My Blog

SUN 21 OCT 2007

The currency regime adds volatility By Michael Pettis

Several of my students who read my posting “The CIC should not invest in Chinese banks” asked me to elaborate further on the concept of pro-cyclicality and self-reinforcing structures embedded in balance sheets.  I thought it might make sense to discuss the idea generally, and then see why it applies especially to China.

 

As is widely known and understood, the cost of capital for any borrower is partly a function of expected volatility.  When an investor lends money to a Chinese entity (or any entity at all) he is effectively short a put option on the assets of that entity.  As with anyone who is short an option, an increase in expected volatility hurts the lender and a decrease helps him. 

 

To see this intuitively, it is enough to point out that lenders, like all unhedged writers of put options, suffer much more from downside risk (they might not get paid back) than from upside risk (the amount they get repaid is capped).  An increase in volatility means that it is more likely that the underlying asset may be worth more or much less than originally expected, but the lender is affected far more by the possibility that the asset drops in value.  For this reason lenders hate volatility and penalize borrowers for increases in expected volatility.

 

My more advanced students will already be arguing that actually for highly distressed debt this is not necessarily true, and of course they are right, but let’s ignore that special case.  In general the more volatile a borrower’s earnings or assets are, the higher the credit spread required by lenders. 

 

Volatility is not the only thing that determines the credit spread of course.  The less debt a borrower has relative to his assets, the lower the credit spread.  Both of these measures are explained elegantly by the idea that the credit spread, or, more accurately, the present value of the credit spread, is the value of the option the lender has implicitly written.  Since the value of any option is equal to the time value plus the intrinsic value, if the time value is low (volatility is low) or the intrinsic value is low (the option is way out-of-the-money – which is the same thing as saying that the value of assets substantially exceed the nominal amount of debt), the credit spread will also be low.  The two best ways to reduce a borrower’s borrowing cost, then, are to reduce debt levels or to reduce underlying volatility, so if China wants to reduce its cost of capital, one way of doing so would be by reducing expected volatility. 

 

What about equity investments in China – are they also affected by reducing volatility?  Deriving the impact of volatility on equity investment is a little more complex but once again the option framework explains what we in fact see in real life.  For entities with high credit spreads (low creditworthiness), the delta of their debt is high and the delta of equity low.  Under those conditions, there is a disincentive for equity investors because much of the improvement that might occur in asset value accrues to lenders rather than to equity investors (remember that among other things delta measures how much of the change in asset value goes to lenders and how much to equity investors).  In national terms, the option framework predicts that declining creditworthiness, which can be caused either by rising debt or by rising expected volatility, encourages disinvestment (capital flight), and vice versa, which is exactly what we see in the real world.

 

Volatility, then, has a very negative impact on the efficiency of investment.  It raises the cost of debt and creates a disincentive for equity investment.  Less volatile countries generally get a bigger bang for investment than more volatile counties. 

 

Although for now China does not seem to be a country that needs to worry about high credit spreads, this is because China has reduced its default risk by the very expensive strategy of building huge reserves (which acts as negative debt).  Nonetheless China, like any developing country, would still benefit from strategies that reduce its expected volatility.  The benefit occurs at all times but it is less noticeable during times of global growth and high liquidity because risk appetite is high and the cost of volatility is low – i.e. implied volatilities are lower than expected volatilities.  It is very noticeable during difficult times when risk appetite dries up and the cost of expected volatility rises, especially since implied volatilities tend to rise even faster.

 

All of this suggests that as part of a process of building insurance against bad times China, like any developing country, should be trying to reduce expected volatility.  There are many sources of volatility in China but one of the most obvious (and potentially destabilizing) is in the structure of the national balance sheet, and I have discussed that in many other postings.  To summarize: the impact of China’s contingent liabilities from the banking sector automatically causes expected volatility to be high because these contingencies act to reinforce external shocks.

