Yesterday, I wondered if after their 29% decline year to date, and 3% decline that very day, the Chinese stock markets might be near a bottom.Today they dropped again, by over 4%.I guess my call was a tad premature.“People are rushing to sell shares in panic,” said Wu Kan, a portfolio manager at Dazhong Insurance Co. in Shanghai, according to a Bloomberg report. “Economic fundamentals and the lack of government support measures have both contributed to the plunge.”
So the market is down; what about other financial imbalances?In my January 24 posting I argued that although fixed asset investment and industrial production had eased a little in recent months, we shouldn’t take much comfort in those numbers as suggesting that the impetus behind the roaring trade surplus was weakening.It seems to me that every time the numbers let up, a lot of analysts sigh in relief and suggest that at last the tightening measures are beginning to work.But as I see it, the tightening measures cannot work as long as China retains an exchange rate policy in which rising foreign exchange inflows are tied to rising investment in the self-reinforcing mechanism I described in my March 26 entry.A slowdown in the rate of growth of industrial production, in other words, is temporary and likely to be reversed soon enough.
But the recent release of the purchasing manager index for March suggests that both headline PMI and the new orders index are near historical highs.According to Credit Suisse, from where I get these numbers, “this indicates a revival in economic activities, potentially fueled by the relatively looser credit control measures seen since the beginning of the year.”They are surprised at the strength of the rebound, especially the rebound in new export orders, and wonder if it has something to do with post-storm rebuilding.I am less surprised, and think it is largely part of the same old story we’ve seen over the last three or four years.
Where we are much more in agreement is on the indications of more inflation.According to Dong Tao, Credit Suisse’s China analyst:
Input prices index aggravated by 4.5pp to 74.6, the highest level ever. This has reflected the seriousness of rising inflation in China, coinciding with the rampant producer and wholesale price increases seen lately. Although the worst of the snow storms has passed, expectations of higher prices did not soothe but deteriorated further.
Almost all major sub-indices have pierced the sizzling 75 mark, with metal products (92.1), general machinery (89.1), and the smelting of ferrous metals (88.3) hovering around the 90 mark. We maintain our view that margins are shifting towards upstream industries at the cost of those downstream and that non-food inflation of the CPI index will face acute upward pressures.
I think Dong Tao is right, and I think (no surprise) that March and April numbers are going to show a slowing rise in food prices and an acceleration of inflation in the non-food sector.This would be consistent with the model of inflation I have discussed many times on this site.By the way the April issue of Far eastern Economic Review has a piece by me explaining in some length why I think high food inflation and low non-food inflation is perfectly consistent with the idea that inflation in China is a monetary problem.As soon as I am allowed to publish it here, I will.By the way March CPI numbers should come out in 10 days.
I was interviewed today by a Chinese financial journal planning a big feature on RMB appreciation and the prospects for China, and in the interview I briefly discuss all these subjects.Since the interview, which covers the range of topics I often discuss here, will be translated into Chinese and presumably read by people that don’t often read my blog (and anyway this blog is hard to access in China), I thought I would copy the questions and my answers into this blog posting.The questions sort of summarize much of what the financial press is thinking and worrying about in China.
In the first quarter of 2008 alone, the RMB has appreciated about 4%, the fastest pace since the exchange reform in mid 2005. What do you think of the appreciation progress? From your stand of point, is this pace good or bad for China?
China should have begun the appreciation of the RMB much earlier than it did and it should have appreciated more aggressively.Unfortunately, perhaps because of the excess global liquidity of the past few years and especially of the past few months, China is now caught in a monetary trap in which the high trade surplus forces the central bank to buy large amounts of foreign exchange, which of course causes very rapid domestic money expansion.This money expansion feeds directly into excessively high levels of investment, which force up industrial production and so causes the trade surplus to rise or remain high.It will be extremely difficult for China to get out of this trap.
