My Blog

SUN 16 DEC 2007

Wu Xiaolin on small loan companies By Michael Pettis

On Friday, Wu Xiaolin, deputy governor of the PBoC, came to the Peking University campus for a presentation.  I didn’t attend because my Chinese is not good enough to make it worthwhile, but my ever-alert assistant Oliver Shang tells me that one of her statements that caught his attention was a comment about “small loan companies”.  According to Oliver, she talked about the development and importance of the system of microfinance China, which he takes to mean mainly the companies that provide micro loans to agricultural families, saying "we will work on and make the small loan companies become legal soon"

 

I am getting all of this second hand, so I don’t want to make too much of this, but I have been thinking a lot about the informal banking system in China – especially as I suspect that one of the consequences of the renewed attempts to constrain credit growth may be to divert funding out of the commercial banks and into the informal sector, where there are neither loan caps or minimum reserve requirements.  I presume “legalizing” these banks means brining them into the regulatory fold.

 

I would be curious if readers of my blog have other information about the activity of the informal banking sector.

 

SUN 16 DEC 2007

More on cross-border banking

In the “Comment” section Brad Setser raises and interesting and important point about one of my December 14 entries (“Foreign companies can now raise money in China”), and I thought it would be more interesting to respond in an actual entry rather than in the “Comment” section.  I haven’t asked his permission to do so, but I am pretty sure he won’t mind.  Brad asks:

 

Why is allowing Chinese state banks (or the Chinese state) to own US banks necessarily a good thing? China very clearly uses its state banks to achieve policy as well as commercial goal – most obviously right now China uses the banks as a took for below market sterilization.  Now in practice the US may not be conceding much, as the promise to treat Chinese banks like other banks is effectively the United States current policy, and I rather doubt a controlling Chinese state bank stake (or a CIC stake) in a large US institution would pass regulatory muster – the USG[overnment] is probably less impressed with the health of Chinese banks than the equity market.  But it does seem to me that allowing a government that uses its own state banks to achieve its domestic policy goals to own banks abroad raises a host of difficult issues.

 

Of course Brad is right in that this does create a complex of issues, but as a general rule I assume that financial openness is a good thing for the US and that allowing foreign banks to bring capital into the US market and add their mix of strategies and interests to the vast pool in the US can only help the process of specialization and differentiation.  It also helps diversify risk by creating an additional (non-correlated) pool of banking capital from which to draw – although given the size of the US market the impact of Chinese entry is likely to be small.  This assumption may be unreasonable, but I think not because it seems to me that developed countries with more open financial systems tend to be better at allocating capital and at withstanding the economic impact of financial crises.

 

If this assumption is correct, and I suspect that Brad will broadly agree, the question then becomes whether a Chinese branch, subsidiary or minority stake in a US bank can cause damage to the US economy or to US national interests in a way that is different from other forms of foreign participation – even if it is being constrained or propelled by domestic policy considerations.  It is true that Chinese banks are forced to assist in domestic sterilization, and may even be “encouraged” to provide cheap capital to Chinese firms operating in the US, but I don’t see how the former would affect the US at all and I think that while the latter may raise cries of unfair competition by the Chinese companies’ competitors, it is always a good thing for the US economy if foreigners give us cheap capital..  This might be a more serious issue if it were possible that cheap capital to Chinese companies in the US might one day propel them to a position of such dominance that they could manipulate US policy, but I find the likelihood of this happening to very low.  

 

One of the things that I teach my students at Peking University is that fear of foreign “control” of domestic assets (which is an obsessive fear here in China) is usually irrational because a foreigner who invests a lot of money in another country is much more of a “hostage” to the local government than the local government is to him – unless, perhaps, he is a relatively large company investing in a relatively small economy, something which can never be the case in the US, or if the local government is in a state of near-collapse and easily manipulable, as was the case in Republican China.

 

If the Bank of China, for example, were to invest a sizable amount of money into a US bank, it would suddenly be forced to comply with the Fed and other US banking regulators in a way that it never before had to.  Fear of undermining the value of its large investment in the US might even force it at least to consider the interests of US regulators in areas outside their direct jurisdiction – for example in offshore banking activity with entities deemed national enemies.

