and indirect debt (and I am not including long term obligations like unfunded pension liabilities) is probably much higher than the official numbers which, depending on how you count, range from 15% to 30% of GDP (by contrast I think US government debt is around 30-35% of GDP and European government debt averages around 60-65% of GDP, albeit with big variations around the average).
However, for reasons I have discussed many times before on this blog, I think actual Chinese government debt exceeds the visible debt. My guess is that without counting the possibility of rising NPLs in case of an economic slowdown (which ultimately can become contingent liabilities of the government), total government debt in China is probably 50% of GDP or higher.That means that China has a lot less room for running large fiscal deficits than we might suppose, and during the time it most needs to run a deficit – when the economy is slowing sharply – we may anyway see a surge in contingent debt as bank NPLs surge.
And it is not just that there may more debt out there than we expect. There is also a problem with the current fiscal balance – it is not as stable as might at first appear.On that topic last week’s EconomicObserver has an article by Xi Si titled “Shrinking Coffers Challenge Chinese Finance Ministry.”According to the article:
Slower tax revenue growth and higher pressure for more spending have posed a challenge to Chinese budget planners in the ongoing drafting of the 2009 budget. Tax revenue growth stumbled in July and August and was likely to continue falling, but there was a growing need for more spending to stabilize prices in China and rebuild disaster-hit areas.
Official data showed that in July, China’s state revenue grew by 16.5% compared with the same period last year, 14 percentage points lower than in June. The growth rate continued to fall in August, when state income dropped below 400 billion yuan. “There will be no problem meeting the budget, but there may not be as much excess income as last year,” an official from the Ministry of Finance (MOF) told the EO.
Compared to the same time last year, budgeted revenue for the beginning of 2008 was up by 14%. By the end of August, the actual revenue saw a year-on-year growth of 28.4%. Judging from this, the above-mentioned official believed there would still be excessive revenue even if the growth rate continued to stumble in the next four months.
The current economic situation at home and abroad, as well as companies’ profit-earning ability, explained why state income had fallen for two consecutive months. Many officials and scholars thus worried that the high revenue era of China might come to an end.
My basic problem with the fiscal numbers has always been that, with both revenues and expenses surging by 30% a year or more, it wouldn’t take much of a shift in the relationship between the two to swing the budget into a large surplus or deficit.With global and domestic conditions in a seeming downturn, it is easy to posit a plausible scenario in which expenses begin radically to outpace revenues.I don’t know if this is happening or not, but even though the conservative in me is happy to see fiscal balance, the bond guy in me gets very nervous when the balance is achieved on the back of such rapidly surging revenues. Very rapidly changing numbers create very volatile potential outcomes.
Yesterday, after listing the several bad days in a row we have had on the local stock markets, I suggested that we would soon be testing 2000 again. It happened sooner than I expected.Today the market had another awful day, with the SSE Composite losing 3.0% to close the day at 2013, although at its low late in the morning the market actually traded well below 2000, to touch 1963.
Once again the regulators have responded by trying to force the market up. Here is what the South China Morning Post says about it:
The China Securities Regulatory Commission has temporarily stopped reviewing applications for initial public offerings, sources said, a sign that Beijing is serious about bolstering the mainland's embattled stock market. The initial public offerings review committee of the CSRC had stopped processing applications between September 16 and the end of this month and the suspension was likely to be prolonged, the sources said.
The sources, who work at brokerages of investment banking units, said the CSRC did not officially inform them of the suspension. However, they said the review process had been frozen as the regulator hoped to curb equity supply to the weak market.
I hate to repeat myself so often, but although preventing IPOs may indicate how serious Beijing is about the stock market decline, it is not going to have any real impact beyond further undermining the government’s credibility in bolstering the market. After trying and failing so many times, every new attempt is likely to be taken less seriously by investors.It would be better to hold back on administrative attempts to support the market and to wait until we really need a confidence booster – something which I suspect is going to happen soon enough.