 

There are at least two other major finance-related sources of volatility for China.  One is its excess dependence on exports, and the second is its currency regime, in which China’s money supply is a seemingly random variable based on the amount of capital and current account inflow.  Fixed exchange rates (and most variations thereof) automatically create pro-cyclical monetary policy because money flows in when conditions are good and flows out when conditions are bad, and this flow automatically shows up as accommodation (when times are already good) or contraction (when times are already bad).  This net flow exacerbates the underlying conditions through its effect on money creation.

 

These two sources of volatility are actually highly correlated, and this is what makes the risk so much greater.  When the world economy is growing, China’s exports and Chinese corporate profits soar, and China’s money supply also soars because of the forced monetization of capital inflows (the PBoC must buy all the dollars that “enter” China).  China gets a double benefit from the good times.

 

Of course if the world were to slow down substantially, and China’s exports were to dry up, the currency regime would no longer act as a money-creating turbo engine.  On the contrary, money creation would slow down just as profits began to dry up, and if the slowdown led to nervousness and capital outflows, money creation would actually go into reverse.  Of course as long as it pegs the RMB, the PBoC could not simply print its way out of monetary contraction because that would almost certainly cause a run on reserves, and the faster it printed money, the faster reserves would run out. 

 

This is not just a theoretical consideration; this boom to bust process has occurred so many times in so many other circumstances that it is still something of a puzzle to me why it has almost always come as a surprise.  The this-time- (or this-country-) is-different argument never seems to die.

SUN 21 OCT 2007

September inflation remains too high By Michael Pettis

I am in France for a board of directors meeting so I have not been as timely with my blogs as I would like to be.  The news that September CPI came in at 6.2% is by now old news.  A lot of people, from the government to a number of research analysts have been trying to put a brave face on it, but I think the number is not something we can ignore, for at least three reasons:  First, although it is less than last month’s 6.5%, it is also much higher than July’s 5.6% and, no matter what, 6.2% is worryingly high.  The fact that is down from its August peak is better than the alternative, of course, but it is not much comfort: average CPI inflation for the third quarter is 6.1%.  Four months ago if someone had predicted September’s CPI accurately he would have been accused of being a reckless alarmist.

 

Second, we don’t really know what the real CPI number is.  There are a lot of rumors flying around that the true number, if it hadn’t been reduced by price controls, and maybe even inaccurate reporting, would be even higher.  Some of my students who live in the provinces have sent me some pretty worrying emails about prices at home – especially, for some reason, in Sichuan.

 

Third, it does no good to blame inflation on temporary supply constraints in agricultural products.  Inflation doesn’t work that way.  A supply constraint causes the price of the affected good to rise, but by diverting expenditures it should cause the prices of other goods to fall enough to negate the overall inflationary impact.  This is clearly not happening.  Inflation may be low in the non-food sector, but the fact that it is rising in spite of serious supply constraints in the food sector indicates that there is real inflationary pressure in the system.

 

Let’s wait for October’s number.

TUE 23 OCT 2007

Food prices and inflation By Michael Pettis

With all the talk about Chinese inflation I haven’t been paying much attention to Hong Kong, so I was very interested in an article written by Lai Ying-kit in yesterday’s South China Morning Post (“Pricey food keeps pressure on CPI”).  Lai writes that CPI was up 1.6% year on year in September, mainly because of food prices:

Last month prices of food…went up 11 per cent. Among them, the price of eggs surged 32 per cent; pork rose 30.4 per cent and canned meat was up 28.8 per cent. Other food that became more expensive included poultry (up 27.8 per cent); beef (26.1 per cent higher); frozen meat (up 15.8 per cent); fresh vegetables (up 14 per cent) and other meat (13.9 per cent higher). 

 

On the other hand, the price of durable goods slid 4.2 per cent and electricity, gas and water fell 2.6 per cent. For the three months to last month, the average monthly increase in consumer prices was 0.2 per cent. For first nine months of this year together, the composite CPI rose 1.5 per cent over a year earlier.

To me this is what should normally happen when supply constraints cause the price of certain goods to rise sharply: the prices of other goods should fall, so that the net impact on inflation should be low or negligible.  This has not happened in mainland China

 

In a related piece in today’s SCMP, there is a report on a recent article written for China Securities Journal by Wang Xiaoguang, a senior economist of the Macroeconomic Research Institute, a think-tank under the National Development and Reform Commission.  According to Wang:

Consumer inflation would average 4.3 per cent this year, up from 4.1 per cent in the first nine months and well above the government’s goal of 3 per cent…But inflation would ease to 3.5 per cent next year due to increased supplies of food, especially pork, the main source of this year’s surge in inflation, Mr Wang said. 

 

Thanks to steps the authorities had been taking to curb exports, including cuts in value-added tax rebates, the mainland’s trade surplus growth was set to slow, he added.  The surplus was likely to hit US$257 billion (HK$2 trillion) this year, up about 45 per cent from US$177.5 billion last year, but would grow 20 per cent next year to US$308.4 billion.

CPI rises only by 3.5% next year?  I’ll take that bet (although I want an out if CPI is kept low artificially by the imposition of price controls).  As I have said many times before, I think most analysts are too focused on food prices in isolation, and are failing to understand how rising food prices should interact with the rest of the CPI basket.  My bet is that once food prices are “under control” inflation will migrate to other parts of the basket.

 

By the way, if next year’s trade surplus is 20% higher than this year’s astronomical $257 billion (Wang’s projection), I wouldn’t be too impressed by the steps he claims the authorities are taking to curb exports.  All Wang is saying, it seems to me, is that the authorities aren’t able to do anything.

 

TUE 23 OCT 2007

A slowing US won’t fix China’s trade imbalance By Michael Pettis

Yesterday I saw an article on Bloomberg about the possible impact of a US slowdown on China, and I think that once again we may need to revive the excess-consumption vs. excess-savings debate to figure this one out.  Among other things the article said:   

Weaker demand for exports because of a U.S. slowdown may be "exactly the tonic China needs" to reduce the problem of too much money in the financial system, Ben Simpfendorfer, a strategist at Royal Bank of Scotland Plc in Hong Kong, wrote in a report this month.  The World Bank has a similar view.  "A moderate global slowdown would mitigate concerns of policy makers on overall growth, inflation and the trade surplus, while China's strong macroeconomic position provides room to adjust the domestic policy stance if necessary," it said in a quarterly report.

This may be missing the point.  If the cause of global imbalances is largely, or exclusively, excess US consumption, then a slowdown in the US would indeed be a good way to slow down Chinese export growth and monetary expansion.  Lower US consumption would drive down the US trade deficit and the required adjustment needed to make the balance of payments balance would be a rise in Chinese savings relative to consumption.  The Chinese trade surplus would then decline, with all the positive things that means for monetary policy in China.

 

But I am not convinced.  If, as I believe, the cause of the monetary imbalance is that high Chinese savings have locked the country into a self-reinforcing trap – in which high money inflow leads to high industrial production which leads to a high trade surplus – then a US slowdown will probably not have much of an impact on China’s trade balance.

In that case the only significant way to interrupt the process would be to slow down or reverse the process of FX accumulation in China, and there is no obvious reason for assuming that a US slowdown will do that.  In fact, over the last year or so global growth outside China has been slowing, but you couldn't tell by looking at the Chinese trade surplus, which has ballooned.  On the face of it there doesn't seem to be much correlation between global growth and the Chinese trade surplus (which I think is more consistent with the monetary-trap argument).

Ah, you might say, in fact Chinese export growth is indeed slowing, so maybe there is a correlation.  Not really.  A slowdown in global demand may slow Chinese export growth, but only a slowdown in Chinese export growth relative to Chinese import growth can reverse the growth in the trade surplus. 

 

This is not happening, and is unlikely to happen even if the US economy slows.  As long as industrial production in China grows faster than consumption, China must run large and growing trade surpluses, and as long as it runs large surpluses, the banking system will ensure that industrial production will continue to soar.  This is why I always refer to it as a trap: it is not clear how China can get out of it short of a major currency adjustment that reverses capital flows.

