My Blog

SAT 8 DEC 2007

Two out of three "prevents" ain't bad By Michael Pettis

The mainland stock markets are down 19% from their highs in October, although Shanghai and Shenzhen both traded up this week, and there is a growing concern it seems, at least judging by the amount of ink spilled, that future IPO first-day-of-trading performances are less and less likely to achieve the eye-popping results that they have in the past.  If this is the case, we should see a lot less money tied up during the “frozen” period before and just after the launch of IPOs.  I would guess that mainland retail investors would be less interested in tying up so much money before an IPO if the expected return on the very small portion of their bids that actually receives allocations drops significantly.

 

This should be good news for small banks, who have been hurt pretty badly by the draining of liquidity caused by these IPOs (see my November 8 entry, “Small banks squeezed by IPOs”).  It would at first also seem to be good news for the PBoC, who has an unenviable task over the next three or four months of draining liquidity from the system without letting interest rates rise too much.

 

In the short-term, however, I wonder if smaller oversubscriptions might increase underlying liquidity by reducing the amount of money tied up in IPOs (which has been significant enough to drive short-term interest rates up in some cases by over 100 basis points).  I am already expecting the $80-100 billion a month on average that the PBoC will need to drain from the system over the next few months, most of which comes from maturing central bank bills, might help propel another leg of the mainland bull market in stocks.  It is interesting that before last week’s Central Economic Conference there was a consensus that one of the proclaimed macroeconomic objectives for 2008 was to help “prevent” asset bubbles, but this was not discussed in the policy statement largely, so I am told, because policy-makers were concerned about an adverse impact on the stock market.  Instead we only had two: “prevents”, prevent economic overheating and prevent spreading inflation.

 

It is not going to be easy to manage the reflation or deflation of the stock market bubble, especially since there is still a fight going on as to whether or not CPI inflation will persist.  Anxiety levels have clearly risen, but I understand that the NDRC is arguing that CPI inflation is limited to food and will subside quickly in 2008.  The institutional “reason” for their beliefs, I guess, is that they are pushing for reform on the pricing of energy and utilities, and this would be all the more difficult to achieve if inflation was spreading throughout the economy.

 

SUN 9 DEC 2007

Minimum reserves hit 14.5% By Michael Pettis

Yesterday evening just as I was about to go on Dialogue, the CCTV9 show, to discuss whether the PBoC would be able to shift its monetary policy from “prudent” to “tight” as proscribed in the leadership conference this week, my assistant called me up to say that the PBoC had raised the minimum reserve requirement for the tenth time this year, but instead of raising it by 50 bps, they raised it by a full 1%.  This brings the minimum ratio to 14.5%, the highest in PBoC history.

 

Although they will probably need to raise rates also to get real interest rates into solidly positive territory, it is pretty clear that constraining loan growth is likely to be preferred to raising interest rates for a variety of reasons.  Raising rates further will put unwanted pressure on mortgage borrowers and SOEs, and may encourage further capital inflows.  It will also raise the financing cost for the PBoC, whose borrowings are getting larger and larger at the same time as the denomination of its liabilities is rising relative to its assets.

 

Raising minimum reserve requirements and capping loan growth passes on the cost to the banks, which might not be a good thing in the medium term because banks desperately need profits to work their way out of their NPL portfolios.  They may also encourage money to leave the banking system to find better uses (for example, from desperate borrowers who are already complaining about slower loan growth).  This latest rise is estimated to take about RMB 350-380 billion in liquidity (around $50 billion) out of the system, but remember that in the next four months we are expecting about $80-100 billion on average of new money to enter the system every month, mostly from maturing PBoC bills ($20-40 from reserve growth).  Still, it is not as if there is much else the PBoC can do besides raising the value of the currency.

 

So can the PBoC shift its monetary policy from “prudent” to “tight”?  No.  The PBoC doesn’t really have a monetary policy.  When you peg the currency you lose control of domestic monetary policy.  That’s the problem.