This may be a smaller point, because I suspect there weren’t going to be many IPOs, anyway, but I wonder if restricting the ability of companies to raise equity (and last week’s new rules allowing companies to issue bonds and use the proceeds to repurchase stock) is a good idea. More equity, not more leverage, will reduce the impact of the crisis if it spreads to China (and obviously enough to most of my blog readers I think it will).This is a time for companies to be restructuring their balance sheets in the direction of greater conservatism, even if that comes at a high cost.The more leverage there is out there, the more difficult the crisis is likely to be, and the greater the financial distress costs.We should be moving in the opposite direction.
On a related issue Macquarie’s Paul Cavey has a very interesting research piece today on why China shouldn’t have cut interest rates.He argues that the main source of China’s imbalances has been the mis-pricing of money via interest rate controls, and that this mis-pricing, coupled with China’s expansionary monetary policy, has led to misallocation of capital on a massive scale and unstable conditions within the financial system.Cutting interest rates only exacerbates the problem.
This issue certainly hasn’t escaped attention in recent years. Calls for appreciation of the renminbi have clearly been loud. While often motivated more from a perception of US national interest, there have also been claims that appreciation would help China. The reason is the tremendous build-up of foreign exchange reserves that is the surest sign of undervaluation. To prevent exacerbating this inflow further, the authorities have kept interest rates low.
The combination is a classic recipe for a bubble. The liquidity creates the excess supply of credit, and the low rates the demand. Indeed, with nominal lending rates of now just 6.9% – the cost of capital – well below nominal GDP growth of 20% – the potential return – borrowing from banks isn’t just cheap for companies, it is a positive no brainer.
In reality, it is hard to find evidence of a credit bubble. Take bank lending growth of around 15% pa. Admittedly, this is a big number in absolute terms. But so are any of the figures that could be used to describe China’s economic growth. Thus, while growing quickly in absolute terms, the stock of outstanding credit has actually fallen relative to the size of the economy, from 125% of GDP in 2003 to around 100% now. This compares with the US, where in the same period credit has ballooned to almost 180% of GDP – and this does not even include the liabilities of the super-leveraged financial sector.
So, contrary to expectations of an unsustainable credit bubble, it looks like bank lending in China has been only just enough to grease the wheels of the rapidly growing economy. The reason is China’s banking sector has been effectively held in a straightjacket. The banks have been ordered not to lend, instructions which particularly this year has been backed up with sterilisation, the process by which the central bank uses reserve requirements and sales of central bank bills to soak up excess renminbi and stop the banks from lending.
Where I disagree with Paul is his implication that we have not seen a credit bubble. I have written extensively about why I believe that strict credit loan constraints, and maybe even interest rate controls, are undermined (and necessarily so) in a system whose monetary policy is consistent with massive credit expansion.
The way I see it, in such a system credit controls are likely simply to push loan growth into less visible parts of the economy, and from what we have seen on the growth of off-balance-sheet transactions and from the anecdotal evidence about growth in the informal and underground banking sector, I would say that China has not been an exception.If there were a good way to measure total credit in the economy, I don’t think we would see the decline over five years of total credit from 125% of GDP to 100% of GDP that Paul cites. I think the problems he warns about have already happened – there has been a credit bubble and we are not sure what will happen when it deflates.
After the globally coordinated rescue package was announced Monday the Chinese stock markets boomed in sympathy with the rest of the world, with the SSE Composite closing up 3.6% for the day. Tuesday the SSE Composite shot up 3.5% within minutes of opening, but the party was already over in China.Over the rest of the day the SSE Composite drifted down nearly 6% from its peak to close the day down 2.7%. Wednesday was another bad day with the marking closing once again below 2000, at 1995, down 1.1% for the day. Nothing, it seems, is able to keep this market up.
The announcement that the US government would use about $250 billion of the $700 billion rescue package to re-capitalize the largest US banks is in line with actions by other European governments, and will reduce some of the credit pressure on the banks.That’s a good thing, even if it turns out not to be enough. A lot of people are calling this move unprecedented, and representing a major change in the institution of financial capitalism in the US, but to me it only confirms that in time of crisis the government has been willing to change its ownership position.I don’t have the numbers in front of me, but I believe that the current move to purchase equity stakes in the large US banks is not much bigger in real terms, and probably smaller in relative terms, than the purchase of bank stocks by the Reconstruction Finance Corporation in the 1930s.
