My Blog

SAT 31 MAY

CSRC to mutual funds: Stop selling! By Michael Pettis

CSRC to mutual funds:  Stop selling!

 

I am not sure what impact this is likely to have in the market, but on Friday and over the weekend there was a lot of discussion about reports surfacing that the CSRC is trying to put pressure on Chinese fund managers to support share prices by restraining their selling activity.  According to Saturday’s South China Morning Post:

 

For the second time in three weeks, the mainland's stock market regulator has told fund managers not to dump shares. And this time, it says they could be punished if they don't comply.

 

The China Securities Regulatory Commission said mutual funds should support falling stocks even though other investors were selling their holdings amid the slump in the nation's equity markets. With concerns rising about the deteriorating economic conditions and with the authorities having so far failed to stem the slide through market-boosting measures, Beijing is now resorting to threats in an effort to maintain so-called market stability.

 

My student Shang Ning tells me that he heard that the funds were lectured about the need to begin acting “politically correctly,” which doesn’t mean what it means in the US and the UK but rather can be interpreted to mean “in the interests of the country.”  I suppose it would be cheap cynicism to discuss what that might really mean in practice.  At any rate, from what I hear, the concern is that whenever the government has changed regulations or otherwise signaled its intention or desire to see higher prices, funds generally were among the earliest participants in the subsequent rally, but they have also been quick to take profits, selling aggressively into excited retail demand.  This has prevented, according to some observers in the government, their signaling effects from having a bigger impact on the market.

 

I disagree.  I wrote many months ago (and this is no great insight of mine – it is fairly well-known) that government intervention is most powerful when least used, and each time the regulators intervene to move prices, they lose credibility.  The government has intervened so often in the last twelve months to push prices up or down, according to the needs of the moment, that it was only a question of time before these interventions stopped having much impact.

 

The market’s reaction to the news on Friday was not terribly positive – it traded up for the day, but only by 0.94%, which in the Chinese stock markets is probably the typical trading range in any given half-hour, and it had little conviction either up or down.  Some analysts are suggesting that this is good news for the market because it indicates how serious the government. Is about propping up prices, and that without heavy mutual fund selling the market is protected from further losses.  Maybe.  But it is just as easy to read this as a fairly desperate attempt to keep prices up, and if I were invested I would almost certainly close out my positions.  If too many people do this, mutual funds could begin to see redemptions, which would force them to sell.

 

.According to the same South China Morning Post article:

 

“It is an open secret that the regulator wants to rig the index above the 3,000-point level," said West China Securities trader Wei Wei. "However, retail investors now refuse to buy it. The worst is yet to come."

 

Everyone seems to think that the government is doing all it can to prevent the market from going below 3000 (it closed at 3391 on Friday).  I have already discussed the market dynamics of a general perception that some large player is trying to maintain a minimum price.  If it breaks below that rpice, it will break big.

 

On a separate note, PBoC governor Zhou Xiaochuan said Friday that the trade surplus was not the cause of China’s huge increase in reserves.  According to another article in the South China Morning Post:

 

“When analysing this issue, you have to make a comprehensive check of the overall international balance of payments,” Mr Zhou said in Beijing yesterday. “If you look only at the trade surplus and FDI, these do not cover everything,” he said, citing trade in services and the increasing sophistication of the country's financial markets.

 

Yes and no.  I think it is pretty clear that trade is no longer the big driver of reserve growth, but I don’t think services and financial market sophistication are the main drivers either.  For many years China was locked into a self-reinforcing system of rising trade surpluses generating monetary growth, which generated further rising trade surpluses, but the risk was always that at some point the subsequent pressure for RMB appreciation would itself start to generate speculative inflows that would eventually become the driving force for reserve growth.  I think we are clearly in this very destabilizing stage.

 

MON 2 JUN

Chinese monetary policy is driven primarily by RMB speculation By Michael Pettis

There is an article in this week’s Caijing that summarizes a survey by Deutsche Bank’s Jun Ma (here, for those who can read Chinese).  I haven’t managed to get it translated yet but blog participant Kar Kheng Giam summarized it for me as:

 

Key points:
For those with 'business' connections/enterprises: 52% opted to bring money in as 'FDI', and 11% as under-invoicing.  For those who bring money the old fashioned ways: 85% use either US$50,000 per person per year, using multiple relatives and friends, or the RMB80000 per day TT limit.  57% of respondents forecast RMB to rise to 5.50-6.00.

The survey seems to confirm what we had more or less guessed – there are an awful lot of ways to bring money into China and what is driving the speculative inflows are some pretty ambitious expectations of RMB appreciation.  The very large trade and investment accounts are a particular important channel for hot money and the family businesses with networks both inside and outside the mainland are likely to be particularly efficient at bringing money in (and are likely to be no less so at taking money out again one day). 

 

The survey also suggests that the “unexplained” portion of reserve accumulation – after backing out the trade surplus, FDI, interest income and revaluation gains – is biased downwards, since there may be substantial amount of hot money in the trade and FDI numbers.  Take this out and add it to the “unexplained” part and the most stable sources of reserve growth – FDI, the trade surplus, and so on – are becoming an increasingly small fraction of total net inflows.  Chinese monetary policy, in other words, is at this point almost entirely driven by hot money inflows.

 

This is a pretty disturbing conclusion and bears repeating: Chinese monetary policy is largely a function of massive and very volatile speculative inflows driven by RMB appreciation.  

 

Headline reserve growth for the first four months of this year was a breathtaking $228 billion.  We know that this number understates real inflows because of the redenomination of minimum reserve requirements and the transfer of assets to the CIC, and my best estimate is that adjusting for these reserves would have climbed by $340-370 billion.  Of this approximately $45-50 billion consists of interest income and valuation gains.  The trade surplus and FDI accounts for $94 billion, but almost certainly a large fraction of this consists of disguised hot money. 

 

Even ignoring the disguised hot money, that still leaves $200-230 billion unexplained.  Part of this unexplained amount will include such things as net tourism and some non-speculative financial transactions, but these aren’t likely to be large numbers, and I suspect that all of them together are probably less than the hot money inflows disguised in the trade and FDI accounts, or at least not a whole lot bigger.  A plausible guess, then, is that hot money inflows are greater than the headline reserve growth, or at least not a whole lot less.

 

Since the PBoC must monetize these inflows – either by issuing currency or by issuing central bank bills – these inflows end up adding to the country’s money base.  With the largest part of the inflows probably consisting of speculative money, that is what I mean by saying that Chinese monetary policy is now driven primarily by RMB speculation.

 

Unfortunately I don’t think we are likely to see much improvement in the next few months, and remember anyway that even if there is a reduction in speculative inflows, it would have to be a massive reduction to mean anything.  As money continues to pour into the country, the problems of inflation and overinvestment are going to persist and get worse.  As they do, it will become all the more obvious that China is facing serious appreciation pressure, and the talk of a maxi-revaluation will simply increase.  Needless to say, this can only increase speculative inflows. 

 

Once again the currency regime has locked the country into a self-reinforcing feedback loop from which it is going to be very difficult to escape.  My hope is that the authorities recognize this quickly and act quickly – and there is some evidence that that an increasing number of senior officials understand the risks.  The next month or two of data will be, as usual, very important, but of course the looming Olympics and the still severe effects of the terrible earthquake limit policy responses.

 

Caijing also had an article this week (“Real Estate Lenders Warned of Rising Risk”) in which it says that China's overheated housing market is showing signs of a downturn, prompting warnings from bank regulators that bank lending for real estate is carrying an increased degree of risk.  But, according to the article, “some banks may be turning a deaf ear.”

 

The article goes on the say that the CBRC (the banks’ regulator) is worried that the excessively rapid increase in real estate loans is likely to leave the banks vulnerable to a decline in real estate prices that may already be happening.  I think the increase in risky lending is both a consequence of the country’s monetary policy and a serious constraint on the policy options available to correct those consequences.  Still, the longer this goes on, the riskier loan portfolios are likely to be and the more difficult the necessary adjustment.

 

TUE 3 JUN

More on speculation and Chinese monetary policy By Michael Pettis

I try not to do two consecutive blog entries on the same topic, but Kheng very kindly went through the Caijing article on the hot money survey by Deutsche Bank’s Jun Ma, which I wrote about yesterday, and translated a large part of it.  This additional information reinforces what I discussed yesterday, suggesting, among other things, that there is a fairly institutionalized process for speculative inflows (and, one must assume, outflows).

 

According to the survey, the ways enterprises bring into China what, from a monetary management point of view, is either hot money or its functional equivalent, is broken down according to the following.  52% of the money comes in the form of FDI, which I assume means an acceleration of approved FDI flows.  21% of the money, roughly evenly split, comes from under-invoicing imports or over-invoicing exports.  8% consists of “foreign donations” – I am not sure what this means.  5% comes from exchanging money with underground money exchangers and 17% comes from various other means, including paying local employees or service providers in foreign currencies, borrowing in foreign currencies, and so on.

Among individuals and households, which I assume include some of those local employees mentioned above who are sometimes paid in foreign currency, nearly half of the foreign currency funding for their purchases of RMB (49%) reportedly comes into China via the US$50,000 per year transfer from abroad permitted to local accounts, while another 20% enters via the RMB10,000 per day limit from HK banks.  15% of speculative inflows enters China via exchanges with local relatives or friends, 9% via underground money exchangers, and 7% via what I assume are legal money changers.

The article includes recommendations about what should be done to reduce hot money channels – for example improving the monitoring of FDI-financed companies’ holdings of cash, stock and bond holdings, building databases to track import and export pricing, reducing the amounts convertible per annum or per diem, and stepping up scrutiny of underground money exchangers – but I suspect that given the variety of channels, the difficulties of monitoring, and the problems with fraud and corruption, there is not a whole lot the authorities can do to deter inflows, except perhaps drive it further underground. 

 

For example, if the $50,000 that residents are permitted to bring into China every year were reduced, I suspect we would simply see a surge in the trading activity of the underground money exchangers.  At any rate just the size of the trade and FDI accounts means that a little fudging of the numbers there can lead to some fairly deep channels for inflow.  What’s more, stepping up the monitoring of trade-related and FDI-related activity comes with the inevitable corollaries – reducing real economic activity by increasing bureaucracy and frictional costs, and increasing the scope for and profitability of corruption, neither of which is good for China’s short-term or long-term growth prospects.

The survey also asked these “speculators” how much appreciation they expected for the RMB.  I am not sure how representative the survey is, and anyway I don’t think these target levels need to be taken very seriously because there is a lot of empirical evidence that suggests that our price targets are heavily affected by current price levels, and tend to change (usually in the same direction) as prices change.  Still, for what its worth, here are the target ranges.  

Expected RMB per dollar	Percent of respondents
6.0-6.5	17%
5.5-6.0	57%
5.0-5.5	26%
4.5-5.0	14%
4.0-4.5	6%

The total, mysteriously enough, adds up to 120%, but it is interesting that those sampled by Jun Ma seem to have fairly aggressive appreciation expectations, with more than one-third of them expecting the RMB to go through 5.5 to the dollar – for a total appreciation of over 25%.  The author of the article argues from this however that as the RMB approaches 6.0 China will begin to experience hot money outflows that could quickly turn into a flood, especially if the market then experiences a financial or economic crisis.  6.00 RMB per dollar represents a little more than a 15% appreciation from its current level of 6.93. 

 

I am not sure I agree that beyond that level we will see a great deal of outflow.  As the RMB steadily appreciates towards that number I suspect that arguments are going to be widely made about a higher equilibrium level, and the market will move towards higher appreciation expectations.  That is what usually happens in similar cases – rising currencies seem, at least for a while, to create expectations of continued rising, and certainly the experience of Japan in the 1980s, Germany in the 1970s, and other surplus countries is that, once it starts, appreciation can go on for a very long time.  . 

 

At any rate, given China’s huge reserves, there is no reason for speculative investors to race to the exits once their target level, whatever that is, is met, unless they expect significant depreciation pressure to follow, which I think is unlikely and can anyway be addressed by a credible peg (and nearly $2 trillion in reserves).  Their decision as to whether or not to keep their money in China will hinge on other factors – mainly the opportunity cost of holding money abroad relative to the expected returns of holding money in China.  Where I do agree with the author is that if the RMB’s trading in the 5.50 to 6.00 range coincides with a financial market collapse or a sharp economic downturn (which is likely to be the same thing), we might see sudden massive capital outflows.  But the key thing here is the condition of the market, not the level of the RMB.

 

One of his conclusions, then, is that China cannot afford a one-off revaluation of 15% or more because that brings the RMB into the capital-flight danger zone.  I would not conclude the same thing.  His data only (perhaps) suggests that China should not attempt a one-off revaluation in the midst of a financial or economic crisis, which I think is probably an obvious enough conclusion.  If anything I would argue that China needs to move quickly on the currency front precisely so as to obviate the need for a maxi-revaluation when the risk of a crisis is higher.  Every month that China has to deal with the massive inflows it is experiencing means a riskier financial system.  On that topic the May 15 edition of The Economist has this to say:

 

According to a study of previous crises by Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard, banking blow-outs lop an average of two percentage points off output growth per person. The worst crises reduce growth by five percentage points from their peak, and it takes more than three years for growth to regain pre-crisis levels.

 

A banking or financial crisis that sharply reduces economic growth (and concomitantly increases political volatility) is far more likely to lead to capital flight sufficiently large to threaten the country’s economy than a more expensive RMB, and a delay in the currency adjustment needed for the PBoC to regain control of its monetary policy is more likely to create the conditions for a banking or financial crisis than a will one-off revaluation.

 

On a related topic I missed an article in Caijing’s May 15 issue.  Among other interesting things it had this to say:

 

Hot money may have contributed to drastic fluctuations in the domestic stock market over the past year, said Bank of China analyst Tan Yaling. The Shanghai Composite Index doubled last year, soaring to more than 6,000 points in the fall, but plummeted to near 3,000 early this year. Tan noted that, while the index swung dramatically, China's macroeconomic conditions, the yuan's appreciation speed, and earnings of listed companies were generally stable.

 

Not all agree with Tan. For example, China International Capital Corp. chief economist Ha Jiming thinks the unexplained cash probably flowed into tangible sectors of the economy, such as real estate development.  Borrowers also may have attracted speculative cash. Since the government tightly controls credit, companies have had an incentive to borrow on the international market. Low interest rates globally have created “an abundant capital supply” for Chinese borrowers, Ha said. 

 

Hot money also may have been used for production projects and transactions, said Gao Shanwen, chief economist with Essence Securities. He said the central bank may be encouraging the influx by enforcing credit control targets set in late 2007 that may be obsolete. China's nominal GDP growth is more than 20 percent, Gao noted, and the capital demands of small entities are substantial.

 

I am often told that a declining stock market is inconsistent with rising hot money inflows because the hot money itself should push up the stock market, but as these various economists suggest, there are a lot of places where hot money can go, not least of which is to companies whose rising borrowing needs are hampered by caps on commercial bank loan growth.

 

Before closing, I should not that Stephen Green has an interesting Op-Ed piece in today’s Wall Street Journal about Chinese inflation.  

 

The still-dominant thinking in Beijing is that all these price hikes reflect a series of supply-side problems. But it is becoming harder to find any falling prices at all – a red flag that this inflation is a monetary phenomenon rather than an unfortunately timed series of supply shocks.

 

You can find the rest of the article here.

 

WED 4 JUN

Chinese savings and US deficits By Michael Pettis

I was just sent a very interesting paper by German economist Jorg Bibow of the Levy Economics Institute of Bard College (The International Monetary (Non-)Order and the “Global Capital Flows Paradox”).  In it the author considers the “paradox” of high and rising capital flows from developing to developed countries during the past decade.  This is a paradox because most economic theory (and history) suggests that developing countries are net recipients of investment, not net providers.

 

This paper came at a good time for me.  About two weeks I had dinner with three senior Peking University finance professors and a well-known and very smart American economist from one of the world’s leading investment banks.  Not surprisingly, much of our conversation during dinner was about China and current monetary conditions. 

 

The American economist and I agreed on most things concerning the financial system in China (and the rest of the world, for that matter) but we did have one disagreement, and that was on the global savings glut hypothesis.  As I understand it this hypothesis argues that policies or conditions that have a caused a systematic increase in savings in several countries, primarily in Asia, have resulted in the necessary corollary of compensating reductions in savings – or increase in consumption – elsewhere.  As the only country deep enough and with a sufficiently flexible labor market and financial system, the US is the natural equilibrator, and so US savings must decline and the US run a current account deficit.

 

For the American economist the hypothesis of the global savings glut made no sense, but as far as I could see his main criticism of it was that it represented a political view which tried to put the “blame” for the current global imbalances on China, Asia, OPEC and anyone else except the US, where, he believed, it belonged.  This is the same position as that of one of the best-known criticisms of the global savings glut hypothesis, which came in the form of a research note published by Stephen Roach of Morgan Stanley in July 5, 2005, in which he said “There may be a deeper and potentially more sinister meaning behind the saga of the global saving glut.  In my view, it is being used as a foil to deflect attention from one of the world’s most serious imbalances -- the excess consumption of America’s asset-dependent economy.”

 

The American economist also argued at dinner that there has been no real increase in global savings, so therefore the idea of a global savings glut made no sense.  Again, Stephen Roach’s piece made the same argument:

 

IMF statistics provide our best gauge of global saving.  In 2004, the IMF’s global flow-of-funds framework put the world saving rate at 24.9% of global GDP.  While that marks the second consecutive yearly increase in this measure, it is only 1.9 percentage points above the 23% norm that prevailed from 1983 to 2000.  Yes, the global saving rate has edged up from its longer-term average, but this hardly qualifies as a glut. 

 

I have addressed both of those very common criticisms before in my blog, but let me summarize very quickly why I think neither of them is valid.  To address the first, the idea that competing theories are proposed largely to assign blame is something that I find of little value in this or most other economic debates.  Furthermore, unlike many other analysts I do not think that such a large US current account deficit is unsustainable over the medium term.  I also think the US-China “imbalance” has actually been better for the US than for China, and so I do not think it is necessary to find someone to blame for US conditions. 

 

At any rate it is obvious, I think, that any imbalance requires at least two players, both of whom are necessarily to “blame” for the resulting imbalance.  The point is to try to understand why and how the imbalance occurs.  There is no question in my mind that loose monetary policy in the US and the fiscal cost of the Iraq war made it easier for the savings glut in one part of the world to balance a consumption “glut” in another, but without the excess savings driving the process the financing of the Iraq war would have created a very different set of outcomes.

 

The second point is, I think, easier to dismiss.  The idea of a savings glut necessarily requires not an increase in global savings but rather a shift in the composition of global savings, in which the share of savings in the “glut” countries increases while the share of savings in the equilibrating countries decreases.  It does not require, and in fact cannot require, an increase in total savings.  In a closed system, like that of the global economy, capital and trade flows must balance.  The only precondition, and hard evidence, we would need for a global savings glut is a major shift in the share of savings within the global economy and, ironically, Stephen Roach provides this very evidence in the same piece quoted above.

 

Alas, the devil is in the detail -- or, in this case, in the shifting composition of global saving and investment.  Two main forces have been at work in reshaping this mix -- namely, a record plunge in the US saving rate matched by an equally large increase in the saving rate of the developing world, especially Asia.  On the IMF’s basis, the US gross saving rate fell to 13.6% of GDP in 2004…That represents a 3.3 percentage point plunge from the 16.9% average that prevailed over the 1983 to 2000 period.  By contrast, the IMF puts the saving rate in the developing world at 31.5% of its GDP in 2004 -- up a whopping 6.5 percentage points from its 1983 to 2000 norm of 25%.  Reflecting the sharp increase in Chinese saving, developing Asia has led the way on the saving front; its overall saving rate is estimated to have surged to 38.2% in 2004 -- up dramatically from the 28.8% norm of the 1983 to 2000 interval.

 

That is exactly the point.  A surge in Asian savings, reflecting especially a surge in Chinese savings, must lead either to a reduction in savings elsewhere or a significant slowdown in global growth.  That is the source of the global imbalance and the justification of the global savings glut hypothesis.

 

What does all of this have to do with the Jorg Bibow paper that I mention in the very first line of this entry?  Bibow also rejects the global savings glut hypothesis, but my understanding of his paper is that he agrees with much of what I understand the theory to be but rejects it on much narrower technical grounds – he claims that the saving glut hypothesis is based on the “fatally flawed” (his words) loanable funds theory.  However his narrative of events seems very close to the one I and people like Brad Setser (also a proponent, I believe, of the global savings glut hypothesis) have developed.

 

But what interests me most is the data he provides in his paper (and you can see the accompanying graphs by following the link to his paper).  First off, Bibow discusses the evolution of the US current account deficit over the past fifty years.  Why is the US current account important?  Because according to the global savings glut hypothesis, the US current account deficit is the almost automatic counterpart to the rise in Asian savings. 

 

Basically, according to the data quoted in Bibow’s paper, the US current account has been within a range of a surplus of 1% of GDP and a deficit of 1% of GDP for most of last fifty years with two exceptions.  The first exception occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990.  The second exception began technically in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, before it began to decline again, but it really took off in 1997-98, when it raced forward in almost a straight line to peak, in 2006, at 6.2% of GDP.

 

If the US trade deficit was driven simply by an out-of-control US consumption binge, it is a little hard to see why it would have followed a pattern of general stability marked by two surges – a small one from 1984-188 and a very large one after 1997.  If it was driven by Asian savings, this pattern becomes a little easier to understand – or at least, what amounts to the same thing, we can posit a more plausible story to explain it.  

 

I will ignore the 1980s surge because this post is already too long, but again one can tell a very plausible story based on Japanese trade policies and domestic savings.  The post-1997 surge is much larger and more interesting.  1997 was, of course, the year in which several Asian countries, after years of tremendous growth and what seemed like invulnerable balance sheets, experienced terrifying financial crises and viciously sharp economic slowdowns, which profoundly impressed Asian policy-makers and has affected policy decisions to this day. 

 

Since the main cause of the crisis seemed to be the sudden reversal of current account surpluses into substantial deficits, along with highly mismatched balance sheets in which large external obligations were mismatched with domestic assets and “hedged” with extremely low levels of foreign reserves, one of the main (if mistaken) lessons policy-makers learned was the need to run current account surpluses and to amass large foreign currency reserves to protect countries from a repeat of the disastrous crisis of 1997.

 

These countries, consequently, but into place decidedly mercantilist policies in order to achieve both goals – persistent trade surpluses and large amounts of foreign currency reserves.  Unfortunately, these policies simply transformed the balance sheet risk and in many cases – that of China being the most notable – locked the countries into positive feedback loops in which trade surpluses and accumulating reserves (or, rather, the domestic monetary consequence of accumulating reserves) fed into and reinforced each other.

 

This (I think plausible) story is reinforced by another graph Bibow reproduces.  The global capital flow “paradox” to which he refers in his title is the fact that developing countries are exporting capital to rich countries.  According to his data, developing countries have always been net recipients of private capital flows – which is what one would have expected from most economic theory and history. 

 

They have generally been net providers of official capital as far as foreign currency reserve accumulation goes, but for most of the last fifty years reserve accumulation on average was significantly less than net private inflows, so developing countries were net recipients of capital.  (For much of the 1980s the balance on both was zero or close to zero, and I suspect that this reflects negative private flows to Latin American and others among the 32 defaulted or restructuring LDCs, as they were then called, netted against positive private flows to Asia.)

 

It is only in 1998 that reserve accumulation among developing countries begins to take off and by 1999 it exceeds net private capital flows to developing countries.  This is when the “paradox” of net capital flows from developing to developed countries begins.  Except for a small decline in 2001 net flows from developing countries surge almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows).

 

I am sure there can be other competing explanations for the timing of these flows, but I am very impressed by the fact that Asian savings, as expressed in reserve accumulation, surge after 1997, as does the US trade deficit.  Given the virulence of the 1997 crisis and the tremendous shock it provided to Asian policy-makers (and policy-makers in developing countries elsewhere), it seems to me that a very plausible argument can be made that it was the effect of 1997 that caused the shift in developing-country policies that led to the surge in savings and the corresponding increase both in trade surpluses and reserve accumulation.  The surge in the US trade deficit after 1997 is also more easily explained by a shift in Asian trade policies and currency regimes than by a shift in US consumer preferences.

 

I am less familiar with the consequences of these policies elsewhere, but it seems to me that for now China has found itself locked into these mercantilist policies, except that in the past year we have seen a major shift take place that must force a sharp adjustment.  The policies aimed at eliminating the risk of a 1997-style financial crisis have worked, but they have not eliminated the risk of crisis.  Instead they have only transformed the risk of an external crisis into the risk of a domestic banking crisis.

 

What is worse, China’s reserve accumulation is no longer being driven by its trade surplus and is increasingly being driven by very unstable private (speculative) capital flows.  I don’t have the data at ahnd, but I suspect (and this was also argued in the Reinhart/Rogoff paper, on which I commented three weeks ago), that when a developing country receives so much speculative capital, balance sheet vulnerability rises inexorably and the likelihood of a shock large enough to force an adjustment also rises.  What happens to global savings and the US current account deficit after that, I am not really sure, but it is something I am trying to figure out.

 

THU 5 JUN

Policy paralysis By Michael Pettis

According to today’s 21 Century Business Herald, Chen Donqi, vice president of the Academy of Macroeconomic Research (research arm of the NDRC), has warned that China needs to take steps to avert the risk of a sharp economic slowdown, including “pro-active” fiscal policies such as reductions in corporate and personal taxes.  On the other hand two days ago China Daily reported a release by the PBoC’s Institute of Finance Research that rejected warnings that a sharp decline in exports are likely to lead to a hard landing for the Chinese economy.  The research institute also said that although the recent earthquake would add to inflationary pressure, its effect was likely to be temporary.  Nonetheless the PBoC should not relax its current “tight” monetary policy.

 

That seems pretty much to represent the split in policy-making.  Various agencies, experts, and government officials make announcement to the press that seesaw back and forth between worried warnings about monetary excess and equally worried concerns about economic slowdown – with the export sector screaming loudest, even though overall exports are still growing sharply.  The NDRC and other groups, such as those in the Ministry of Commerce, are worried about a slowdown and want to see steps taken to prevent any significant reduction in economic activity, while analysts around the PBoC and many of the top universities are worried about massive hot money inflows, see rising inflation as a real concern, and want to continue running a tight monetary policy (although, as I have many times written in this blog, I think monetary policy is anything but tight).

 

There is developing a strong consensus that May CPI inflation numbers are going to be sharply down because of declining food prices, although the real thing to watch now is the non-food component.  If the problem is too much money, and not too little pork, we should expect to see an inflation “valley” as renewed food production takes short-term pressure off CPI inflation, but as excess demand is no longer fully absorbed by rising food prices, it will quickly shift to other goods and services, and inflation will surge again.  Of course if the problem is too much pork, food prices should begin to drop permanently while non-food prices remain stable.

 

If May CPI inflation drops below 8% year on year, as many expect it to (April came in at 8.5%), I think it is going to be very hard for the monetary alarmists around the PBoC to take control of the debate.  There are many reasons to think that we are going be strongly biased towards the relaxation side for the next month or two – a benign inflation number, the need for earthquake relief, and continued worries about global demand for Chinese exports.  If oil and food shortages become a problem, or if the non-food component of CPI surges, it will be harder to make the case for relaxation.

 

I think the most important thing to watch over the next few months is hot money inflows.  They have probably been massive for several quarters now, but the last six months or so have been, as far as we can tell from the evidence, simply extraordinary, and I can’t think of any way these inflows can be managed domestically without causing serious damage to the country’s financial system and balance sheets.

 

Meanwhile the stock markets are inching closer to the 3,000 level, around which most participants believe the government will intervene.  It hasn’t traded with much conviction one way or the other – today it bounced around several times within a fifty-point range before closing the day down 0.54% at 3352, a scant 12% from the perceived intervention level. Driving the market are worries that price controls, especially on steel and coal, are going to hurt profits.  At this point the market clearly believes that there is inflation in the system, and they understand that price controls (and subsidies) convert inflation from CPI increases into higher taxes and lower corporate profits, and they are reacting.

 

FRI 6 JUN

Administrative measures trump market measures (for now) By Michael Pettis

In a sign of how worried the authorities are about rising speculative inflows, in a report released yesterday SAFE said it would step up the monitoring of foreign capital inflows.  Yesterday I wrote about the policy paralysis that seems to be occurring as different groups within the government have some fairly radically different ideas on what are the biggest problems facing China.  Under the circumstances, I argued, it is very hard for those who are worried about inflation, overheating, stock market excesses, and speculative inflows to organize the consensus needed to take the rather more dramatic steps China needs to take.

 

That was not completely correct.  Where policy paralysis seems to be occurring is actually in deciding what appropriate market measures need to be taken – adjusting the currency, raising domestic interest rates, liberalizing the markets, or relaxing price freezes.  There does not seem to be a lack of consensus – or perhaps it is more appropriate to say that a wide consensus is really not needed – when it comes to administrative measures.  The government continues to use administrative measures and various forms of signaling in its attempts to address the stock market and inflation, and it seems that its first weapon of choice with which to attack hot money inflows is likely to be attempts to strengthen capital controls.  That is how I read the SAFE announcement.

 

Clearly greater vigilance on this front is likely to have some impact on capital inflows at the margin, but I think there are at least three problems.  First, by now it seems that speculative inflows are so large that reducing them by a little is not likely to create a whole lot more breathing room for the PBoC.  Although many commentators are only now starting to concede that hot money is a big problem, the fact is that it almost certainly was a problem even a year ago.  Given the nature of these inflows it is hard to get a real sense of how rapidly they have grown, but one Chinese commentator claims that inflows this year are running at three times last year’s pace.

 

I have no idea if this is true, and certainly can’t prove it one way or the other, but even if he is way off, I think few of us who have been trying to estimate the numbers would argue that hot money inflows have not increased dramatically, and we all agree that they are now a much more serious problem.  In that case, it would take a very large reduction to “fix” the problem, and I don’t think increased monitoring is going to have that impact given how complex and large China’s trading and investment networks are and how easy it is for agents to skirt the law.

 

Second, this increase in monitoring will necessarily raise the cost of legitimate transactions, and very tight monitoring might seriously hamper economic activity.  Trade is important to China, as is FDI, and the bureaucratic delays and frictional costs associated with a step-up in monitoring may have a significant economic cost.  Finally, most of the empirical evidence suggests that in a developing economy with weak governance an increase in monitoring will deepen illegal channels and strengthen corruption.  This can’t be in China’s interest.

 

So China’s fight against hot money will be like its fight against inflation and its fight against stock market volatility.  Instead of market measures it will first try a variety of administrative measures. I think this fits more comfortably within the intellectual and cultural framework with which the leaders are most familiar and it gives the sense of managing the process in a non-disruptive way.  If it ends up having no effect, as I think it won’t, the consensus will gradually build for more realistic measures.  The problem, of course, is that this may take much too long.

 

On a separate, but related, note, one of my former students who has spent the past three years as a trader sent me the following (edited) note:

 

There has been market talk that CIC is placing USD deposit with onshore banks (both local and foreign).  one-year onshore USD is quoted at L+900 bps, so it’s economically correct for CIC to do so.  This is the main reason why onshore FX swaps are bought up at -6000 to -2600.

 

Personally I think this is real, but I am not able to find out or even guess how much money they lent out onshore.  The onshore banks will have to place a bigger amount of USD reserve with PBOC, but I am not sure whether this will have any impact on the FX reserve number

 

Another thing, in reference to the rapid growth in USD loans onshore in the first quarter that you discussed on May 18, I checked with several banks, and many of them tell me that the corporates are borrowing USD and swapping the USD into CNY thru fx swaps, to get CNY funding.  (Following a query the student told me that these corporates are swapping with the banks that lend them USD.).

 

Let’s see if I understand.  Corporations are borrowing US dollars from local banks and then swapping into RMB.  Why?  I guess that this allows them access to RMB funding without, technically, taking out RMB loans, which would come under the lending cap.  Logan, if you’re reading this, what do you think?  Does this fit with what you are hearing?