 

MON 10 DEC 2007

Oh-oh! M2 growth is 18.5% and PPI is up – CPI comes out tomorrow By Michael Pettis

On the National Bureau of statistics website (stats.gov.cn) they have just released the PPI report.  For November the cost of manufactured goods rose 4.6% year on year – much higher than expected.  The biggest price increases occurred in mining and quarrying (15.1%), the foodstuff component of consumer goods (9.1% – consumer goods overall rose 3.7%), and raw materials industry (6.8%).  On their website the PBoC also released money supply and credit information – M2 was up 18.5%, above expectations and well above the PBoC’s target.

 

Tomorrow we should get CPI inflation numbers and most commentators believe that it will equal or surpass last month’s 6.5%.  What is worse we should probably see price rises in far more than the food component, which has been the main source of CPI inflation in the past.  This shouldn’t be a surprise.  I was never comfortable with the idea that “temporary” increases in food prices could exist without deflationary (or at least disinflationary) pressures on the non-food component of the CPI basket, but inflation in the non-food section, although relatively low, was rising.  For surging food prices to co-exist with rising inflation in non-food items has always suggested to me that the inflationary pressures were at least partially structural, and not just cyclical.

 

By the way there seem to be continued fuel shortages, which suggest that there may be further pressure to raise fuel prices again.

 

MON 10 DEC 2007

Cooling China

My students can't afford a subscription to the Wall Street Journal and they asked me to post the Op Ed piece I wrote in today’s paper.  Here it is:

 

For all the energy U.S. and European politicians have exerted pressing Beijing over the yuan, internal economic problems are the greater concern for Chinese policymakers. And whether or not Beijing realizes it, a policy move last week to clamp down on bank lending may hasten the day when China is forced to revalue its currency.

 

China’s financial authorities face two contradictory policy demands. They need to rein in out-of-control growth before it sparks rampant inflation. They also need to maximize job creation to avert social unrest that might stem from growing income inequality. And they are running out of policy tools.

 

Beijing has tried for at least three years to moderate growth, but with minimal success. In 2007 alone, the People’s Bank of China (PBoC), China’s central bank, raised its benchmark loan rate five times, to 7.29%. It also raised the minimum required capital reserve for commercial banks nine times, to 13.5%, the highest level in the PBoC’s history. Administrative measures have been introduced to limit bank lending, reduce price subsidies, redirect investment, and talk down speculative and investment activity. Last week, Beijing rolled out its next-to-last big gun, a Draconian administrative cap on new credit.

 

Still, GDP growth this year is expected to hit 11.6%, well above the already high 10% forecasts at the beginning of the year, and the fifth consecutive year of double-digit growth. Inflation has risen steadily to 6.5% in October from 2.2% in January, and there are reasons to believe that next year inflation might get worse. Most of the other warning indicators — expansion of the money supply, credit growth, speculative activity in the local stock and bond markets, increases in fixed asset investment and industrial production — are well above official targets.

 

Earlier measures have failed because they have skirted the underlying reason for China’s problem: its currency regime. Because the PBoC rigidly fixes the foreign exchange value of the yuan within a narrow trading band, it has lost control of domestic monetary policy. China’s money supply is determined primarily by the net inflow of foreign exchange on its capital and current account. Because the value of the yuan is set so low, China runs a large trade surplus, whose magnitude is further exacerbated by large amounts of foreign direct investment and speculative inflows.

 

These large inflows must be converted by the PBoC into local currency or central bank bills, so that the fantastic rise in China’s foreign reserves is matched by an equally large rise in its domestic money supply. As the money supply surges, it encourages massive increases in fixed asset investment (up 27% so far this year), which in turn causes industrial production to surge. Since China cannot consume as fast as it produces, the balance must be exported, thus forcing ever greater trade surpluses and locking the country into a self-reinforcing cycle of monetary excess. Until this mechanism is broken there is little China can do to control its economic overheating.

 

Beijing is still reluctant to consider a dramatic revaluation. Instead, last week’s meeting of the Central Economic Work Conference, an annual meeting of key policymakers, recommended a sharp clamp-down on credit growth. Banks will reportedly be permitted to increase their total loan portfolios next year only by an amount equal to this year’s lending increase. This is expected to bring loan growth down to 13% next year from 15% in 2007.

 

Caps on loan growth have failed before, thanks to lax enforcement, although most reports suggest that this time authorities are far more determined. Whether that is likely to happen during the run-up to the Olympics remains to be seen, but there is reason to believe that even if the authorities were successful, loan caps would have only a minimum impact on moderating underlying conditions. The measure would only force excess monetary expansion into other conduits for funding rapid economic growth.

 

Domestic measures to slow the consequences of monetary expansion will not work if the underlying monetary expansion continues unabated. The newly proposed curbs on Chinese credit growth, if they are effective, are only likely to fuel growth in the local stock and bond markets and to push money into the informal banking sector, where conditions are flexible and restrictions ignored.

 

The outcome of last week’s Beijing conference suggests a shift in the balance of power away from those determined to maximize employment growth and toward those concerned about the dangers of monetary excess. But the credit clamp-down suggests Beijing still hopes to address China’s economic imbalances without touching the currency regime. If and when last week’s measure fails to produce the desired results, the need for yuan revaluation will come even more sharply into focus.

MON 10 DEC 2007

Slower loan growth does not necessarily equal lower FAI By Michael Pettis

Does the market believe the declared loan tightening measures?  After the announcement Saturday afternoon that the PBoC was raising the reserve ratio 1% to 14.5%, Shanghai opened down Monday (my assistant told me that it opened more than 1% down, but I am not smart enough to get the intra-day info off the SSE website) but quickly recovered, and then kept moving up to close the day nearly 1.4% in the black. Just another uneventful day, I guess.

 

As I said in yesterday’s entry, I am not too optimistic that the renewed determination to limit credit growth is going to be very useful.  A serious attempt to reverse the monetary excess of previous years and to wring out inflationary expectations is going to require, like it or not, a real reduction in the rate of economic growth.  That means a reduction in the rate of employment growth, too, and with unemployment edging up even with the ferocious growth we have seen in the past three years, that translates into rising unemployment, likely to be worse among the young.  I am not sure whether the senior leaders really have that much appetite for an increase in unemployment, especially in an Olympics year.

 

In an Op Ed piece I wrote for today’s Asian Wall Street Journal (“Cooling China”, see entry below) I said:

 

Caps on loan growth have failed before, thanks to lax enforcement, although most reports suggest that this time authorities are far more determined. Whether that is likely to happen during the run-up to the Olympics remains to be seen, but there is reason to believe that even if the authorities were successful, loan caps would have only a minimum impact on moderating underlying conditions. The measure would only force excess monetary expansion into other conduits for funding rapid economic growth.

 

Several people have asked me what I meant by saying that the new measures “would only force excess monetary excess monetary expansion into other conduits”.  

 

The Chinese economy is a very large, very complex system with many moving parts, huge inefficiencies, and different ways of doing things, and given the furious expansion that has taken place in a system chock-full of regulators, bureaucrats, restrictions, rule changes, and conflicting directives, it should be no surprise that one of the great strengths of Chinese businessmen is that they have learned to be very flexible and to find ways around the thousands of irritations that buffet them on a daily basis.

 

This entails a huge diversion of resources to non-productive uses, and since the goal of much of this activity is to get around stultifying government-imposed restrictions, not surprisingly it also complicates the attempt by the central government to impose discipline on the economy.  If there is a ferocious demand for capital by rapidly expanding companies, and a huge supply of capital caused by the lack of a domestic monetary policy, successful attempts to interrupt the ability of commercial banks to intermediate the process might simply reduce the importance of banks as intermediators.  In today’s Financial Times Henny Sender (“China Loan Curb Hits Businesses”) shows one way how this might happen::

 

…Working capital has become a problem for many businesses in China as, worried about the possibility of an overheating economy, the government in Beijing has tightened controls on bank lending.

 

…In response, many companies are finding ways to circumvent the measures.

