On Friday the Chinese stock markets had their second up day in a row (a rare occurrence this year), with the SSE Composite trading up 2.0%.Today, however, the markets reverted to form, and the SSE Composite dropped 2.9% to close at 2327 which is, I think, the lowest point they have reached since February of last year.
What seemed to drive the market down today was a confluence of events suggesting that government fears of an economic slowdown may be reasonable.Today the China Federation of Logistics and Purchasing released its calculation of August PMI (purchasing managers’ index).It registered a seasonally adjusted 48.4, the same as in July, and the second month in a row that it came in at contractionary levels (anything below 50).At the same time CLSA released its own PMI calculations, which also came in below 50 – the first time this has happened since the survey began nearly three years ago.
I think the main thing to watch now is consumer demand.Growth in consumer demand in the past few months has been quite good, but as I discuss in my August 14 entry, it is not clear if at least part of this might not simply be anticipated consumption for the Olympics.If that is the case, we may see a slowdown in consumer demand in the coming months.
Remember that the three pillars of Chinese growth are domestic consumption (both private and public), net exports, and domestic investment.Global conditions are generally weak, which suggests that exports are going to be a lot less powerful in fueling Chinese growth than they have been in the past. If domestic consumption also starts to grow more slowly, that places much of the burden of fueling growth on domestic investment, but without foreign or Chinese consumption to buy its production, it will only be a matter of time before the third pillar begins to wilt too.
Most hopes are on an expansion in fiscal spending to solve the growth problem, and there is little question that policy-makers are seriously considering their options here. There has been a lot of discussion, both publicly and privately, about government proposals to stimulate the economy via tax cuts or infrastructure spending. I have always been a little skeptical, however, about how easy this is likely to be.
In first place, if there really is an economic slowdown we may see a sharp rise in NPLs in the banking system, and along with it a sharp rise in contingent liabilities on the part of the government sufficiently large to constrain their ability to spend.Given how big the loan portfolio of the banking sector is relative to GDP, a small rise in the NPL ratio will have a big impact on total government debt via contingent liabilities.
Secondly I am less certain than others about the fiscal position of the government. In this I guess I have been a bit of a contrarian, since nearly every other analyst I have read or spoken to points to the relatively healthy fiscal position of the government and the sharp rise in fiscal revenues as an indication of how much room the government has to prime the fiscal pump.
But for me, the fact that fiscal revenues have risen so sharply while the government has maintained its fiscal position in a small deficit or surplus, depending on which period you measure, indicates an equally sharp rise in fiscal expenditures, and I doubt that an economic slowdown will have nearly as big an impact on lowering expenditure growth as it has on revenue growth. On the contrary.
In that light I was interested to see an article in today’s South China Morning Post that suggests that although not as pessimistic as I am, the Ministry of Finance might not be as optimistic as some others are:
The mainland's finance ministry yesterday warned of increasingly austere times ahead as funds flowing into government coffers last month slowed sharply from the revenue expansion seen earlier this year. Slowing growth in fiscal revenue reflects tougher times in the world's fastest-growing economy as well as heavy spending on disaster relief and earthquake reconstruction.
The July figures come at a time when economists widely expect Beijing to be more proactive in spending to boost the economy after first-half gross domestic product growth slowed to 10.4 per cent from 11.9 per cent last year
Fiscal revenue last month grew 16.5 per cent from July last year to 607 billion yuan (HK$692.83 billion), compared with the 30.5 per cent expansion in the first seven months, the Ministry of Finance said. Beijing projects an increase of 14 per cent in fiscal revenue for the full year, according to the government's budget at the start of the year. Fiscal revenue rose 32.4 per cent last year.
The article goes on to say that in July, fiscal expenditures rose 40.9% year on year, or 29.7% for the first seven months of the year versus the same period last year.That disparity in growth between revenues and expenditures strikes me as worth wondering about, even before the economy faces the consequence of a slowdown.
I know, I know, I am going to be accused of being overly pessimistic, but perhaps many years of bond trading (and in developing countries no less) has left me looking for potential trouble spots, and it really can’t be controversial for me to point out that when things go bad, they tend to go bad on several fronts simultaneously. If there is an economic slowdown I am willing to bet that we will see both a sharp deterioration in the government’s fiscal position and in banks’ loan portfolios, and I also suspect that the growth impact of a major fiscal expansion will be less than we expect.
At any rate the newspaper quotes the MoF as saying:
"We expect fiscal income will follow this trend of expanding only moderately for the rest of the year and the pressure for spending to increase is big," the finance ministry said. "The past growth was achieved on the basis of the steady and rapid development of the national economy. Extra money is needed to stabilise prices and cope with natural disasters. We can't ignore the fact that the fiscal conditions are actually quite tight."
Perhaps the MoF really believes this or perhaps they are simply positioning themselves to ward off an expected massive call on their resources. We’ll know some time next year, I guess.
Meanwhile the PMI release did bear some good news.PMI input prices have dropped sharply in July, which suggests that PPI might not rise as quickly in the next few months as it has in the past.I am prepared to be wrong about my alarmist inflation forecasts if PPI begins to subside quickly, but I am not ready to change my views for another two or three months since I think we can easily see temporary respite within a much longer inflationary trend. I mention this especially since yesterday’s newspapers reported (another) strike by Shenzhen’s bus drivers and conductors that have left thousands of travelers stranded.Although China does not freely allow workers to organize or strike, the fact regular strikes over low pay in Shenzhen over the past months have disrupted service suggests that wage pressures have not gone away.
Before concluding this already long entry I want to mention an August 28 MNI article forwarded to me by Logan Wright.One of the things that I try to teach my students is to use simple models to try to anticipate changes that may take place in the economy, and then to look for these changes. They are not always obvious if you are not looking for them.
