Sorry. My blog site was down so this Wednesday entry was posted Thursday, one day late.
I was too busy to post anything Tuesday, but there wasn’t a whole lot new to say except to bemoan the stock market’s performance, again.The SSE Composite dropped 3.1%.Today after a rocky start it seemed to find its legs, trading up 1.8% by lunch, before giving it all up to end the day almost perfectly flat at 2701.It is now trading almost exactly 10% below 3000, which as recently as three weeks ago was the market’s imagined government-intervention level.
The property market doesn’t seem to be doing a whole lot better, at least in Shanghai.Two articles in today’s South China Morning Post warn that Shanghai’s property sales are down.According to one, “The sale of new flats in Shanghai measured by floor area, plunged almost 50 per cent in the first half, and sources said the market was unlikely to turn around until September, traditionally the peak season for property sales.”Shanghai residential prices have been under pressure for a while as a consequence.The second article suggests that commercial property is also seeing selling pressure, although increased selling interest is not necessarily causing prices to drop:
The queue of investors seeking to sell their Shanghai properties is getting longer, leaving analysts divided over the impact of a fresh wave of disposals on the market…
"All these asset disposal plans will add uncertainty to the outlook for the investment market," said Clement Leung Wai-ming, an executive director for China valuation at property consultant Knight Frank. But with Shanghai residential prices holding firm despite a sharp fall in deal volumes last month and evidence that new investors are ready to step into the market, others have a more optimistic view.
I think the fact that there is so much hot money flooding into the country has made the clearing mechanism complex.Fleeing sellers are matched with buyers flush with cash, and the market, while trending down, hasn’t really gone down as much as it might.Needless to say, this is very worrisome (but you knew I’d say that, didn’t you?).Property exposure is extremely high within the Chinese banking sector, and if what is propping up real estate prices, however tenuously, is hot money inflows, then we have yet another nasty little volatility machines embedded in the banks’ balance sheets.
Why?Because hot money, as is sometimes forgotten, is almost by definition highly pro-cyclical, and is likely to flee exactly when conditions are bad and it is needed most – just as the banks are struggling to deal with the consequences of a future financial or economic contraction, in other words, the legs are likely to be kicked out from under the real estate market.China has too many of these busy little pro-cyclicality machines embedded in its balance sheet, which means that good conditions as well as bad conditions are likely to be exacerbated by the dynamics of the balance sheet.Perhaps that is one of the major reasons why China has seemed like the rest of the world hopped up on super steroids.
By the way it is becoming increasingly clear that a lot of real estate developers – frozen out of the banking system – are turning to the informal banks for short-term and expensive funding.For a long time I have been discussing and wondering about the role of the informal banks in all of this, and I said several times that I was willing to bet that the informal banking sector in China was growing rapidly, if only there where a way to measure it.I am glad to say that over the past few weeks this has suddenly become a very hot topic, so it is getting a little easier to get a sense of its impact.I was particularly interested by an article in today’s China Daily (“Irregular financing channels rampant”).According to the article:
Many small and medium-sized enterprises now mainly rely on “underground” funding to finance their businesses as credit tightening measures have dried up bank loans.Policymakers have been tightening the purse strings to fight inflation since last year. The benchmark interest rate has been raised six times, to 7.47 percent, and the reserve requirement ratio for banks raised 15 times since last year.These measures have made it all the more difficult for SMEs to get bank loans, a vacuum promptly filled up by underground financing channels, said industry observers.
The article goes on to quote one of these informal bankers:
“A lot of small firms come to us. Only the bigger enterprises go to the banks,” said an underground lender, who declined to be named. He has lent out 10 million yuan - he declined to say how he made that kind of money - at 30 percent annual interest rate.“Interest is not an issue. They will go bankrupt if they don't get our short-term loans,” he said. “Our money is available at short notice. We can deliver the cash within 24 hours, while a bank loan might take at least six months. But I am only small fry, there are bigger fishes out there with more than 100 million yuan parked in underground financing.”
The article also refers to a survey conducted by Beijing's Central University of Finance & Economics, which found that underground lending totaled 1.98 trillion yuan in 2007, equal to 28% of the amount banks lent.This is a pretty large amount, and there is a lot of circumstantial evidence that the informal banking sector has gotten significantly larger, especially as hot money inflows seem to have grown very rapidly in the past few months at the same time that lending caps and hikes in the minimum reserve requirements have sharply curtailed loan growth in the formal banking sector.
The size and growth of the informal banking sector is not just of academic interest.It has at least three implications for those of us worried about monetary conditions in China.First, it makes the management of domestic monetary policy, to the extent that such a thing exists, much more difficult because the PBoC has no direct control over the informal banks.If, for example, a lending cap on the commercial banks simply pushes loan origination off the commercial bank balance sheets and onto the informal banking sector, the lending cap can’t and won’t have much of an effect on domestic money or credit growth.In addition, because the rate informal banks charge on loans is also beyond the reach of the regulator, the PBoC’s management of interest rates is also partially constrained (although on balance, given negative real rates and the consequent misallocation of capital, this is probably a good thing).
Second, it raises important questions about the structure of Chinese corporate balance sheets.We don’t know for sure, but there are very good reasons to believe that loans extended by the informal banking sector are of much shorter maturity and of much higher rates than is typical for the commercial banks.If this is true, and it almost certainly is, corporate balance sheets are much more vulnerable to an economic downturn or a sudden liquidity contraction than we might otherwise think (yet another dynamic little volatility machine embedded in China’s balance sheets).
Third, the rise of informal banks partially answers the question about where, if China is indeed being flooded by hot money, as I have been arguing since early last year, is all this money going?Part of it is going into the informal banks.Add the role of informal banks to the mix of rising bank deposits, the hoarding of commodities, real estate investment in secondary cities, and so on, and it is not so difficult to see where the money goes.
At the end of the China Daily article, the piece confirmed in a rather macabre way what my lunch companion last Saturday told me.As I wrote on my Sunday blog entry:
We discussed what would happen in the case of a default – besides the proverbial visit by the man with a baseball bat he suggested, with a completely straight face, it was also likely that one of your kids might be kidnapped.
According to the China Daily article:
“Many a time, the borrowers cannot pay back,” the private lender said. “What can you do in such cases? You just have to resign yourself to your fate.”But not all lenders give up that easily. Some can go to the extent of hiring gangs to kidnap the borrowers or their family members to recover the loan, he added.
We definitely need to think more about the informal banking sector in trying to get our arms around China’s financial risk profile.
Besides informal banking, the other “hot” topic about which a few of us have been pounding the table for months is, of course, hot money inflows.I think increasingly people in China – and not just at the PBoC – are waking up to the sheer magnitude of the problem.Today’s Xinhua has an article titled “Unprecedented capital inflows test Chinese regulators.”According to the article:
China has taken a series of increasingly aggressive measures in the past several months to blunt the impact of so-called "hot money," amid the explosive growth of its foreign exchange reserves, which have soared beyond what can be explained by trade and investment flows.The inflows have been so massive as to raise alarms over the country's financial security.
The article is worth reading because it gives a sense that either there is rising concern in official circles about the impact of hot money in China or, alternatively, someone, probably in the PBoC, wants to raise such concern.I am working on a piece, which I hope to complete soon, discussing the implications of the increasing role of hot money in China’s burgeoning reserve accumulation.One interesting data point:In the first quarters of 2005 and 2006, the combination of FDI and the trade surplus accounted for 60-70% of reserve accumulation.By 2007, it accounted for only 46% of reserve accumulation.This year, it accounted for 45% of headline reserve accumulation, but if you adjust for the “outsourced” portion of reserve accumulation (transfers to the CIC and minimum reserve redenomination), it amounted to barely 20%.
This is a dramatic shift.I know I have been pounding this drum over and over again quite a bit recently, but I am absolutely convinced that it is just a question of time that this, too, becomes a hot topic.My prediction: worries about the shifting composition of China’s reserve accumulation will soon be one of the big stories in the financial pages.
As an total aside, after complaining last week that since the fuel price hike it has been almost impossible for me to find a taxi with air-conditioning here in hot, sticky Beijing, three of the four taxis I rode today were air-conditioned.This is not a very scientific indicator, but given that taxi fares haven’t risen to match the increase in fuel costs, and their incomes must be wilting, I wonder if taxi drivers have at least come to some sort of agreement with the government.Yesterday I had lunch with my friend Pierre Mongrué, with the Economic Department of the French Embassy, and he thinks that there may be an agreement to subsidize or otherwise accommodate taxi drivers.If there is, the process of managing the very complex relationships of subsidies related to fuel price caps must be a nightmare, not to mention highly distortionary.
Sorry for posting two longish entries on the same day, but I wasn't able to post yesterday's entry until this morning, and both days have had some important events worth writing about.
Stepping up the battle against "hot money" flowing into and out of China, three Chinese central governmental departments are to link their internal electronic systems from July 14 in a trial check of foreign exchange receipts and exports settlements, the State Administration of Foreign Exchange (SAFE) said Thursday.These measures were interpreted by analysts as one of the latest efforts by the Chinese government to monitor capital flows and prevent more so-called "hot money" from flooding in and out of the country.
Exporters will now be required to place revenues in special accounts while the authorities verify that the funds were the result of genuine trade transactions. We now begin an extended curriculum on the difficulty of eliminating hot money inflows through administrative measures. I am reasonably confident that this new move will slow hot money inflow through the trade account in the short term while in the medium term it will have little impact (although it is worth noting parenthetically that most of our estimates for hot money don’t take these into account anyway, and if the measure only succeeds in driving hot money inflows out of the trade channel and into other channels, its main impact will have been a welcome but unintended increase transparency). It will also create significant frictional costs for the trading sector and so dampen real trade transactions. Finally, the new administrative measures may ultimately be used as a tool to manage trade, i.e. minimize imports, and so add to international trade tensions.
I won’t say too much about this directly because I think the press is covering it quite well (see for example Geoff Dyer’s “China in clampdown on ‘hot’ money” in today’s Financial Times), but I will say that it does suggest that there isn’t an awful lot the authorities can really do about inflows.It is also not going to make a big difference. Bloomberg today gives one expert’s reasoning, citing Li Youhuan, a researcher at the Chinese Academy of Social Sciences:
“Speculative money can always find loopholes,'' said Li, who undertook an investigation last year into how hot money was entering China. “Inflows through service deals are even faster and simpler than via the exchange of goods. How can the regulators judge whether the prices paid for corporate identity designs, for example, are fair or not?”
As Stone & McCarthy Logan Wright pointed out in a note today:
Overall, this is likely to be the first of several attempts by financial regulators to monitor speculative capital inflows; more supervision of foreign companies' bank accounts and registered capital may appear in the coming weeks or months. However, independently, the new SAFE restrictions on exporters are unlikely to have a significant effect on hot money flowing in through the trade account, and are likely to create cashflow difficulties for exporters already suffering from declining sales volumes and higher input costs. The measures suggest that the central government is much more likely to turn to administrative measures to target capital inflows rather than accelerating the pace of yuan appreciation (or pursuing a one-off revaluation), because controlling capital flows reflects the path of least political resistance. However, as long as market expectations for further yuan appreciation exist, speculative capital flows are likely to continue, despite the Chinese government's attempts to tighten controls.
On a related note, two days ago Morgan Stanley published a widely-read piece by Qing Wang on hot money flows (“China: Counting Hot Money”) in which the author cautions about attributing too much of the reserve accumulation net of the trade surplus and FDI to hot money, which he refers to as the “residual” method. In particular he points out that there are several other types of transactions that can affect the net number which have not been taken into account by most analysts estimating hot money inflows.
First, this indicator treats some items under the current account such as remittances and income, for which high-frequency data are not available, as part of hot money flows. This tends to overstate the amount of hot money flows. Second, this indicator is a net flow concept and fails to take into account capital outflows/inflows originating from China-based financial institutions, which are at times heavily influenced by domestic policy changes. Third, changes in US dollar-denominated FX reserves could simply reflect changes in the cross rates between the US dollar and other major reserve currencies (e.g., euro, yen); however, this indicator attributes these valuation effects to changes in ‘hot money’ flows.
Some of his comments are fairly obvious – and most credible estimates of hot money do take them into account, but he does point out two things that are worth repeating. First, the net numbers do not take into account capital outflow transactions, most of which officially directed:
Capital outflows originating in China are mostly carried out by domestic financial institutions and closely reflect government policy, in our view. For instance, we think that the large amount of purchases of MLT debt securities that originated in China in 2006 reflected the special FX swap arrangements between the PBoC and several large domestic banks in 2006, under which the banks were asked to park their funds (some of which were raised from the mega bank IPOs in Hong Kong) offshore.
Wang concludes that the “residual” method of calculating hot money underestimated hot money inflows in earlier years and over estimates them currently, which, if true, suggests not that hot money inflows are not substantial but rather than they have been less volatile than previously estimated.This is a point well worth making.
In fact much of what Wang says is reasonable, but I have some disagreements with his conclusions.He says:
A key reason for ‘hot money’ becoming a popular issue among market participants is the concern about the potential negative impact on the economy if ‘hot money’ inflows were to turn suddenly into outflows. The common fear is that in the event of ‘hot money’ outflows, the renminbi exchange rate would come under considerable depreciation pressure and there could be serious domestic liquidity shortages that may potentially destabilize the domestic banking system.
While these concerns are not entirely unwarranted, they are overdone, in our view. First, despite the considerable uncertainty in the current market environment, the underlying fundamentals of the Chinese economy remain very robust, and we do not envisage circumstances that could bring about a major downgrade of investors’ medium-term outlook for the economy and thus reverse the direction of capital flows.
Second, we estimate that the potential amount of the ‘hot money’ stock is likely to be US$200-300 billion. Even if all these funds were to leave China, this would be unlikely to generate much depreciation pressure on the renminbi exchange rate. With US$1.8 trillion in FX reserves outstanding and rising, China should be able easily to defend the renminbi exchange rate in the event of potential outflows of a magnitude of about 15% of the total FX reserve stock.
Third, the potential negative impact of ‘hot money’ outflows on domestic liquidity can be easily mitigated as well, in our view. With China’s current ratio for required reserves (RRR) at 17.5%, one of the highest levels in the world, the potential liquidity impact as a result of US$200-300 billion ‘hot money’ outflows could be effectively offset by the PBoC lowering the RRR. We estimate that the liquidity impact of US$200-300 billion in outflows could be offset by a reduction in the RRR of about 500bp from 17.5% currently to 12.5%. Even at 12.5%, the RRR level is still very high by international standards.
His first point is correct as it stands, but Latin American and other developing country experience suggests it is irrelevant.Of course the underlying fundamentals in China seem robust.This is almost a precondition for hot money inflows.But in previous cases, whether we are discussing hot money inflows into Argentina in the late 1990s, or into Thailand, Malaysia, Indonesia and Korea in the three or four years before the 1997 crisis, or in Mexico in 1992-93, it was robust-seeming conditions in every case that precipitated the inflows.
These inflows themselves created the conditions for the subsequent outflows – most importantly over-extended balance sheets and unstable financial systems. In the case of China the danger is not that hot money is pouring into a country that is clearly on the edge of disaster – it never does. The real danger is that if conditions turn, whether because of domestic or international shocks, the inflows can reverse and exacerbate the impact of the shock.
My problem with the second point is that I think he dismisses, and very effectively, the wrong concern.I don’t think the worry people like Logan Wright, Brad Setser and me have is simply that capital outflows could force a depreciation of the RMB one day (in my case I don’t even think it is likely). The worry is that capital outflows could drive domestic liquidity from the financial system and expose very vulnerable balance sheets.The idea that a financial crisis is by definition a currency crisis may be deeply established, but it is wrong. Most financial crises historically have been domestic financial crises, and as I have said perhaps too many times, the next set of crises will more likely be domestic banking crises than external debt crises (with Argentina being, as it always has been, the honorable exception).
This also suggests what it wrong with his third point.It is true that rising minimum reserve requirements constrains lending growth, but it is not equally true that lowering them forces lending growth. Minimum reserve requirements are a constraint on, not a determinant of, lending volume. If we experience the conditions in which China would suddenly see massive capital outflows, it is a pretty safe bet that banks would be more concerned about preserving liquidity than about lending as fast as they were legally permitted.This does not even consider the impact of illiquidity on the informal banking sector, which according to one estimate (see yesterday’s entry) may comprise not too much less than one-third of total banking assets.
One final point, the biggest concern about hot money is not whether or not it is hot money by definition. The biggest concern, for me at any rate, is its sheer size and its pro-cyclicality. It doesn’t matter too much whether a specific inflow is illegal or otherwise constitutes someone’s definition of hot money. What matters is whether it forces the PBoC to expand the money supply, and whether it is likely to increase or decrease underlying economic and financial volatility.I would argue that most of the recent increases in headline reserves do both.
Certainly last night’s announcement by SAFE indicates that the PBoC is also very worried.
For the past few weeks Beijing weather has been either hot and drizzly or, even worse, ferociously hot.Today we got a little bit of variation by interspersing ferociously-hot with the occasional tropical downpour. I really hope things get better before the Olympics or else soon enough we are going to have a lot of very bad-tempered out-of-towners running around the city monopolizing all the taxis.
At least the gloomy weather more or less matches the mood of the stock market.The market was up 2.0% yesterday and down 1.2% today to finish the week just over 2.3% down, at 2670. Banks are surprising on the upside with better-than-expected profits, but higher oil prices drove most of the rest of the market down.
Meanwhile the RMB dropped 0.116% today to 6.859. The PBoC, as even little children are now widely aware, is trying to curb speculative inflows by adding dollops of “uncertainty” to the RMB’s upward trajectory. Unfortunately, the fact that everyone knows what the PBoC is doing and why they are doing it isn’t likely to make this measure particularly effective.
We will probably see the currency fairly flat over the next couple of weeks before it shoots up again.Even the daily newspapers are saying this.I have had this discussion many times on this blog, so I don’t want to reignite it, but I am afraid that the net effect of all this “uncertainty” is likely to be nothing more than that people who were very eager to bring money into China as quickly as possible may be, if they really believe that the trajectory is slowing down for a week or two, in a little less of a hurry.Some of the June inflows, in other words, will show up only as July inflows.This isn’t going to make much of a difference.I think the last time they did this was in April, during which month reserve accumulation, at $75 billion, hit at an all-time world record.
One final thing, I was discussing with my students over coffee the effect of the new export-management controls on inflows announced Wednesday night (and discussed in Thursday’s entry). We agreed that if these measures are at all effective in seeking out hidden hot money inflows, the monitoring period would probably add a few weeks to the time between when foreigners pay for an exported good and when the cash is actually disbursed to the Chinese exporter. One of my students, whose uncle is a Southern-province-based exporter, told me that he believed (he wasn’t sure) that typically exporters would need to find financing for this period, and since most of them are excluded from commercial bank financing, they would need to take short-term loans from the informal banking sector.This sounds pretty plausible.
I have heard that short-term loans are going for 5% a month, and my friend Victor Shih tells me that he has seen even higher rates for “prime” borrowers.That means that if we assume that disbursals are two weeks later than payments for export shipments, the cost of production, including financing, for many Chinese exporters will go up by a minimum of 2-3%.Given razor-thin margins in many of the export sectors, I wonder how exporters are going to deal with this.
My guess is that after a few weeks of this we are going to see a lot of pressure by exporters to roll back the measures announced Wednesday, or else many of the provinces, especially Guangdong and nearby provinces, will quietly let the monitoring process slip.
Just a very quick post today, largely consisting of two news articles.The first comes from Xinhua.
Yesterday, according to the article, Li Yining, a leading economist and member of the all-important Standing Committee, told the Second Meeting of the Standing Committee of the 11th NCCPPC, the country's political advisory body, that:
China is facing a pressing challenge of preventing inflation turning into stagflation.He said stagflation, the co-existence of high unemployment and high inflation, might occur if improper measures were taken to fight inflation so as to disrupt market expectations, or the economy failed to survive the global slowdown…
The economist said China should continue to take a firm grip on the country's foreign exchange flows, and be alert to problems that might occur in the context of a global slowdown given the huge forex reserves.
He said the government should not over-reach itself in fighting inflation or be misled by the concept that only a low inflation rate would be a complete success in the anti-inflation campaign. "The inflation rate, if controlled at about 60 percent of the growth rate, would be appropriate, such as keeping the rate at around six percent for a 10-percent growth in economy," he said.
I don’t have an awful lot to say about his comments except that his warning of stagflation risks is even more interesting to me because of the play it got in the Chinese press (The very large headline is “Economist warns of stagflation risks to China”).
The second article, first pointed out to me by blog reader Jonathan Lerner, appear in various forms in a wide number of papers. The best account I think was Denise Tang’s “State academics push temporary yuan free float” in the South China Morning Post.She says:
China should temporarily let its currency float freely to control runaway inflation and speculative capital inflows, said two government-backed academics, rekindling the debate on the politically sensitive issue. He Fan and Zhang Yue of the Chinese Academy of Social Sciences see the temporary free exchange of the yuan as a quick and cost-effective way to thwart speculation, especially as inflation rises and the room to tighten monetary policy shrinks, according to their commentary in China Securities Journal yesterday.
The government think-tank academics painted a gloomy picture for inflation in consumer and producer prices, and they warned of a cash crunch at companies as well as a possible jump in banks' non-performing loans as side-effects of existing currency measures.
As Jonathan points out in his email to me, major policy changes, especially on economic and financial issues, are almost always preceded by non-official or quasi-official commentary and debate in the official press.That doesn’t mean, of course, that they are about to float the RMB, but it does mean that there is some discussion and debate going on in policy circles about what is, after all, a pretty sensitive topic.I would assume that academic researchers with CASS are unlikely to propose something that seems so radical without some sense that there are people in the government willing to listen.
I don’t want to read too much into this, but if we see more articles along this line it would be significant. By the way, one way of interpreting the debate about a free float is in the context of the debate over a one-off currency revaluation.The more extreme idea of a free float may make it easier to reach a compromise position on the amount of revaluation necessary.
Today was a very good day for the Chinese stock markets and a wonderful start to the week.The SSE Composite rose 4.6% to close at 2792, after reaching a high in the later morning of 2802. Of course it is worth noting that in the last month we’ve seen other very good days – the market was up 5.3% on June 18, another 3.0% on June 20, and again 3.6% on June 25 – but these were always followed by sharp declines the next day that took away all of the gains.As has often been the case in the past few weeks today’s rising prices were led by banking stocks, after two of the best Chinese banks – large but not among the Big Four – said that first half earnings were likely to more than double from the previous year.
Is the rally likely to be sustained?Today’s Bloomberg quotes a Hong Kong fund manager justifying today’s surge in the Chinese stock market:
Liu Yang, managing director at Atlantis Investment Management Ltd., which oversees about $4 billion in assets, expects a rebound. “Fundamentals are very strong in China compared to any other Asian nation,” said Hong Kong-based Liu. “Chinese stocks are trading at crisis valuations. Do they deserve to trade at crisis valuations? The answer is no. The market deserves a very good rebound from here.'”
I am not sure what “crisis” valuations are, but it is interesting that she says this, and for reasons which she perhaps did not intend.To explain what I mean, I should point out that part of the reason for investor optimism was almost certainly some comments made by Premier Wen over the weekend. According to a Reuters article carried by the South China Morning Post:
Some traders said a visit by Premier Wen Jiabao to Shanghai and Jiangsu province at the weekend, when he said fighting inflation remained his priority but the government would seek “sound and fast development”, had prompted speculation that economic policy might shift somewhat towards sustaining growth in the second half of this year.
There is a sense among a lot of businessmen and economists here that the government is planning to loosen conditions in order to ensure that Chinese growth prospects are not seriously hurt by the bad news coming from both domestic and international markets. Wen’s visit and comments on the economy were covered widely in the Chinese press and many think he seemed to be indicating or guiding what is likely to be coming out of the meeting of the country’s top economic policy-makers to be held later this month, probably after the July 17 release by the National Bureau of Statistics of the economic figures for the first half of 2008.
Premier Wen Jiabao has said the country will maintain the fast and steady pace of economic development despite the challenges from home and abroad this year.Wen's remarks came during his three-day trip to eastern Jiangsu province and Shanghai from Friday to yesterday, where he met with local officials, farmers and entrepreneurs.
The country's economy is developing in the expected direction after overcoming challenges from home and abroad, he said.Wen urged governments at all levels to improve macroeconomic controls further and optimize the economic structure to avoid serious fluctuations in the economy.
Fighting inflation is still one of the major tasks, he said, and governments should try to make price rise “acceptable” both for the industries and the public.
As recently as March and April preventing inflation was the number one policy task and one of Premier Wen’s “two prevents” (preventing overheating was the other), but now it is just “one of the major tasks”.Fighting an economic slowdown seems to have taken priority.
It seems pretty clear to me that we are backing away from the fight against inflation as policy-makers become increasingly worried about a possible economic slowdown.This is not necessarily a contradiction – a slowdown itself can, in some circumstances, resolve inflation – but it does indicate what to me is a worrying policy shift.
In that vein I already mentioned in Saturday’s posting the comments last week by Li Yining in a speech to the country’s political advisory body that
the government should not over-reach itself in fighting inflation or be misled by the concept that only a low inflation rate would be a complete success in the anti-inflation campaign. “The inflation rate, if controlled at about 60 percent of the growth rate, would be appropriate, such as keeping the rate at around six percent for a 10-percent growth in economy,” he said.
That statement by Li, I think, was very different from much of what we had been hearing since last summer: that inflation was a scourge, one of the “two prevents”, that had to be resolutely defeated. Mr. Li seems to be saying that 6% or 7% inflation is not so bad – and this just a few months after the government officially targeted 4.8% inflation for 2008.
His views, of course, are not universally shared.Last week the People’s Daily published a report by CASS (you can read about it here) in which CASS economists argued that even with tight controls on prices CPI inflation this year would exceed 7%. They advised the government to stick to its tight monetary policy, although they did warn that more rapid RMB revaluation could cause of harm to the economy.
I think, as the CASS report indicates, policy-makers and analysts still misread the relationship between inflation and the value of the RMB, which is why the widespread comments that a rising RMB has been associated with even higher inflation is not relevant. It is not directly via an undervalued RMB that the currency regime is importing inflation, but rather because of the role of the currency regime in domestic monetary expansion.Inflation won’t end because a rising RMB makes imports cheaper. It will only end when the RMB has reached a level at which China is no longer flooded by money inflow.That is why China needs to revalue sharply, and that is why the current “rapid” appreciation strategy, which has only encouraged spectacular amounts of hot money inflow, won’t end inflation.Only a one-off maxi-revaluation will do that, although I am worried that we have waited so long that even this “least bad” policy is going to come at a heavy cost.
At any rate the point I wanted to bring out was that just as we have suddenly stopped hearing about the “two prevents”, we start getting senior officials saying that a little bit of inflation is perhaps not such a bad thing. Today’s South China Morning Post makes a very interesting observation, in the context (“Beijing planners walk tightrope on growth, inflation”):
An official source at a high-level conference last month said when it came to the priority task of the nation at the meeting, “Premier Wen Jiabao ranked inflation prevention the first, while party leader Hu Jintao put development at the top.”
I have never been an inflation hawk and I do agree that sometime a little bit of inflation is very far from being the end of the world, but as regular readers of my blog know, I think in the last few years China has been sitting on explosive and potentially very destabilizing money inflows, with the attendant money creation, and so I suspect that China does not really have “a little bit” of inflation as one of its policy options.I think that, like the US in the early 1970s, in China we’ve had our delightful monetary party with all the attendant good things, but the party is nearly over and it is going to be very hard to keep the lid on inflation over the next few months and years.I think by the end of this year it will get much worse.
That is why I highlighted Liu Yang’s complaint cited above that “Chinese stocks are trading at crisis valuations.”Perhaps it is not unreasonable for stocks to be trading at crisis valuations. On the one hand there is a potential economic slowdown that could depress earnings sharply. On the other hand, a policy shift to combat this potential slowdown risks an even greater undermining of national balance sheets which, when combined with the huge money creation and the increasing role of very pro-cyclical hot money in that money creation, could very well lead to a crisis.
Underlying conditions are becoming more and more complex, and the risks, as nearly everyone here seems privately to acknowledge, are becoming greater. Last week the government tried to address hot money inflow disguised as trade by increasing the regulation of export revenues, even though as I and many others have pointed out, the evidence is that most hot money comes in from other sources. This week there are suggestions that the authorities are planning to extend the strategy.This is from Bloomberg:
China is drafting regulations to control cross-border payments for services to curb rising inflows of “hot money” betting on gains in the yuan, according to an official at the nation's currency regulator.
Controls on international payments for consultancy or franchising fees are “relatively weak” and need to be strengthened to stop speculative capital inflows, said the official at the State Administration of Foreign Exchange, who declined to be named. The regulator is consulting with agencies including the commerce ministry on details before announcing the new rules, he said.
If this report true, the actions will simply increase costs for legitimate business without seriously hampering hot money inflows. Because of the enormous increases in inflows away from the FDI and trade surplus accounts, many of us assume that that most of China’s speculative inflows show up in the “unexplained” parts of the published balance of payments.
But if it is true that FDI and trade actually do conceal a very large amount of hot money, and so the new monitoring measures will matter, then all the seemingly high estimates of hot money by the likes of Stone & McCarthy’s Logan Wright will have seriously undercounted the real inflow.That is just a very long way of saying, I guess, that if these new trade and services monitoring measures are not a waste of time, then the problem is much worse than we imagined.
On a related but different subject, one of the things I’ve been trying to figure out is how hot money inflows are affecting the headline trade surplus numbers. If – as we all believe, and as the government seems also to believe, given Wednesday’s new regulations by SAFE in which export earnings are going to be closely monitored for evidence of over-invoicing – exporters are over-invoicing sales and importers are under-invoicing purchases in order to disguise capital inflows, then the real trade surplus, which consists of real exports minus real imports, is lower than the nominal trade surplus.
My student Shang Ning compiled for me China’s trade surplus for the first five months of 2007. These are the figures in billions of US dollars:
Date
Exports
Imports
Trade Surplus
2008-01
109.64
90.17
19.47
2008-02
87.37
78.81
8.56
2008-03
108.96
95.56
13.41
2008-04
118.77
102.10
16.68
2008-05
120.50
100.29
20.21
Year to date
545.24
466.93
78.32
On average if we assume that 1% of export proceeds are falsified, the real trade surplus is 7% lower than the nominal trade surplus.The corresponding number for imports is 6%.In other words if you assume that 1% of export revenues are really hot money disguised by over-invoicing exports, you should adjust the trade surplus downward by 7%.
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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, “The sale of new flats in Shanghai measured by floor area, plunged almost 50 per cent in the first half, and sources said the market was unlikely to turn around until September, traditionally the peak season for property sales.”
December, 2007