 

…In a complicated game of cat and mouse, as regulators try to close down loopholes, borrowers and intermediaries seek to locate others in their search for funds. For example, leasing companies have escaped the clampdown on lending. So if a company is unable to finance the purchase of equipment from the banks, it can turn to leasing companies instead.

 

…The cash crunch is particularly dire for smaller and private companies because Chinese banks favour their larger, state-owned clients. So when the bankers have to cut back credit lines to meet Beijing’s rigid new quotas, they first turn towards what amounts to the bottom of the corporate food chain.

 

I suspect that if the credit growth capping measures are successful, we are going to see a growth in financial “ingenuity”.  Informal banks and “non-bank” banks (as we used to call them when I was in business school) will increase their activity, and even the bond market will help take up the slack.

 

Not to end this on a note of pessimism, I see that one English newspaper is speculating that the Blackstone Group, perhaps with the help of the CIC or other Chinese institutions, may be preparing for a bid on Rio Tinto (which would involve at least $150 billion).  Encouraging outward expansion creates its own set of problems for the Chinese economy, but it does have one great advantage (besides the obvious one of heating up the market for China-based investment bankers just when I am thinking of returning to the market) – it does reduce the pressure on domestic monetary expansion.  But unless outward investments mushroom to frightening levels, none of this will really matter to overheating until the currency is fixed.

 

MON 10 DEC 2007

CPI is up 6.9%, trade surplus at a near record By Michael Pettis

The CPI numbers came in today, and as I expected they didn’t look good.  Most of the news services reported consensus expectations ranging from 6.7-6.9%, with the actual CPI inflation coming in at the high end – at 6.9%.  During the previous three months it was 6.5%, 6.3% and 6.5%, respectively.  Year to date prices have risen 4.6%, versus a target of 3%.  If we assume that 2007 inflation will be 4.7% for the full year, it will be the highest recorded number since 1996.

 

Food was up 18.2%.  Since major adjustments in the composition of the CPI basket occur only every few years, and minor adjustments only at the beginning of the year, food still officially comprises 33% of the food basket.  By now I would assume it must make up a larger share of the total basket than it did in January.  Raising food’s share by 10% to 36-37% of the basket adds about 0.5-6% to headline inflation.

 

Total inflation excluding food was 1.4%.  This may not seem like much, but it is the highest number all year, and substantially higher than the 1.1% last month.  What’s more, it suggests to me that we cannot take much comfort in the argument that inflation is primarily a one-off food problem.  If that were the case, we should see deflation, or at least disinflation, in non-food items, rather than increasing inflation.  I expect inflation numbers will not improve in the next few months and in fact will begin to spread into other categories as food inflation subsides.  By the way, I understand that there continue to be fuel shortages in parts of China, which increases pressure for reducing the fuel subsidy.  My understanding is that the NDRC is eager to convince senior authorities to approve more pricing deregulation, but I guess this will probably hinge on how well they are able to convince those authorities that inflation is just a food problem.

 

Here is one more reason to worry that inflation is likely to be sustained: the trade surplus for November, at $26.28 billion, was lower than October’s record $27.1 billion but still the third highest on record.  As such, it continues to act as a great source of monetary expansion.   

 

November’s trade surplus was 14.7% higher than last November’s trade surplus, and reflects a 22.8% rise in exports since last November and a 25.3% rise in imports.  The numbers are not good, but at least they are moving in the right direction in one sense.  Exports for the first 11 months were up 26.1%, versus imports, which rose 20.5%.  I don’t know if this is a seasonal effect, but it seems that later in the year import growth has sped up relative to export growth.

 

There is not a whole lot to say about any of these numbers because they do little more than confirm the story of the past three years: China is stuck in an expansionary monetary policy and nothing the authorities have done to extricate themselves has had any effect, nor is it likely to until they address the currency problem.  Most newspapers that reported today’s batch of numbers added that Chinese authorities announced last week that that China was switching its monetary policy from “prudent” to “tight”, but this announcement misses the point.  