It seems that many Chinese exporters such as textile and shoe makers can no longer bear a faster RMB appreciation. They say that the faster appreciation plus increasing costs plus decreasing demand nearly killed them. From your observation, are these exporters going to lose their competitiveness and collapse? What is the real picture of China's exporting industry?
I think they are mistaking the cause of their trouble.If it was the rising RMB that caused them difficulties or caused them to go bankrupt, we should see China’s exports slowing sharply and unemployment, especially in the south, rising quickly.But we see neither.Exports continue to surge and unemployment in the major exporting regions of the economy seems to be relatively low (indeed companies complain bitterly about upward wage pressures, which is not normally consistent with high unemployment).What is causing trouble to certain exporters is something very different.As China’s labor force, especially in the wealthy south and southeast, move out of low value-added assembly and into higher quality manufacturing and service jobs, companies that rely on cheap, unsophisticated labor will necessarily find conditions more difficult and may even go out of business.
Although these companies may suffer individually, their problems will have no impact on overall employment in China because it is precisely the higher wages and better employment opportunities for workers that caused them to leave.It also does not affect China’s overall exports because the production of these exports is shifting away from highly developed areas like Guangdong to less developed areas in the interior of China.The growing bankruptcies of these companies is not a sign that the currency is appreciating too quickly but rather a sign that policies aimed at creating a higher quality manufacturing and service base in places like Guangdong are succeeding.As long as overall exports continue to grow it is hard to see how the rising RMB has caused trouble for Chinese exporters in general.
As you know, the CPI of China has been very high in recent months. Many say that a faster appreciation will ease inflation. But we have seen now is that China's domestic prices keep increasing. Why?
This is another common mistake in the debate.In China, appreciation will not reduce inflationary pressures through the price impact on imported goods.It can only really reduce inflation if it reduces the amount of foreign exchange the central bank has to buy every month, and so reduce the growth of the domestic money supply.As long as China’s money supply keeps expanding at such a fast pace, it will be impossible to bring inflation down, and as long as the central bank is forced to purchase very high levels of foreign exchange every month, China’s money supply will keep growing too quickly.The recent appreciation has done nothing to slow the trade surplus but it may have increased speculative inflows, so it actually causes an even further increase in the money supply.
Many economists are calling the Chinese government to rethink the appreciation mechanism. Some suggests a one-off appreciation just like 2005 to reduce import costs. What do you think of this? What is your outlook for the RMB's exchange rate by the end of the year?
When I first argued, a little more than a year ago, that the government was eventually going to be forced into a large, one-off appreciation, I made the argument because no other solution would get it out of its monetary trap. I still believe this and I believe that recent events have actually strengthened the argument.It is a very difficult policy choice, but the alternatives are all worse.If China wants to reduce inflationary pressures it must move as quickly as possible to reduce foreign currency inflows, and the only way to do that is to surprise the market with a one-off revaluation large enough to slow export growth and, more importantly, to cause speculative inflows to reverse and leave the country.
But the revaluation must be large enough to be credible.A revaluation of less than 10-15% will almost certainly make matters worse since it will still leave the market believing that the RMB is undervalued, and it will signal how desperate the situation has become for the central bank – thus convincing everyone that the central bank will be forced to act again.This will cause speculative monetary inflows to surge.
Once again I have had trouble posting onto my blog, so I was only able to post this morning the following entry from yesterday.
After an awful first quarter for Chinese stock markets (down 34%), there seems to be a rising crescendo for stock market support measures by the government.Today the China Securities Journal quoted a report by the State Information Center, an NDRC-affiliated think tank, calling on the government to take concrete steps to support local stock markets.Since the stock market plunge was “not in line with the country’s economic fundamentals,” argued the authors, it needed to be stopped.According to the report: “Historically speaking, a country with a fast-growing economy and an appreciating currency should see its stock market develop rapidly. China is exactly at this period of its development.”