 

In addition its actions would probably be scrutinized much more carefully than its US equivalent.  But if its presence helped in any way at all to provide capital to US-based businesses (Chinese-owned or otherwise), the net impact would be an increase in total US investment and a strengthening of US domestic competition (which is, in my opinion, almost always a good thing), and that would be good for the US economy.  On the other hand if it ever began behaving in a disruptive way, there would almost immediately be a domestic outcry that would cripple its activity.  This is just the flip side of the common Chinese (mistaken) belief that if Citibank opens more branches in China, Chinese sovereignty would be eroded.  Actually China’s sovereignty would probably be strengthened because its economy would be better served (much better served, in this case).

 

I remember that in the 1980s many of the same fears were expressed about Japanese financial institutions (and in the 1970s it was OPEC control of banking deposits), with some people worrying that the tremendous power of Japan’s MoF and the tendency of Japanese banks to herd and/or to form the core of major industrial groups made them akin to being state-controlled, or at least controlled by interests that were not purely banking profit-oriented.  In the end, however, it seems to me that the Japanese banks did little more than transfer a lot of cheap capital to the US.  They were neither formidable banking competitors nor formidable tools of state intervention.  They were largely just cosseted banks that had a brutal time surviving in the US markets even with their lower cast of capital.

 

At any rate if for no other reason than to protect one of the great US strengths – its openness – I would want the burden of proof to fall on those who would constrain the Chinese banking presence in the US.

 

MON 17 DEC 2007

Don’t turn the shower faucet to hot too quickly By Michael Pettis

Yesterday the State-owned Assets Supervision and Administration Commission (SASAC) announced they would require dividend payments from after-tax earnings for state owned enterprises.  Although commercial-bank lending constraints seem to be partially working, there has been no real reduction in fixed asset investment in China as of yet (the November reduction seems to have been more of a statistical effect).  This may be because informal and illegal banks, leasing companies, and direct investment have expanded by more than enough to take up the lending slack, and it seems pretty clear that large amounts of retained earnings are being plowed back into investment even in cases where the economic rationale for doing so is dubious.

 

To address the latter, and to reduce the amount of cash available for re-investment, SASAC is requiring state-owned companies to pay a share of their profits to the government in the form of a dividend.  Just over three-quarters of the 151 firms administered by SASAC will pay dividends equal to between 5% and 10% of after-tax profits.

 

I am not sure this is enough to make much of a difference.  According to today’s South China Morning Post “Two finance ministry officials reportedly said in June that the maximum payout ratio would be 20 per cent. They said some 60 billion yuan could be raised if an average 10 per cent payout ratio was applied.”  Transferring less than $8 billion from corporate retained earnings to the government won’t make much of a dent on investment, which exceeds $1 trillion annually, and anyway the transfer will reduce the government deficit and, along with it, government borrowing.  In that case it might free up as much new money in the bond markets as it withdraws from retained earnings.  Still, given the concerns I have about a sudden jump in contingent liabilities from the banking system if there is a sharp adjustment in the Chinese economy, I am glad to see anything that reduces government debt.

 

Of course there are also more rumors running around about additional PBoC actions and finger-wagging to slow the economy.  The PBoC is clearly considering more minimum reserve and interest rate hikes, but now there is talk of “differentiated” reserve requirements – that is different requirements for the larger banks, who take in more deposits as a share of funding than the smaller banks, or higher reserve requirements for new deposits.  It will be very interesting to see if these new measures make taking deposits less profitable for banks and so create incentives for them to discourage additional deposit growth.  This might have the effect of simply channeling monetary expansion into areas where the PBoC has a more difficult time controlling and regulating.  By the way deposits grew rapidly in November.

 

The PBoC actions are definitely hurting property speculation. Gerry Xu Feng, the chief officer of the research department at Midland China in Shenzhen, said, according to the SCMP, that about 10% of the 30,000 estate agents in Shenzhen had quit their jobs.  I guess it is getting harder to make a living churning property.  Real estate prices are reportedly lower in the main cities, and property developers have been among the worst performers in the domestic stock markets. 