As an aside, rumors are once again swirling around about leadership changes in the large Chinese banks and among regulators, but these rumors have been around for several months, and with everyone expecting announcements around the time of the October holidays, this seems to be happening more slowly than expected – a possible indication that leadership discussions are paralyzed by the uncertainty surrounding the crisis.I have also heard several of my friends in the written and broadcasting media say that there are increasing constraints on what may and may not be said in the press and on TV about the international financial crisis and its possible impacts on China.
All this suggests that authorities are very nervous.While the PBoC periodically announces that conditions are solid, the banking sector sound, and the economy slowing but still strong, the South China Morning Postreported yesterday the creation of a new very high level crisis committee:
Vice-Premier Wang Qishan will head a committee being set up to deal with fiscal uncertainties caused by the deteriorating global financial crisis, according to an official source. The decision to set up the committee is the latest step by mainland authorities to try to prevent the domestic economy following western countries into recession.
At the end of the Communist Party Central Committee plenary session on Sunday, the leadership said that despite the international turmoil, the mainland's basic economic situation had not changed. However, precautions to guard against the side effects of the international slowdown were needed. The source said the central government believed "losses from the international financial crisis are limited and the country's risk and exposure to the crisis is still controllable".
The new committee will be at the core of efforts to deal with the international problems. It will monitor financial changes overseas and respond by adjusting mainland economic policies when necessary.
It is definitely a good idea to create a high level crisis committee to monitor risks and to formulate policies for a rapid response, but if the thinking really is that the main risk to China is of contagion from international exposure, I am a little puzzled.
To me the real risk has always been that the same excess monetary expansion that led to overextended and vulnerable financial systems abroad will have done the same thing in China.In other words the risk was not so much (in my opinion) that there was a huge amount of hidden exposure to sub-prime mortgages or some other foreign toxic waste that will bring the Chinese banking system down, but rather that we have our very own time bombs hidden in the various formal and informal parts of the domestic banking system and that any sufficiently large adverse shock – financial or economic or even political – can cause a sharp contraction in the banking system.
The fact that the authorities seem much more obsessed with the direct contagion impact – and that the media may have been instructed not to discuss these issues too openly – makes me wonder if there is not a lot more here than I at first imagined. I am surprised that there has been so little debate within China about whether or not the crisis presents a huge buying opportunity for China (the foreign media has been much more excited about discussing this).Could it be that SAFE and the CIC already have such a mess on their hands that no one has any intention of buying more assets abroad for a long time?
This is all just speculation, of course. The real news yesterday was the release of PBoC reserve numbers, but as an indication of how furiously busy things have been, it was only by late today that I have been able to look at the numbers. After going through the numbers and talking to my friend Logan Wright, who keeps sharp tabs on the PBoC, I have to say that there are two easy conclusions from the latest release. First, hot money inflows have almost certainly slowed and maybe even reversed.Second, the data is getting fiendishly hard to interpret, just as we are most eager to get a little clarity.
Headline reserve growth was $96.8 billion in the third quarter. This is an extraordinarily high number by any standards, but it is a measure of how out-of-control reserve growth has been in China that it is being seen by researchers and the press as a serious moderation in reserve growth. Once again (as in the good old days before hot money hijacked the process), most of the reserve growth is fully explained by the trade surplus (which soared in the third quarter of 2008) and FDI, which was higher than average for the last few years but lower than the first two quarters (much of it puffed up by anticipated investment – a nicer name for a form of speculative inflows).
However there is a lot of confusion in the numbers.Currency valuation changes during the quarter, especially in August, added a lot of volatility to our analysis. We can only guess at the currency composition of PBoC portfolio, so unfortunately even small errors in our estimate are going to have a magnified impact on our final numbers.
There were also some strange goings-on in the dollar account at the PBoC account which, following my previous usage (although the name is no longer fully appropriate) I have put in the “Reserve hike” account.I won’t go into too much detail here because the numbers aren’t big enough to change the conclusions.
” in which the author, Zhu Yifan interviewed a number of economists on prospects for the RMB.