History is always a sinuous thing in modern China, one whose main purpose is to support current policy goals, so it probably doesn’t do much good to point out that there are plenty of cases in history of slumping stock markets in rapidly growing economies – not especially surprising when you consider that the stock market is supposed to be a gauge of future expectations, not a report card for past GDP growth.What is more interesting to me is that a major think tank supported by the NDRC, the country’s top economic planner, is calling very explicitly for government intervention to support the market. “It is a common practice for governments to directly and resolutely intervene in financial markets in instances of major volatility, even in Western countries,” the report claimed, more or less clinching the argument.
Perhaps in line with the SIC sentiments, yesterday an official at the China Securities Regulatory Commission denied a rumor that there were net redemptions at mutual funds of about RMB 100 billion during the first quarter of the year.On the contrary, he claimed, total redemptions were about RMB 17 billion and total new subscriptions nearly twice that amount, according to today’s ChinaDaily.The rumor, which seemed to have come from a 21st Century Business Herald article, “goes against the facts and is misleading to investors,” according to the official.
The good news doesn’t end there.Today’s Xinhua reports that “Investors remain optimistic about stocks.”According to a recent survey released by the CSRC, more than 60% of Chinese investors expect stock prices to rise.The Xinhua report goes into a great deal of detail about the composition of the retail investor base (or at least that part who answered the survey) but doesn’t say when the survey was taken – although my best guess from reading between the lines is that it took place in January, before the big crunch, so I wonder how many people now still believe stock prices will rise.
My own interpretation of all these claims and clarifications is that the government is very worried about the stock market collapse and is doing everything it can to pump up excitement about the market.If this doesn’t work I suspect that they will take more concrete steps.By the way the market was up a little today – about 0.6%.
Of course if there is a turnaround in the stock market, it may solve one pressing concern but it may also worsen another – and this is one of main difficulties in which China finds itself: each of its problems is interlocked with other problems in such a complex way that policy choices are sharply constrained.Specifically, if there is a sharp stock market rally (and given monetary conditions, a slow, gradual rise in stock market indices has a very low probability of happening – it is either boom or bust), it may create yet another reason for speculative inflows.In the past it seemed that speculative inflows were correlated with the thrilling performance of the stock market.When that game was over, inflows seemed to have shifted to bank deposits to take advantage of the more-rapidly rising RMB. A renewal of the stock market bull will only make monetary policy harder than ever to manage since it will probably encourage hot money inflows even more.Damned if you don’t and damned if you don’t.
Meanwhile there continues to be bad news on the food-price front.Today’s China Daily reports that northern and northeastern China is suffering from the worst drought in decades.This will have a terrible effect on agricultural production, especially in the province of Heilongjiang, a province that is, according to China Daily, the country’s largest supplier of commodity grains, including corn, soybean, rice and wheat.Up to 51% of the province’s total planted area could face severe drought during the spring plowing season.This means that even if the inflation problem in China really is pork, and not money, as Ken Rogoff memorably put it, the pork problem may very well persist.
Nine more days to the March CPI release.I haven’t been hearing much in the way of price rumors, but I expect month-on-month inflation to be down a little and year-on-year inflation to be up over 7%.
There seem to be conflicting stories in the recent press about inflation and inflationary expectations in China, but I think they may say more about confusion over the causes of inflation than they say about the real trend in prices.According to today’s Bloomberg, “China's top economic planning agency has started to allow dairy and cooking oil price increases, a move that indicates the government may expect inflation to cool from an 11-year high.”The article goes on to quote JP Morgan’s Wang Qian, who said “The authorities consider inflation may trend down from the peak in February, so allowing companies to raise prices would give food makers more incentives to increase supply.”Later in the article Bloomberg says:
Price gains may be cooling. An index of agricultural products compiled by the Ministry of Commerce shows wholesale prices have fallen consecutively on a weekly basis since mid- February.