 

China does not have a monetary policy.  It has an exchange rate policy, and as a consequence domestic monetary policy is largely a residual.  In one sense it seems to me that they are finally addressing the underlying monetary problem by encouraging capital outflows, but this is simply another, albeit more powerful, way to avoid addressing the fundamental problem.  Encouraging more and larger-scale outward FDI may take some pressure off the PBoC, but it runs the risk of pushing Chinese companies to invest outside of China before they are ready.

WED 12 DEC 2007

Chinese industrial production is “only” up 17.3% By Michael Pettis

In a piece of good news, the 17.3% growth in industrial production in November was well below expectations and below last month’s 17.9%.  This is, for me, a key figure.  Rising industrial production is central to the monetary trap in which China is stuck.  As production surges ahead of consumption, the trade surplus must also grow (since the excess must be exported), and as it does it forces the PBoC to expand domestic money supply in a way that then reinforces fixed asset investment and future growth in industrial production.  A reduction in the rate of growth would imply a future reduction in the growth rate of the country’s trade surplus. From a monetary point of view that is a very good thing.

 

Before we get too happy, however, it should be pointed out that growth rates are still too high.  Last year industrial production rose 16.6%, and for the whole of 2008 it is likely to rise by roughly by 18.5%.  They may have also declined a little because of the tightening measures that were recently put into place, and by the fact that companies haven’t yet learned how to get around them.  Let’s see if they continue to come down over the next few months.

 

WED 12 DEC 2007

Weak RMB? No! Weak dollar! By Michael Pettis

It looks like the Third Sino-US Strategic Economic Dialogue isn’t turning out to be much fun, although I think it is good for both sides to put their problems squarely on the table.  Chen Deming, China’s Vice Minister of Commerce, formerly Vice Chairman of the NDRC and expected to become Minister of Commerce in March, is by all accounts opposed to rapid RMB appreciation.  In his comments he argued that rather than focusing on excessive weakness in the RMB the US should be trying to do more about excessive weakness in the US dollar.  At one point he said, according the South China Morning Post, "What I am worrying about now is the weakening dollar and its potential impact on global growth. The dollar is the major currency for trade, and its continuous depreciation will push up prices of oil and gold and reduce the wealth of dollar-holding nations. So I want to see a strong dollar.”

 

This is a little disingenuous, I think. The dollar is not weak across the board. It is weak only against the euro and those currencies (and commodities) whose prices are allowed to float, and in those cases it is weak most probably because Japan, China, and other parts of the world especially in Asia intervene heavily to keep their currencies weak against the dollar.  As a consequence, the floating currencies have to take the full brunt of the adjustment needed to reduce the US trade deficit.  If there were less intervention to keep the dollar strong against local Asian currencies, I think we would quickly see a reversal of dollar weakness against the euro and other floating currencies.  I am not sure if Chen Deming doesn’t understand that or if his comments are simply meant to be part of the bickering, but it seems to me that when PBoC governor Zhou Xiaochuan talks about the weak dollar, he seems more careful and perhaps more aware of the role of the RMB in dollar “weakness”.  

 

Chen also argued – rather tiredly, by now – that the US trade deficit with China benefits the US because it allows US consumers to purchase cheap goods.  The fact that I mostly agree with him – I think the current US-China trade relationship is better for the US than for China, although mostly because it is bad for China – doesn’t keep me from finding this argument a little annoying.  If he really believes this, what would happen if the US delegation were simply to thank China for its generosity and then demand that China raise the value of the RMB substantially so that the US could repay China by selling China very cheap goods?  I am sure that he and most Chinese would reject the equivalent US generosity with horror.

 

Hank Paulson continued arguing for a more flexible exchange rate policy.  I am not sure what he means by this but I don’t think “flexibility” is in the best interests of China for the time being.  On the contrary, I think China should continue to keep its currency pegged, but at a much higher rate so that it can regain some control over its jet-fueled domestic monetary policy.  Given how weak and undeveloped the country’s financial system is, China needs much longer before the country can absorb too much flexibility in the exchange rate, and to allow the currency to float freely any time in the near future would be extremely painful for the economy.  Better to revalue and peg.

 

For all the bickering, the US needs to resist calls for protectionism at home, and I am pretty embarrassed by some of the comments from the presidential candidates – I hope these are mostly for public consumption and do not represent real policy positions.  I know there is disagreement on this front – for example my friend Brad Setser takes a much less benign view than I do about the domestic employment effects of the US trade deficit – but I don’t think the current trade imbalance is harmful for the US and it may even be necessary in the medium term as Europe, Japan, Russia and, most worryingly, China, are forced to pay for the very ugly demographic adjustments they will need to make in the coming decades.

 

For China the value of the RMB is part of a very complex set of policy changes that can have serious economic (and political) repercussions, and there is clearly a great deal of worry in Beijing.  I think they are making a big mistake on the RMB issue, largely because gradualism has become a new ideology in China and it will take a real disaster to break with it, but the problems the Chinese are wrestling with are substantial.  The US really needs to be more patient.

 

By the way, as I have said many times, China is increasingly likely to face a very uncomfortable adjustment to its domestic monetary policy (or lack thereof), and if this were to happen after a forced appreciation of the RMB, it is an almost dead certainty that the US will be blamed and that there will be a revival of very ugly nationalism in China.  A little forbearance from the US and less silliness from domestic politicos would not be a bad thing.  China’s RMB policy is definitely very harmful – but mostly for China.  For the US it really does mean that Americans get cheap stuff, much of which isn’t, or shouldn’t be, made in the US, from doubly underpaid Chinese.

 

FRI 14 DEC 2007

Foreign companies can raise money in China By Michael Pettis

Mainland Chinese subsidiaries of foreign companies will soon be permitted, at least in theory, to issue stocks and bonds on the mainland markets.  I say “at least in theory” because companies, whether Chinese or foreign, still have to jump through a confusing number of hoops before they are allowed to list, and it is pretty easy for the authorities to prevent any company they want from raising money in the domestic securities markets.  Last week I was having lunch with the CEO of a mainland company here and asked him if he was interested in raising money on the local stock markets.  He said that he was considering doing it for some of his subsidiaries, but that it might take as long as a year between the application and the actual listing.  It is not an easy process and, worse from a business point of view, it is not a particular predictable process.

 

Still, allowing mainland Chinese subsidiaries of foreign companies to issue stocks and bonds on the mainland markets is a step in the right direction, although like all other major policies in China it is cursed with the ideology of gradualism – i.e. it is really a tiny step forward towards at least four goals that are clearly in the best interests of China.  First, by allowing high quality companies to list on domestic markets, the new measure is likely to improve the quality of companies and financial reports available to Chinese investors.  Second, increasing the supply of stock is a far better way to dampen the incipient bubble than the other, heavy-handed and market-distorting measures that the authorities have preferred. .

 

Third, this clearly helps the development of Chinese financial markets by improving the professionalism of the issuance base and raising reporting and governance standards.  Finally, and most importantly from the point of view of this blog, it may help the PBoC, albeit only slightly, in managing monetary inflows.  This is because foreign-owned companies that need to increase their capital will not have to import additional foreign exchange through the capital account.

 

It is a little strange to me that these new regulations came out at then end of the third China-US SED meeting between US Treasury Secretary Paulson and his Chinese counterparts, as if they were a form of concession offered to the US – the South China Morning Post in an editorial today called it “one of (China’s) bigger concessions”.  I can’t think of any reasons why this move hurts China and many reasons why it helps, so why is it a concession? 

 

On the other hand I would argue that the US “concession” to the Chinese, reportedly making it easier for Chinese banks to acquire stakes in US financial institutions, isn’t much of a concession either, if a concession is something you give up to obtain something else.  One of the greatest strengths of the US economy and its financial system is its openness, to Americans and foreigners alike.  Allowing Chinese institutions to participate in that process is unquestionably a good thing for the US, in my opinion.  The US and China shouldn’t need bilateral negotiations to do what is in their best interests anyway.