My Blog

May 7, 2008

The Chinese stock market started the day well, with the SSE Composite starting below yesterday’s close but quickly trading up to 3767 within the first hour of the morning – a hefty 2.3% jump from yesterday’s close.  But investors quickly lost heart, and the market subsequently gave up nearly 200 points from its peak today to close down at 3578, for a very ugly 4.11% loss for the day, with banks, real estate-related companies, and Olympics-related companies leading the way down.  The steepest declines took place in the last 90 minutes of trading, when a slew of selling orders ran up against a sharp decline in trading volume.  For all the talk of government support it does not seem that there is a great deal of confidence in the market. 

A lot of investors are still wondering what, if anything, the government can do next to stimulate the market.  I don’t doubt that there are still things government agencies can do to signal official intentions, but there doesn’t seem much they can do actually to influence real supply and demand in the market for more than a few days.  As expected, their many interventions are losing credibility.  Institutional investors seem to be using every rally as an opportunity to get out of their positions, while retail investors are filling internet bulletin boards dedicated to discussing the stock market with anxious and angry comments.

On the inflation front, according to a Credit Suisse report today, Dong Tao, who has had a pretty good call on Chinese inflation, is expecting the April CPI number to come in at 8%.  Like many other analysts he expects second-quarter inflation to stay high, but well below the drastic first-quarter numbers.  However he, like me I might add, is worried that as food price rises decelerate non-food inflation will soon take center stage and drive the index up higher in the send half of 2008.  In that context I should mention a piece from Capital Economics on the subject of inflation in Asia.  “Inflation has re-emerged as a unifying theme across many Asian economies in recent weeks. Driven by the continuing high international oil and food prices, persistent upside surprises to inflation have forced a rethinking of monetary policy in the region.”

I think this should not be a surprise.  After the 1997 Asian crisis a number of Asian economies, including China, have been so determined to protect themselves from a repeat of those events that they put into place a set of systematically mercantilist polices aimed at limiting exposure to external debt – often by managing their currencies so as to run persistent current account surpluses and burgeoning reserves.  The problem with these policies, as I have discussed often on this blog, is that they seem to have misjudged the cause of the earlier sequence of crises.

Financial crises do not occur because countries have currency mismatches.  They occur because they have asset-liability mismatches, of which the currency mismatch is only one form.  By managing domestic monetary policy so as to minimize the risk of a currency mismatch several Asian countries may have simply transferred the balance sheet risk into a different form.  Specifically, interventionist currency regimes have often resulted in significant monetary expansion, which create not just the risk of inflation but can also lead to domestic balance sheet imbalances, most dangerously in the banking system.  Remember that in the 1920s the US also experienced massive capital inflows on the trade and capital account, resulting in the accumulation, in John Maynard Keynes’ words, “all the gold in the world.”  The result, in the case of the US, was not a national balance sheet impregnable to disruption.  On the contrary, the US experienced the stock market crash of 1929 and the banking crisis of 1930-31 that led to the consequences with which everyone is familiar.  The lesson is that current account surpluses and massive reserve accumulation are no guarantee against financial disruption.

Headline food prices do seem to be moderating in China, so we will see a deceleration in CPI price rises, but I am not sure this is for all the right reasons, and I wonder if food price increases can continue to be restrained.  As a long-time trader and observer of developing countries I always get a little nervous when government officials keep repeating that they don’t have a problem in some specific area, so I guess I am getting a little nervous about yet another announcement, this time from the NDRC, that they have “ample grain to keep food prices stable”, as the prominent headline in today’s China Daily put it.

We are starting to get these assurances nearly every two or three days now.  “Our grain supply and demand is basically stable, our reserves are full, and we can ensure supply and stable grain prices,” the NDRC said in its statement.  The same article pointed out that customs and commerce authorities are cracking down on illegal grain exports by traders hoping to profit from surging international prices.  It points out that whereas price of rice in Thailand has soared from $300 a ton to $1000 a ton in six weeks (wow! can this possibly be true?), the price of rice in China is still frozen at $300 a ton.

Not surprisingly this seems to have led to wide-spread rice smuggling.  Another article in the same issue of China Daily also makes this point: “But there are concerns about how long the nation can hold its rice price at about one-fourth of that in overseas markets, given recent reports of illegal rice exports in the past months.”  Not only do we have a problem of local “businessmen” smuggling oil out of the country to take advantage of the heavily subsidized prices in China, but the smuggling problem now seems to be spreading to grains too. 

I suppose this was only to be expected.  With such long and complex borders, and with an endemic corruption problem, it was inevitable that the huge disparities between the subsidized prices of certain commodities in China and their equivalents in neighboring countries would lead to “arbitrage,” as the more polite among us might put it.  I have no idea of how extensive this smuggling is, but given the fact that the authorities are publicly admitting the problem (and twice in a single issue of the China Daily), I would guess that it is a big problem.  The monetarist in me would also point out that smuggling rice out of China will have a similar monetary impact as bringing foreign currency into China, so this is not just a problem for the Ministry of Finance, who has to raise taxes to pay for the subsidy going to smugglers, but also for the PBoC.

One final note: John Garnaut, of the Sydney Morning Herald, wrote an interesting article three days ago on unemployment in China.  As worthless as the official unemployment numbers are (the Economist recently argued that they are the least accurate of all the important economic numbers provided by the Chinese government), it may well be that unemployment in China is much lower than many in the government think.  If this is true, the social consequences of further monetary tightening may not be as grave as many government officials fear, especially given that the expected economic slowdown caused by China’s slowing export growth is likely to have been counteracted by a recent surge in infrastructure spending.  There may still be time to take the steps needed to reduce China’s out-of-control monetary growth.

Comments (7) for "How long will the inflation ...

The monetary crisis is a collective response to a diminishing rate of return. When a country's economy is booming, asset prices seem to be relative cheap. So capital pours in. While there are too much money and the investment return is lower than rest of world, money will run out. The problem is: if money are flowing out, they always run altogether due to various reasons. Nobody can avoid the overshooting. Thus, in short term, you will have a probelm of finding capital in the country. Unless you are really big and developed, there will be a crisis or depression. I doubt the rice price cited in that article. It seemed to be the future price. I do not think it is the rate of actually transcation. By fatbrick - 5/6/2008 9:11 PM

Regarding unemployment. I heard that lots of shut down will happen soon, since they need to clean the air ahead of O game. I am not in China now and I have not check the official news. I will be a little suprised if many plants shut down in May/June. But if this ever happens, you bet the unemployment rate will have a spike. By fatbrick - 5/6/2008 10:34 PM

CBOT Rough Rice for May 08 delivery closed last night at $2155 per ton. The same contract was priced around $1900 per ton 6 weeks ago. Maybe $300pt refers to Thailand's domestic price. $300 to $1000 in 6 weeks is a lot but still very low compared to $2155. Pegging domestic price at $300pt will simply encourage aggressive smuggling. By Kheng - 5/7/2008 10:57 AM

100% Grade B Thai Rice benchmark export price was quoted at $941 per tonne yesterday, up 10% since cyclone hit Myanmar. At its peak in April, it was quoted at $1300 per tonne. I cannot find the benchmark export price 6weeks ago, but according to a chart on WorldBank website http://eapblog.worldbank.org/content/rising-food-prices-and-east-asia-trends-and-options, rice price increased from around $300 per tonne to around $900, in about 6 months. If China rice is priced similarly to Thai B in the export market, the margin between the controlled and export prices is large. By Kheng - 5/7/2008 12:27 PM

Thank Keng. Clearly rice has been on a tear internationally, and the failure of rice prices to adjust domestically is going to be costly. It seems that the China Daily figures, surprising as they are, were more or less correct. Fatbrick, the air still haen't improved much here but there is a consensus that factories will soon be closing down (and drivers limited in their ability to use their cars). This might affect employment in and around Beijing but overall in China I don't expect it to have a big impact, especially as factories in other parts of China will probably benefit from the closing of factories near Beijing, so they may increase employment to meet the higher orders. I do think you are right to be worried about a massive capital outflow. Next week I will be writing about the recent Reinhart/Rogoff paper on the history of financial crises. One of the points they make is that countries experiencing massive capital flight and financial crises usually experienced massive capital inflows before the crisis. Unfortunately the mechanism that causes money to pour in, when it reverses, can often cause money to pour out, and the impact of money popuring in often leads to the type of balance sheet vulnerability that exacerbates shocks. By Michael Pettis - 5/7/2008 1:43 PM

Chances are bringing money in when hot money is flooding in will be much easier than taking money out when hot money is ebbing out. When, and if, the flow reverses, expect stricter controls to prevent an exodus the scales of Asian Financial Crisis. The prospect of massive repatriation at times of financial shocks must be a big concern. Prof Pettis, can you shed some light on how the Japanese govt managed money outflow when the parties ended in 1990? By kheng - 5/7/2008 3:12 PM

Kheng, I am not an expert on Japan but I believe they have no capital controls, so there was attempt by the government to manage flight. I also think credibility in Japan is high enough that there were no significant outflows, especially since I believe reserves climbed during much of that period (i.e. the net current and capital acocunt was positive). Countries with highly credible financial systems don't normally experience capital flight in response to crisis (capital flight generally is a problem only when people believe that there are or may soon be restrictions on their ability to withdraw). The problems credible countries face tend more to be in the form of hoarding -- and bank hoarding was an especially big problem in Japan, as far as I understand. By Michael Pettis - 5/7/2008 3:28 PM