I think we may be getting ourselves caught up in a statistical illusion.Given the very high price rises in February, caused mostly by food price increases – February’s CPI was up 2.5% over January’s CPI, versus monthly price increases of just under 1% on average for the previous three months – it would be pretty reasonable for food prices to decline in March.This, however, would not necessarily imply any reduction in underlying inflationary pressures.On the contrary, if CPI in fact declined by up to 1.8% in March, year on year inflation would still exceed January’s 7.1%.More specifically, if we assume that non-food prices rose at 1.8% year on year in March, like they did in February, a 1.8% decline in CPI would require a 6.1% decline in food prices, which I don’t think anyone is expecting – and recent PPI numbers suggest that non-food inflation is likely to be accelerating, not holding steady.
This is just a very roundabout way of saying that although March year on year inflation is likely to be lower than February’s sharp jump to 8.7%, we should be careful about how we read the numbers.It will not be easy for March year on year inflation to come in below January’s 7.1%.It is in fact likely to be much higher – perhaps as high as 8%.The fact that February numbers were exceptionally high because of special circumstance – the freak storm and the Spring Festival holiday – does not mean that lower food prices in March represent an easing of inflationary pressures.They may just represent a return to the earlier trend or steadily rising inflation.
The government’s decision to allow dairy and cooking oil prices to increase may nonetheless be good for Chinese inflation because price controls can actually worsen food inflation in the medium term by limiting the salutary impact higher prices might have on supply.Still, declining prices for agricultural goods are much more likely to be caused by a reversal of the freak February numbers than by a decline in inflationary pressures.
On the other hand there is a very different story about inflation expectations in today’s China Daily. In discussing plans to increase water prices in some cities, they have this to say:
The central government emphasized the importance of combating inflation Wednesday as some cities plan to raise water fees.Tang Tiejun, director of the Pricing Department of the National Development and Reform Commission (NDRC), told the 2008 Strategic Forum on the Urban Water Sector that the government hoped some cities would delay raising water fees amid surging inflation.
Tang said that cities wishing to hike water charges should consider the consumer price index (CPI), per capita income and general price levels
Inflationary pressures seem to be spreading to water and other non-food components of the CPI basket, just as we would expect if the underlying cause of inflation were excess money growth.This is, by the way, consistent with the recent PPI data.
Meanwhile Xinhua reported today on the results of a just-released AC Nielsen survey on the impact of inflation among Chinese consumers.According to the survey, “the recent increase in food and oil prices is likely to keep more Chinese shoppers at home and change their way of spending.”The survey also found that most consumers said they would not cut their food spending, with only 18% saying they would reduce their grocery food bills.
If most Chinese continue to consume as much food as they did before, and if food prices have risen by 20%, it seems pretty clear that they must necessarily either save less or spend less on other goods (or both).If, as the survey seems to imply, one consequence of rising prices is to keep shoppers at home, the reduced spending on non-food items should have been fairly significant.This is the mechanism by which we should have expected deflationary pressures on non-food items – assuming Chinese monetary policy is consistent with the 2-3% inflation targeted by the PBoC.
Since there is clearly inflation – albeit low – in the non-food component of the CPI, and since this inflation seems to be rising, my interpretation of the inflation data, as I have pointed out many times before, is that inflation is caused by monetary conditions that are far from consistent with the PBoC’s inflation target.This is why I believe inflation is caused by too much money, and not too little food, and why I think the current crop of inflation-containing measures simply will not work.Although most of the analyst reports I read continue to argue that Chinese inflation is a limited phenomenon caused by special factors that are reversible, I think more and more of them are switching to the monetary argument, or at least hedging their bets.I think this makes sense.
One other thing.If it is true, as the AC Nielsen survey claims, that 82% of Chinese households have not reduced their food consumption, even with the higher food prices, I cannot believe that the food component of the CPI basket can have remained constant over the past year.As I understand it, food comprised just over 33% of the CPI basket in the beginning of 2007. It continues to comprise that level in today’s calculations.
