My Blog

June 26, 2008

For most of us the purpose of traveling to a developing country is to get the frisson of authenticity that we can’t get at home, and it annoys us no end when locals don’t play their roles correctly.  Last week at my friend’s wedding in Koh Samui I had to listen to a long diatribe by a very nice Australian lady involved in the arts who was furious that Westerners were apparently forcing Thai people to live Western life-styles rather than leaving them to enjoy their own culture.  In Koh Samui, I guess, there are too many refrigerators and motorcycles and not enough buffalo carts.  I was going to argue that the Thai might themselves prefer the modern urban conveniences, and were perhaps indifferent about helping us foreigners achieve our much-desired authenticity, but I didn’t want to be thought a cold-blooded imperialist by the many nice people at the wedding.

It’s not just in Thailand.  Most of my foreign friends who visit China, especially my European friends, are determined to see the “real” China while they are here, and of course they are even more determined that the “real” China look like it belonged in a Bertolucci film.  Of course enterprising Chinese know this, and so they have created little enclaves, like the annoying Nan Luo Gu Xiang, a little hutong street just north of the Forbidden City dotted with picturesque jewelry shops, backpacker bars, local restaurants, and various crafts outlets, most of whose merchandise looks like the vaguely Tibetan stuff you can buy in any authentic local shop in Guatemala, Marrakesh or New Mexico (or Koh Samui, for that matter).

Occasionally I like to bring foreign visitors to the neighborhood McDonalds, partly because it always generates a lot of outrage and partly because you are far more likely to find a McDonalds outlet replete with local residents conducting their everyday life than you ever would in Nan Luo Gu Xiang, which is much more likely to be peopled by European tourists and upwardly-mobile Chinese who like to eat and shop in the places foreigners do.  McDonalds, on the other hand, is as local as it gets for young urban life in most Chinese cities, and it is rare to see one that is empty.

Sorry for that non-economic digression.  I mention all this not because I own McDonalds stock or like the food, but rather as a prologue to the large headline in today’s China Daily:  “McDonald's raises prices in China.”  McDonalds, along with KFC and Pizza hut, is extremely popular in most major Chinese cities not just with students but also with middle class families and dating couples.  The fast-food outlets are almost always full and often there are lines to get in.  Right-thinking Westerners may deplore this, but one of the best young underground bands in Beijing even has a song about how many times McDonalds has saved the singer’s life (mostly because of the clean bathrooms, however).  It is a fairly important place to many urban Chinese and so its pricing policies matter, as the China Daily headline indicates.  According to the article:

There's no escaping rising inflation - signs of it are everywhere. The latest sign could be in your meal at a fast-food outlet. McDonald's, the world's largest fast food chain, yesterday raised its prices in China, for the second time this year, following measures to increase prices in January.

The US group is not alone in its decision. Many Western food chains are now increasing prices on their menus in China.

The article goes on to say that in the latest price hike, the cost of most items rose by RMB 0.5-1.5 per item (7-21 American cents).  I don’t know what the typical item in McDonalds costs, so I don’t know what this means in percentage terms, but I am struck by the fact that they hiked prices in January and then again in May, even though food prices declined in May.  This suggests to me that inflation, and possibly wage inflation, has become a serious enough problem for at least the fast food outlets.  I don’t know how much of their costs consists of food purchases and how much is non-food, but I would have thought that two price hikes in four months is a lot.

Most analysts by the way expect that CPI inflation will decline again in June because food prices continue to decline.  The question, as always, is whether non-food prices are stable or are increasing.  The hike in energy prices last Thursday will almost certainly have an inflationary impact, but it is too early to say what kind of impact.  The NDRC, whose policy-making role seems to have strengthened recently, apparently believes that the fuel price hike will only raise CPI by about 0.4%, but the Observatory Group’s Xinxin Li says the PBoC disagrees:

PBoC officials believed that the real impact to the general price level would be much higher.  Internally, the government’s 2008 inflation target has been readjusted to 6% from 4.8% since the beginning of the year.  After the recent price hikes, the PBoC essentially abandoned the 6% target, but is anticipating 7% now.  Whatever the formal target, it is more concerned about the pass through from this price hike to broad-based price levels and to higher public expectations of future inflation.

Again the differing interpretations of domestic problems are making policy difficult.  PBoC governor Zhou Xiaochuan last Friday warned again about inflation and hinted pretty broadly that he was considering an increase in interest rates.  In response, Chinese bond markets have been pretty bedraggled this week, especially today.  According to today’s Bloomberg:

China's 30-year government bonds fell the most this month on speculation the central bank will raise interest rates as early as this month to cool inflation…The yield on the 4.5 percent 30-year bonds advanced 14 basis points from the price compiled by Bloomberg yesterday to 4.91 percent as of 5 p.m. in Shanghai.

But it is very widely believed that recent meeting of top government officials made it very clear that an economic slowdown is now a much greater concern than inflation.  That would make it very hard for the PBoC to garner much support for a rate hike, especially as both the real estate and stock markets would probably be badly affected and the stock market has only just managed to pull itself back from the brink.  I have no real expertise in handicapping the race, but it seems to me that the PBoC is probably facing a lot more opposition to its monetary concerns, and my guess is that the pro-growth camp has the upper hand for now.

Talking about stock market exhaustion, last Thursday’s fuel price hike certainly seems to have impacted the stock market in a positive way.  After the big run-up in stock prices on Friday I expected the market to be weaker this week, but I was wrong.  The week did start badly, with the SSE Composite dropping 2.5%, but over the next two days it turned around and gained a total of 5.2% before, after a very rocky day today in which it bounced around several times in an 80 point range, it closed at 2901.85, down 0.1% for the day.  That leaves it up 2.5% for the first four days of this week.

Before closing I want to mention two things.  The first is a June 24 Financial Times article I read yesterday on the plane (“Vietnam suspends gold imports”).  Because my adorable godson is Vietnamese, and his parents are involved in the world of finance and government, I have been keeping an eye on the events unfolding there.  No, I don’t think the problems in Vietnam are at all like those facing China – with its massive current account deficit Vietnam has a very different set of risks than China – but I was intrigued by the fact that this week Vietnam had to suspend gold imports in order to ease its large and growing trade deficit.

Apparently, and in order to protect themselves from inflation, so many Vietnamese are buying gold that Vietnam has suddenly overtaken China and India as the world’s largest market for gold bullion.  This orgy of gold buying has, of course, worsened Vietnam’s trade deficit, although I would argue that gold imports for investment purposes should be seen more as a reduction of the capital account surplus than an increase in the current account deficit, but either way it represents a drain on reserves.  Although gold imports are regulated, until the suspension Vietnamese gold imports had soared.  Gold imports for the first quarter of 2008 were up 71% over the same period last year, and imports of gold bar (which of course is what gold investors typically buy) were up 110%.  I have said many times in this blog that I suspect that if we see problems with inflation or capital flight in China, one form these are likely to take are through gold purchases.

The second thing I want to mention is a very strange story on Chinese Law Prof Blog, written by a friend of mine, Donald Clarke, who teaches law at George Washington University Law School and who is particularly knowledgeable about legal and business conditions in China.  According to Don, government officials had turned down a foreign acquisition of a Chinese asset on the grounds that the appraised value of the asset was much higher than the price at which it was held on the owner’s books (the “book value”) , indicating to them that the foreign investors were paying too much for the acquisition.  A friend of his was the legal advisor on the transaction.  Don goes on:

A market price higher than an appraised value is not surprising or indicative of anything wrong; Chinese appraisers often rely on book values that take no account of certain intangibles and future earning power. In the past, foreign acquirers have run into difficulties with approval authorities when the negotiated price was lower than the appraised price; the authorities, who have more faith in the solidity and apparent objectivity of book numbers than in evanescent and subjective market valuations, would suspect that assets were being sold off cheaply to crafty foreigners, or that kickbacks or other underhanded dealings were involved.

It is clear why the authorities should be concerned if the buyer was paying too little – that might indicate that there was corruption or some form of fraud taking place, but why should anyone care if the buyers seem to be paying too much?  Apparently, according to Don’s friend, because it might indicate a very different kind of illegality:

What’s going on here? The problem is that apparently approval authorities are now more worried about hot money inflows than they are about Chinese sellers getting taken to the cleaners by crafty foreigners. They just don’t want all this money coming into the country. Surely there is something wrong with an exchange rate policy that leads to this kind of result.

In several of my entries I have tried to explain why it is not such a simple matter for the authorities to deal with burgeoning speculative inflows by imposing tighter restrictions on the inflow and outflow of capital.  With so many legitimate transactions of such a wide variety occurring over so extensive a trading border, it would take an enormous amount of monitoring to reduce speculative inflows, and this monitoring would seriously hamper real economic transactions.  Don’s story is a particularly bizarre example of just how such hampering might occur.

Comments (12) for "Inflation? Or stagnation?"

I am a regular visitor to your website. The observation on Shanghai Markets (Index) caused me to refer to this article in NYT: For Chinese, the Reality of Higher Gas Prices (http://www.nytimes.com/2008/06/21/business/worldbusiness/21gas.html?ref=business). The oil price hike helps the two companies named in the article : Sinopec and PetroChina and as the subsidy gets reduced oil prices could cool down translating into lower prices and so on. I know it is too far fetched to say so, with so many theories on causes of rising oil prices floating around making me dizzy. regards: ganesh By ganesh - 6/25/2008 9:00 PM

Michael, following up to my e-mail today, I would like to bring to this forum some ideas that might contribute to this discussion: 1- Hot money inflows: I am not 100% sure how they are done, but I definitely do not picture the one million or so Chinese crossing the HK border with the USD 50K suitcase. Rather, I suspect they come in the loopholes and back doors (which I am sure there are many) of China´s official and unofficial financial system, i.e. over/under invoicing imports/exports (here in Brazil they do it without a single good moving through the border), overpricing investments (such as it seems to be the case of this particular matter discussed in this issue), borrowing from a local bank in rmb while lending the same amount overseas to that back (this one must be a huge one), and also, through the black market itself. 2- Volatility of the fx regime: a couple of weeks back in this blog, 2fish had some arguments defending the thesis that increased fx vol would discourage outward CNY appreciation speculation, which was contested by Michael and others, due to the nature of the hot money inflow, and the fact that they are long term investments. I strongly disagree with this, as even for real state investors, short term changes in prices does affect their risk appetite, as their p/l book changes. Lets suppose for instance that a huge and well connected Chinese real estate / banking conglomerate ran by the same family engages on the following transaction betting that their unofficial dollar holdings will lose value compared to a potential CNY investment. This banking conglomerate them borrows from itself abroad (look at the figures of increased private Chinese debt abroad) and lends to itself in CNY to fund some real state project (also look at China´s investments to GDP ratios), while leaving the excess cash in the bank for the 4% deposit rate. As long as the CNY appreciates, even if the net present value of this project is not the best this is a great transaction, as in the end the family conglomerate will end up with a much more valuable real state holding in China than it would have in its dollar holdings. Now let´s also think that given the foreigners appetite for CNY appreciation this conglomerate starts doing this over and over again, hedging this CNY exposure in the future markets - there you have the other side of the CNY appreciation trade, they must be the ones that have actively put their cash into china, and are exploiting the extraordinary carry of 4% deposits + implied valuation of the CNY, which is yet another positive guaranteed carry (used to be 8% p.a., went down to 4% in the April-May CNY appreciation slow down, now is back to over 6% and climbing). Now, apart from declining real state prices, which seems to be already occurring in some parts of China, another way to deter such moves is precisely making the CNY path more unpredictable, as increasing currency volatility would increase the risk profile of such a move, as a couple of months of negative carry could force players to book their loses and stop over investing in China. Moreover, another issue which was not touched, is the degree that local Chinese companies are prepared to deal with a floating fx regime, as they were used to the peg, and now an ever appreciating currency. It would be fair to say, in my opinion, that increasing the volatility of the CNY (both sides of the trade) would not only allow it to move to a market equilibrium faster, but also give local players more time to get used to a volatile market driven fx regime. Also, it would not make so many companies bankrupt as an abrupt one off revaluation change would. 3- Inflation: there are some similarities between China now and Brazil in the 70s (military regime, big infrastructure investments with not so well measured net present value analysis, oil shock, inflation or rather growflation) that the only refreshing different things are high savings rate in china (over 40% as opposed to high teens in Brazil), and huge reserves. However, it only takes one wave of capital flights from China to bring those reserves to nothing, hence I believe that in the future (once fx appreciation has reached its limit), China will need to deal with a much more serious inflation problem than now. As a matter of fact, I think the whole world will, as the limits of human exploitation of Earths resources becomes reality. Until that time comes (we are still some decades from then), we can still discuss the cost benefits of fighting inflation with fx appreciation vis a vis restricting monetary policy, in the end I believe Chinese policy makers will do what they always have, balancing both, as losers in one policy force the other to be implemented, given that in the end inflation is a much bigger problem for all. Lets also look for the next data sets on the trade surplus, as if it is able to sustain itself high, the odds are that fx will endure most of the task of fighting inflation, otherwise the pendulum will swing to the unpleasant monetary policy. By Eduardo Guelman - 6/26/2008 6:37 AM

Sorry to repeat here a question I asked on yesterday's entry: Can dark pools and black pools operate in mainland markets (through HK, or Chinese investment companies or any other loophole) ? Can the central government effectively regulate/restrict such inflows of liquidity? By TGS - 6/26/2008 10:15 AM

Don't be too quick to throw in the towel, professor. It looks like you were right after all about the performance of the market this week. As of 30 minutes from closing, the market is down by over 6%, which not only wipes out all of this week's gains, but also eliminates the gains Friday right after the fuel price hike was announced. So far your call on the market is still unblemished. By MarketMan - 6/26/2008 2:42 PM

Thanks, MM, but I think today's fall had more to do with bad markets in the US and elsewhere, and with more rumors of an interest rate hike, than as a belated response to the fuel price hike. Still, as they say on Wall Street, it's better to be lucky than to be smart. EG, artificially induced volatility is not the same as uncertainty. If RMB volatility really left investors worrying about the future direction of the RMB, it would affect money inflows. But in China's case, volatility simply means a bumpy ride up. A 1% decline in the RMB today, for example, only means even faster increases in the next few days or weeks to regain the upward march. This will not stop investors from bringing money into the country. At any rate the proof should not be about what ought to happen but about what is actually happening, and so far the increase in RMB volatility of the past five or six months has most certainly not been correlated with a decrease in hot money inflows. On the contrary. TGS, I am not sure what you mean by dark pools and black pools. So far it does not seem that the government has been terribly effective in regulating or restricting inflows because almost every proxy used for measuring speculative inflows has risen dramatically. We do know that there are very signficant amounts of "informal" financing in China, and these probably rely to a significant extent on speculative inflows for funding. By Michael Pettis - 6/26/2008 5:18 PM

Eduardo, I don't think your point number 2 makes sense, even if your example were the only way hot money comes into China, and it is not. Adding volatility would slow hot money for investors in futures, where margin calls would make a difference, but unless your investors are funding their Chinese RE investment with one-day or one-week loans at the maximum margin permissible, and these loans are rigorously marked to market in RMB terms at the end of every day, and the lenders required the investor immediately to sell the real estate any time their value fell in RMB terms by a few tenths of a percent, it could not possibly make a difference if the RMB declines for one or two days. Of course if your Chinese RE investor really is borrowing under those insane conditions, both your investor and the bank that made the loans would probably collapse in weeks -- these terms would be absolutely idiotic for any real estate investment. Most real estate loans are term loans and any default or call provisions would require a significant drop in appraised value -- not a one or two percent drop in the value of the currency over a few days. Also why do you bring up the consequences of hedging these loans? if they are hedged in the NDF markets not only would the hot money speculator not be speculating, but he would have no risk. And if adding volatility does slow down hot money, why has hot money come into China faster than ever over the same period that RMB volatility has increased? By ChinaBull - 6/26/2008 5:49 PM

Hey Michael, not sure if you are aware, but your site is being blocked in China now. I had to log on to vpn to gain access. Wonderful piece on inflation. I completely agree; menus are changing; I think more serious inflation in on the horizon. Somehow, all the major banks are taking a very sanguine view of the situation..... By Victor - 6/26/2008 6:09 PM

Yes Victor, it has been blocked since last October. Apparently the site I use, Sampasite, has a blog on Tibetan buddhism, and so all the blogs have been blocked. I do post most of my entries on a sister site inside the firewall. It is not well-formatted, and the need for approval means that the site publishes my entries many hours after I actually post them, but if you are inteested the address is: http://blog.sina.com.cn/mxpettis By Michael Pettis - 6/26/2008 6:20 PM

ChinaBull: the idea I attempted to portray is that although china has a closed capital account (Although SAFE points out that this account has moved almost USD 2 trillion in the debit and credit side - 1 billion each), there are several ways that capital pours into the country (which you seem to agree, I only sugested one). Moreover, I strongly disagree that the NDF market for the RMB bears no implications into the real world (and vice-versa), hence if someone is selling RMB fowards they must be "hedged" somehow by actually owning RMB, I only attempted to illustrate one way Chinese Financial Conglomerates (both state and private) can "arbitrate" this market wining on both sides of the trade. Moreover, there is huge empirical evidence that this is currently being done given the high level of Investments in China and also huge increase in Chinese companies liabilities abroad, that is all... By Eduardo Guelman - 6/27/2008 4:54 AM

Also, to add up to the increased fx vol idea, I think that looking at the past as empirical evidence of higher vol = more hot money is flawed, as the refered higher vol in the past 6 months was assimetrically skewed towards the side favoring hot money, or at least stagnant during the april-may 7 rmb/usd rate. I believe that only after a couple of months of moves to the other side of the trade (i.e. depreciating yuan) would qualify as real fx vol, and hence diminish hot money, as players would rush to find the few exits that there are to such trades. By Eduardo Guelman - 6/29/2008 11:19 PM

Eduardo, The idea that the already undervalued RMB could appreciate for a few months without setting off a trade war in Europe and the US and creating greater imbalances domestically is something that few people in the Chinese government, thank god, seem to believe. I think that is what Pettis means when he says that everyone knows it is a one-way trade and any temporary depreciation would quickly be reversed. Your proposal is not at all realistic. By TR - 6/30/2008 10:57 AM

I think it is nor only realistic, but might as weel be the best policy choice of the Chinese politburo: http://www.bloomberg.com/apps/news?pid=20601089&sid=aZ7eYN90dXDc&refer=china By Eduardo Guelman - 7/1/2008 3:54 AM