My Blog

SAT 13 OCT 2007

The costs of corruption By Michael Pettis

A recent Carnegie Endowment for International Peace report, authored by Minxin Pei, claims that using a conservative estimate, kickbacks and theft account for about 10 percent of government spending and transactions.  This suggests, according to the report, that corruption and bribery costs China at least $86 billion a year.

 

I assume that Pei’s figures do not include corruption involving the private sector.  This can be pretty large.  One of my Peking University students told me last year that his job (he was very apologetic in describing it) consists of making friends with the heads of computer services at the hundreds of banks in China so that the small company he works for, which creates ATM-related software, can sell their products. 

 

Why is this friendship important?  Because the only way to get one’s products purchased, according to him, is by paying off the head of computer services, and since the person receiving the bribe needs assurances that the bribe-offerer is not working for the police, he will only accept bribes from people he knows well.  My student assured me that all his competitors have someone filling a similar function.

 

According to the Carnegie Endowment report corruption is concentrated in areas with extensive state involvement, such as infrastructure projects, real estate, government procurement and financial services.  I don’t know how good Pei’s figures are but if they are reasonable, they probably understate the cost of corruption significantly since they focus on public sector corruption, and as my student’s story suggests, corruption is widespread in the private sector too.  $86 billion is a high number – about 3-4% of GDP.  China, by the way, was ranked 72 on the Corruption Index among the 180 countries ranked in 2007 by Transparency International.

 

Although corruption is always harmful to an economy, when thinking about its economic impact we should distinguish between different kinds of corruption.  If corruption is stable and predictable it can nonetheless allow businessmen to continue to develop their businesses, employ workers, and create value.  In that case corruption is merely a kind of tax – inefficient in that it distorts business activity, like all taxes do, and of course even less likely than normal fiscal expenditures to be put to socially beneficial uses, but it need not significantly harm economic growth prospects.  This is not to say anything about the political and social impact of corruption, which of course may be highly destabilizing.

 

However there are at least two cases in which corruption can be much more harmful to a country’s economy.  If corruption is random and unpredictable, it can raise business uncertainty enough to cause a significant drop in investment.  As a Brazilian friend of mine told me, before the presidency of Collor de Melho in the late 1980s he used to know who he needed to bribe in order to get approval for projects, access to water and electricity, roads maintained, and peace from the unions.  He hated to make the payments, but at least the rules were clear and he could plan his expenditures with reasonable certainty.

 

Under Collor, however, things became so random and government officials so rapacious that he was never sure who he had to pay next, and since once he had made a significant investment the corruption escalated (because he had already made a big enough commitment that it made sense for officials to bleed him dry), he decided to stop investing altogether and to take his money out of the country.  When corruption significantly increases the uncertainty under which businessmen operate by disrupting the rules of the game, they disinvest.

 

The second case is when corrupt officials discount the future at very high rates (perhaps because of uncertainty about their period in office, or factional fighting, or political instability).  This changes their attitude towards long-term development.  A “rational” corrupt official wants to maximize his economic rent (I love this value-neutral term for corruption) over the long term, so it is in his interest that local businessmen over whom he has power are successful and their profits grow over the long term.  The bigger and more profitable they are, and the longer the bribe-giving relationship, the more money the official receives.  In these cases long-term growth is very compatible with official corruption, and in fact it is pretty easy to think of cases that exhibit this kind of “far-sighed” corruption.

 

In cases where the corrupt official has reason to question the stability of his stay in power, however, what matters is to maximize rent in the short term, not in the long term.  In that case he is more interested in looting the company of whatever assets it has that can be easily liquidated, even at the risk of killing the company.  These are particularly harmful cases because the bribe-offering managers also know that the risk to the company, so presumably they also become much more interested in looting assets than in building a profitable business.  This kind of corruption (along with the former) was characteristic of the last few years of Nationalist rule in China.

 

I have no idea what the mix of corruption in China is, but I suspect that we are largely experiencing the “good” kind of corruption (blog readers please disagree if you think otherwise).  It is not just the current mix that is important, however, but also how things can change.  For example, if factional fighting becomes bitter and so forces officials to discount the future at higher rates (because it is harder to predict how long they will retain power), I would imagine that we would see more of the latter kinds of corruption develop.  In a way the fight against corruption, if it ever becomes effective (which I doubt), might even have the perverse consequence of increasing the looting mentality because corrupt officials will be concerned about getting enough money out of the country as quickly as possible before they get noticed and caught.

 

Most importantly we should understand how a great deal of corruption, even of the “good” kind, can add instability by creating a self-reinforcing mechanism that amplifies decline.  By this I mean that in case where there is any sort of political or economic crisis, of the threat thereof, it may force officials to change the type of corruption – as Color de Melho’s presidency in Brazil in the late 1980s did – so that it amplifies the decline.  In that case the danger of corruption is that, probabilistically speaking, it fattens the tails of the distribution of potential outcomes and, as every finance geek knows, fatter tails raise financial distress costs.  In fact maybe we can think of corruption is a type of financial distress cost – the economic cost of corruption rises with the probability of crisis.

SAT 13 OCT 2007

$23.9 billion surplus in September By Michael Pettis

China's trade surplus was $23.9 billion in September, less than August’s $25.0 billion but a lot more than last September’s $15.3 billion.  In fact it was the fourth largest monthly trade surplus ever (June’s was the largest, with July and August close behind).  The trade surplus year to date is $185.7 billion, handily beating 2006’s full year’s surplus of $177.5 billion, which at the time seemed like an extraordinary number – and we haven’t hit the busy end of year months yet.  So far we are 69% higher than we were at this time last year.  A straight-line projection suggests that the total trade surplus for 2007 is likely to come in at $300 billion for the year.

 

According to an article in Friday’s FT, Zhang Yansheng, a director at the Institute of International Economic Research in Beijing, said he expected China’s trade surplus to keep growing for the foreseeable future. But he argued that the exchange rate was not the solution to the imbalance.  “The yuan is not the answer to solve the problem because exporters in China are not so sensitive to prices,” said Zhang, whose think-tank is affiliated to the National Development and Reform Commission, the main economic planning agency.  Similarly, in today's FT, Richard McGregor writes that "Few economists believe that a stronger renminbi will transform bilateral trade relations with Beijing, as China’s export growth reflects in part its repositioning as the last point of assembly for Asian goods shipped overseas."

 

I think McGregor is right to note that many economists agree that the currency level is not directly the cause of the trade surplus, but I think Mr. Zhang's statement is a bit disingenuous.  If moving the yuan will not hurt China’s export sector, then why put up with the huge domestic imbalance in money supply?  Like most policy-makers Zhang seems to misunderstand the relationship between the currency level and the trade surplus. 

 

The currency regime is at the root of the exploding trade surplus not because of its direct impact on relative pricing but because of its impact on monetary policy (or the complete lack thereof).  Raising the value of the yuan might not directly affect export competitiveness as much as people hope or fear (I think it might have some noticeable impact on exports, but I accept that trade experts have a far better grasp of this than I do), but if raising the value of the yuan encourages imports and slows down capital inflows (or even reverses them), China's monetary policy will not be so incredibly expansionary and Chinese industrial production will moderate, so reducing the prssure for export expansion.

 

By the way exports were up 22.8% year on year whereas imports were up only 16.1%.  Surely this might have something to do with the declining yuan versus the euro, no?  According to today's FT, year-to-date exports to the EU were up 37% and to the US they were up 16%

 

SAT 13 OCT 2007

More of the same By Michael Pettis

Yesterday the PBoC raised minimum bank reserve requirements for the seventh time this year from 12.5% to 13.0%.  Needless to say the market subsequently rose. 

 

In related news, the PBoC reported that its reserves had grown by $101 billion in the third quarter to $1.43 trillion.  I am not sure how much money has been extracted for the CIC, so I don't know what the real increase was.  Brad Setser estimates that valuations gains on their portfolio of euro and yen paper accounted for about $20 billion of that increase.  Add $73 billion for the quarter's trade surplus and another $15 billion for estimates of the rest of the current account (again Brad Setser's estimate), and it adds up to $108 billion. 

 

What's missing?  Inward FDI (running at about $15-17 billion per quarter), net hot money flows, and outward FDI.  If ownership of Central Huijin has already been transferred to the CIC, that would mean that "real" reserve increases were $67 billion higher, and if the $3 billion for the Blackstone investment were also transferred, then the real increase in PBoC reserves would be $171 billion, but I am not yet sure about the numbers.

 

In completely unrelated news, Sotheby's had its first major auction since the subprime crisis broke.  Eight paintings by living Chinese artists were sold, four of them well above their high estimates.  Although there were also paintings on offer by Damien Hirst, Francis Bacon, Richard Prince, Ed Ruscha and Indian artist Shaw, the highest price went to China's Yue Minjun, for "Execution", a 1995 painting of laughing men in underwear.  It was sold for 2.9 million pounds.

 

 

MON 15 OCT 2007

The CIC should not invest in Chinese banks (2) By Michael Pettis

Knowing this rather brutal history, I think one of the main goals of the CIC should be to act as a balance sheet corrective – to take on positions that may deteriorate when China’s underlying conditions are good but appreciate when things turn badly.  At the very least this can smooth out government creditworthiness, which is a major source of instability because of the impact of perceptions of government credit on investment decisions and capital flight. 

 

To a certain extent that is the purpose of central bank reserves – they are there for liquidity purposes – but the CIC should manage this risk much more aggressively.  This means identifying possible reasons for a crisis in China and then to take countervailing positions.  A crisis reduces Chinese government ability to service debt, which can both cause and be exacerbated by capital flight (another, among the most damaging, self-reinforcing balance sheet structure).  If the CIC invests in a way so that its debt servicing capacity increases at exactly that time, it would reduce investor concerns and eliminate one important source of volatility.

 

It is a complex process to discuss all the possible major risks China faces and what the countervailing corrective balance sheet positions might entail, but I think everyone would agree that a banking crisis is one obvious disaster scenario – even if we disagree on its probability.  Chinese banks, already insolvent or barely solvent if loans were correctly marked, have seen tremendous loan growth during optimal liquidity and GDP growth conditions, and knowing what we know about how inexperienced Chinese banks are in managing major economic volatility, it is hard to imagine why they would be an exception to the almost unbroken history of banking systems making bad lending decisions in times of excess liquidity.  This risk is highly pro-cyclical because of course a slowdown that caused a rise in NPLs would also cause an economy-wide hoarding of liquidity and a contraction in lending, as in Japan in the 1990s, which would exacerbate the slowdown as well as the rise in NPLs..

 

I know, I know, many people who assume that there are only two banking systems in the world – that of the US and that of China – will point out that banking history isn’t relevant since the two countries are radically different. In China, we are told, the banks are state-owned, and so will not contract their lending because the government can simply order them to keep lending. 

 

Rather than explain why this is unlikely to be the case, I should just point out that banking crisis have actually occurred very often in countries other than the US, and in many of these countries the governments also owned the banking system.  Government ownership of the banking system (or of anything else) is almost certainly not a useful indication of immunity from crisis.

 

If you agree that there is a real possibility of a banking contraction, you would probably also agree that a banking contraction may cause a surge in government debt, partly to cover rising NPLs and partly because of increased fiscal expenditures to counteract a contraction (along probably with reduced tax collection).  You would also probably agree that a position in which the government benefits during a banking crisis and suffers during a period of banking improvement (in other words, a hedge to the banking system), would reduce the country’s balance sheet risk by hedging the government’s debt-servicing capacity.

 

There are many possible ways to hedge – for example a serious banking crisis in China would almost certainly see a rise in the value of US Treasury bonds – but of course the simplest hedge would be to go short Chinese bank stocks.  We cannot expect the CIC to take a massive short position in Chinese banks stocks (which the government can do more efficiently anyway by privatizing its shares), but we can argue that for it to take a massive long position just does not make any sense from a balance sheet perspective. 

 

As I have written elsewhere, Chinese bank share prices contain a lot of time value and very little intrinsic value, so they are enormously susceptible to changes in expectations.  During any sort of economic or banking contraction, experience from other developing countries with high-time-value banks suggest that drops in value of as much as 50-75% are not implausible, so if China were to experience a banking crisis, one consequence would almost certainly be a collapse in bank share prices.  It would not boost investor confidence much to see the value of the CIC’s investment drop – perhaps by as much as 50% or more – just when the country was experiencing trouble.

 

If the CIC is truly to be useful to the long-term growth prospects of China, it should not simply be an investment fund but should combine some of the interests of a central bank (stay liquid in case of a repayment crisis), a stabilization fund (smooth out the impact of commodity price volatility on the economy), and a balance sheet stabilizer.  Under none of these three cases should it invest in Chinese banks.

 

I realize that on the one hand China has such high levels of reserves that protecting the value of reserves in a crisis may not seem like a particularly pressing need, and on the other hand that through its purchases of bank stocks the CIC is not increasing government exposure to the banking system – it is merely receiving the transfer of existing ownership – but I still do not think it should own the banks.  The ownership of the banks should be funded by domestic borrowing, not by reserves, and good risk management practice should always be put into place not when conditions are bad but precisely when conditions are so good that risk management seems like a stupid idea.

 

It is always dangerous to make predictions, but I have absolutely no fear of making one prediction.  As JP Morgan famously said when asked which way the market was expected to move, markets will fluctuate, and good times will inevitably be followed by bad times.  Developing countries with poor governance frameworks, unstable banking systems, weak information disclosure and rigid political structures (sound familiar?) have a history of veering violently from good times to bad times, and balance sheet structures that exacerbate volatility are always one of the prime culprits.  China could become a real innovator in developing country liability management if it used the CIC to attempt to correct these balance sheet imbalances, rather than exacerbate it.  Of course that means acknowledging the possibility that things can go dramatically wrong, and this is not always an easy idea to sell to a politician.

 

MON 15 OCT 2007

The CIC should not invest in Chinese banks (1) By Michael Pettis

After netting out its existing commitments, the CIC has not $200 billion but closer to $70 billion to play with.  It is paying the PBoC $67 billion to take over Central Huijing’s bank shares and is making further investments of $40 billion in the sickly Agricultural Bank of China and $20 billion in the China Development Bank.  Taking out the $3 billion that was used to invest in the Blackstone IPO leaves a mere $70 billion of the original $200 billion for other investments.  With reserves growing at its current astronomical rate ($400-450 billion in 2007?), it would be a surprise, however, if the CIC’s assets under management weren’t substantially increased at some point.

 

Most market expectations are that the CIC will be a passive investor, looking to put together a diversified portfolio that emphasizes getting the highest returns possible within some risk parameter.  This is not going to be easy, since the CIC’s funding cost – interest rate plus expected RMB appreciation – exceeds 8% and may well exceed 12-13% if, as many expect, the RMB were to appreciate at a faster pace.

 

Much of the discussion on reserve management strategy focuses on plans for maximizing returns, stabilizing commodity import prices, or managing the money for strategic purposes.  I would argue that there is another strategy, closer in spirit to the stabilization fund but a little different, that China should consider.

 

In a very useful May 2007 research piece on sovereign wealth funds, Andrew Rozanov of State Street Global Advisors claims that "defining a liability profile is arguably the most important step in designing and running any fund."  As I see it, a fund needs to figure out what kind of liability structure it has and how much risk it is willing to take, and this risk is often largely a consequence of the relationship between the asset and liability sides of the balance sheet (this applies to funds, companies, countries and even individuals).  Besides the normal economic volatility that developing countries must accept, there is another great source of volatility that arises from the mismatching of assets and liabilities.

 

One of the great weaknesses developing countries have is what statisticians call “fat tails”.  Whatever the average expected outcome over many years of such measures as GDP growth, the fact is that for a number of structural reasons there is a much wider range of plausible outcomes for developing countries than for developed countries.  While one can argue for example that “expected” GDP growth for China over the next several years may be between 8% and 9%, it is not implausible – in fact it is very likely – that for individual years, and maybe even for the whole period, growth rates can be significantly higher or lower.  Any estimate of future expected growth is incomplete if it doesn’t come with a warning that the range of plausible outcomes is extremely wide – much wider, for example, than a prediction for the equivalent European, Japanese or US figures.

 

During the boom period we are currently living through it may be very hard to imagine that China might ever experience many years of very low growth, but this just reflects the tendency we have towards simple projections of the recent past.  In my previous developing-country experience, it was very hard during the boom years to convince anyone that Latin American or Asian countries might soon experience sharply slower growth, let alone debt crisis or defaults, and it is now equally difficult to argue that China is also likely to experience some serious turbulence.  However it would be a massive historical anomaly (anomalous even in the context of China’s own economic history) if this were not to be the case.

 

These fat tails around our average expected outcomes have a real cost.  Not only do they increase political and social instability, but they are one of the main reasons why the cost of capital for developing countries can be so unstable and generally so high.  They also have a tendency to encourage massive simultaneous inflows and outflows as investors chase the tails (or, more correctly, as they chase the swings to either extreme of the range of outcomes).  Anything a developing country can do to smooth out its development path and narrow the range of possible outcomes will, in the medium term create much more growth and political stability.

 

There are many reasons for fat tails – for example, an excess dependence on commodity exports, or a tendency to major policy changes and reversals caused by unstable political centers – but one of the major reasons the range of expected outcomes for developing countries have such fat tails is that weak financial systems and national balance sheets tend to exacerbate economic conditions, both for good and for bad.  This means that the countries’ balance sheets, which are often seriously mismatched, tend to incorporate structures that are self-reinforcing or pro-cyclical. 

 

This causes positive shocks to drive a country into a virtuous circle and a better than expected outcome, and vice versa.  In the current case of Brazil, for example, the very high and worrying government deficit, funded mostly by short-term borrowings, has exactly this sort of effect.  When conditions are good, interest rates fall, thereby causing the deficit to drop sharply (interest expense accounts for more than 100% of the deficit), which boosts confidence and so causes further interest rate declines.  Of course the opposite can happen, in which case rising interest rates and rising fears of government deficits reinforce each other until the point of crisis or near crisis, as in 1998 and 2002. 

 

Countries that borrow in dollars (or any external currency) to fund domestic operations also have this problem.  Mexico in 1994 and Korea in 1997 both suffered from very high levels of dollar debt, which seemed like a good idea during their earlier periods of high confidence and growth, because the value of dollar debt declined in real terms (with the real appreciation of the local currency and of domestic asset prices) just as things were doing so well.  Needless to say, when conditions reversed, both countries found themselves struggling to contain dropping asset prices and rising debt levels (caused by the depreciating local currency) which were mutually reinforcing because corporations with dollar debt were desperate to hedge, and the only way they could hedge was by selling local assets and using the resulting local currency to buy dollars, which caused further declines in the local currency as well as in local asset values. 

 

In both cases good conditions on one side of the balance sheet begat good conditions on the other, and bad begat bad.  There are other sources of this balance sheet instability.  Rigid or insolvent banking systems, excess commodity dependency, high levels of government contingent liabilities, and weak governance, for example, can all create or exacerbate balance sheet instability.  I discuss other such structures and their impacts in my book, The Volatility Machine.

 

MON 15 OCT 2007

Still censored after all these days By Michael Pettis

No postings in three days followed by six postings in two days -- no, I am not suffering from manic depression, its just that I have had real difficulty in posting my blog entries thanks to the refusal by the Chinese censors to permit any Sampasite blogs to be viewed in China.  I finally got back on yesterday, and so posted all at once the things I had been writing over the previous four days.

 

For the curious, the best explanation I have for the censorship is that one of the blogs on Samapsite is dedicated to Tibetan Buddhism, and I think that is considered a sensitive enough topic for the censors to decree it off-limit during the period before the 17th CPC Plenum.  Not content with just closing access to that blog, they have closed access to all Sampasite blogs.  This has been happening to thousands of other sites besides mine and is a source of a lot of complaints by foreigners and Chinese alike.

 

Nonetheless I have been able to get back onto my blog by that most Chinese of remedies, I asked Oliver Shang, my very smart Peking University undergraduate assistant, to solve the problem for me, and of course he and his equally smart classmate Yi Jiang did.  Thanks guys.  

 

For any of my blog readers in China who are having similar problems, please don't write asking me how the problem was solved.  I am not smart enough to tell you, and all I will be able to say is that the solution is to get some very smart Chinese kid to fix the problem for you.  For those who are concerned about the effect of censorship on Chinese development, it will definitely slow things down here, but many of these kids are smart enough to treat most censorship as a tedious joke.  It is mostly older guys like me who find it to be a real annoyance.

 

MON 15 OCT 2007

Will CITIC buy a stake in Bear Stearns? By Michael Pettis

My past seems to be closing in on my present.  Six years ago, before I decided to move to China (for two years, but who’s counting?), I was a Managing Director at Bear Stearns where I had been working for nearly five years.  Today, after hearing rumors for a long time, I find in the FT that CITIC has been in talks with Bear Stearns about their buying a significant stake in the US investment bank.

 

For Bear Stearns if this happen I think it will be a very good deal.  They will not only get a wad of cash but they will suddenly become real players in the Chinese markets, where until now, frankly, they are barely on the radar screen.  For CITIC I think the deal would be more mixed.

 

First of all, as I discussed in a series of entries on October 3 and October 8, financial institutions whose share prices consist mainly of time value should see their share prices suffer if anything reduces the expected volatility of their future earnings.  Making a major acquisition in the US will do just that for CITIC since it will significantly diversify their earnings and asset base.  If an announcement were made that CITIC is indeed making a major investment in Bear Stearns, I expect the news would first send the price up in Shanghai and possibly Hong Kong as the market reacted with nationalist pleasure to the sight of CITIC flexing major muscle, but would then come down in Hong Kong as the implications set in.  In Shanghai it is hard to imagine anything that would cause CITIC’s price to tumble save a bursting of the local stock market bubble.

 

Nonetheless from a strategic point of view CITIC would gain a huge amount of international credibility and would certainly be in a position to learn a lot from the tie-up.  Bear Stearns, in spite of the recent sub-prime embarrassment, is an excellent bank with what I think is the best risk management of any major Wall Street firm.  I think they are good at managing risk because they depend on a lot more than risk-management models to assess and moderate risk – their risk managers have real power and walk around the trading floor carrying big sticks.  Frankly I think Chinese banks need more of the latter and less of the former to get it right.

 

Bear Stearns also has one of the best sales efforts in the US, and although US firms still cannot buy much in China, once capital controls are removed the CITIC-Bear-Stearns partnership would almost immediately make it the biggest conduit for US/Chinese capital flows.

 

For regulators wanting to professionalize Chinese investment banking and ensure that national champions can survive the brutal international markets, the tie-up may seem like a great idea.  Unlike most major banks Bear does very little in China and so there wouldn’t be much fighting over turf.  However, it should be pointed out that foreign acquisitions of US investment banks have never been easy and the relationship is unlikely to be cozy.  Bear Stearns has a ferocious take-no-prisoners culture that is unique on Wall Street and which will make it very hard to assimilate.

 

As of this writing CITIC was trading in Hong Kong around 6.40 per share.

 

TUE 16 OCT 2007

- By Michael Pettis

Oliver, my assistant, prepared the following graph showing monthly CPI and PPI numbers since 2004.  We should have already received the September figures (October 11), but because of the 17th Plenum the release was postponed to October 24.

 

 

 

TUE 16 OCT 2007

September money growth By Michael Pettis

In September M2 was up 18.5%, up from 18.1% the previous month.  M1 grew by 22.1%, down from last month’s 22.8% (all numbers are year on year).  In either case it is clear that money growth is still too high, and small changes up or down won’t matter, especially since excess money growth is a stock problem as much as it is a flow problem – the “right” amount of money growth must take into account the removal of previous excess.  

 

I believe August and September’s M1 growth rates are the highest year on year figures recorded since late 2000.  M2 growth was slightly below the levels achieved for a few months during early 2006 and about 2% below most of 2003, but they are well above the average growth rates for the past three years or indeed for this decade, and it seems very difficult to bring them down.  Those of us who believe that China’s monetary policy is at the root of its economic imbalances are as worried as ever.

 

New loan issuance is down, to RMB 273 billion in September.  That puts the monthly average for the third quarter at RMB 273 billion (compared to RMB 474 billion for Q1 and RMB 374 billion for Q2, according to calculations by Credit Suisse).  On an annualized basis loans during the third quarter are growing at a rate equal to roughly 15% of GDP.  Year to date they have grown by over 21% of GDP. 

 

Meanwhile RMB deposits continue to drop (by just over RMB 52 billion in the last two months) presumably to go into the stock markets, but with RMB 17.2 trillion in the banking system (about $2.3 trillion), there is plenty more where that came from.

 

Some predictions?  The recent pressure to slow down loan growth will abate after a few months, as it always does, and loan growth will accelerate once more.  The PBoC recently issued more mandatory central bank (low coupon) notes to banks that they believe are lending too aggressively.  To me, the fact that they are doing this is not evidence of the success of administrative measures but rather a sign of how difficult it has been (with several minimum reserve and interest rate increases) to slow loan growth.  At any rate they have issued $95 billion of these this year over six different occasions.  There doesn’t seem to me much infamy associated with being punished this way.

 

If the root cause of money and loan growth is expanding reserves – up $367 billion year to date, or roughly 17% of GDP, without counting the amount of reserves, if any, that were transferred to the CIC – then it doesn’t much matter what kind of administrative measures they use. At most, bank restraint would simply increase money flow into other forms of financing.  Kelvin Zhao, one of my former Tsinghua students, recently wrote to me about some rather weird real estate transactions that are taking place in Wenzhou (China’s capital of “informal” banking).  I don’t fully understand his explanation of what is happening, but it seems pretty clear to me that a lot of people are still finding it a little easy to raise money.

 

TUE 16 OCT 2007

Inflation for September? By Michael Pettis

According to a report in today’s Bloomberg, Chen Deming, Vice Chairman of the National Development and Reform Commission, said in a speech to the congress today that consumer prices rose 4.1 % in the first nine months of 2007.  That apparently calculates to a rate of between 5.8% and 6.2%, but I don’t have the numbers to do the calculation myself.

 

Not surprisingly, this was presented as good news (“Inflation has clearly moderated” he said), but even compared to August’s 6.5% number, it is not particularly good news, and certainly is not compared to the 5.6% reached in July.  I am not sure how important the price freezes have been, but I would guess that they must have had some effect in artificially depressing the nominal number, and if inflation has been caused by more than a couple of temporary factors (monetary expansion maybe?), the price freezes shouldn’t have any positive effect.  Anyway my trusty calculator tells me that this means inflation for the past three months has been 6.0%, well above the PBoC target.

 

By the way the article also mentions that property prices jumped 20.8% in Shenzhen and 12.1% in Beijing in August from a year earlier

 

WED 17 OCT 2007

A different CPI estimate? By Michael Pettis

Amy Auster, in an ANZ research report today titled “A sixth Hike is on the Way”, says “Following the rise in August inflation to 6.5%, rumours in the market suggest that September inflation will remain well above 6% and may even reach 7%.  Although the pork price, which is the primary diver of inflation, has been falling in recent weeks, the prices of vegetables, poultry and eggs have all been rising in September.”

 

This is a very different September CPI estimate from the one I discuss in the entry below.  Needless to say it is a great deal more alarming.  Unfortunately we have to wait another week before we will know the truth, or at least the officially approved version of the truth.

 

WED 17 OCT 2007

Will a stock market crash matter? By Michael Pettis

Shanghai-based economist Andy Xie (formerly Morgan Stanley’s chief Asian economist and one of my favorite economists on China), has an interesting Op-Ed piece in today’s FT in which he argues that the Chinese stock market may well be in a bubble but that its bursting will have a minor impact on China’s economy.  Among the points he makes is that whereas the value of Chinese stocks and residential property is equal to 3.5 times China’s GDP, in Japan in 1989 and Hong Kong 1987 their combined values peaked at nearly ten times their respective GDPs.  This means that in GDP terms a collapse in stock or residential property prices will have a smaller economic impact in China than it might have had elsewhere. 

 

He says for example that a 50% drop in the Chinese stock markets would eliminate as much paper wealth as only a 15% drop in the US stock markets.  Xie’s point is that if there is indeed a stock market and real estate bubble, when it bursts it might not have enough of a fundamental impact on the underlying economy to matter.  He even implicitly argues that given how expensive housing has become, a drop in real estate prices may be positive because it will reduce, not increase, social tensions: “If the property market drops 30 per cent, most people in China will laugh; only the rich and powerful will grumble.”

 

I often worry that one of the reasons financial crises take us so often by surprise is because we assume that they are caused by misalignments in the underlying economy, whereas I am convinced they are caused by balance sheet misalignments.  For that reason my hackles were a little raised by his comment on the impact of a real estate crash on the banking system.  He says: “The banks may suffer bad debts. But the Chinese government has a tendency to pick up the tab after a party and gets another one going right afterwards. It still has the money to do so.”

 

Maybe.  Regular readers know that I am skeptical about how much room the government has to pick up yet another tab as glibly as all that.  I think contingent debt levels are much higher than most of us think, and I am pretty certain that if there is a sharp break in the market, people will suddenly want to get a sense of how much debt there really is – and when that happens the lack of transparency will no longer be seen as a virtue.

 

By the way around a year ago we were saying that stock market capitalization was only 40% of GDP, so a crash would have a minor economic impact.  Now we are saying that stock market capitalization is only 115% of GDP (and only one-third of the shares float, as opposed to one-fifth back then), so a crash would still have a minor impact.  Still, an awful lot of paper wealth has been created, and this wealth creation has not been spread out evenly over China.  Much of it has been concentrated among middle class residents of the largest cities.  I would guess that this is not a group whose opinions can be too easily dismissed.