But how can this be true?If 82% of Chinese households eat as much as they used to, in spite of the 20% or so price increase in food, even if the remaining 18% of Chinese households reduced their food consumption by enough to keep their total food expenditures exactly level (which is pretty unlikely), I would have thought that the food component of the basket would have risen to at least 35-36%.This may not seem like a big difference, but in that case the inflation in the adjusted CPI basket should have been higher than the headline number, by about 0.4-0.5 percentage points.The headline CPI inflation, in other words, may understate real CPI inflation.
Inflation is not just a Chinese concern, of course.It seems to be a rising problem around the world, especially in countries that intervened regularly in the currency markets to promote mercantilist export policies.This is more evidence, I think, that my theory that the recent policies among several developing countries, aimed at protecting them from the threat of another Asian-Crisis-style meltdown, may have simply transformed one kind of balance sheet mismanagement into another kind.In their determination to protect themselves from one kind of unstable balance sheet, they seem to have constructed a different, but equally unstable, kind of balance sheet.
Several of China’s neighbors are suffering from domestic monetary problems that resemble in some ways (though not all) the problems China is facing.I have spoken several times recently to one of my favorite former Columbia-University students, a young Vietnamese.Besides his stellar subsequent career in the Vietnamese government, he is distinguished by also being the father of my very bright and very cute godson.During the past week we have had several conversations on monetary and financial conditions in Vietnam, and it seems, at least from first glance, that Vietnam is suffering from an even more acute monetary problem than is China.Given what seems like a heavier and less stable debt burden, their policy options may be even more constrained.Several countries in the region seem to have similar problems, and I suspect that the next round of developing country financial crises is going to affect East Asian pretty severely.
Vietnam and China were two of the main topics of a release by the Asian Development Bank, who have recently weighed in on the subject of inflation.They released a report yesterday that listed their projections for GDP growth and inflation for all the major Asian countries.The ADB revised their Asia ex-Japan forecast for 2008 GDP growth down from 8.2%, in September, to 7.6%, and they expect inflation in most Asian countries to rise.
They forecast 10% GDP growth for China – which I think is on the high side of most growth forecasts.They also forecast CPI inflation in China of 5.5% for all of 2008.This strikes me as so low that I wonder if it is their real opinion or whether they are merely being polite to one of their shareholders.Given that in the first two months of the year CPI inflation in China was already 3.8% on a nominal basis (25.1% annualized), they are effectively implying that they believe monthly inflation for the rest of the year will average less than 0.2%, or just 2.0% on an annualized basis.
So they think China can go from 25% annualized inflation to 2% annualized inflation over the rest of the year? I’m not sure I’d want to take their side of that bet.
ICBC, one of China’s Big Four commercial banks, released a report yesterday forecasting year on year CPI inflation in March to be 8.2%.This may seem like a big improvement over February’s 8.7% inflation number, but it actually represents a significant deterioration if ICBC turns out to be right because it will nonetheless represent a big jump over the more “normal” December and January numbers (6.5% and 7.1% respectively.February was a particularly bad month because the combined effect of the freak January storms and the Spring Festival had inflation shoot up in February by an annualized 35%.
8.2% year on year in March implies a month-on-month decline in the CPI index of about 0.8%, which after January’s and February’s 1.3% and 2.5% increases would imply that annualized inflation in the first quarter of 2008 will have just exceeded 12.5%.I don’t have the facilities to generate my own independent projection of monthly inflation, but ICBC’s projections are in line with some of the other projections I have seen and have come to trust.At that rate we can expect the headline year-on year CPI inflation number significantly to exceed 10% by May, which I think is a safe bet, although some analysts, for example those at ANZ, disagree – they think February’s number represents a peak for year-on-year inflation.
I suspect that if the panic button hasn’t been pressed before then, a 10% CPI number in May should be enough to set it off, although I still think there is enough confusion in policy-making circles about the causes of inflation that it may be a while before a consensus develops over what needs to be done.My guess is that if we do see May numbers exceed 10% there will be at best an acceleration of current policies to restrain inflation, but I don’t think these will have much effect.