If a US slowdown results in lower combined US and European net imports, how can the world nonetheless accommodate high and rising Chinese trade surpluses?  I guess other developing countries will see their own exports begin to dissipate.  In fact isn't that already happening?

 

TUE 23 OCT 2007

Markets and chaos By Michael Pettis

What a week already.  My assistant Oliver Shang tells me that yesterday Shanghai A-shares dropped 2.00% in the morning, rallied 0.77% from their lows, and then gave it up to end the day 2.59% down.  This morning the market rallied 1.10% before heading straight down 2.73% by mid-afternoon, and then turned around to regain 3.50%, ending 1.87% up for the day.

 

Why this volatility?  After the market closed yesterday it was announced that 10 futures brokers had been given their licenses, spurring speculation that the index futures will come to market soon.  On the other hand, there might be no good reason at all.  In such a highly speculative market it makes more sense to remember all the stuff we used to read about chaos theory – significant things happen for insignificant reasons.

WED 24 OCT 2007

Maxi-revaluation being discussed?

An October 24 article on Reuters (“China's NDRC unaware of yuan revaluation report” has a tantalizing story:

 

A news department official at the National Development and Reform Commission said on Wednesday he was not aware of an in-house report suggesting that China should consider a one-off yuan revaluation of 15-20 percent.  Market News International said that the internal NDRC report summarized the economic issues facing China and was distributed to leaders of the planning agency prior to the Communist Party Congress that ended on Monday.

Premier Wen Jiabao has repeatedly ruled out another one-off revaluation.    China revalued the yuan by 2.1 percent against the dollar in July 2005 and has since let it rise another 8.2 percent.

In May I wrote pieces for the Far Eastern Economic Review and the Wall Street Journal explaining why I believe a large one-off revaluation (15% or more) followed by a credible peg is the only workable alternative for the PBoC in regaining control of monetary policy.  The proposal might have seemed completely crazy at the time and was likely to be rejected out of hand by almost any analyst or government official, but I argued that over time (within a year) I believed that a consensus would develop that this was at least a possible topic of discussion.

 

It looks like this is beginning to happen, and I think that policy discussions are increasingly going to move in that direction.  I think by now there is definitely a consensus that China needs to speed up the process of revaluation, both for domestic reasons and to head off increasingly angry US and European officials, but because of its impact on encouraging hot money inflows I think a policy of faster revaluation is too risky and will cause further destabilizing inflows  It also runs the risk of significantly overshooting because there is no credible way to signal to the market when enough is enough, and hot money inflows will pour into China even long after the currency has reached a reasonable level, whatever that may be.  A speeding up of the revaluation in the trading band will only get China all the well-known evils of revaluation but none of the benefits (a reversal of capital inflows)

 

My guess?  China’s money supply and trade surplus will continue to surge – even a US slowdown will have no impact, as I explain in yesterday’s entry.  Inflation will stay high and probably even rise.  Some time in the first quarter of next year officials will become so concerned about China’s out-of-control monetary policy that the consensus will move increasingly in the direction of a one-off maxi-revaluation, although that probably won’t happen until after the Olympics.

 

Two additional points:  First, even if the consensus moves in the direction of a maxi-revaluation, the government will flirt with the idea of a much smaller-than-needed jump – perhaps 5-10%.  That would be a terrible choice because the markets will know that this isn’t enough to rebalance capital flows and investors and businessmen would immediately make big speculative bets that there will be one or two more moves.  The risk is that even when the government has revalued a second time and done all it needs and wants to do, it wouldn’t be credible, and so these “one-off” revaluations would simply encourage more speculative inflows.

 

Two, monetary growth has been so excessive that China will suffer a financial contraction anyway even if it were to revalue tomorrow.  But since the contraction is likely to come after the maxi-revaluation, there will be a terrific temptation to claim a repeat of Japan in the 1980s – the crisis happened not despite but because of the revaluation.  It will all be the fault of the US.  The argument doesn’t make sense in Japan – the bubble there was created by letting money supply expand too quickly before the revaluation, and when Japan finally accepted the need to revalue, it turned the adjustment process into a one-way bet for speculative inflows.  For similar reasons it will not make sense in China, but it will be politically very popular nonetheless to blame the US for the ensuing contraction.

