My Blog

TUE 1 JAN

$20 billion for China Development Bank complicates monetary policy By Michael Pettis

I spent the last week at my family’s home in Spain for the holidays, but spent most of the time in bed with a flu that I brought with me from Beijing, so I haven’t posted anything in several days, even thought there has been a lot to write about.  Now I am back in Beijing, recovering from last night’s party at D22. 

 

While gingerly reading the newspapers today, a little surprised that the world hadn’t stopped turning during a day in which most people I know stopped doing useful things altogether, I see that yesterday Central Huijin Investment, an arm of the China Investment Corp (CIC), signed a formal agreement with the China Development Bank (CDB) in which it committed to provided $20 billion to recapitalize the bank.

 

"The injection is a fundamental step to transform China Development Bank into a fully-fledged commercial bank," the central bank said in their comment.  "This capital injection will markedly raise CDB's capital adequacy ratio, reduce its vulnerability to risk and help its all-round commercialization."

 

This capital injection by the CIC seems to me evidence of some continued confusion about the role of the CIC in monetary policy.  If the CIC were simply another, more efficient or more strategic, way for the PBoC to manage its reserves, the CIC would only invest those reserves outside China and would not use them in ways that might have a domestic monetary impact.  Here, however, they do have a domestic momentary impact, and the net result will be that ultimately the PBoC is going to have to buy (and monetize) another $20 billion that it wouldn’t have needed to. This is because the “default” way for the CDB to raise capital is to issue shares domestically (whether to the government or to third parties).  By issuing shares instead to a government entity that holds dollars offshore and uses them to buy the shares, the monetary effect is as if CDB were raising money abroad and bringing it back home to China.

 

Let me try to explain why.  If it makes sense for the government to recapitalize the CDB as part of its “commercialization”, and I am sure it does, then the most obvious and direct way is for some government entity to raise money domestically and buy additional shares in the CDB.  Basically this makes very explicit the fact that the CDB is being recapitalized by an increase in government debt or taxes, and the increase in CDB’s cash and liquid assets would be matched by a reduction in the public’s cash (which it used to buy the bonds).  The increase in capitalization will then allow the CDB to expand its domestic loans.

 

Doing it via the CIC may have certain organizational advantages, mainly that Central Huijin is owned by the CIC, but it doesn’t change this basic fact.  It does, however, obscure it.  Remember that the CIC has dollars because the MoF borrowed RMB domestically, and effectively gave the RMB to the CIC, who then used them to buy dollars from the PBoC.  When they use the dollars so obtained to purchase shares in the CDB, the net effect is that the government borrowed RMB via the MoF, and used those RMB to recapitalize the CDB.

 

So far so good, but rather than capitalize the CDB directly with RMB, the government did it with dollars via the CIC – it effectively sold US treasuries (or whatever) and bought CDB shares.  This was done for solid organizational reasons, I realize, but it seems to me that these good organizational reasons may counteract the PBoC’s attempts to manage domestic monetary policy.  Why?  Because recapitalizing the bank will allow it to expand its domestic lending activity.  Had the CDB been recapitalized directly with RMB, say via a new bond issue by the MoF, we would see that there would have been some reduction of domestic money (the sale of MoF bonds) that corresponds with the recapitalization.  By using the CIC’s dollars, we have all of the expansionary effects of recapitalizing the CDB with none of the counteracting contractionary effects.  In a way it is like the difference between the CDB’s raising money with a foreign stock offering versus a domestic one, whether the money raises is ultimately kept in dollars or RMB.

 

When it was first announced that one of the roles of the CIC would be to fund domestic businesses and hold bank stocks, I mentioned that I was a little uneasy that this might be using PBoC money to complicate PBoC money management, but I think now I am pretty certain of it.  The more dollars the PBoC transfers into the CIC for use in capitalizing domestic banks, the more dollars it has to buy in the secondary market. 

 

WED 2 JAN

Is China sneaking in a revaluation? By Michael Pettis

The RMB keeps strengthening, to 7.2948 as of yesterday.  This has it rising at its fastest pace since the peg was broken in July, 2005.  According to my friends, some local currency traders see the burst of appreciation we have experienced recently as a sort of back-door “revaluation”.  By forcing up the currency over the past few weeks at its fastest pace (2.3% in the past two months), the PBoC is effectively engineering a revaluation over several weeks, while seeming not to violate its promise that it would not do so after the first revaluation in July 2005.

 

This may well be true.  By now I think the old argument about whether or not the RMB needed to appreciate is more or less over.  The mistake made by many was that contrary to the assumptions of many the need for China to appreciate had little to do with the direct impact of the value of the RMB on the relative prices of Chinese exports and everything to do with China’s lack of domestic monetary policy.  

 

Those of us who have been arguing sine 2003 or 2004 that the country’s currency regime had left it locked into a monetary trap that was going to lead to ever-increasing trade surpluses and ever-expanding domestic money, however, still have one big disagreement.  One side argues that China needs to adjust the currency as quickly as possible and the best way is to speed up the rate of appreciation.  The other side argues that China has forced itself into a position in which the only possible solution is a large (say 15-20%) one-off maxi-revaluation.  Over the next few months we will see whether the more-rapid-appreciation school or the one-off-revaluation school will do a better job of predicting what the government actually does, but for the record I believe that China has no choice but for a maxi-revaluation.

 

The main thing to watch, I think, is hot money inflows.  If these pick up substantially as the RMB continues appreciating, the impact of the current rate of appreciation will be at first to make monetary conditions even worse as more money floods into the country.  This will result in greater fixed asset investment, rising industrial production and, what may at first seem paradoxical, a high and even rising trade surplus.  It will also keep pressure on inflation. 

 

If we see reserves rising as fast as ever as the currency’s appreciation speeds up to 7-10% a year, this will almost certainly be an indication that the new policy is not working.  By the way, and as an aside, an important problem with the appreciation strategy, although this will not be apparent for a while, is that once the RMB has reached its targeted level there is no way for the PBoC to signal credibly to the market that the currency has reached its target and will no longer appreciate, and hot money will continue to pour in, putting more appreciation pressure on the currency.

 

At any rate if reserves continue to surge as the currency rises, the impact of currency appreciation on bringing control back to monetary policy will be negligible or even negative – and currency appreciation is the last tool the PBoC has left with which to combat inflation and overheating.  In that case the PBoC will be forced to something far more dramatic to stem capital and current account inflows, and it seems to me that only a one-off maxi-revaluation followed by a credible peg will do the trick.  The argument in favor will also seem easier to sell domestically because policy-makers will be able to see that the currency can appreciate rapidly with no real collapse in the export sector.  The argument will be faulty, of course, because this was never about relative export prices, but it will still make it easier to sell the maxi-revaluation policy to local authorities.

 

The bottom line, I think, is that if the currency continues appreciating at 1/2-1% every month, we should watch reserves growth carefully, and of course make sure we back in transactions that result in reductions in headline reserves but which will have no domestic monetary-contraction impact. If reserves still grow at their furious pace, the PBoC will be forced to shoot the last arrow it has left in its quiver

 

WED 2 JAN

The government condemns Chinese financial markets to speculation By Michael Pettis

Two weeks ago when I was being interviewed for Dialogue, a local current events show on CCTV 9, I was asked about the sophistication of Chinese investors, and I responded that China does not have a real investor base.  The whole market here is speculative, I argued, not because Chinese investors are naturally speculative but rather because the structure of the market does not permit any other form of investing.

 

The other guest on the show, the chief economist of a major Shanghai fund, disagreed, saying that Chinese investors are not speculators but are simply investing based on their perception of what the government is going to do.  In China, he explained, the only important question for an investor is “What will the government do tomorrow?”

 

He is right of course in his description of the motives of Chinese investors, but he is wrong in saying that this isn’t speculative.  In fact investing based on perceptions of government behavior is a classic speculative strategy, and it explains why Chinese markets are so inefficient at allocating capital and why, for all the attempts by financial authorities to make local markets more “sophisticated”, nothing is likely to improve in the near and medium term.

 

Basically speaking most investment strategies can be fit within a triangle whose three corners represent the purest form of the three main investment strategies.  In one corner, value investment or fundamental investment involves buying assets in order to earn the long-term economic value generated over the life of the investment.  In the second corner arbitrage or relative value trading involves exploiting short-term pricing inefficiencies to make low-risk profits.  In the third corner speculation takes advantage of “technical” information that will have an immediate effect on prices by affecting short-term demand or supply. 

 

Each of these investment strategies plays a different and necessary role in ensuring that a well-functioning market is able keep the cost of capital low, absorb financial risks, and allocate capital efficiently to its more productive use.  Fundamental or value investing allocates capital to its most productive use.  Speculation, because it involves frequent trading, provides the liquidity and trading volume that allows value investors and relative value traders to execute their trades cheaply.  It also ensures that information is disseminated quickly.  Arbitrage or relative value trading forces pricing consistency and improves the information value of market prices, which allows value investors to judge and interpret market information with confidence.  It also increases market liquidity by combining several different, related assets into a single market.  When buying of one asset forces its price to rise, for example, relative value traders will sell that asset and buy related assets, thus spreading the buying.

 

China does not have a well-balanced investor base.  There are almost no arbitrage or relative value traders because they require low transaction costs and the legal ability to short securities, neither of which is available in China.  There are also very few value investors because the quality of financial and macroeconomic information is poor and corporate governance and regulatory frameworks are weak and inconsistent.  If we broadly divide information into “fundamental” information, which is useful for making long-term value decisions, and “technical” information, which refers to short-term supply and demand factors, it is easy to see that the Chinese markets provide a lot of the latter and almost none of the former.  The ability to make fundamental value decisions requires a great deal of confidence in the quality of economic data and in the predictability of corporate behavior, but in China there is little such confidence.  Furthermore, regulated interest rates and pricing inefficiencies makes it nearly impossible to develop good discount rates.

 

On the other hand there is plenty of technical information, and as a consequence the vast majority of investors in China must be speculators.  Insider activity is very common in China, even when it is illegal.  Corporate governance and ownership structures are opaque, which can cause sharp and unexpected fluctuations in corporate behavior.  Markets are illiquid and fragmented, so large price movements can easily be caused by determined traders.  In addition, the single most important player in the market, the government, is able and very likely to behave in ways that are not subject to economic or value analysis.  One consequence of this is that local markets do a poor job of rewarding companies for decisions that add economic value over the medium or long term.  Another consequence is that Chinese markets are very volatile, and this raises the cost of capital for business.

 

All investors in Chinese markets must be speculators if they expect to be profitable, and if Warren Buffet moved to China he, too, would be forced to become a speculator.  As long as this is the case, investors will not behave in a way that promotes the most productive capital allocation mechanism in the markets.  In order to change this, Chinese authorities must reduce the importance of speculative trading by reducing the impact of non-economic behavior from government agencies, manipulators, and insiders.  They must also improve corporate transparency.  They must continue efforts to improve the quality of both corporate reporting and national economic data.  Finally they must deregulate interest rates and open up local markets to permit arbitragers to enforce pricing consistency and to allow better estimates of appropriate discount rates.

 

Unfortunately, Chinese financial authorities are not reducing, but are in fact increasing, the importance of technical information related to government activity.  In recent months the importance for investors of predicting government attitudes to the markets has actually increased.  The authorities are caught in a tough position, because they are worried about a bubble in the stock and real estate markets, but their inability to keep their hands off the market is actually seriously undermining the development of a balanced investor base by reinforcing the perception that only the government matters.  This will continue to be a largely speculative market for many more years.

 

FRI 4 JAN

Chinese census numbers By Michael Pettis

I am often asked if the one-child policy is still in force here in China.  It is a confusing topic and I know there are lots of exceptions, but China Daily recently released some interesting information about the most recent population census.  In 1990 there were 3.92 people in each family in China, on average.  That declined to 3.44 people in 2000, and to 3.13 in the most recent census, which ended in early 2006.  This seems to me to be a pretty dramatic decline in family size in such a short time.

 

People under the age of 14 represented 19.55% of the population in 2006, down from 22.89% six years earlier.  The share of the population of people over the age of 65 rose from 6.96% to 9.10%.

 

Urban population in 2006 was 44.8% of the total population, compared to 36.1% in 2000.  A rough back-of-the-envelope calculation suggests that this implies net migration over the last six years if about 110-120 million, although I am sure this is understated, since many rural migrants are living illegally in the cities and are probably still listed as residing in their home towns – and although this should have been captured in the census, I am not sure illegal migrant workers are likely to want to talk to guys taking notes..

 

By the way, in another article today, the China Daily says, in reporting about the recently released (Thursday) annual report on social development by the Chinese Academy of Social Sciences: “The Engel Index, a measure of what percentage of a person's income goes into food, was 35.8 percent for urban residents, 1.9 percent less than in 2002. For rural residents, it was 43 percent, 3.2 percent less than in 2002.”

 

Adding all this stuff together, I get that food spending comprises 40% of total income on average for the country.  I am not sure how you calculate the food component of the CPI basket from this, but I would guess that since total expenditures are less than 100% of total income, the food component of the CPI basket should be higher than 40%.  I cannot reconcile this number with the claim that food comprises 33% of the CPI basket.  As an aside the report says that 66.5% of urban respondents and 57.6% of rural respondents listed rising prices as the most worrying social issue of 2007.

 

FRI 4 JAN

Chinese consumer spending is down By Michael Pettis

In today’s edition the China Daily discusses a new report by the Chinese Academy of Social Sciences which claims that Chinese consumer spending will hit a two-decade record low this year:

 

Despite a rosy picture about income growth, consumption by Chinese residents remained at a low level. It contributed about 36 percent to the country's gross domestic product (GDP) in the first three quarters, according to the report. The 2007 figure would hit a record low against around 60 percent in the period from the country's opening up initiative in 1978 to 2002. The figure had slipped by bigger margins thereafter to reach a low of 50 percent in 2006.

 

I haven’t seen the report, but the China Daily article suggests that the combination of high food prices, high real estate prices and monetary tightening measures are driving consumption down.  If so, imports are also likely to decline, and with declining imports we will inevitably see more upward pressure on the trade surplus.  As I wrote last week, the model you use to explain Chinese inflation will determine whether the tightening measures are likely to make things better or worse. I am afraid that a rising trade surplus will make things worse, not better.  The next few months of inflation data will tell us.

 

FRI 4 JAN

Why hasn't the PBoC given us loan growth targets? By Michael Pettis

The PBC ended its annual policy meeting yesterday.  I am still waiting for the translation of the statement coming out of the two-day conference to appear on the website, but from what I gather, what they did not announce may be more interesting than what they did.

 

The PBoC said it will take more steps to cool inflation and overheating, using “tighter monetary policy” to “prevent price increases from spreading.”  No big surprise here, since the annual end-of-year Economic Conference last month made it pretty clear that overheating and inflation are the government’s top concerns for 2008.  The PBoC also announced the standard stuff about reforming the exchange rate system and liberalizing financial markets.  The statement seems to have been, however, a little skimpy on specifics. 

 

More importantly the PBoC did not announce growth rate targets for money creation or new loans, which, if I remember correctly, they have always announced in previous years.  Cary Huang of the South China Morning Post reports that “Sources said the meeting failed to announce the projected annual growth rate for the money supply or for lending due to differences among officials.”

 

There have been rumors for a while now about sharp disagreements between “pro-growth” elements of the leadership versus those who are worried about imbalanced growth caused by excess monetary expansion.  The former see little to no overheating in the economy, are worried about a US recession and about domestic unemployment, think inflation is a one-off food problem that will soon be reversed, and want to leave the money spigots on more or less at full blast.  The latter worry about overinvestment and excess capacity creation, rising inflation, and explosive growth in money and new lending, and are looking for ways to slow down money creation.  For me the most important result of December’s Economic Conference was that it seemed to represent a shift in concern away from the former to the latter, but that doesn’t mean that the conflict is resolved.

 

In and around March there will be the major reshuffling of top level positions, including provincial governorships, decided during the Plenum, and traditionally the imposition of new leadership is a time of explosive growth in new investment projects as the new provincial leaders try quickly to make a favorable impression.  That may be part of the reason for resisting caps, especially quarterly caps, on new loan growth.  I understand also that a number of banks are under pressure to provide more loans to their best clients and are worried that they may be constrained from doing so.  Finally, the possibility of a US recession is also weighing heavily on the minds of some.

 

The argument over China’s future monetary policy is far from over, and that is going to matter a lot in 2008, even if you believe, as I do, that their attempts so far to rein in excess money are focusing on the wrong things.  If inflation and investment numbers stay high in the first quarter of this year, which I expect, the pro-growth groups may lose further prestige and power, but if China is indeed suffering from monetary expansion, as I think it is, the longer we keep this game going the harder it will be to adjust.