In their report yesterday ICBC also said that inflation would begin to decelerate in the second half of 2008 as the government’s macro controls and support for agricultural production began to take effect.I of course am skeptical. I do not believe the government will be willing to tighten by nearly enough to wring out several years of excessive monetary growth.I suspect we will need to see continuing accelerating inflation well into the end of 2008 before there is enough of a consensus built to recognize that inflation is not a temporary problem and must be addressed more vigorously, even at the cost of a short-term rise in unemployment.
Nonetheless as long as there is a sense that the fundamental problem is a food-supply constraint, the government continues to try to encourage an expansion in agricultural expansion. Amid spreading talk around Asia of a rice crisis, Jiang Dingzhi, vice chairman of the China Banking Regulatory Commission, urged banks yesterday to ensure loans and credit to grain producers and other agriculture-related enterprises, even while they maintained strict loan caps.In an effort that I think is unlikely to bear much fruit, Jiang even urged rural cooperatives, commercial and policy banks to “follow credit ethics and take on their social responsibilities to support rural development,” according to a Xinhua report today.I am not sure appealing to their “better” instincts is an effective way to get the responsible parties to do what the government wants, but even if these kinds of appeals are successful in raising agricultural production, it will just make it easier for inflationary pressures to show up in the non-food component.
Why do I say this?This month the Far East Economic Review published my piece explaining why I believe that “solving” the food problem will not solve the inflation problem. In the article I point out that from the monthly releases provided by the NBSC since last year, it has been clear that almost all of the increase since last year in the value of the CPI can be explained by the roughly 20% increase in food prices. The price levels of the non-food component of the CPI have been relatively stable, rising at well under 2% year on year. This seems like prima facie evidence that inflation in China is primarily, if not exclusively, a food problem, caused by food supply constraints that are temporary in nature.
So according to the pork model of Chinese inflation (based on MIT professor Ken Rogoff’s formulation of the debate as pork versus money), China is not suffering from monetary inflation. It is suffering rather from a sharp and unexpected decline in agricultural production relative to the rising food-consumption needs of a large, rapidly growing economy. Once the factors that have constrained food production are eliminated or wear off, the growth in food production will keep up with Chinese consumption needs and the price of food will return to levels consistent with the PBOC’s inflation target of 3% or lower.
For believers in the pork model the real danger facing China is that several months of high food-based inflation can nonetheless cause a generalized change in inflation expectations, which itself will change the behavior of households, consumers and producers in ways that will lock inflation into place. On February 11 Premier Wen very specifically addressed concerns about inflation expectations when he said: “We are sticking to the 4.8% target because it helps stabilize consumer expectations. When prices soar, expectations can be more horrifying than the increases.”
The concern expressed by Premier Wen and others in his government is that if workers begin demanding higher wages to compensate them for the decline in their purchasing power, if households worried by rising prices accelerate their purchases of consumer goods, and if savers reacting to the negative real interest rate on bank deposits withdraw money from the banking system and spend it, their behavior can cause inflation to spread into other sectors of the economy. In this case the main strategy of the government must be to create the necessary incentives to get agricultural production back on track as quickly as possible and to squeeze out inflationary expectations—partly by constraining demand, partly by selling food reserves, partly by freezing prices and partly by simply talking down inflation prospects, as Premier Wen was seen to be doing.
Given that CPI inflation has largely been limited to food, how can monetarists argue that inflation in China is caused by too much money, and not too little pork? Aside from the fact that the prices of a number of non-food components such as gasoline prices are frozen, so that their inflationary impact shows up not as CPI inflation but as lower profits or higher taxes (but the upward pressure nonetheless exists), there is a much more serious argument as to why non-food inflation is actually too high and possibly indicative of more generalized inflationary pressure.