 

We all want to see a slowdown in property speculation, of course, but many people, including me, wonder about exactly how much exposure the banks have to the property sector (direct exposure is high enough, but there is anecdotal evidence that indirect and hidden exposure is also extremely high).  The danger of all these attempts to slow property speculation and other effects of excess monetary expansion may make China like the bather, in an analogy attributed to Milton Friedman, who gets scalded after turning the hot water all the way up in a chilly shower.  Because of the lags and the difficulty of transmitting monetary policy into the non-coastal provinces (where a very interesting study I read last month – I can’t remember the citation – suggests that there are problems with the transmission mechanism for PBoC monetary policy), the belated attempt to get out of the freezing water of property speculation may lead to the scalding water of a surge in real-estate-related non-performing loans.  There really are no easy or obvious policies for the PBoC to pursue as long as their currency regime imports such massive amounts of liquidity.

WED 19 DEC 2007

More worries about the stock market? By Michael Pettis

Shanghai was up 2.19% today, supposedly because of a new report that says that the government wouldn’t “massively” sell shares in companies it owns.  Separately it seems that the stock index futures, which have been on the verge of being introduced all year, have been postponed again.  Premier Wen is reportedly worried that the introduction of the futures may cause massive selling in the underlying stock.

 

This is becoming an increasingly difficult balancing act – managing the consequences of explosive monetary growth without creating too much damage to confidence or to the underlying economy, all the while using tools that don’t seem to work.  I am glad I am just an observer.

 

WED 19 DEC 2007

The value of the RMB DOES matter, but not for the obvious reasons By Michael Pettis

According to the Commerce Department, the U.S. current account deficit fell to $178.5 billion in the third quarter, the equivalent of 5.1% of GDP.  This is happening at the same time that Europe’s trade deficit is surging.  Part of this reduction in the trade deficit may be caused by a slowdown in the growth of US demand, but it seems pretty clear that relative currency values do matter to a country’s trade balance.

 

In today’s International Herald tribune there is a piece by Behzad Yaghmaian, a US-based academic, on why, regarding US-China trade, “the yuan is not the problem.”  Yaghmaian makes the argument that a revaluation of the RMB would not fix the US trade imbalance with China.  Part of the argument is pretty standard.  In his words:

 

The revaluation of the yuan would have had the desired effect were the goods imported from China also produced in the United States. Facing the rising prices of imports caused by the revaluation, some American consumers would have switched to domestic substitutes.  

 

But that is not the situation with most Chinese imports, for which there are few American substitutes. The Chinese apparel, computer parts, electronics, furniture, toys and many other things in the lengthening list of imports no longer compete with similar American products. If not from China, the United States would have to buy them from elsewhere. The deficit would remain; it would only be with other countries.

 

Yaghmaian adds the point, however, that a significant and growing component of the trade relationship between the US and China is the value of subcontracted imports.  This component tends to be priced in US dollars, and he argues that if the RMB were revalued it would not affect the relative value of the goods sold into the US, so it would not affect the trade balance.  He adds:

 

However, the revaluation hurts the profitability of the subcontractors that face a reduction in their income after conversion to the local currency. To make matters worse, many American firms have been demanding lower prices from their subcontractors, threatening to move to India, Vietnam or elsewhere

 

I don’t fully agree with this point for two reasons.  First, if Chinese companies were not able to absorb the lower value of the dollar by reducing profits, a revaluation would force them to charge higher prices on their contracts in the future.  This might not be soon enough to help many of them from avoiding bankruptcy, but it would nonetheless affect the price of Chinese goods in the US.  

 

Second, many countries in Asian are suffering, like China, from the monetary consequences of holding down the value of their currencies against the US dollar, and are only unwilling to allow their own currencies to appreciate because they fear losing out to cheaper Chinese production.  If China were to permit more flexibility in the value of the RMB, a number of other countries in Asian would also follow suit.

 

Still, I think he is right in pointing out that a revaluation would be painful for many small exporting companies who have not in the past been able to hedge the value of the dollar, and this must be at least part of the reason why Chinese financial authorities have dragged their feet for so long in adjusting the currency.  He agrees that streamlining the market and weeding out inefficient producers may be a welcome consequence in the longer term of the policy for China, but he still worries that such a policy would in the short-term effect pose greater hardship for Chinese workers

 

I don’t disagree at all with Yaghmaian’s argument as far as it goes, but I think he makes the same mistake that other American defenders of China’s foreign exchange policy make – he sees China’s RMB policy purely from the point of view of trade and only looks at the direct impact a revaluation will have on relative pricing.  But as I have argued many times before, the real reason China must revalue is to attempt to regain some control over its explosive monetary growth and, were it to do so, the trade relationship would indeed change, and change dramatically.  

 

It is not the cheapness of the RMB that is the primary cause of the huge and growing Chinese trade surplus.  It is the fact that China has locked itself into a monetary policy that forces excessive momentary expansion as the PBoC has to buy up the torrent of dollars that flow into the country via the trade and capital accounts.  Thanks to inefficiencies in its financial sector very easy money automatically forces industrial production to grow at unhealthy rates, and this growing industrial production has not and cannot be absorbed by rising domestic consumption.  The consequence is a currency regime that forces Chinese exports to grow more quickly than its imports, and so forces a rising trade surplus.  China’s trade surplus is basically a residual of the growing imbalance between Chinese production and consumption, and this imbalance is growing precisely because of the currency regime.

 

WED 19 DEC 2007

China buys more of Wall Street By Michael Pettis

Rick Carew has an interesting comment in his Wall Street Journal piece today. In commenting on the $5 billion investment by the CIC into a Morgan Stanley mandatorily convertible bond, he says:

 

For the first time, Chinese companies and the government bought more overseas than foreign buyers have invested in China.  Chinese buyers have spent $29.2 billion acquiring foreign companies so far this year, while investors from the rest of the world have bought $21.5 billion of Chinese companies, according to Thomson Financial.

 

Of course total FDI into China was greater – around $60-65 billion expected for this year, but Chinese acquisitions abroad, while still small compared to the size of inflows, seems to be rising.  One small caveat about Rick’s article, he says “The terms of the Morgan Stanley deal guarantee CIC a 9% annual return, well above the fund's 5% cost of funding, until it converts its investment to shares in 2010.”  Actually it is only above the CIC’s funding cost if the RMB appreciates at less than 3.8% a year.  Otherwise the CIC will run a negative carry on the deal, which will only be reversed if the bond trades up sufficiently and the CIC sells.

 

WED 19 DEC 2007

Currency swapping does nothing to improve Chinese liquidity By Michael Pettis

Friends of mine who try to keep track of monetary conditions by tracking central bank reserves – like Logan Wright and Brad Setser – have not always had an easy time of figuring out what is happening in China.  Since August, however, things have gotten more difficult.  At $20-25 billion a month, growth in reserves during the past four months has consistently come in lower than what one would have expected by adding together the current account surplus, FDI, and estimates of hot money inflows – year to date,. For example, monthly reserve growth has averaged nearly $40 billion.

 

Normally this would be a good thing.  The faster reserves grow, the more currency and central bank bills the PBoC has to create in order to fund this growth in reserves (the PBoC must buy the net inflow of foreign exchange in order to maintain the desired currency level – and while reserves are the asset side of the balance sheet, they are matched by RMB liabilities).  This forces an expansion in the country’s already excessively large money supply.  If reserves are growing more slowly, as they seem to be, this should mean that China’s money supply is also growing more slowly, which is an unambiguously good thing for the country at this point.

 

But it turns out that there are at least two major sets of transactions that are clouding the figures we have for growth in reserves and their impact is to reduce the headline foreign exchange reserve figure.  First, and most obviously, the PBoC has completed or soon will complete the transfer of $200 billion of its reserves to the CIC, where it will presumably be managed more aggressively.  This will reduce the headline foreign exchange reserve level by $200 billion. 

 

Will this represent a real $200 billion reduction in the amount of currency and central bank bills in circulation?  Yes, but its net impact on overall liquidity will be somewhat less.  The CIC was able to purchase the $200 billion in reserves with the RMB 1.55 trillion it received from the MoF, who in turn got the money by issuing long-term bonds to the market.  These bonds all or mostly sit on the balance sheet of the PBoC or a commercial bank intermediary, but as the PBoC gradually sells these bonds into the market, the net effect will be an exchange of highly liquid central bank bills for less liquid MoF bonds.  Although these bonds are still effectively part of the country’s money base, their net impact on domestic liquidity will be positive (i.e. they will reduce domestic liquidity, although not one-for-one)

 

The second set of transactions is much more confusing, at least to me.  Beginning in August of this year, as it has been raising minimum reserve requirements, the PBoC has also been forcing banks to hold at least part of their new required reserves in the form of dollars at the PBoC.  One simple way of thinking about this is that it is as if Chinese commercial banks have had to increase their required RMB reserves, and then have been forced to swap these new required reserves into dollars – so that they go from holding RMB in their PBoC required reserve accounts to holding US dollars in the same accounts.

 

What is the point of swapping RMB required reserves into dollars?  It seems to do two things.  First, holding dollars in China is a losing proposition because of expected RMB revaluation, and so by forcing commercial banks to use RMB reserves to “buy” dollar reserves, the PBoC is effectively transferring the future foreign exchange loss from its own balance sheet to that of the commercial banks (unless it has hedge agreements in place, in which case it has no impact on profits and losses).

 

Second, by forcing a transfer of dollars from the PBoC account into the commercial bank accounts, it reduces the headline foreign exchange reserve number and seems to imply that there is both less pressure on the currency and less money in domestic circulation.

 

But I don’t think either of these two implications is correct.  It seems to me that forcing banks instead of the PBoC to hold dollars says nothing about pressure on the currency.  I would argue that the total net inflows are exactly the same except for one thing – commercial banks have been asked to assume part of the PBoC’s normal functioning (i.e. to buy dollars so as to maintain the country’s foreign currency regime), and as they assume this function the resulting purchases of dollars are whisked off the PBoC balance sheet.  But nothing real has changed, except that now banks, instead of the PBoC, will be forced to assume the foreign exchange losses.

 

Second, what is the effect of this “swapping” of currencies on the domestic money supply?  None at all, it seems to me.  Banks will have exactly the same amount of loans outstanding as they did before the currency swap, and all the other monetary aggregates will be the same. This is because the required reserves held at the PBoC are effectively “dead” anyway, and redenominating their currency changes nothing real.

 

Headline reserves will be lower, of course, but Chinese money supply will be exactly the same as if the required reserves had never been swapped into dollars.  It is the existence of minimum required reserve rates that presumably has an impact on domestic monetary policy, not the denomination of those required reserves.  The PBoC could force banks every month to swap from RMB into dollars and back again, and the only real impact would be to change headline reserves every month.  Real money supply in China would not change at all.

 

If my analysis is correct, (and if any reader thinks it isn’t, please correct me) I think the policy to force banks to hold part of their required reserves in dollars does nothing to improve China’s liquidity position but makes the PBoC less transparent.  I am not sure how this helps.

 

By the way Logan Wright (“Paying for RRR Hikes in USD”, Stone & McCarthy, December 19, 2007) estimates that impact of this swapping might have reduced headline foreign exchange reserve growth by an average of just over $20 billion a month for the past four months – he assumes that the four hikes during this period took about 190 billion out of the system each time, and that this amount was “swapped” into dollars in the PBoC accounts of the various commercial banks.  With reported monthly foreign exchange reserve increases of $23.4 billion in August, $25.0 billion in September, and $21.4 billion in October, he may have explained rather niftily why monthly reserve growth fell off from the average of just over $44 billion in the first half of 2007. 

 

FRI 21 DEC 2007

Droughts and inflation By Michael Pettis

A few weeks ago I saw a report that China had suffered its worst drought in recent times.  The dates and details were a little vague, so I tabled the article and decided at some point I wanted to find out a little more about it.  Today both Bloomberg and the South China Morning Post have articles about the drought.

 

Bloomberg stares its piece by saying:  “China's most severe drought in a decade is expanding throughout the country, threatening the normally humid areas along the southern coast.”  I searched for more news on China Daily and found a whole slew of articles.  Parts of China are suffering their worst drought since the early 1950s, about 400,000 hectares of crops have already been damaged this year, and the State Flood Control and Drought Relief Headquarters reports that 37.4 million tons of grain will be lost.  China Daily adds: “In recent times, drought has been striking more areas of the country with greater frequency. It had extended from the north and western regions to the south and eastern areas, worsening water supply conditions for both agriculture and industry.”