For example, I have always assumed that the huge supply of money created by China’s currency regime and the huge demand for funding created by its inefficient growth would have to meet. Much of the intermediation has taken place via the banking system, but of course with the lending constraints that were put in place over the last year, bank loans have grown much less quickly than we would have expected.
For many analysts, this is more or less then end of the story. Policy-makers were able to slow lending growth, as planned. But that didn’t make sense to me: the supply of and demand for funds was as strong as ever. In that case, I assumed, lending constraints were just likely to force intermediation into other parts of the financial system.
Based on this simple model, I made two predictions.First, that the informal banking sector and other parts of the banking sector not covered by the lending constraints were probably growing very quickly. Second, that banks would increasingly engage in activity that would allow loan growth to take place off the balance sheet and away from the formal constraints.I remember telling my friend Chris Keogh, one of the heads of Goldman Sachs China activities, that I expected there to be a burst in securitization taking place as banks shifted loans off balance sheet.
The first prediction seems to have happened.We have no good numbers on the informal banking sector but anecdotal evidence suggests that indeed it is growing quickly.In fact over the past few months a lot of ink has been spilled on the subject – informal banks are now a hot topic. Also, as Stephen Green of Standard Chartered pointed out a few months ago (see my May 18 entry), loan growth among policy banks and in the dollar loan portfolios of commercial banks, neither of which is covered by the lending constraints, have grown very quickly.
The second prediction turned out to be a lot less successful.There have been loan securitizations in China in recent months, but not nearly as many as I expected. I put this down mainly to a non-transparent regulatory system that made it difficult for banks to innovate around restrictions.
It turned out, however, that I may have just been looking in the wrong place.Here is what MNI says:
Chinese banks are bypassing tough controls on their lending behavior by raising money for their clients via wealth management products, a move which analysts said highlights the limits of the government's attempts to control the banking system through quantitative measures.
Wealth management products have exploded in popularity this year, with 53 banks selling 2,165 products equivalent to around one trillion yuan ($146.3 billion)during the first half alone, more than the 819 billion yuan in such products sold over the whole of last year.
But all is not as it seems. Industry observers note that over a third of the value raised has been for products which are structured like non-transferable debentures, with banks repackaging them as wealth management products and marketing them on behalf of clients.
Apparently the banks are packaging loans as securities, but rather than sell them in the public markets they have been selling them privately to their high net worth clients. The article goes on to say:
Xu Hanfei, a Shanghai-based bond analyst with the Industrial Bank of China, said that around 300 billion yuan raised through the sale of these kinds of wealth management products in the first half of this year wound up with Chinese companies or local government vehicles. Sichuan-based Southwestern University of Finance and Economics estimated that Chinese companies and local governments raised around 385 billion yuan via these products during the first seven months of this year.
That compares with the 2.8 trillion yuan that Chinese banks extended via their traditional loan books during the same period. The People's Bank of China introduced a quarterly loan quota system this year in a bid to hold loans at last year's 3.6 trillion yuan.
Xu acknowledged that wealth management products are being used to bypass the loan quota and continue raising funds for clients, even if the banks themselves aren't taking on the actual risk. “Wealth management products are a good substitute for bank lending – banks want to maintain the pace of loan expansion but the PBOC has capped lending growth with a quota so we've had to improvise," Xu said.
This kind of activity is not necessarily a bad thing for the banking industry – on the contrary, it helps banks to learn about securitization and to earn fee income while limiting their risks by passing them on to clients. We should worry however about the level of sophistication of their clients and whether, if there ever is a problem, these loans are truly gone from the banks’ balance sheets. The recent problems faced by UBS, Citibank and many others show that just because a loan has been shoved off the balance sheet onto investors does not mean that the bank has totally eliminated its exposure, especially if large scale defaults lead to political pressure.
But the real point of this article, as I see it, is to highlight the difficulty of addressing the symptoms of a problem without addressing its root cause. China’s “tight” monetary policy has been anything but tight.
It is easy to claim that China’s rapid monetary expansion can be controlled simply by placing limits on the consequent credit expansion.It is naïve to believe, however, that the reality is that simple. China continues to suffer from rapid monetary expansion. When policy-makers try to control the consequences of that expansion without controlling the fundamental problem – for example by placing lending constraints on the banks, or by trying to control the rise of prices – they are likely to be doing little more than shift the problem from where they can see it to where they can’t.
The Chinese stock market had a fairly volatile day, with the SSE Composite bouncing up and down by 1% or more several times during the day before it closed at 2306, down 0.8% for the day.I think we have to go back to end of 2006 before we can find a lower close.We have pretty much wiped out all the spectacular stock market gains of 2007.
The decline was led by financials, largely, I think, on speculation that there will not be the credit easing that many had hoped for.This is still a market looking almost exclusively to government policy and intentions for direction.I have no strong reason for saying this but I wonder if we aren’t at or near a bottom.Multiples are pretty reasonable (especially if you consider B-shares, which foreigners are allowed to buy directly) and most of the comments I hear in the market suggest that many fund managers have given up on optimism.
Still, three days ago the South China Morning Post ran an article that had a different take:
Nonetheless, some managers remain unfazed, saying they are optimistic amid Beijing’s loosening of monetary policies and a slide in global crude oil prices.Eight fund managers surveyed by Reuters recently suggested that their allocations for equities will increase.
The same article pointed out that a Galaxy Securities report showed that about one-third of mainland asset managers running the funds have less than a year’s experience, so maybe we shouldn’t take their opinions too seriously, although funnily enough the article was titled “Mutual funds double fees despite 1.1tr yuan losses.”It discussed how in spite of losing $170-80 billion this year (of their $440-50 under management at the start of the year), they earned total fees of nearly $2.8 billion, 120% more than they did over the same period last year.Of course this is an unfair comparison because they had a lot more under management this year than last.Still, it’s nice work if you can get it.