In order to see why, it is important to remember that a price increase in any particular good or group of goods caused by a supply constraint is not inflationary. Prices of individual goods and services rise and fall all the time, whether the overall monetary environment is stable, inflationary or deflationary. Normally the only effect of a price rise in a particular good should be to cause a shift in relative prices, not average prices. If the price of food rises, in other words, it should cause a diversion of spending away from non-food goods and services, so putting downward pressure on the prices of those other non-food goods and services. In a perfect world, the downward pressure on other prices would net out perfectly against the rising price of food. Although there would be a change in relative prices there would be no inflation, which is a change in average prices
Of course we don’t live in a perfect world, and because of various kinds of price stickiness price changes do not necessarily net out. Still, the price-equalizing pressures are there, and it is even possible to calculate how much the price of non-food goods and services would need to decline to maintain the balance. This allows us to measure the downward pricing pressure that rising food prices are placing on the rest of the economy.
If we assume that the PBOC is running a monetary policy that is consistent with a target of 2% to 3% inflation, the 18.5% rise in food prices year on year to January 2008 would require a sharp decline in other prices in order for the PBOC to attain its inflation target. Specifically, the price of non-food goods and services would have had to decline by 5% to 6% year on year in order for overall inflation to fall within the PBOC target. (I am not using February CPI numbers because they were exceptionally high and may distort the calculation, but if we used them, non-food prices would have had to decline by 7% to 8% for the PBOC to attain its inflation target.) Food inflation, in other words, should cause such a large diversion of spending away from non-food goods and services that their prices would have to fall by nearly 5% or more if the PBOC’s monetary policy and inflation targets were credible.
It might be unreasonable to expect 5% deflation in the non-food component of the CPI basket, but certainly China does have a recent history of price deflation in many goods, and there is no reason to assume that prices in China are so sticky that deflationary adjustments are impossible. Clothing prices in China, for example, have fallen pretty consistently year on year by an estimated 1.7%, 1.9% and 1.4% during the three months to February, according to an April 3 report just sent to me by Macquarie Bank’s Paul Cavey. Still, even if deflation of this magnitude were unrealistic, sharply rising food prices should nonetheless have put significant downward price pressure on the non-food sector, and this downward pricing pressure should have had at least some material impact on actual price performance.
Under these circumstances the fact that non-food inflation is low but rising, and has in fact accelerated to 1.6% in February from 1.5% in January (rising nearly 3% in February on an annualized basis), is not very comforting. Instead of significant downward pressure on Chinese CPI inflation there is small, but upward pressure. This suggests that monetary policy has been too loose and that there is an underlying monetary cause to inflation. The food-supply constraint has helped mask the monetary pressure for inflation by diverting increased spending towards food and away from non-food goods and services.
But it has only masked this pressure—it did not create it. Thanks to abnormally fast-rising food prices, in other words, inflation has not yet shown up in the non-food component because rising food prices have absorbed the inflationary consequences of an excessively loose monetary policy. Once food prices stop rising dramatically, however, inflationary pressures will show up in a much broader range of goods and services.
As I have mentioned many times on this blog I am one of those who sees the great global imbalances of the present period as largely a consequence of a global savings glut, and as the biggest saver China is one of the most important players in this process.As the system is currently undergoing a great deal of stress, it is going to be forced to change one way or the other, and there is no reason to believe this change must be benign, either for the world or for China.
How does the savings glut work?In recent years we have seen a combination of a structural savings glut (mercantilist policies in a number of countries, especially in Asia, have included a rigid currency regime which exports high domestic savings) and a cyclical savings glut (commodity exporters, especially oil exporters, have seen export earnings grow much faster than imported consumption). The combination of these two has resulted in a vast building up of foreign currency reserves among the saving countries. The accumulation of foreign reserves is largely the consequence of accumulated trade surpluses, which because they imply total consumption that is less than total production, is the way in which domestic savings – forced or otherwise – is exported to the rest of the world.
In a system in which most countries of the world are tied together by trade and capital flow links, a savings glut of course does not mean that there has been a net increase in global savings. It means that excess savings in one part of the system will automatically lead another part of the system into excess consumption so as to keep the overall system in balance. With its very flexible financial system, its deep pockets, and the high credibility of its financial markets (not to mention the eagerness of many of its citizens to increase consumption), it is no surprise that the US economy and financial system have been the great equilibrator, running the significant trade deficits over the past several years needed to match the mercantilist and commodity-export-related surpluses of those countries with surplus savings.
But falling house prices and slowing demand are forcing the US to increase its own savings rate and so to reduce its ability to balance the excess savings abroad – we can see this by noting the rapidly declining US trade deficit.A world of excess savings, in other words, is being forced into an adjustment in which the savings of its largest economy is set to grow – and it cannot be a good idea to increase savings in a world that is already experiencing a savings imbalance of this sort.
Of course this adjustment cannot happen in a vacuum, and either the excess savers must cut savings and increase consumption, or another very large and credible economy must take up the US consumption slack.The former certainly does not look like it is happening, and in fact it cannot happen as long as the excess-savers’ central banks keep intervening in the markets to keep their currency values low – their intervention is the very process by which high domestic savings are exported to the rest of the world.
So the latter is happening. Europe is being forced to absorb an increasing share of the savings imbalances as the US reduces its share.As I have often written here, I am very skeptical about whether Europe has the financial or economic flexibility, or the political flexibility for that matter, to replace the US as the great equilibrator.But what is the alternative?Even if global savings are eventually reduced by declining commodity prices, I see little evidence that the mercantilist savers are bringing their consumption levels up quickly enough to enable the global economy to regain some balance.
That suggests to me that at some point, perhaps quite soon, European trade imbalances will be high enough to cause significant problems at home.Either Europe will react by trying to limit imports, or the euro will crash against the dollar, sending the role of equilibrator back to the US, or mercantilist savings will decline sharply and maybe even reverse.As I see it these are the only three likely options to restore balance.Neither is likely to be benign, but I guess the trick is to figure which of these is likely to be the less damaging and work towards that direction.
Meanwhile, and as an aside, Friday’s South China Morning Post has a story on QDIIs, a subject I have covered a lot in this blog because QDIIs act as a sort of proxy for speculative interest and they indicate one of the ways in which China is trying to diversity the exporting of its excess savings. China’s QDII’s, which are funds specifically designed to allow Chinese investors to invest abroad (capital controls prevent foreigners from easily investing in China and Chinese from easily investing abroad) seem to be under continued pressure from disgruntled investors who are fed up with the losses they have taken.An article titled “Mainland funds deny QDII cash pressure,” has this to say:
Beleaguered mainland fund managers have denied they are facing pressure from investors who want to cash out of their qualified domestic institutional investor products in Hong Kong. The QDII scheme, which allows mainlanders to invest in foreign markets such as Hong Kong through approved funds, has come under close scrutiny after Minsheng Bank was forced to liquidate a product late last month after the net asset value fell by more than 50 per cent.
“We don't feel redemption pressure,” the article quotes Zhang Houqi, the deputy president of China Asset Management, as saying. China Asset Management was one of the first mainland fund houses to embark on the QDII scheme. The story goes on: “Analysts said QDII funds were being forced to increase their cash positions before potential heavy redemptions since the first batch of buyers wanted to cut losses.”
When managers are busy assuring the market that they don’t feel redemption pressure, that is usually a sign that there is redemption pressure, isn’t it? After all it is not hard to think of the name of one or two banks who recently told us that they were not under liquidity pressure, only subsequently to find that indeed they were.
If there are sufficient redemptions in the next few weeks or months that force these funds to liquidate, I suppose we will see a jump in the already high monthly increases in central bank reserves, as money which previously left the country (and so relieved the PBoC from mopping it up) returns to the perceived safety and relative high returns of Chinese bank deposits.
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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, a portfolio manager at Dazhong Insurance Co. in Shanghai, according to a Bloomberg report. “Economic fundamentals and the lack of government support measures have both contributed to the plunge.”
September, 2007