 

On the other hand, the country seems to be making good preparations for the spring festival.  Zeng Liying, the deputy director of the State Grain Administration, said on the agency’s website that "China has stored enough grain to fully meet market demand.”  She also said, somewhat surprisingly to me given the other news, that "The country's grain harvest is expected to exceed 500 million tons this year, rising for the fourth consecutive year."  

 

Not surprisingly food and grain consumption shoots up during the annual spring festival, and I would guess that the government will do what it can to restrain price increases because it will want a happy festival.  If that means using up grain stocks to depress prices temporarily, it will help in the short term, which is fine if Chinese inflation really is just a temporary food problem.  In that case fighting inflationary expectations will be the government’s main task, and using up food stocks to depress prices will be a successful strategy.

 

If inflation is really a monetary problem, however, or if continued drought drives food prices up over a longer period, trying to restrain price increases in the short term may cause more trouble later in 2008 after the festival. With food prices around the world rising too, I continue to believe that inflation next year is going to shock on the up side.  As an aside, the government this week promised to double its fertile-sow subsidy to farmers.  It will also spend additional money to support large-scale pig production.  I assume that this means that they are concerned that pig-rearing is growing as fast as they had hoped.  I think the government and most other forecasts for CPI inflation in 2008 are in 3.8-4.5% range (I need to check, so please don’t accept these numbers uncritically).  I think it will be much higher.

 

FRI 21 DEC 2007

China's risky bet on overheating By Michael Pettis

For the sixth time this year the People’s Bank of China raised interest rates, which was not a surprise. The PBoC raised its 1-year benchmark lending rates by 18 bps to 7.47%.  Changes in deposit rates were a little more complex.  The 1-year benchmark deposit rate went up by 27 bps to 4.14%, the 6-month deposit rate rose 36 bps to 3.78%, and the 3-month deposit rates rose 45 bps to 3.33%.  

 

The PBOC actually cut the deposit rates on current deposits by 9 bps to 0.72%, from 0.81%.  The PBoC statement accompanying the hike claimed that the move "will guide more money into short-term time deposits to help consumers better handle rising prices while maintaining enough liquidity."  I think here the concern is that a lot of money has been held in current deposits in order to take advantage of IPOs, and as huge amounts of money flow from current deposits to brokerage accounts, they cause spikes in sort-term rates that really hurt the smaller banks.  By encouraging depositors to tie up their money, the PBoC may hope that it reduces the amount of IPO oversubscriptions.

Overall it is pretty clear that the PBoC is trying to encourage savers from withdrawing deposits – with CPI inflation over the past four months averaging over 6%, depositors have to be very unhappy with the return they are getting on their savings.  I am not sure about the exact mix of deposits, so I don’t know what the interest spread is, but the spread between one-year deposits and one-year loans has narrowed by 9 basis points (I think altogether it has narrowed by 27 basis points this year, but I have to check).  Banks rely on the interest spread for 85-90% of their profits, so the continued squeezing of the spread, along with the ten minimum reserve hikes this year, should have two impacts: it will put serious pressure on bank profitability next year, and it will create strong incentives for bankers to lengthen loan maturities.

 

There may be problems with China’s strategy.  On their website the PBoC argued that "This adjustment will be beneficial in preventing the rapidly growing economy from turning to overheating, and prevent the structural rise in prices from becoming clear inflation."  If raising the deposit rates is intended to fight inflation and prevent overheating, I imagine that it would do so by constraining consumption.  However constraining consumption will also mean constraining import growth, which of course means adding further upward pressure on the trade surplus, and so further upward pressure on money creation as the PBoC monetizes these inflows.   

 

In addition it is pretty clear that these increases in interest rates cannot help but make speculative inflows even more profitable – even if the dollar-RMB “arbitrage”, as some argue, is not the main reason for speculative inflows.

 

A lot rides on which model for explaining inflation and overheating is the correct one.  If it is excessive lending and temporary food price increase that have caused the two, and if rising inflationary expectations are the main concern, then the current strategy may be the right one to combat the problem.  Restraining spending and calming inflation expectations should do the trick.

 

If, however, the fundamental problem is the lack of monetary policy caused by the currency regime, then these solutions will only make things worse.  Anything that encourages inflows through the current or capital account will simply make the PBoC’s job of managing the domestic money supply even more difficult and will exacerbate the overheating and inflation problems.  We may find ourselves in a vicious cycle.