One of the big questions for stock market investors is China’s currency policies, about which here has been a lot of attention again recently and a lot of back-and-forth.In the past month there has been little appreciation in the RMB against the dollar – and even some depreciation, depending on what period you measure.The impression most of us have is that by allowing the RMB to weaken the government hopes to introduce enough uncertainty to make the one-way bet on the RMB a lot more risky.
Maybe.This currency strategy is part of a basket of policies aimed at reducing speculative inflows.In an article two days ago the People’s Daily reports
China will start regular annual checks of banks’ foreign exchange operations to make sure they observe relevant rules, the foreign exchange regulator said on Friday.The move is a concrete step towards implementing the country’s newly approved foreign exchange rules that were set earlier this month and curbs cross-border speculative capital flows, analysts said.
These new annual checks are part of the heated debate over how the PBoC can regain badly-needed control over its explosively expansive monetary policy.Fortunately in spite of increased attempts to control the border, much of the debate is still primarily about what to do with the exchange rate.On Monday, joining the growing European chorus against China’s exchange rate policy, German Finance Minister Peer Steinbrueck, in a four-day meeting with his Chinese counterpart in Beijing, called for China to let its currency appreciate more quickly against the euro.
In contrast, or perhaps not, Cheng Siwei, vice-chairman of the standing committee of National People’s Congress, and an influential voice in Chinese economic policy making, told the Financial Times on Sunday that China does not need to accelerate the appreciation of the renminbi – against the US dollar, at any rate.According to the article:
“My point is that we don’t need to accelerate the appreciation of the renminbi. The dollar will not weaken very much and may get stronger, as happened [in August],” Mr Cheng told the Financial Times in an interview. “This makes appreciation of the Chinese currency against the dollar less necessary,” he said, because the renminbi was still likely to appreciate against other currencies.
He is certainly seems to be reflecting the public consensus among many policy-makers, but whether they really believe this or are merely trying to convince the world not to bet on an appreciating RMB I am not really sure.At any rate I think that a lot of this talk misses the point.It continues to posit RMB policy largely in terms of its trade impact, instead of its domestic monetary impact.
As a domestic monetary problem, I think, the argument for appreciation is much stronger.In that context there is an excellent new piece out by Ronald McKinnon and Gunther Schnabl (MS), with the title “China’s Financial Conundrum and Global Imbalances”.Although I think I disagree with its main recommendation, it is a typical McKinnon piece – elegant and informative – whose abstract includes the following:
China’s financial conundrum arises from two sources: its large saving (trade) surplus results in a currency mismatch because it is an immature creditor that cannot lend in its own currency. Instead foreign currency claims (largely dollars) build up within domestic financial institutions. And economists—both American and Chinese— mistakenly attribute the surpluses to an undervalued renminbi. To placate the United States, the result is a gradual appreciation of the renminbi against the dollar of 6 percent or more per year.
This predictable appreciation since 2004, and the fall in U.S. interest rates since mid 2007, not only attracts hot money inflows but inhibits private capital outflows from financing China’s huge trade surplus. This one-way bet in the foreign exchange markets can no longer be offset by relatively low interest rates in China compared to the United States, as had been the case in 2005-06. Thus, the People’s Bank of China (PBC) now must intervene heavily to prevent the renminbi from ratcheting upwards—and so becomes the country’s sole international financial intermediary.
Despite massive efforts by the PBC to sterilize the monetary consequences of the reserve buildup, inflation in China is increasing, with excess liquidity that spills over into the world economy. China has been transformed from a deflationary force on American and European price levels into an inflationary one. Because of the currency mismatch, floating the RMB is neither feasible nor desirable—and a higher RMB would not reduce China’s trade surplus. Instead, monetary control and normal private-sector finance for the trade surplus require a return to a credibly fixed nominal yuan/dollar rate similar to that which existed between 1995 and 2004.
MS argue that “Currency stabilization would allow the PBC to regain monetary control and quash inflation,” and point out that China’s immature financial system and rapidly transforming economy make monetary aggregates pretty useless in discussing domestic monetary conditions – something I have argued many times.They conclude: “For a developing country like China on the periphery of the dollar standard, the exchange rate is best considered just an extension of domestic monetary policy – and not an instrument of trade policy.”
I agree wholeheartedly.The issue for the PBoC is not what they should do to the RMB directly to rebalance international trade.As I have argued many times, China’s trade surplus is more a function of the way the currency regime converts capital inflows via the banking system into increasing industrial production.Of course part of the reason China runs a trade surplus is that the RMB is undervalued – and I am sympathetic to Nicholas Lardy’s and Morris Goldstein’s argument that thanks to China’s rapid productivity growth relative to that of its trade partners the RMB may be even more undervalued today than it was earlier in the decade.
But it has always seemed to me that the soaring trade surplus was largely a monetary phenomenon – locked into place by the self-reinforcing cycle of rising trade surplus leading to expanding money leading to surging fixed asset investment leading to a rising trade surplus.That is why in 2003 and 2004, when most analysts were arguing that China’s then-seemingly-large trade surplus was a temporary phenomenon that would soon subside, I instead argued that it would continue to rise inexorably.
What is worse, as MS recognize, is that more recently China’s trade surplus has been augmented by rising speculative inflows based on the expectation that the RMB must rise in order to rebalance the trade surplus.Rather than make things better (rebalance trade, reduce inflation), however, a rising RMB has actually made things worse.It has caused an already excessively loose monetary policy to careen out of control.
MS blame this mostly on “China bashing” – the criticism of China’s currency regime as the root cause of the trade imbalances has created appreciation pressure – because it has created widespread expectations of currency appreciation.If the market hadn’t been convinced of the need for the RMB to appreciate in order to rebalance trade, it wouldn’t have bet so heavily on appreciation and in so doing worsened China’s domestic monetary problem.
So what should China do?MS argue that in order to regain control of the money supply China needs to eliminate expectations of a rising RMB.One possibility is to let the RMB float, but MS quickly reject this option.