 

WED 24 OCT 2007

PPI is up too By Michael Pettis

Two days ago my assistant, Peking University undergraduate Oliver Shang, told me very worriedly that the rumors were that PPI was going to come in higher than expected.  Yesterday at a news briefing the NDRC said September PPI was up 4.0% year on year, following a 2.6% number in August. 

 

According to Dong Tao at Credit Suisse (and as far as I know he has had the best and most consistent call on Chinese inflation), that brings PPI inflation for the first nine months of 2007 to 3.6%, versus 2.5% for the same period last year.  Steel and cement drove much of the rise – so we can’t blame pigs for this one. 

 

Gasoline prices are vulnerable too.  The last time the government hiked prices (and still kept them below a real market-clearing rate) was when oil was at $60 a barrel.  Might gasoline go up soon, or will we continue to bury that component of inflation in higher taxes?

FRI 26 OCT 2007

Don’t take comfort in reduced GDP growth numbers By Michael Pettis

China’s GDP grew by a too-high 11.5% in the third quarter of 2007.  Commentators trying to put a good face on this number were eager to point out that at least it didn’t grow by 11.9%, which was the rate for the second quarter.  Li Xiaochao, the statistics bureau spokesman, tried to offer us comfort by assuring us that “The surging economy has stabilized, while rising prices have been brought under control through a combination of monetary, fiscal policies and administrative measures.”

 

I am not so sure – 11.5% is a very high number, and the fact that China’s GDP grew at an even higher pace three months ago is scant comfort.  In fact among the numbers released yesterday is one that undermines, in my opinion, any positive spin on slowing GDP growth. 

 

To explain why let me go back to an earlier entry.  In a September 12 entry I wrote the following, concerning the decline in industrial production growth:

 

Industrial output grew at a slower pace in August, to 17.5%, from 18.0% in July.  The government had taken a series of market and administrative measures to slow growth down, of which I believe the most important has been, as it always has, instructions to banks to tighten credit to certain sectors of the economy.

 

This has happened many times before.  When growth numbers get out of hand the authorities put pressure on the banks to reduce loan growth, and for a couple of months loan growth slows, followed by slower growth in industrial production…

 

…My guess is that we will see a continued moderation of the pace of growth for a few more months but, unless the world economy contracts, before the end of the year growth in industrial production will accelerate again.  FDI for the first eight months of the year, by the way, was $41.95 billion, mostly into the manufacturing sector.  This figure is 12.8% greater than the amount over the same period last year.  That doesn't suggest to me that lending to the industrial sector declined willingly.  

 

I was partly wrong – there was no continued moderation in the growth rate of industrial production.  In fact for September it grew by an alarming 18.9%, much higher than August’s 17.5%.  Basically, as I expected, it didn’t take long for the slowdown to peter out, and even though at its lowest the growth in industrial production was too high, it very quickly turned even higher.

 

For me this is a very important number because it is at the heart of the self-reinforcing cycle: the high trade surplus leads to high monetary growth and investment, which leads to a further increase in production relative to consumption, the balance of which must be exported, so creating an even higher trade surplus.  If industrial production rises, expect the trade surplus to rise too.  China must export what it produces but doesn’t consume.

FRI 26 OCT 2007

The firewall has gotten worse By Michael Pettis

Contrary to expectations the firewall has gotten even worse and less discriminating after the completion of the 17th Congress.  Once again I cannot access my site except through a proxy, which cannot be used for postings, so I depend on a friend outside the mainland to make my entries for me.  I apologize for posting things a little late.  One of my Chinese colleagues recently expressed intense frustration at how the censors are making it harder than ever for Chinese students to use information technology even while another part of the government proclaims its intention to make China a technological powerhouse.  He is furious.  I am merely annoyed.