The stock market started out badly today, dropping 1.8% during the first two hours of the trading day, before a press conference by Hu Jintao, stressing the need for growth, brought back optimism over government-engineered policies to boost growth. From its low the market surged 2.8%, to close at 2802, up 0.9% for the day.According to an article in today’s Financial Times:
Answering questions solicited beforehand, Hu used carefully worded answers to flag hopes to tame inflation while keeping the engines of growth primed, and he held out the prospect of some political reforms in the wake of the Olympics.”We must see that currently there are uncertain and unstable factors in the international environment, and China’s domestic economy faces increasing challenges and hardships,” he said.
Hu singled out inflation as a big concern but balanced that with a call for continued growth.“We must maintain steady, relatively fast development and control excessive price rises as the priority tasks of macro adjustment,” he said.
None of this should have been a surprise. There have been rumors for weeks of a shift in orientation and last week’s Politburo meeting and PBoC announcement have pretty much confirmed that the authorities are far more nervous about slowing growth than about rising inflation.Of course lip service continues to be paid to fighting inflation largely, I suspect, because many seem to believe that inflation is more likely to be a consequence of rising inflationary expectations than of rising money supply.
As part of this effort to boost growth – and clearly as a sop to angry Southern exporters – export rebates were reduced effective August 1, according to an article in China Daily. My student Cui Enze, who is currently in an internship in New York, reports in an email today:
On July 30, State Administration of Taxation published a new policy that reduced textile industry export rebates ratio from 13% to 11%. Obviously this policy is in response to ease the strong complaint from exporters and aimed to stop the slowdown of textile exports. A government official in NDRC attributed the difficulty of textile exporters to four reasons, RMB appreciation, external demand slowdown, labor and material cost rise and domestic macroeconomic policy including export rebates, among which RMB appreciation is the most important.
There are also strong rumors – and of course not at all unexpected – that the strict new lending caps announced late last year are going to be further softened.According to an article in the South China Morning Post, “China’s central bank has raised banks’ lending quotas by 5 per cent, banking sources said on Friday, the most substantial move yet by Brijing to prop up the economy in the face of slowing demand for the country’s exports.”Because this move hasn’t been put in writing – it was apprently announced during meetings on Thursday, according to unnamed sources – it is not totally clear what this actually means in terms of loan volume, but it is clear that loan caps are being relaxed.
It is worth pointing out that the recent surge in bank deposits means that loan caps have been a far more serious constraint on lending than have the several increases in minimum reserve ratios.This relaxation comes just in time.An article in the current National Business Daily warns that, given current rates of loan growth, the existing lending caps mean that by November Chinese banks will have to stop all new lending.
More interesting to me was the announcement yesterday in the China Securities Times of the creation of a new department within the PBoC whose mandate, it seems, is to coordinate and manage foreign exchange policies. Cui Enze also compiled information about this in his email to me. He continues:
A new department launched within the PBoC – the Exchange Rate Department – has just been approved by the State Council. This new department will combine part of the PBoC's monetary policy department, financial market department and also parts of the functions of SAFE, and it will be an individual department dealing with exchange rate policy research and formulation.
This suggests that the government wants to pay more attention and place a more important status on the exchange rate. It will help also help smooth the process of exchange rate reform. Moreover, it is very interesting to note that under the current difficult conditions that this Exchange Rate Department has been set up. I think it is a preparation for more aggressive RMB reform. So far, no time schedule has been set.
A very interesting report on ChinaStakes.com gives us additional color:
The PBoC has twelve departments and six bureaus. The exchange rate office currently operates under the Monetary Policy Department. Now the PBoC seeks to strip the exchange rate office from the Monetary Policy Department and make it an independent department.
A researcher，under anonymity, at the Chinese Academy of Social Sciences told Chinastakes.com that by making the exchange rate office an independent department, the PBoC may reinforce the influence of exchange rate policy in macroeconomic control in future. The Monetary Policy Department is the most important department at the PBoC. The director of this department will usually be promoted to a higher position in the PBoC.
It has been three years since the launch of exchange rate reforms in July 2005. The establishment of the Exchange Rate Bureau indicates the increasingly important or even key role of exchange rate policy in China’s current monetary policy system.
It may also mean that the Monetary Policy Department is unable to formulate internal and external monetary policies at the same time, and it may be better to transfer the responsibility of making exchange rate policy to the Exchange Rate Bureau, so the Monetary Policy Department can focus on domestic policies such as interest rates, and credit.
Victor Shih has an early and thorough analysis on his RGE blog entry of what this may mean, and some of the potential problems that may arise.To me it is interesting that they are trying to coordinate exchange rate policy within the larger context of capital flows in China and abroad and local financial markets.China’s monetary policy is, for the most part, simply an extension of its currency regime and it does make sense to place the exchange rate at the center of a whole set of policies.
I am not sure, however, about separating monetary policy from the exchange rate policy, but perhaps this is in preparation for a future in which the PBoC will actually be able to determine domestic monetary policy (after the currency floats?). Whether Enze is right – that this is preparation for more aggressive RMB reform – will take time to decide, but my guess is that whether or not that is the intention, when the exchange rate moves back squarely back into the center of the policy debate, as I expect it to do by the end of this year, this department may play an increasingly important role in Chinese policy formulation.
The stock markets had a bad day, with the SSE Composite dropping 2.1% to close at 2741.7. Part of the reason for the decline was concern that a roughly $1 billion upcoming share sale by China South Locomotive and Rolling Stock Corp. will draw a lot of liquidity from the market (stock sales tend to be vastly oversubscribed, with investors required to put up 100% of the bid amount in cash in their stock accounts), but the decline was hastened late in the day when reports came in of a terrible attack on a police station in Xinjiang province that left 16 policemen dead.