I agree with their rejection of the option to float, although for different reasons (I think).MS say that China’s financial immaturity forces a significant currency mismatch onto domestic balance sheets, which makes currency volatility very risky and perhaps self-reinforcing.This volatility would have an adverse impact on domestic production and consumptions.
I would argue that if the RMB were to float, rather than quickly reach some sort of stable equilibrium it would suffer from massive and persistent volatility as small changes in the perception of relative Chinese risk or growth prospects caused large, self-reinforcing flows into or out of the country.Perhaps we are arguing the same thing, but I am not sure.
The other option is for China to peg the RMB credibly against the US dollar until its financial system was sufficiently robust and flexible to permit it a floating exchange rate.Of course I agree with this option, and have been arguing this for a long time.
Where MS and I disagree is on the definition of “credible”.I think MS argue that except for the effect of the “blame China” crowd, as they put it, a reasonable level at which to peg would be the current RMB exchange rate.Because it would require a reduction in trade-related criticism to eliminate the expectations of appreciation (and thus to achieve credibility), this would have to be done as part of an internationally coordinated effort.I think many analysts have interpreted MS as saying that the RMB is not undervalued, and perhaps this is indeed what they are implying.
In my opinion, however, that the RMB is definitely undervalued, and if it is, a peg at current levels runs the risk of locking current imbalances into place for much longer.I am not so worried about the adverse impact of China’s trade surplus on the rest of the world, although I do agree that long-running imbalances can create balance sheet vulnerabilities that can later prove destabilizing.Still, this is probably the biggest disagreement I have with my friend Brad Setser, who is much more worried about the economic consequences of China’s trade surpluses on the US, Europe and the rest of the world.
For me the issue is, as MS point out, largely a domestic monetary issue.If this can be fixed (i.e. if net inflows can be sharply reduced) and China can regain control of its domestic monetary policy, then the trade surplus will quickly adjust, via a better balance between the growth in consumption and growth in industrial production.
But what is a “credible” rate at which to peg? Since the beginning of 2007 I have been arguing that China needed to engineer a one-off 15-20% revaluation and peg.There was nothing “fundamental” about that 15-20% number.It was merely the smallest amount by which I thought a revaluation would be credible.For my way of thinking, any other option would either lock in the monetary imbalances for too long (e.g. a peg at current levels, or a slow appreciation) or cause an explosion in speculative inflows that would undermine the very goal an appreciation was trying to achieve (e.g. a rapid appreciation).A “non-credible” revaluation and peg would, of course, fall into the latter camp.
I continue to believe that China needs to engineer maxi-revaluation before it pegs, but now I think the needed revaluation is less than what I used to argue for.At this point I think an 8-10% revaluation followed by a peg would do the trick, especially if the PBoC announced explicit market-oriented measures to make the peg credible – for example by providing tools for speculators that allowed them to bet on continued appreciation without increasing speculative inflows (I have written about these elsewhere).
I am convinced that financial risks have risen enough in China that a smaller revaluation should be enough to stop or even reverse speculative inflows, which should bring monetary growth much more into line with PBoC wishes.The fact that a smaller revaluation is enough to halt or reverse inflows is not a good thing, by the way.The last two years of monetary growth have almost certainly resulted in a much more vulnerable banking system, and I think investors are nervous enough that their exit level is lower than it had been before.The longer the PBoC wait to regain control of monetary policy, by the way, the less it will take to cause speculative investors to flee the country.
The biggest risk continues to be the effect of a revaluation on bank balance sheets, which are, I think, vulnerable and getting more so all the time. On that note Caijing has an article claiming that government auditors have accused nine banks and four fund managers of lending billions of RMB for illegal stock market and real estate speculation.I am sure the real number is much higher than whatever the auditors found.Bank instability is a real risk for an abrupt change in the exchange rate policy, but it is pretty clear to me that the longer breakneck monetary expansion continues, the more vulnerable the banking system will be to a shock.
The Chinese stock markets declined further today, with the SSE Composite punching its way through the psychologically important 2300 in the first hour of the day, to trade as low as 2248 in the later afternoon (with 2500 often cited as another important “barrier”, below which the government was presumed to intervene) for a total loss of 2.5%. It recovered part of its losses in the last hour of trading to close at 2278, down 1.2% for the day.
This should have been a big event but most participants seem pretty inured to bad news by now.Given the gloom I continue to wonder if we might not be close to a bottom in the stock market.
On a separate front I think my pessimism about the financial system is being matched, if not exceeded, by others.Andy Xie, who has been one of the savviest of commentators on China, has another warning piece in Caijing, probably the most open and hard hitting of local periodicals. Among other things Xie writes:
There is obviously a liquidity problem in China's economy. Triangular debts, especially in the form of receivables, are piling up. Lack of money at local government level may be the root cause. Local governments are quite dependent on land sales and taxes in the property sector to fund their expenditure. That dependence motivates them to spice up the property market, which is a major reason for the bubble.
At a deeper level, the declining share of fiscal revenue for local governments in the past ten years has motivated local governments to search for new revenue sources, which eventually ended in the property market. The massive land sales last year at record prices may not bring the promised cash for local governments. The property bubble has burst. Developers cannot sell properties like before and can't keep their promises of paying for last year's land purchases. Slowing property sales also decrease their taxes. The cash-short local governments cannot pay their contractors that in turn can't pay their suppliers.
This is the second time I have heard him warning about “triangular debts” among Chinese companies. I haven’t been following the issue closely except to note that inter-company loans have risen rapidly, and represent yet another way in which lending caps imposed on the banking system have been undermined. They also create a worrying mechanism for credit and liquidity problems to spread from one company to others.
Xie adds: “China's financial system, in particular, is a heavy burden on the economy.”He goes on to say:
You might find my assertion strange. Chinese banks are among the largest banks in the world in terms of bank capitalisation and profits. Chinese brokers made big profits last year, although they are down this year in a slumping market. If profitability is the best guidance for efficiency, China's financial system should be the most efficient. The problem is that China's financial institutions have made profits from licensed monopolies and government-regulated interest rates. As credit is rationed and, hence, is in short supply and government mandates interest rates, Chinese banks can make fat profits from their credit quotas. Their profits don't reflect their efficiency. Rather, their profits are a tax on the economy.
China's securities industry is more ridiculous. Stock market is the most capitalist market. Securities firms that service the stock market should be the most capitalist too. In China, securities firms are mostly state-owned. It is impossible to find an example of a successful state-owned securities company in the world. It is surprising that China doesn't see the problem in its approach.
The inefficiency of China's financial system is a huge cost for the economy. My guesstimate is that the burden could be five percent of the GDP, i.e., China's financial sector has negative value added of five percent on the economy. Addressing the inefficiency in the sector could be a significant stimulus for the economy. China should start by raising deposit rates to narrow the lending spreads to a normal two percentage points. Of course, the central bank should likewise lower the deposit reserve ratio in order to normalise the banking system. The outflow of hot money provides a good environment for cutting the ratio.
China's stock market is a big failure. The Shanghai A-shares index surged from 1,000 to 6,000 in two years and then dropped to 2,400 in one year. You can't blame people for thinking that China's is a Mickey Mouse market. China should completely revamp its market to prevent future crisis like this one. The most important change should be to disentangle the government from micro interventions in the market. When laws are laid down, the market should function on its own. It is the only way to have a healthy market.
On a separate note Xinxin Li at the Observatory Group writes in a September 2 about changes in the financial leadership. According to him, “a looming personnel change in the PBOC could provide important guidance about the outlook for monetary policy beyond the short‐term.Vice Governor Yi Gang, who is in charge of monetary policy in the PBoC, is likely to become the new chief of the National Statistics Bureau in a few weeks.If his successor comes from the pro-growth camp, that may indicate an important shift in Beijing’s monetary policy.”
There have been tons of rumors for quite a while about leadership changes at the PBoC and the banks. I have referred broadly to these several times in my blog but am wary of being too concrete.I don’t want to get into trouble.If as Xinxin suggests Vice governor Yi becomes the head of the Statistics Bureau, that might indicate a strengthening of the monetary camp since Yi is well-known to be tough on monetary issues, but truth is not that obvious. The key questions are about who will replace him and whether there will be other even more senior changes in the PBoC.Many of us (including me) are expecting imminent changes in leadership within the financial system that will result in a stronger voice for the pro-growth camp. I think analysts are watching this more closely than any other issue right now.
To close on a related bit of good news, yesterday the National Bureau of Statistics published a report in China Information News that suggested that thanks to declining food and oil prices CPI inflation would ease further in August and September.That is certainly what the bond market seems to think. According to Credit Suisse in today’s Emerging Markets Economic Daily one-year treasury yields are currently at 3.31%, down 23 basis points from the beginning of August.
Clearly this news will embolden the pro-growth camp to push for greater fiscal and monetary stimulation. At first glance this ight even be showing up in the exchange rate policy. Recently the pace of appreciation of the RMB has declined – it even depreciated quite sharply during the first two weeks of August.
Logan Wright, however, in his August 25 Stone & McCarthy research piece, argues that while many analysts interpret this slowing appreciation as an indication that the PBoC is targeting not just the US dollar but a basket of currencies in its overall appreciation strategy (the dollar rose against the euro for much of this period, bringing the RMB up on a trade-weighted basis), he disagrees. He argues instead that this is just political interference aimed at dissuading investors from believing that the RMB is a simple one-way bet.
The goal is, presumably, to introduce enough uncertainty to discourage speculators from flooding the domestic monetary system with foreign currency inflows. I agree with Logan’s interpretation.In expect that after some period the RMB will resume its upward march against the dollar. As I suggested nearly 18 months ago, China needs to revalue its currency sharply to regain control of its monetary policy, but a gradual rapid appreciation would inevitably undermine that goal by encouraging massive capital inflows.This is what seems to have happened.
Another terrible day on the stock market saw the SSE Composite, led kicking and screaming by energy and financial companies, trade more or less straight down by 3.2% to close the day at 2203.The brilliant autumn weather in Beijing (and the best week for air quality I have seen in seven years of living here) seems to have bypassed the market altogether.
Away from the weather there is plenty of bad news for those looking for it.Yesterday Reuters cited a Lehman Brothers report on declining August car sales:
China's passenger car sales fell 10 percent in August from a year earlier, preliminary data showed, due to the impact of the Olympics and weakening consumer confidence, Lehman Brothers said in a research report on Thursday.
The report said auto sales in China, the world's second-largest car market, were expected to remain lacklustre for the rest of 2008 and possibly into early 2009. Compared with the month before, sales were down 12 percent, the report said.
Growth in Chinese steel consumption is expected to slow markedly in the second half of this year amid weakening demand from the construction, household appliance and automobile industries, according to industry experts.
Yang Siming, general manager of Nanjing Iron & Steel told a steel conference in Xiamen this week that most Chinese steel mills had cut output last month, because of shrinking demand and high costs of raw materials. ”We’ve been cutting production since last month, and according to my knowledge, most domestic mills are cutting output too,” Mr Yang said.
One of the possible adverse consequences of excessively rapid money growth has been the channeling of this money via the banking system into excess production. This was fine as long as a healthy world economy could absorb Chinese excess production, but a slowing global economy has meant that Chinese producers have been forced to turn to a domestic consumer market that hasn’t been able to take up the slack.As I have mentioned many times before, rising inventories are one of the warning signals I am most concerned about.I don’t think we are there yet, but I will be trying to keep an eye on the subject as well as I can.
All this bad news is making policy-makers worried, and they seem eager to try to encourage some optimism. I was struck by the list of top five articles under the “Macro-Economy” section in today’s Xinhua:
Three of the top five articles today and all of the top five yesterday seem to be saying the same thing:Don’t worry, things are still ok.
Still, not all the news is bad. As I wrote Wednesday it looks like CPI numbers for August, which will be released next Thursday, are going to come in without too much implied inflation.Most estimates are that CPI inflation will come in below 6% for August. Today Xinhua reported that “China's consumer price index (CPI), a key measure of inflation, was expected to show a rise of about 5 percent in August from a year earlier, said analysts on Thursday.” They go on to quote Fan Jianping, chief economist of the State Information Center, as saying that “the CPI growth rate might sink below 6 percent in August.”Logan Wright of Stone & McCarthy told me today that he expects it to come in around 5.5%.
Of course CPI numbers are pretty tainted by price controls at this point, but I am willing to bet that a low CPI inflation will make it much more likely that energy prices are allowed to rise again. Shortages continue to be a real problem and energy producers are being squeezed mercilessly by rising costs and frozen prices. In his comments yesterday Fan Jianping said he expected August PPI to rise by 10.0-10.3% (compared with the 10.0% rate posted in July).
On a separate note a very interesting article by Keith Bradsher in today’s NY Times discusses a predicament for the PBoC that many of us have been wondering about for a while.As the RMB rises against the US dollar, the PBoC is forced to take losses on its currency mismatch – it buys dollars and funds them with RMB borrowings. These losses have become so big that, according to Bradsher, the PBoC has been warned by the IMF that it may have too little capital. The article says:
Now the central bank needs an infusion of capital. Central banks can, of course, print more money, but that would stoke inflation. Instead, the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.
The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts. This could heighten trade tensions with the United States. The Bush administration and many Democrats in Congress have sought a stronger yuan to reduce the competitiveness of Chinese exports and trim the American trade deficit.
The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries.
There is no need to worry about whether or not the PBoC is insolvent – the central bank is not a commercial stand-alone entity and its credit is at least as good as that of the central government (sometimes better), but the article is nonetheless interesting.I hadn’t really thought of the political ramifications until I read the article, but if the PBoC needs to turn to the MoF to shore up its capital, and if this represents a transfer of power from the PBoC to the MoF, it may very well represent a further weakening of the monetary camp in China.
This might not bode well for the future of the financial system in the short term, although in the long term it is not clear to me that monetary soundness is necessarily correlated with more rapid growth.I say this because I have seen no evidence that countries with very sound and conservative financial systems grow faster than countries will looser and riskier financial systems (although they do seem to have fewer financial crises).I have more than once made reference to Belgian bank historian Raymond de Roover’s comment that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.”Still, excess financial instability can significantly raise financing costs and in the case of China, where political credibility is always an issue, there may be other things to worry about if the guardians of monetary soundness are further weakened.
Astonishingly enough (but perhaps not surprisingly), a lot of mid-level policy-makers in China seem to believe that the PBoC currency losses are the “fault” of the US, according to my friend Victor Shih of Northwestern university.The New York Times article goes on to say about Victor:
He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.
Many Chinese seem to be inordinately fond of conspiracy theories, but in this case it seems pretty obvious that if the RMB were indeed undervalued all these years – like the US government has been saying for a long time – then exchanging Chinese goods for massive amounts of US Treasuries by definition meant that China was subsidizing American consumption, and that this subsidy necessarily represented a loss for China. If you exchange something below its fundamental value for something above its fundamental value, it is only an accounting trick that allows you to pretend you haven’t booked a loss.
Revaluing the RMB does not create the loss.It simply forces recognition of that loss.And as long as China continues to accumulate US dollar assets purchased with undervalued RMB, the PBoC will continue to run losses, whther or not they are fully recognized.Perhaps you need to be a trader, and not a government official, to get the point.
Talking about Victor Shih, I should highlight another very interesting commentary by him on RGE Monitor.He starts his entry:
Due to strong political pressure at the highest level and seemingly declining inflation, the State Council caved and increased the credit quota by some 200 billion RMB. Well, that only goes so far, and much of it still goes to larger firms. So, how are they dealing with the continual liquidity problem? Bundling!! Local governments, including Sichuan, Chongqing, Henan, Beijing, Liaoning, Zhejiang, and Shenzhen, are all planning to issue tranches of corporate bonds whose cash flow comes from a group of small and medium enterprises (SMEs). Each province will issuing 1 to 2 billion RMB of notes for the approved SMEs.
The local governments will guarantee these notes, which have 3-5 years maturity!! This is a familiar scheme of borrowing to fulfill current policy needs and leaving bad debt for future leaders of a province or city. This is why the central government banned local governments from issuing debt, but it is coming back in a latent form. Granted, it is on a small scale now, but it can really take off.
I think the NDRC is backing this effort, though I am not sure if the financial regulators in Beijing like this. This will also create good business for domestic investment banks, especially those with local government ties. It might also give a boost to state owned asset management companies which are trying to transform themselves into investment banks
When we all start trying to figure out how much debt the central government really has (something that will become a popular sport sometime next year, I suspect), it will be useful to remember that these notes are going to be guaranteed by the local municipalities, and these municipalities in turn are guaranteed by the central government.
On Sunday I am off to New York for a week where I will have a number of meetings and presentations which will give me the chance to gauge the mood of investors and financial policy-makers outside of China.It’s been over a year since I went back, and I suspect the gloom and worry I saw last July hasn’t fully lifted, to say the least.
The stock markets have had a mixed week so far.On Monday the SSE Composite declined by 2.7%, before regaining a fraction of that on Tuesday to close up 0.1% and another 0.2% Wednesday.Banks and real estate developers again led the decline.Things weren’t helped by August car sales which, as I wrote Friday, Lehman Brothers had correctly predicted would decline, although by 6.2% rather than the 10% they predicted.Some people are saying this decline is temporary, but on the back of several months of rising car inventories it is nonetheless ominous.
The most interesting news this week has been the slew of numbers released earlier today by the National Bureau of Statistics.Of these the most eagerly anticipated, CPI inflation for August, was surprisingly good, coming in at 4.9% year on year, which is well below July’s 6.3% and also well below market expectations of around 5.5%.The decline in CPI inflation was driven mostly by declining prices in pork and vegetable oil.
Quite honestly I am puzzled by this unexpectedly low CPI inflation number.Part of me would like to conclude that I have been overly alarmed about the threat of inflation all year, and that inflation is no longer the risk that I always assumed it was.That would certainly be good news, and would give the government greater room for maneuver on the money and credit side, although Mark Williams at Capital Economics says in his research piece today that he actually thinks there is a risk of deflation next year.
But I am still puzzled.Money growth has been so rapid in the past couple of years, and probably credit growth too if you count all loans in the formal and informal banking sector, that it seems very strange that inflation could come down so quickly.Is it possible that the huge decline in stock market prices and the smaller decline in real estate prices have had a correspondingly large impact in reducing money in the system?Or did food prices shoot up so quickly early this year for what were extraordinary reasons, and now as they revert to some more reasonable level of implied inflation they are causing a sharp but temporary decline in inflation.Or could it even be that price controls and other administrative measures (e.g. selling of food stocks) have seriously tainted the CPI numbers?I am not really sure.
And there are still other things that are hard to reconcile with the CPI numbers.All the decline in CPI occurred in the food sector – non food inflation was steady at 2.1%.More worryingly PPI inflation remains high and actually accelerated slightly year on year, from 10.0% in July to 10.1% in August.Yesterday I was at the office of a friend of mine, Columbia professor Dan Rosen, and he showed me a graph he had prepared setting out CPI and PPI inflation over the past several years.What was striking about the graph was that the two numbers were extremely closely correlated until the past few months, when they diverged sharply.This month’s data causes the divergence to widen even further.
One can easily make the case for a strong correlation between the two, but it is very hard to explain why they might diverge so sharply without, at some point, one feeding into the other.Of course if oil and other commodity prices continue to drop, their decline will help ease PPI inflation in the future, but it seems to me that it will need a lot more than this to bring the two into line again.
Yesterday’s Bureau of Statistics release also included trade data.Imports grew last month at a 23.1% in August, down sharply from 33.7% in July.It would be easy to credit the slowdown in growth to a decline in world commodity prices, but Mark Williams claims that the decline in commodity prices only accounts for half of the slowdown in growth.The Olympics may have distorted the numbers, so it would be risky to draw conclusions with too much confidence, but the reduction in import growth may reflect a decline in domestic demand growth, something that I have been expecting.
Exportgrowth also slowed, to 21.1% year on year in August from 26.9% in July.That left the trade surplus for August at a record $28.7 billion – a number which will help ensure that China’s money supply will continue expanding sharply in August.Growth in nominal fixed asset investment moderated slightly from 29.2% in July to 28.1% in August.I think this is still a little high given the slowdown in foreign and domestic demand growth, and suggests that export growth will remain relatively high in the coming year (relative, that is, to slowing international demand) and that the threat of rising inventories remains strong.
What are the policy implications of the most recent batch of numbers?I would hope that no one draws too much confidence from the first set of post-Olympic data, since there may be all sorts of temporary distortions in the numbers, but it seems pretty clear that the pro-growth camp will have been strengthened.Anyone who has been arguing that the risk of inflation is no longer a real constraint on policy will have been heartened by the most recent CPI numbers, and if he has also been arguing (as is likely to be the case) that the real threat is that of a sharp slowdown in growth, the numbers are more or less aligned in his favor.One consequence is likely to be a further relaxation of price controls.My guess is that there will also be increased pressure for fiscal expansion to counteract a perceived slowdown in domestic and foreign demand, and that concerns about a too-loose monetary policy will subside further.
The record high trade surplus will put international pressure on China to let the RMB appreciate, but the southern exporting lobby will still argue – incorrectly, in my opinion – that slower export growth is a consequence of the rising RMB.I am not sure how this pans out, but I suspect that the recent slowdown in RMB appreciation is more of a “head fake”, one aimed at slowing hot money inflows, than a real policy consensus.Although the monetary camp continues to be weakened in the policy debate, I think there nonetheless continues to be real worry among policymakers about the pace of money growth in China.
On a separate note I have met a few investors so far in my trip to New York but Wednesday and Thursday I have a lot of meetings that will, I hope, give me a better sense of what they think about global conditions and about China.I will try to write something about this later in the week.For now I am still struggling with m jet lag, although I have to say the weather here has been really nice.
There is still no respite for the Chinese stock market (or, for that matter, of any of the other global stock markets).On Thursday the SSE composite fell more or less in a straight line, losing 72 points, or 3.3%, rising a single point on Friday to close at 2079.We are now less than 4% away from 2000, yet another barrier that may not prove to be much of a barrier.
There is no lack of bad news on the economy to drive the stock market down.Thursday saw the release by the PBoC and the National Bureau of Statistics of another big batch of data, and it seems pretty clear that the economy is slowing, and perhaps very rapidly.
Industrial output grew by 12.8% year on year in August, versus 14.7% in July, and 17.5% last August.There was weakness in almost every sector, with iron and automobile production actually contracting versus one year ago.Clearly the industrial sector is slowing, and this puts all the more pressure on rising consumer demand to keep the economy strong.
At first glance consumers seemed to be doing their job.Retail sales, the main measure of Chinese consumer spending, grew by 23.2% year on year in August, slightly less than July’s 23.3% but substantially better than last August’s 17.1%.This growth, however, may have more to do with Olympics spending than with long-term trends, and we will probably need to see September and October numbers to get a real sense of how consumers are responding, although I suspect these will be excessively low because at least part of July and August’s robust growth in consumption probably consisted of anticipated spending for the Olympics.
Loan and M2 growth were also slightly weaker than expected.Given the existence of the large informal lending market I am not sure what that means for total loans in the system, and given the complications imposed by a rapidly changing society and a very inefficient financial system, I am not sure how valuable M2 or any of the other monetary aggregates are in explaining money supply.Sill, I would argue that the continued rapid growth of foreign currency reserves at the PBoC is probably being countered by the sharp fall in real estate and stock prices to represent money growth below what we would have expected (and I wonder if we will soon begin to see hot money outflows).The fact that loans in the banking system – much cheaper than loans available in the informal sector – grew by less than they could have under the loan caps, suggests that either companies are reluctant to borrow and invest because of concerns about the slowing economy, or that banks are reluctant to lend because of credit fears.
Neither of these explanations is very comforting.Morgan Stanly just released a report saying the real estate sector is on the point of an imminent collapse, which suggests even that perhaps both explanations might be true.Needless to say a collapse in the real estate sector is one of the biggest risks in China.Not only would it cause havoc in the banks’ loan portfolios, causing a sharp rise in NPLs, but it would contract one of the main pillars of Chinese growth, real estate development.The one piece of good news is that I have heard anecdotal evidence that developers that reduce prices have seen very strong subsequent demand for apartments and offices, so perhaps the problem is as much one of high prices (which can be fairly easily fixed) as of oversupply (which cannot).
One of the questions I have been getting a lot from my investor meetings in New York concerns the sharp split between rising PPI inflation and declining CPI inflation.What does this indicate about inflation and financial conditions in China?
I have already indicated my puzzlement in my entry of two days ago that CPI inflation has come down so quickly, and I worry that we may not be capturing all the inflation correctly.But aside from that, if you assume that PPI inflation is a proxy for rising input prices among corporations, and CPI inflation is a proxy for rising output prices, the tremendous gap between them suggests that corporate profits are going to be killed.This already seems to be happening, with corporate profits down and most analysts expecting them to decline further.
How do corporations react? I think there are two ways they can react.First, if they are able, they will raise prices, and so PPI inflation will then cause a subsequent surge in CPI inflation to bring the two back into line.This is what I always thought would happen, but now I confess I am not so sure.If the economy is slowing, capacity rising, and demand falling off (although we have not yet seen the third condition), companies will have great difficulty in raising prices.In that case we may see a sharp drop in profitability and even a rise in bankruptcies, to the extent that the banking system is forced to contract.
One way or the other the system has to adjust to the tremendous monetary expansion of previous years, and there are two ways it can do so.We can see high inflation, which brings nominal demand and nominal supply back into balance by adjusting prices.Or we can see an equivalent contraction in the money supply because of a contraction in banking.
Neither of these is a good outcome, but excess money expansion – as we are seeing, by the way, in the US – must eventually cause something to adjust, and the adjustment is rarely benign.Historically it almost always consists either of rising prices inflating away the growth in money supply or of a sharply contracting banking system reversing the earlier money contraction through debt deflation.The key determinant of which path this takes, I think, is the fragility of the banking system and the response of the central banks.
I can’t rally predict which outcome we will see in China.On the one hand I have been notoriously bearish on the quality of the banking system for so long – and, I suspect, to the annoyance of many of my colleagues in the market – that it seems to me very reasonable to me to expect real problems in the banks that lead to loan contractions and the hoarding of liquidity.By the way, reducing minimum reserve requirements will have little effect on lending if banks don’t want to lend, borrowers don’t want to borrow, or if informal banks have acted to undermine the impact of lending constraints, which I believe has happened in China.
On the other hand it is always easy to inflate your way out of trouble, and this tends to be the politicians’ preferred response to a banking contraction, especially in systems with limited central bank independence.I suspect that in China we may see concerns about unemployment in the short term trump concerns about inflation in the long term.The point is that if I am right in having argued for so long that we have seen out-of-control money growth in the past few years, we will inevitably have to see an adjustment that is as likely to be a sharp rise in inflation or a sudden debt deflation.As Robert Frost might put it:
Some say the world will end in fire
Some say in ice
I hate to sound so apocalyptical, but this week in New York everyone around me seems to have been filled with dread, and I – no stranger to worried pessimism, as all my blog readers surely know – am also being infected by the mood.
I finally got back to Beijing on Monday, but after an interesting lunch with a group of pessimistic Brazilian hedge fund managers who were concerned about financial fragility in China and its impact on Brazilian markets, I had to fly that afternoon to Hong Kong for two days of meetings. It is not a lot of fun traveling in a period like this, especially when people are asking your advice on market events, because whenever you are away from the screens for more than an hour or so it seems that another earth shattering event has taken place that makes all of your comments immediately out of date.
Not surprisingly, the Chinese stock markets did very badly this week. Monday was a holiday, but when the market opened Tuesday the SSE composite quickly lost 4.4%, and dropped a further 2.3% on Wednesday and 1.7% today to close at 1898.Clearly 2000 was not the bottom.In an effort to stop the decline the authorities announced today that effective Friday they will cancel altogether the stamp tax on stock buying.
Big deal.They have tried so often to signal the market up or down that I am pretty sure that they have little credibility left, and so I suspect that this cancellation will have absolutely no effect. Real news – either domestic or from abroad – is going to drive the market tomorrow.
Unlike in the rest of the world the local media seems to have been fairly muted in reporting the developing financial crisis. For example there seem to be more visible headlines in the People’s Daily and in Xinhua about the successful end of the Paralympics and of the tainted milk scandal than about the global financial crisis, much of which reporting was relegated to the business sections.I suspect that the authorities are worried about the impact of the rising gloom on retail spending, as perhaps they should be. Rising consumer demand was one of the few bright spots in recent economic data releases, and although I suspect that the Olympics had a lot to do with that, it won’t pay to scare Chinese consumers into saving more in reaction to the growing global uncertainty.
Actually a lot of journalists have been asking me today about the impact of the stock market on consumption and confidence. I don’t think there is likely to be a very
that had a different take: