My Blog

September 5, 2008

Another terrible day on the stock market saw the SSE Composite, led kicking and screaming by energy and financial companies, trade more or less straight down by 3.2% to close the day at 2203.  The brilliant autumn weather in Beijing (and the best week for air quality I have seen in seven years of living here) seems to have bypassed the market altogether.  

Away from the weather there is plenty of bad news for those looking for it.  Yesterday Reuters cited a Lehman Brothers report on declining August car sales:

China's passenger car sales fell 10 percent in August from a year earlier, preliminary data showed, due to the impact of the Olympics and weakening consumer confidence, Lehman Brothers said in a research report on Thursday.

The report said auto sales in China, the world's second-largest car market, were
expected to remain lacklustre for the rest of 2008 and possibly into early 2009.
Compared with the month before, sales were down 12 percent, the report said.

Also yesterday the Financial Times warned that “Chinese steel consumption set to fall”:

Growth in Chinese steel consumption is expected to slow markedly in the second half of this year amid weakening demand from the construction, household appliance and automobile industries, according to industry experts.

Yang Siming, general manager of Nanjing Iron & Steel told a steel conference in Xiamen this week that most Chinese steel mills had cut output last month, because of shrinking demand and high costs of raw materials. ”We’ve been cutting production since last month, and according to my knowledge, most domestic mills are cutting output too,” Mr Yang said.

One of the possible adverse consequences of excessively rapid money growth has been the channeling of this money via the banking system into excess production.  This was fine as long as a healthy world economy could absorb Chinese excess production, but a slowing global economy has meant that Chinese producers have been forced to turn to a domestic consumer market that hasn’t been able to take up the slack.  As I have mentioned many times before, rising inventories are one of the warning signals I am most concerned about.  I don’t think we are there yet, but I will be trying to keep an eye on the subject as well as I can.

All this bad news is making policy-makers worried, and they seem eager to try to encourage some optimism.  I was struck by the list of top five articles under the “Macro-Economy” section in today’s Xinhua:

Analysts: China's inflation to continue easing in August

China economy "slowing but resilient," HSBC report says

Noted Chinese official: Chinese economy not in downturn, but adjustments needed

Crude oil plunge good for China economy, analysts

Economists: China's economy still in shape

Three of the top five articles today and all of the top five yesterday seem to be saying the same thing:  Don’t worry, things are still ok.

Still, not all the news is bad.  As I wrote Wednesday it looks like CPI numbers for August, which will be released next Thursday, are going to come in without too much implied inflation.  Most estimates are that CPI inflation will come in below 6% for August.  Today Xinhua reported that “China's consumer price index (CPI), a key measure of inflation, was expected to show a rise of about 5 percent in August from a year earlier, said analysts on Thursday.”  They go on to quote Fan Jianping, chief economist of the State Information Center, as saying that “the CPI growth rate might sink below 6 percent in August.”  Logan Wright of Stone & McCarthy told me today that he expects it to come in around 5.5%.

Of course CPI numbers are pretty tainted by price controls at this point, but I am willing to bet that a low CPI inflation will make it much more likely that energy prices are allowed to rise again.  Shortages continue to be a real problem and energy producers are being squeezed mercilessly by rising costs and frozen prices.  In his comments yesterday Fan Jianping said he expected August PPI to rise by 10.0-10.3% (compared with the 10.0% rate posted in July).

On a separate note a very interesting article by Keith Bradsher in today’s NY Times discusses a predicament for the PBoC that many of us have been wondering about for a while.  As the RMB rises against the US dollar, the PBoC is forced to take losses on its currency mismatch – it buys dollars and funds them with RMB borrowings.  These losses have become so big that, according to Bradsher, the PBoC has been warned by the IMF that it may have too little capital.  The article says:

Now the central bank needs an infusion of capital. Central banks can, of course, print more money, but that would stoke inflation. Instead, the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.

The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts. This could heighten trade tensions with the United States. The Bush administration and many Democrats in Congress have sought a stronger yuan to reduce the competitiveness of Chinese exports and trim the American trade deficit.

The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

There is no need to worry about whether or not the PBoC is insolvent – the central bank is not a commercial stand-alone entity and its credit is at least as good as that of the central government (sometimes better), but the article is nonetheless interesting.  I hadn’t really thought of the political ramifications until I read the article, but if the PBoC needs to turn to the MoF to shore up its capital, and if this represents a transfer of power from the PBoC to the MoF, it may very well represent a further weakening of the monetary camp in China.

This might not bode well for the future of the financial system in the short term, although in the long term it is not clear to me that monetary soundness is necessarily correlated with more rapid growth.  I say this because I have seen no evidence that countries with very sound and conservative financial systems grow faster than countries will looser and riskier financial systems (although they do seem to have fewer financial crises).  I have more than once made reference to Belgian bank historian Raymond de Roover’s comment that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.”  Still, excess financial instability can significantly raise financing costs and in the case of China, where political credibility is always an issue, there may be other things to worry about if the guardians of monetary soundness are further weakened.

Astonishingly enough (but perhaps not surprisingly), a lot of mid-level policy-makers in China seem to believe that the PBoC currency losses are the “fault” of the US, according to my friend Victor Shih of Northwestern university.  The New York Times article goes on to say about Victor:

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

Many Chinese seem to be inordinately fond of conspiracy theories, but in this case it seems pretty obvious that if the RMB were indeed undervalued all these years – like the US government has been saying for a long time – then exchanging Chinese goods for massive amounts of US Treasuries by definition meant that China was subsidizing American consumption, and that this subsidy necessarily represented a loss for China.  If you exchange something below its fundamental value for something above its fundamental value, it is only an accounting trick that allows you to pretend you haven’t booked a loss.  

Revaluing the RMB does not create the loss.  It simply forces recognition of that loss.  And as long as China continues to accumulate US dollar assets purchased with undervalued RMB, the PBoC will continue to run losses, whther or not they are fully recognized.  Perhaps you need to be a trader, and not a government official, to get the point.

Talking about Victor Shih, I should highlight another very interesting commentary by him on RGE Monitor.  He starts his entry:

Due to strong political pressure at the highest level and seemingly declining inflation, the State Council caved and increased the credit quota by some 200 billion RMB.  Well, that only goes so far, and much of it still goes to larger firms.  So, how are they dealing with the continual liquidity problem?  Bundling!!  Local governments, including Sichuan, Chongqing, Henan, Beijing, Liaoning, Zhejiang, and Shenzhen, are all planning to issue tranches of corporate bonds whose cash flow comes from a group of small and medium enterprises (SMEs).  Each province will issuing 1 to 2 billion RMB of notes for the approved SMEs. 

The local governments will guarantee these notes, which have 3-5 years maturity!! This is a familiar scheme of borrowing to fulfill current policy needs and leaving bad debt for future leaders of a province or city.  This is why the central government banned local governments from issuing debt, but it is coming back in a latent form.  Granted, it is on a small scale now, but it can really take off. 

I think the NDRC is backing this effort, though I am not sure if the financial regulators in Beijing like this.  This will also create good business for domestic investment banks, especially those with local government ties.  It might also give a boost to state owned asset management companies which are trying to transform themselves into investment banks

When we all start trying to figure out how much debt the central government really has (something that will become a popular sport sometime next year, I suspect), it will be useful to remember that these notes are going to be guaranteed by the local municipalities, and these municipalities in turn are guaranteed by the central government.

On Sunday I am off to New York for a week where I will have a number of meetings and presentations which will give me the chance to gauge the mood of investors and financial policy-makers outside of China.  It’s been over a year since I went back, and I suspect the gloom and worry I saw last July hasn’t fully lifted, to say the least.

Comments (13) for "Is the PBoC running out of c...

Prasad seems to be a bit of a cookie cutter. Yes, if a central bank depletes its capital in the course of conducting an independent monetary policy, having to ask the government for additional capital (typically by a transfer of government debt), gives the government an opportunity to influence the central bank in return. But in this case, the PBoC does not appear to have much independence, and the policy of intervening to prevent the rise of the renminbi that has resulted in the losses is, as Bradsher says, a policy that seems to have been imposed on the central bank. If anything, running out of capital gives the PBoC the opportunity to say "told you so; better do it our way in future"! As you know Michael, I often contribute to the comments on Brad Setser's blog. No-one who reads that could believe that the Americans have tricked the Chinese into accumulating loss-making reserves in recent years; in fact, the resentment about China's exchange rate policy frequently expressed there by Americans suggests quite the opposite. But a point I make there from time to time is that I do think that the Chinese would justifiably feel cheated if dollar depreciation is associated with "surprise" inflation as the Fed sets aside its inflation target in an attempt to maintain growth. By RebelEconomist - 9/4/2008 6:42 PM

About the SME notes, the devil is in the details, and given the problems that China has with financing SME's, I'm not convinced that having local governments issue guarantees is necessarily a bad thing. Also it's not necessarily the case that debt by a local government is guaranteed by the central government since you can create a special purpose vehicle that limits the liability of the government. Again, the devil is in the details. By Twofish - 9/4/2008 7:22 PM

Today and recent ones have been glorious days for smart investors to use smart ways to short the SSEC and garner big winnings resulting from their perspicacity of basic changes in the market and general investor sentiment in China. The ensuing days will be difficult for the investor that requires the market to rise just to make money. It is always the case that most investors are nonplussed when the market takes a deep dive and stays there for years. Even though this is usually the logical outcome of prior investor exuberance based on faulty logic and faulty insufficient knowledge of what is actually happening in both the market and also the real drivers that impact the true health of the economy. There is always generalized exultation when the markets approach their PEAK. And then such stridency of PIQUE when they nose dive. But, such investors are not good gamblers. And one has the greatest respect for any investor that can take a huge loss, and still raise a cup of tea, with not a single tremor, AND not castigate the market. By Andy DuoYao - 9/4/2008 8:30 PM

I suspect that Sep. CPI will come back again. At least from food price I can see that. M2M change is small but Y2Y change will have an impact. By fatbrick - 9/4/2008 9:39 PM

Another point which I would make is that it is by no means certain (as many US commentators assert) that China will lose on its dollar investments in the long run. The present shifting relationship between the US and China is rather like the handover of economic leadership from Britain to the US in the early twentieth century. Despite the depreciation of sterling and its loss of status as the principal reserve currency, investors in sterling did not lose versus the dollar, because, over time, the rise in British interest rates associated with the diminished standing of its debt more than compensated for depreciation losses. For more detail see my blog posting at: http://reservedplace.blogspot.com/2008/01/it-is-often-asserted-eg-in-brad-setsers.html By RebelEconomist - 9/4/2008 9:56 PM

While SSEC watchers are still in an quandary about how to accurately read the market, and just thinking about sitting on the fence post, to wait and see. While waiting, there is a very entertaining interview done by Charlie Rose discussing interesting topics with Ted Turner, the Barron of the Bison Burgher Bistros. Turner is always fun to listen to, very opinionated, with a drawl and a gift for gab which draws in almost any listener. So, if any investor is feeling disheartened regarding today's negative stock returns, then this gambler just might find a lift by watching the interview between Charlie Rose and Turner, the guy that sailed through a huge storm during the 1979 Fastnet race, when 25 of the 306 boats were lost, and 15 sailors lost their lives. Turner won it in his boat, the Tenacious, designed by Sparkman & Stephens. This interview can be found at Google Video. The link is: http://video.google.com/videoplay?docid=3235659543898921467 Hard to think of anyone who invests in China who does not enjoy Turner, this guy is a true swashbuckler, and any guy in China might want to think of himself, even making huge deals, as if he were Turner sailing in the Fastnet race with a Force 7 wind, no help in sight until after the storm, boats sinking all around, but still pushing to win the race. AMAZING. By Andy DuoYao - 9/4/2008 10:45 PM

"Revaluing the RMB does not create the loss. It simply forces recognition of that loss. And as long as China continues to accumulate US dollar assets purchased with undervalued RMB, the PBoC will continue to run losses, whther or not they are fully recognized. Perhaps you need to be a trader, and not a government official, to get the point." Mr Pettis haven't you seen the (odd) trader who refuses to close loss making positions so that losses aren't realised, in a similar fashion, though hjardly equivalent to rebeleconomist's stance, the chinese afre thinking that ultimately losses might be offset or even reversed. as for conspiracy theories, hmm, wouldn't discount the american penchsant for that either, just wait for the xenophobia to start speaking. btw, aren't you even slightly interested in knowing what happened to hoffa? there's been heated discussion of the same article on setser's site, good luck on moderating things By Judy Yeo - 9/5/2008 8:58 PM

To follow up on Judy Yeo's post, when you take a system that relies heavily on objective, easily quantified indices in the evaluation of officials, and combine it with a relative lack of sophistication in finance, you are going to get a system in which losses don't count as losses until they are recognized, despite the perverse incentives this results in. It's very possible that officials in charge face an incentive structure (formal or informal) in which recognition or not makes all the difference. (Imagine that you are the Politburo member in charge of this trying to explain to other senior leaders Michael's point about how recognition or non-recognition of losses doesn't make any substantive difference, when they are clamoring to know how you managed to lose so much money.) By Don Clarke - 9/6/2008 1:56 AM

Although forbidden to issue municipal bonds or loan from bank directly, nowadays many Chinese local governments still manage to get bank loans in an indirect way. In the past few years, they depend on the revenue from land sale. With the real estate boom waning, now increasingly more local governments turn to bank loans. They are not allowed to do so directly. But I see some cases indicating that there are many ways to circumvent current regulation. For example, some local governments use local enterprises as "proxy lenders" to take money out of banks and finally bank loans go to local government's ambitious infrastructure projects or just end in party bosses' luxurious private consumption. I don't have any specific number of the scale of de facto government loan from the bank. But I notice that the local governments seem not prepared to shift to a more cautious lender or consumer when the economic terms is turning harsh. I think this trend is not in the right side of history. By Jimmy - 9/6/2008 4:03 AM

Yeo: haven't you seen the (odd) trader who refuses to close loss making positions so that losses aren't realised. They do not have a choice in the matter. Once you run into your risk or loss limits, it's like maxing out on your credit card or being overdrawn on your checking account. The systems in place will automatically close your positions and keep you from starting new ones. Asking to do a trade at that point is like calling up the bank to get a credit limit increase, the answer is likely to be no. By Twofish - 9/6/2008 5:00 AM

The other mistake that people seem to make a lot is to assume that perverse incentives are only found in governments and that private entities are somehow immune to them. We are finding out this weekend with the GSE bailout that this just isn't true. Also "proxy lending" is something that has happened for the last thirty years. The question is what the level of the lending is and whether there is more or less of it. Also local enterprises are legally separate from local governments which means that if a local enterprise defaults, there is no way of forcing the government to repay the debt. This could be a big, big problem is you have loans to local enterprises come from commercial banks. On the other hand, what has happened is that local governments sometimes gets funding from "quasi-banks" and if those go bad, the government has sometimes walked away from the debt (GITIC's default for example). By Twofish - 9/6/2008 7:13 AM

The more the SSEC falls, the more that people must be praying. I do not know about you. But, my amah told me to buy much Much stock last September, and all of the Amahs, that I know probably purchased, collectively, about 900,000USD of stock, back in October when the bourse was still rising.. But now, no one amah can understand why the market keeps falling. And, many amahs have already purchased about 1/2 years of their income's worth of stock. But, the important problem is not stock losses. The real problem is the sour faces of all these amahs which played and lost. There was a time when one could have an egg for breakfast, served up with a smile. But now, after the the crash, all one gets is a dour, sour, and, too gloomy visage, with ones breakfast fare, each and every morning. This hurts much more than the losses, I can tell you! By Turtle Egg - 9/8/2008 6:04 AM

2fish They do not have a choice in the matter. Once you run into your risk or loss limits, it's like maxing out on your credit card or being overdrawn on your checking account. The systems in place will automatically close your positions and keep you from starting new ones. Asking to do a trade at that point is like calling up the bank to get a credit limit increase, the answer is likely to be no. By Twofish - 9/6/2008 5:00 AM if that were always the case, you wouldn't have the regulatory authorities "occasionally" investigating proprietary traders who took just that bit of liberty with the rules... as for proxy lending, sure it's nothing new but it also happens to peak just when more official avenues dry up, which also happens to bw when credit is most needed and people are most desperate... walking away is always an option till walking away exacts a bigger cost than facing up to the music, what was it about the devil and the big blue sea? not disputing 2fish's wisdom or breadth of knowledge but someone always finds some way round the rules, that's only human, that's why life is always so interesting?! By Judy Yeo - 9/12/2008 6:20 PM