Here in Beijing security has become so intrusive (although sometimes it is hard to see how some of the “security” measures can have any impact on actual security) that even my Chinese friends are complaining that they feel like outsiders in their own neighborhoods, and I suspect that the Xinjiang attack will only make things worse.Still, traffic is certainly better, and except for today the past few days have seen an improvement in the air quality. The town is slowly starting to fill up with tourists, and areas like Houhai (the lakes north of the Forbidden City) have a real lively atmosphere. If we aren’t completely prohibited from drinking, dancing and arguing about sports this may turn out to be a fun couple of weeks.
But the rest of China continues without the distraction of living in an Olympic city. Yesterday’s Bloomberg had an interesting article in which they quote the Wen Wei Po newspaper as saying that, according to “lenders and market watchers it didn't identify”, the total amount of underground lending in China exceeds RMB 10 trillion.I don’t know how accurate this number is, but I think total loans in the system are RMB 29-30 trillion, so this suggests that loans in the informal banking sector are roughly equal to 33% of loans in the formal banking sector.A UIBE professor last year suggested that they were equal to around 25%, so assuming they are not simply quoting each other, the numbers are consistent.
Finally, and in contrast to the panicked reports of a sharp slowdown in China leading to a surge in unemployment, an article in People’s Daily reports that, at least officially anyway, Chinese unemployment is down:“China's registered urban and township unemployment rate stood at four percent in the first half, down 0.2 percentage point from the same period last year, the Ministry of Human Resources and Social Security (MHRSS) said on Thursday.”I don’t think anyone really believes that these numbers represent the actual urban jobless rate (I hear estimates that are two times or more as high), but the trend in the official unemployment number suggests that for all the talk of bankruptcies among southern exporters, it is not necessarily leading to rising unemployment.Actually I have long argued that it is higher demand for workers that is the real culprit behind the declining fortunes of some of China’s exporters.
Falling oil prices in the international markets haven’t helped local stock markets as much as they had in the recent past.Oil fell earlier today to below $120 a barrel for the first time in three months, but the SSE Composite nonetheless dropped 51 points, or 1.9%, to close at 2690.As in the recent past, the decline was led by property developers and brokers, which is particularly striking since we received confirmation today of last week’s rumor that the PBoC would relax the lending caps by 5% for national commercial banks and by 10% for local commercial banks (who are presumed to be more likely to lend to the struggling SME sector).This means they can lend up to 105% or 110% of their lending caps, which should be good news for funding-pressed property developers.
For me however the most interesting news today was a report by Bloomberg on the possible acquisition of Germany’s Dresdner Bank by China Development Bank, the largest of the Chinese policy banks.According to the article:
China Development Bank is competing with Commerzbank AG to buy Allianz SE's Dresdner Bank, Germany's third-largest lender by assets, three people familiar with the matter said.
China Development Bank, which funds the nation's public works projects, has conducted due diligence on Dresdner Bank in Frankfurt, said the people, who declined to be identified because they aren't permitted to publicly discuss the matter. The 23.3 billion euros ($36.6 billion) Allianz paid for Dresdner Bank in 2001 is more than six times the biggest overseas acquisition by a Chinese company.
It is probably unlikely that CDB actually makes the purchase.Aside from the fact that the CDB, and Chinese institutions in general, have lost a lot of money so far in their acquisitions of foreign financial institutions (Bloomberg reports that their $19 billion of investments are now worth only $12 billion, including a $1.7 billion loss on CDB’s $3 billion purchase of a stake in Barclays), European governments have been very reluctant in the past to permit the acquisition of major domestic banks by foreign banks, even when the foreign bank is European.
The fact that CDB is owned by a non-European government, and a government of a country that is largely, and increasingly, distrusted by Europeans, makes this a pretty tough transaction to approve politically. Still, the fact the CDB is even doing due diligence on the deal must provide a frisson of thrill to investment bankers everywhere – it certainly indicates the global ambition of Chinese banks.
If the deal were to happen it would be a very interesting transaction, not least, in my opinion, because of its impact on the valuation of CDB.In the January/February issue of the Far Eastern Economic Review, I published a piece (“Buying Into China’s Volatility”) that uses an option framework for understanding the high valuations placed on Chinese banks by the international markets.I argued that the very high valuations reflect not investor perceptions that the banks are in good shape but rather the desire of investors to bet on the expected volatility of the Chinese economy.
In that discussion, which was extended in four consecutive October entries on my blog, I pointed out that insolvent financial institutions are usually the most effective vehicles for optional plays on an economy that is changing rapidly.This fact explains the very high market valuations placed on troubled banks, not just in China but in a whole host of other developing countries experiencing major economic reforms (my own experience came from advising the Mexican government on the privatization of its largely insolvent banking system in 1990-92).Insolvent or barely solvent bank share prices are not “encumbered” by intrinsic value (the excess of asset values over liabilities) and consist purely of time value, which is highly sensitive to changes in expected volatility.
The option framework makes two useful predictions.First, and most obviously, since bank share prices are not anchored in intrinsic value, like they must be for highly solvent companies, their share prices will be extremely volatile.This is because they will largely reflect changes in time value, whose value is set almost wholly by changes in expected volatility (and intrinsic value is usually far less volatile than time value).
The second prediction, which emerges from the first, is that if a Chinese bank were to make a large acquisition of a foreign bank its stock price would drop dramatically.This is because a large acquisition abroad would significantly reduce the expected volatility (diversifying assets and earning streams always reduces expected volatility).
Since CDB does not have outstanding stock (it is preparing for an IPO), we will not be able to see the direct impact of a Dresdner acquisition on its share price if the acquisition does go through, but I would predict that when CDB stock is finally made available in the market, after its IPO, it will trade at a much lower multiple if the acquisition has been completed.Investors will explain that lower multiple by complaining that unlike with the other large Chinese banks, with CDB they are not getting what they want – a pure play on the growth of the Chinese economy.
Note that I am not simply predicting an averaging out of valuations.If a Chinese bank valued at three times book acquired an equally large foreign bank valued at two times book, it would not be a surprise if the new bank traded at less than three times book – say 2.5 times book.What I am actually predicting is that the new entity will trade at a far lower valuation than the average of the two because of the impact of diversification on the very high time value implicit in the Chinese bank’s share price.Intrinsic value for the two entities will actually rise (diversification usually increases intrinsic value because of its positive impact on financial distress costs), but time value will decline (diversification always harms time value).Since Chinese bank share prices consist mostly of time value, the loss in time value will be much greater than the gain in intrinsic value, and the net impact will be a big loss for shareholders.
That doesn’t mean, however, that the CDB’s biggest shareholder, the government, will object.Aside from the political considerations, the government has a very complicated economic relationship with its banks.It is effectively the guarantor of the banks (or, in option terms, it is short a put option on the underlying assets), so that as guarantor it benefits both from the increase in intrinsic value and the reduction in time value brought about by diversification.Reducing banking volatility is always a net benefit for the government – it is only the outside shareholders who will suffer.
For a couple of weeks now there have been rumors and reports about new foreign exchange regulations being put into place, partly to limit hot money inflows and partly, once these begin to reverse, to make it more difficult for money to leave. Yesterday SAFE announced a new set of measures.Today’s South China Morning Post says the following about the announcement:
China has issued new controls on transfers of foreign currencies, moving to contain growth in its foreign exchange reserves and curb speculative inflows blamed on fuelling inflation. The new rules, issued late Wednesday with immediate effect, call for penalties of up to 30 per cent of the capital involved in any unauthorised inward or outward foreign currency transfers.
“As China’s economy becomes more internationalized and the movement of international capital flows accelerates, there is a need to improve the system and oversight of multinational capital movements,” the State Administration of Foreign Exchange, or SAFE, said in a statement posted on its website.
The new regulations appear broader in scope than new limits announced by SAFE last month that called for authorities to check invoices to ensure they are not being inflated as an excuse to bring unauthorised money into the country. The new rules order government departments to simplify regulations on foreign direct investment and authorises them to crack down on illegal transactions.
Last Friday the State Council said it was revising the rules concerning capital inflows and outflows, and this was generally interpreted as revising the regulations so as to allow the authorities to impose emergency restrictions on a sudden outpouring of money leaving the country.It is clearly important for SAFE to have some handle on inflows and outflows, but I am worried that most policy-makers continue to believe that rapid outflows leading to a 1997-style crisis is the only, or main, risk Cgina faces in relation to the current hot money inflow.In fact in my opinion the main risk is that these inflows have created unsustainable and vulnerable structures within the domestic banking system, in which case the risk of massive outflows is only part of the problem.
The real problem is excess lending leading to misallocated capital, overinvestment, and what Hyman Minsky termed “Ponzi” debt structures, which are clearly already happening, if the evidence of SMEs borrowing at rates of 80% or more suggests anything. The problem is that under these conditons we could easily see a sudden rise in inventories, non-performing loans, capital hoarding, and faulty debt structures among corporations – mainly small and medium enterprises, I would guess.Unfortunately, in my opinion, the only adjustments that will prevent the system from getting worse – specifically a revaluation of the RMB to the point where inflows subside or even slightly reverse – have been put off for so long that it is becoming increasingly hard to see how the authorities will manage an adjustment without triggering problems in the banking sector.
At any rate I know that it is getting increasingly difficult to bring in money for my business here in Beijing.I have a small, independent CD label specializing in developing the Beijing new and experimental music scenes.It is officially registered as a cultural institution (all media companies require that or a similar registration), and we regularly bring in money to pay for operations and production costs, but we have to work harder than ever to bring money in. Unfortunately the capital regulations do not easily distinguish between investors bringing in money to fund real activities in China and investors bringing in money to bet on RMB appreciation.I recognize the desperate need of the PBoC to regain some semblance of control over the money supply, but there are economic costs to doing so, especially onerous for small companies like mine.
Meanwhile both HSBC and RBS, according to Bloomberg, have issued reports arguing that RMB forward contracts (NDFs) are priced low enough to offer “clear value”.The recent slowdown in RMB appreciation has convinced many investors to lower their 6-month and 1-year expectations for RMB appreciation, but – and I agree with HSBC and RBS if this is their argument – the reduced pace of appreciation is not sustainable and soon enough, probably before the end of the year, the debate about what to do with the RMB will re-ignite.This will lead to faster appreciation one way or the other.
But for now policy-makers clearly think enough is enough on the appreciation front. Tuesday’s People’s Daily had a very revealing interview with Liu He, vice-minister of the Office of the Central Leading Group of Financial and Economic Affairs, which was carried in a lot of other local papers.Mr. Liu clearly seems to believe (or is repeating the government’s position) that China needs to loosen up further on the monetary and credit front.
He says, in response to a question about Hu Jintao’s recent statement about the need to “keep policy stable” that “There is no need to further tighten the marco-control measures. Given the economic environment, the current measures are already appropriate.” In Beijing, it seems to me, the phrase “current measures are already appropriate” is usually code for policy recommendations to relax credit limits and slow RMB appreciation.In case the message was ambiguous, he added “At the moment, we should not rush more tightening measures.”
He also repeated the by-now well-worn phrase: “We shouldn't sacrifice development to curb inflation.” This is certainly not something anyone would argue against, of course, further and balanced economic development is the key issue for China, but the implicit dichotomy is a false one.The fight against inflation is necessary precisely to ensure continued economic development.It is not an alternative to development.
The most worrying part of the interview was, in my opinion, the following:
Q: Do you think it's possible to curb excessive inflation by the end of the year?
A: First of all, we should identify the main reason of the inflation. It's largely due to the depreciation of the US dollar, which triggers price rises of primary goods. For us, the key to deal with inflation is to stabilize our policy, ensure supply, subsidize the poor and adjust prices.
We should also tame the public's inflation expectations. We should not be afraid of price rises as the adjustment of some underpriced products is unavoidable. But it's possible for inflation to moderate in the second half as oil price is falling and domestic agricultural supply is recovering. Inflation may well ease by the end of the year.
Given that Chinese inflation has occurred mostly in domestic food prices, little of which is imported, and that many commodity prices, including oil, are price controlled, so that there is little to no pass-through in local costs, it is something of a shock to me that anyone believes that Chinese inflation is caused by a weakening dollar (and even more of a shock that this claim is used to buttress the argument against further appreciation of the RMB).
It is also worrying to me that in the policy response to fighting inflation, taming inflationary expectations is considered a major concern, whereas nothing is said about the role of capital inflows in expanding the domestic money base.I remember in my teenage years in the 1970s there was a belief in the US that then-rising inflation was largely an oil price and expectation problem, and so various administrations jawboned, imposed price controls, wore “Whip Inflation Now” buttons, and did everything else except adjust monetary policy to kill off inflation. It didn’t work.I am not going to pretend that in those years I was more interested in Nixon’s monetary policy than in the rumored upcoming Spanish tour by the Rolling Stones (I was living in Spain then – and unfortunately a sudden burst of ETA terrorism killed plans for the Rolling Stones tour), but I do remember how ineffective those measures turned out to be. I guess I don’t really believe in “inflationary expectations” as a major cause of inflation.
At the end of the interview, Mr. Liu did point out to an important issue that needs to be addressed:“In the second half, we need to push forward reforms in the financial sector. Presently, SMEs are usually the first victims of credit tightening measures. This reflects the rigidity of China's financial system. Moreover, we need to push forward reforms of the pricing mechanism for energy and resources products.”I think he is certainly right to be concerned about the unequal access to capital for SMEs, although I worry that he is pointing that out mainly to support an argument for credit loosening.
It has been an eventful week in the run-up to the Olympics. Beijing is spruced up, traffic has improved dramatically, the weather is not too bad, most people are in a festive mood (although not artists and musicians – small clubs and CD shops specializing in Beijing art and music are being closed, presumably because the authorities believe foreign visitors will be more impressed with clean,well-scrubbed middle-brow entertainment than with the messy and chaotic cultural vitality Beijing typically exhibits). Even the stock market has been tame and well-mannered, if a little grumpy. It market was slightly up today (0.3%), following a relatively good day yesterday (up 1.1%), although overall for the week to date it is down 2.6%
The Olympic opening ceremony Friday was truly a spectacular event and left a lot of people here, at least among my students, with a sense of nearly euphoric pride. I watched the ceremony on television at D22, my music club near Peking University, and during the ceremony I received dozens of phone messages from current and former students – most of whom were at home in various locations around the country – expressing their excitement and happiness about the magnificent display their country was putting on, and I suspect several of them were near tears.I know a lot of people around the world were disturbed by what they thought was an ugly nationalism associated with the event, but I have to say that among my students and friends, the feeling was a very inclusive joy and pride, and it was infectious.All of us, Chinese and foreign, were in a great mood that night.
We are still marveling at the technological and theatrical prowess displayed, and in D22 – and in many other bar and restaurants, no doubt – the first hour of the ceremony was regularly interrupted by cheering and whooping, although the nearly interminable subsequent march of 204 national teams dampened the mood somewhat (and is, in my opinion, one of the strongest arguments against the granting of independence to too many small countries). The weather is not very good (in fact as I write this it is pouring rain outside) but Beijing is nonetheless in a festive mood.
The stock market, however, has decided to buck the festive trend. On Friday, in spite of the tremendous anticipation is the air, the market had a sloppy day until, mostly in the last hour, sloppiness turned into what seemed like panic selling that saw the SSE Composite drop 121 points, to close at 2606, or down 4.5% for the day.
Some analysts blame renewed worries about security and terrorist attacks (and I see in the press that over the weekend there were more terrorist attacks in Xinjiang province, with at least five dead), while others claim that investors were anticipating the announcement of additional government measures to shore up the market during the Olympics, and when no announcement was made, they panicked.
It will be interesting to see what happens on Monday and during the rest of next week. We may see some government-inspired buying, or even patriotic Olympic-related buying, or more measures from the authorities aimed at propping up the markets, but if none of those, I think the very bad mood could be extended. As I’ve said before in this blog, I think expectations about the transformational consequences of the Olympics are unrealistically high, and I think there is bound to be some disappointment.
In that context I have previously mentioned on this blog the parallels with the 1873 crisis that began in Vienna.Here is how I describe it in my book The Volatility Machine (Oxford University Press, 2001):
By the beginning of 1873 there was a general sense that the Viennese market was overvalued and unsustainable, but investors were looking forward to the World Exhibition to be opened in Vienna on May 1.They were irrationally hoping that the Exhibition would change the underlying situation and somehow justify the high asset prices.During April of that year, in response to a period of weak and declining stock prices, the local banking authorities became concerned about the position of banks and made a series of attempts to support the market.As a precaution, however, nervous banks were contracting credit and attempting to raise liquidity by calling in loans.When the Exhibition opened on May 1 and, not surprisingly, nothing really changed, investors lost heart and began selling.
The selling pressure in the market built steadily.On May 5 and 6, the market began falling and on May 8 it suddenly crashed. With the crash a full-blown panic began in Vienna that was almost immediately felt throughout the country as banks and investors rushed to dump assets.
I am not implying, of course, that events in China are going to resemble those of Austria in 1873, but 1873’s World Exhibition in Vienna drew some of the same fevered expectations as the 2008 Beijing Olympics have, and it is worth noting the impact of excessively high non-economic-related expectations on the markets.So much hope has been invested in the success of what is, after all, just a sporting event, that it will be hard for any result, no matter how positive for China, to live up to expectations.After the Olympics little will have changed.
Still, even during the Olympics work must go on. We should soon be getting a new set of economic numbers for the month of July.I hear that year-on-year CPI is expected to decline from 7.1% in June to around 6.5% or even lower in July, well below its April high of 8.5%.Partly this reflects a high base effect, partly price controls, and partly continued food price declines from the very high levels of February and March.What will be most closely watched is the non-food component of CPI.
In contrast year-on-year PPI, which hit a high of 8.8% in June (from 8.2% in May), is expected to stay high.I think this may be the worst combination of numbers. Declining CPI will convince many policy-makers, particularly those in the pro-growth camp, that inflation is no longer a problem and excessive monetary growth nothing to worry about.High and rising PPI, however, indicates that inflation has already spread out of the food sector and will increase inflationary pressures by the end of the year.
Yesterday I suggested that July’s PPI inflation might be a little higher than June’s already-high 8.8%. Most other analysts seemed to agree with me, with the median estimate according to Bloomberg at 9.0%.
The actual number, which was released today by the National Bureau of Statistics, was a bit of a shocker.PPI inflation in July rose to 10.0%.Raw material, fuel and power were the biggest reasons for the jump in prices which, according to an article in the South China Morning Post, is the highest year-on-year PPI number since 1995’s 14.9%.Much of the increase can be blamed on rising global commodity prices, which seem to have turned around a little recently, but with continued high prices internationally and shortages domestically, there is a risk that producers will eventually be forced to pass higher prices onto consumers.
CPI inflation numbers are expected to come out tomorrow and I think most of us still think they will be substantially lower than last month’s 7.1%.My expectation has been that we would see moderate CPI inflation for the next couple of months before it picked up again towards the end of the year. The moderation would give further ammunition to those policy-makers more worried about slowing economic growth then about the consequences of unabated money expansion, and I assumed that their current dominance in the policy-making debate would only be strengthened, until inflation reared again late in the year, causing the balance of power to shift once again to the monetary alarmists.
But this PPI number may make up for a declining CPI in its effect on the policy debate.It is very clearly a warning signal that inflation has not disappeared, although falling commodity prices world-wide may relieve some of the PPI pressure in the coming months. As an aside, I have heard several times recently that a very senior policy-maker who has lost a lot o credibility in the last year, a leader of the monetary camp, was going to lose his post in a post-Olympics shuffle (I don’t want to mention who he is because it could get me into trouble, but I suspect a lot of readers know who I mean).
China’s trade surplus for July, also released today, came in a lot higher than expected.Here is Xinhua’s report:
China's trade surplus fell to 123.72 billion U.S. dollars in the first seven months, down 13.1 billion U.S. dollars, or 9.6 percent year on year, the General Administration of Customs said on Monday. Analysts said the fall was partly a result of China's policies to tame surplus, but was also in part due to the rising prices in energy and resources China imported.
The Jan.-July exports had increased 22.6 percent year-on-year to 802.91 billion U.S. dollars, however, imports rose 31.1 percent to 679.2 billion U.S. dollars. The total trade volume in the first seven months stood at 1.4821 trillion U.S. dollars, a year-on-year rise of 26.4 percent.
July's trade volume rose 29.8 percent to 248.07 billion U.S. dollars with exports totaling 136.68 U.S. dollars, up 26.9 percent. Imports were up 33.7 percent to 111.4 billion U.S. dollars. The July trade surplus stood at 25.28 billion U.S. dollars.
The trade surplus for July of $25.3 billion, versus $24.4 billion last July, was much higher than the $20.3 billion median estimate (also much higher than June’s $21.3 billion).On Friday a Bloomberg article titled “China Trade Surplus Likely to Narrow for Fourth Month” had the 17 economists it surveyed predict that exports in July would climb “only” 16.8% year on year. In fact the National Bureau of Statistics release recorded a 26.9% year-on-year increase in exports, a big increase over June’s 17.6% gain.
These kinds of numbers would seem to strengthen the skepticism that analysts like CFE’s Brad Setser have expressed over the story of China’s collapsing export sector.Given the slowdown in the world economy I would have thought that a 16.8% jump in exports, if the pessimistic expectations of most analysts had turned out to be true, would have nonetheless been pretty impressive, In fact I think the woes of a small but powerful segment of the export industry – low-value-added processors in the south of China, who have been hit primarily by rising wages and a welcome shift in the southern economies towards higher-value-added goods and services – have created a false impression about dire conditions for China’s exporters.For such a large exporter to see its exports grow so rapidly, and during a global slump, does not suggest to me an export industry in its death throes.
The good trade numbers and the bad PPI numbers (which will hurt corporate profitability), combined with more worries about political instability in Xinjiang province, had a terrible effect on the country’s stock markets. Declining international fuel prices and a strong market in Hong Kong were not able to alter the gloomy mood on the mainland. After dropping 4.5% Friday – mostly at the end of the day on panic selling – the market opened down today, bounced around during the morning session, and then all but collapsed during the afternoon.The SSE Composite lost 136 points to close at 2469, 5.2% down for the day.That’s nearly 10% in two days, and it would have been worse if some companies today had not hit their 10% limit and stopped trading.
When almost exactly one month ago the SSE Composite finally broke 3000, the level below which it was believed the government wouldn’t allow the market to fall, it lost ground pretty swiftly (down 17.7% in the next month).Rumors quickly emerged that the new minimum level at which the government would support the market was 2300. I have already written several times about how damaging these perceptions of a minimum government-intervention level can be, but I would guess that Friday’s and Monday’s drops have already set alarm bells ringing in the offices of financial policy-makers. If investors don’t see anything being done to stop the slide, after a short rebound tomorrow we could easily see the market test 2300 before the end of the Olympics.
CPI inflation numbers were released today by the National Bureau of Statistics.As expected, they showed a continued decline in the year-on-year CPI inflation, although at 6.3% the figure was better than market expectations of 6.5%.Given the trajectory of food prices so far this month CPI inflation for August could fall below 6%.On average prices in July rose 0.1% month on month.
This is great news, but it is not unambiguously good. The non-food component of CPI rose from 1.9% year on year in June to 2.1% in July, so although it is low, it is rising – not a good sign, in my opinion.We are also hearing more and power about power shortages and rationing outside the Olympic-blessed city of Beijing. World fuel prices may be declining, but they are still substantially higher than they are in China, thanks to price freezes. This can’t help but put continued upward pressure on the cost of energy.
So now we’re caught in the bind that I discussed yesterday.Declining CPI inflation will encourage those policy-makers who are mostly worried about slowing growth to insist that China back away from the various monetary and credit tightening measures it had tried to impose over the past nine months.High and rising PPI inflation will strengthen the concerns of those who think China’s main risk is from excessive monetary expansion.
Nothing has really changed to shift the argument decisively in one direction or the other, and I suspect we will continue to see tentative policy moves in both directions.The most amount of effort – or at least visible effort – seems to be that expended on tightening capital controls, but it is hard to know what this portends. If the capital controls are very successful – and I am doubtful they will be – it might create breathing space and give the authorities reason to speed up RMB appreciation again, with the controls preventing an accompanying surge in speculative inflows.If not, it puts greater pressure on them to regain control of monetary policy via a one-off maxi-revaluation. Either way I still think China cannot resolve its current imbalances without a significant currency adjustment.
As for the stock market, at first it seemed pretty unambiguously in favor of the CPI data which, among other things, suggested that the authorities are more likely to be inclined to relax the “tightening” measures.After a very bad opening that left the SSE Composite down by a little more than 1.5%,the mid-morning release of CPI data turned the market around sharply, so that by lunch it had regained all it had lost, plus an extra 0.2%.
But the happiness didn’t last. Perhaps there were rising worries that the huge gap between PPI and CPI inflations would hurt corporate profits, or perhaps investors are just to depressed to enjoy a rally (worrying, among other things, about unrest in Xinjiang province, where the death toll over the last week is up to 31), but immediately after lunch after a quick 7-point jump in the first five minutes the market suddenly lost its legs and began sliding.It bounced around all afternoon, with the SSE Composite ending the day at 2457, just over half a percent below Monday’s close.
I think it is going to take a major effort to get this market to regain confidence, but even with a major government intervention I think there may be more bad news on the earnings front. Today’s Emerging Markets Economics Daily (produced by the research guys at Credit Suisse) has this to say about car sales:
Total vehicle sales growth in China moderated sharply in July to 4% yoy.According to the China Association of Automobile Manufacturers, sales of commercial vehicles contracted 3% yoy in July (to 177,600 units), the first contraction since January 2006. Passenger vehicles sales managed to maintain 7% yoy growth (to 488,200 units), but this was the first single digit growth since August 2006.The data reflect weakened domestic demand in China.
Credit Suisse goes on the say that their equity analyst, Michele Mak, believes commercial vehicle sales will slow even more dramatically over the rest of they year.
Three weeks ago on my blog I cited a Bloomberg article that said that “China's stockpile of unsold new vehicles rose about 50 percent in the six months ended June, hitting a four-year high, as automakers expanded production and sales growth slowed.”In the article some commentators brushed off the rise in inventory saying that they were expecting a surge in car buying later in the year.If it doesn’t happen, I suppose we will necessarily see rapidly rising car inventories.Rising inventories is one of the main warning signals we have to watch for as evidence that the over-investment cycle is finally about to end.
The stock market had another marginally weak day, losing 0.3%, after dropping 0.4% yesterday, to close at 2438. There was no obvious reason for the decline and little volume in the market.On the one hand the statistical bureau released figures showing that industrial production rose by 14.7% year on year in July, below June’s 16.0%, which also happened to be the median estimate by most economists. This suggests the possibility of a future export-related slowdown, but is as likely to have been caused by Olympic-related pollution-measures, like closing of factories in the Beijing area.
On the other hand yesterday the statistics bureau released figures showing that retail sales grew at the fastest pace in nearly a decade. According to an article in yesterday’s Bloomberg:
China's retail sales expanded at the fastest pace in at least nine years in July as incomes and prices climbed in the world's fastest-growing major economy. Sales rose 23.3 percent to 862.9 billion yuan ($126 billion) after gaining 23 percent in June, the statistics bureau said today. That was more than the 22.4 percent median estimate of 19 economists surveyed by Bloomberg News.
This is good news because China very clearly needs to rebalance its economy away from its over-reliance on exports and investment, although it is unclear how much of this growth may be caused by Olympics fever.I entered the apartment building yesterday of one my friends, and on the ground floor under the stairs there were two sets of boxes that had obviously been part of the packaging of two very large television/entertainment units. My friend laughed when he saw the boxes and said that obviously his neighbors had bought new TV sets to watch the Olympics, and he told me that his parents had recently done the same. I guess this is happening quite a lot, and may affect the consumption numbers – at any rate TCL, China’s biggest consumer electronics company, said on Tuesday that it sold nearly 5.4 times as many liquid-crystal display TV sets in July than it sold in July 2007.
On that note I have been asked several times recently if I think there will be a post-Olympic slowdown – for example today two friends of mine who work in one of the government think tanks wanted to discuss this over coffee.They seemed concerned about the possibility.
I am not smart enough to say. Given the feverish excitement about the Olympics, the rise in Olympic-related consumer-goods sales, and the number of people who have traveled to Beijing either to watch the games or to act as volunteers, I would imagine that there has been a temporary spike in spending that will be reversed in the next few months – or will at least act as a drag on future spending.
I don’t know how serious this reduction in spending will be, however.I think that at least part of the answer is psychological. China has been on a massive high recently, and I expect it to continue (China is doing very well in the Olympics and is clearly in the lead in capturing gold medals). After the Olympic Games are over and the rush of excitement gone, it will be interesting to see what the mood of the country is. In the major cities, I suppose, at least part of the answer may depend on real estate and stock market prices.
Today is an anniversary of sorts. Thirty-seven years ago, in 1971, President Nixon stunned the US by announcing the imposition of extensive wage and price controls in an effort to reverse rising inflation in the US.In retrospect it is pretty clear that the price and wage controls were unlikely to reverse several years of booming money creation, and even the WIN buttons (“Whip Inflation Now”) distributed by President Ford a few years later weren’t enough to do the trick
The EconReview gives a short, potted history of the time:
In a move widely applauded by the public and a fair number of (but by no means all) economists, President Nixon imposed wage and price controls. The 90 day freeze was unprecedented in peacetime, but such drastic measures were thought necessary. Inflation had been raging, exceeding 6% briefly in 1970 and persisting above 4% in 1971. By the prevailing historical standards, such inflation rates were thought to be completely intolerable.The 90 day freeze turned into nearly 1,000 days of measures known as Phases One, Two, Three, and Four. The initial attempt to dampen inflation by calming inflationary expectations was a monumental failure.
…The wage and price controls were mostly dismantled by April, 1974. By that time, the U.S. inflation rate had reached double digits. While there were skeptics in August, 1971, there were a great many who thought "temporary" wage and price controls could cure inflation. By 1974, this notion was thoroughly discredited, and attention gradually turned toward a monetary approach to inflation. In a complete reversal, the policy to curb inflation in now thought to be an increase in interest rates rather than an attempt to hold them down.
A quick look at inflation rates in the US show that inflation had reached a temporary peak of 6.19% in 1971 Q1, and had been declining when Nixon imposed the controls in the middle of Q3 (5.46% and 4.26% over Q2 and Q3).It continued to decline thereafter for several more months, reaching a low of 2.18% in 1972 Q2, before reversing course and marching upwards over the next two years to hit a second temporary peak of 12.38% during the third quarter of 1974.
After another period of improvement over the next two years (inflation declined to 4.21% by the second quarter of 1976), prices began another surge, which took inflation up over four years to a high of 10.36% in the fourth quarter of 1980 (it actually peaked in March at nearly 15%), after which time the very sharp and brutal economic contraction engineered by Paul Volcker of the Fed brought inflation back down again.
One has to be careful about drawing lessons.What happened to the US in the 1970s tells us nothing about what must happen to China today, but it is worth remembering a couple of important points. First, following a period of rapid monetary growth, which at first was able to deliver rapid economic and productivity growth, booming stock, real estate and art markets, and low inflation, the consequences of excess money creation only later led inexorably to higher prices. Although a number of economists proposed higher interest rates and tighter money to combat the rising prices, the first instinct of Nixon’s economic advisors was to protect economic growth by using administrative measures to rein in inflation.This didn’t work.
The second important point is that the process of rising inflation is rarely a straight line. The US saw several fairly long-term reversals of the upward inflation path, but these reversals were temporary as long as the root cause of inflation – excessive growth in money – was not addressed.In the end, however, the overall trend was upward and the cost of reversing it was significant – and it probably lost the election for Jimmy Carter.
One of the things we are wrestling with here in China is the extent to which the US experience is relevant. In many ways it is not.For example, today the National Bureau of Statistics released a report that had total investment in fixed assets for the first seven months of 2008 at RMB 7.2 trillion.This represents 27.3% increase over the same period last year.For the six months before July, FAI grew by 26.8%, and most analysts were expecting July’s number to be a little below that.FAI is clearly very high.
I have been discussing the implication of these recent figures, including PPI and CPI inflation numbers, with several of my friends. One of the questions that is always raised is about the transmission mechanism from high PPI inflation to rising CPI inflation. On the face of it the surge in FAI suggests a future surge in industrial production that, especially given faltering global demand, is likely to create an oversupply of manufactured goods in China, which should make it more difficult for producers to pass rising costs onto consumers. In that sense, it seems that the reduction in CPI inflation may be sustainable, even with last months’ unexpected jump in PPI inflation.
But I have to confess that I have a problem – perhaps instinctual – with this line of reasoning. It is true that an excess of manufactured goods should put downward pressure on prices of those goods – or at least limit the ability of producers to raise prices – but is this enough to eliminate inflation?
The way I see it, excess money growth creates excess demand for goods and services at current prices.This excess demand isn’t necessarily uniform, but it exists, and it should result in rising prices on average.During the past year in China, the excess demand coincided (perhaps) with problems in the food supply, so that food prices soared.There was a lot of talk a few months ago about food hoarding, and this talk has all but disappeared, so it may very well be that rising food prices were at first exacerbated by speculative hoarding, but at some point this behavior in turn put downward pressure on food prices as speculators sell off stocks (I am only guessing that this might have happened but have no real proof).
At any rate rising food prices absorbed all or most of the excess demand, so that there was little upward price pressure on the non-food sector. In fact, there should have been significant downward price pressure on the non-food sector given the huge run-up in food prices, but we actually saw non-food inflation low but rising. This, by the way, is why I believed and still believe that inflation in China was caused by monetary conditions, and not by a food-supply problem.
What happens if rising FAI and surging industrial production now put downward pressure on the prices of manufactured goods or, at the very least, make it hard for companies to pass on price increases? One obvious thing is that profits will sag, bankruptcies will rise, and companies will eventually be forced to cut back sharply on investment and production (exports might also surge).
But what happened to the excess demand caused by excessively rapid money growth?It still has to have an impact on the average price level. One possibility may be that we will once again see food consumption surge and, with it, the price of food. Another possibility is that price increases will show up in the service sector. A third is that they show up also in the price of manufactured goods that are not in oversupply, where there will be bottlenecks.Inflation, in other words, won’t disappear.
There is also another, perhaps even less benign, scenario. It is possible for there to be no inflation because there is a sudden collapse in the money supply.
How could that happen?In a worst case scenario rising bankruptcies could put so much pressure on the banking system that Chinese banks would be forced to cut back on lending and Chinese banks and businesses would begin to hoard liquidity. This would result, I believe, in a sharp reduction in money supply (via a collapse in velocity perhaps?) that would cause China to exchange the risk of inflation for the risk of deflation.
I think this is what happened in the US in the 1930s. Following a period of rising inflation in the 1920s – and for many of the same reasons: a rapid expansion in the US money supply caused by massive reserve accumulation in the 1920s – the overextended banking system was unable to survive the economic downturn, and a previously inflationary period was suddenly converted into a period of sharp deflation. There was even a 2-year period at the end of the inflationary period (1927-29) in which the US was absolutely swamped with speculative inflows.
There are lots of different periods in US economic history to look at to get a sense of some of the issues that China needs to deal with. Unfortunately none of this makes prediction easy, but I think there is one prediction I can safely make: so many years of wild money growth must result in an adjustment and this adjustment is not going to be easy.Whether the adjustment results in inflation or deflation depends crucially, I think, on the state of the banking system and the reaction by banks to an economic downturn.
On another note, the stock market had its first good day in a while.It closed at 2461, up 0.9%.Most of China is still focused on the medal count, although I should mention that we’ve had our first day of really beautiful weather in Beijing today.
Today’s unexpected withdrawal by hurdler Liu Xiang from participation in the Olympics – because of a leg injury – has been a real emotional blow to many of my friends and students in China.Condolences to all.It is a disappointment to see such a great athlete unable to defend his title in his own country. Sad as his withdrawal has been for many of us here, there is still a lot to be excited about as the Olympics wind down.Tomorrow I will see Brazil play Argentina in the soccer quarterfinals, thanks to the generosity of my former Tsinghua student Richard Zhang, now a rising star at McKinsey, and on Wednesday one of my favorite Beijing musicians, Shouwang, is taking me to see track and field events at the Bird’s Nest (finally I get to see the magnificent stadium from the inside!).
But not all the news is Olympic-related. Xinhuareports today that the first half of 2008 saw a slowdown in the growth rate of loans to real estate developers and buyers.According to the article:
Chinese bankers held loans totaling 5.2 trillion yuan (about 580 billion U.S. dollars) to real estate developers and housing buyers by the end of June, up 22.5 percent year-on-year, the People's Bank of China (PBOC) said Friday.
The central bank said the growth rate was two percentage points lower than the same period last year, representing a decline for seven consecutive months since last December. Loans to real estate development stood at 1.9 trillion yuan by June, up 17.7 percent year on year. The growth rate was eight percentage points lower than the same period last year.
The country's lenders granted 3.3 trillion yuan to housing buyers buy June, representing an increase of 25.6 percent year on year. The growth rate was 1.8 percentage points higher than the same period last year. Real estate developers and housing buyers received 398.84 billion yuan in loans between January and June, which was 170.66 billion yuan less than the same period last year, said the PBOC.
in today’s Financial Times: