My Blog

September 3, 2008

The Chinese stock markets declined further today, with the SSE Composite punching its way through the psychologically important 2300 in the first hour of the day, to trade as low as 2248 in the later afternoon (with 2500 often cited as another important “barrier”, below which the government was presumed to intervene) for a total loss of 2.5%.  It recovered part of its losses in the last hour of trading to close at 2278, down 1.2% for the day.

This should have been a big event but most participants seem pretty inured to bad news by now.  Given the gloom I continue to wonder if we might not be close to a bottom in the stock market.

On a separate front I think my pessimism about the financial system is being matched, if not exceeded, by others.  Andy Xie, who has been one of the savviest of commentators on China, has another warning piece in Caijing, probably the most open and hard hitting of local periodicals.  Among other things Xie writes:

There is obviously a liquidity problem in China's economy. Triangular debts, especially in the form of receivables, are piling up. Lack of money at local government level may be the root cause. Local governments are quite dependent on land sales and taxes in the property sector to fund their expenditure. That dependence motivates them to spice up the property market, which is a major reason for the bubble.

At a deeper level, the declining share of fiscal revenue for local governments in the past ten years has motivated local governments to search for new revenue sources, which eventually ended in the property market. The massive land sales last year at record prices may not bring the promised cash for local governments. The property bubble has burst. Developers cannot sell properties like before and can't keep their promises of paying for last year's land purchases.  Slowing property sales also decrease their taxes. The cash-short local governments cannot pay their contractors that in turn can't pay their suppliers.

This is the second time I have heard him warning about “triangular debts” among Chinese companies.  I haven’t been following the issue closely except to note that inter-company loans have risen rapidly, and represent yet another way in which lending caps imposed on the banking system have been undermined.  They also create a worrying mechanism for credit and liquidity problems to spread from one company to others.

Xie adds: “China's financial system, in particular, is a heavy burden on the economy.”  He goes on to say:

You might find my assertion strange. Chinese banks are among the largest banks in the world in terms of bank capitalisation and profits. Chinese brokers made big profits last year, although they are down this year in a slumping market. If profitability is the best guidance for efficiency, China's financial system should be the most efficient. The problem is that China's financial institutions have made profits from licensed monopolies and government-regulated interest rates. As credit is rationed and, hence, is in short supply and government mandates interest rates, Chinese banks can make fat profits from their credit quotas. Their profits don't reflect their efficiency. Rather, their profits are a tax on the economy.

China's securities industry is more ridiculous. Stock market is the most capitalist market.  Securities firms that service the stock market should be the most capitalist too.  In China, securities firms are mostly state-owned.  It is impossible to find an example of a successful state-owned securities company in the world.  It is surprising that China doesn't see the problem in its approach.

The inefficiency of China's financial system is a huge cost for the economy. My guesstimate is that the burden could be five percent of the GDP, i.e., China's financial sector has negative value added of five percent on the economy. Addressing the inefficiency in the sector could be a significant stimulus for the economy. China should start by raising deposit rates to narrow the lending spreads to a normal two percentage points. Of course, the central bank should likewise lower the deposit reserve ratio in order to normalise the banking system. The outflow of hot money provides a good environment for cutting the ratio.

China's stock market is a big failure. The Shanghai A-shares index surged from 1,000 to 6,000 in two years and then dropped to 2,400 in one year. You can't blame people for thinking that China's is a Mickey Mouse market. China should completely revamp its market to prevent future crisis like this one. The most important change should be to disentangle the government from micro interventions in the market. When laws are laid down, the market should function on its own. It is the only way to have a healthy market.

On a separate note Xinxin Li at the Observatory Group writes in a September 2 about changes in the financial leadership.  According to him, “a looming personnel change in the PBOC could provide important guidance about the outlook for monetary policy beyond the short‐term.  Vice Governor Yi Gang, who is in charge of monetary policy in the PBoC, is likely to become the new chief of the National Statistics Bureau in a few weeks.  If his successor comes from the pro-growth camp, that may indicate an important shift in Beijing’s monetary policy.”

There have been tons of rumors for quite a while about leadership changes at the PBoC and the banks.  I have referred broadly to these several times in my blog but am wary of being too concrete.  I don’t want to get into trouble.  If as Xinxin suggests Vice governor Yi becomes the head of the Statistics Bureau, that might indicate a strengthening of the monetary camp since Yi is well-known to be tough on monetary issues, but truth is not that obvious.  The key questions are about who will replace him and whether there will be other even more senior changes in the PBoC.  Many of us (including me) are expecting imminent changes in leadership within the financial system that will result in a stronger voice for the pro-growth camp.  I think analysts are watching this more closely than any other issue right now.

To close on a related bit of good news, yesterday the National Bureau of Statistics published a report in China Information News that suggested that thanks to declining food and oil prices CPI inflation would ease further in August and September.  That is certainly what the bond market seems to think.  According to Credit Suisse in today’s Emerging Markets Economic Daily one-year treasury yields are currently at 3.31%, down 23 basis points from the beginning of August.

Clearly this news will embolden the pro-growth camp to push for greater fiscal and monetary stimulation.  At first glance this ight even be showing up in the exchange rate policy.  Recently the pace of appreciation of the RMB has declined – it even depreciated quite sharply during the first two weeks of August.

Logan Wright, however, in his August 25 Stone & McCarthy research piece, argues that while many analysts interpret this slowing appreciation as an indication that the PBoC is targeting not just the US dollar but a basket of currencies in its overall appreciation strategy (the dollar rose against the euro for much of this period, bringing the RMB up on a trade-weighted basis), he disagrees.  He argues instead that this is just political interference aimed at dissuading investors from believing that the RMB is a simple one-way bet.

The goal is, presumably, to introduce enough uncertainty to discourage speculators from flooding the domestic monetary system with foreign currency inflows.  I agree with Logan’s interpretation.  In expect that after some period the RMB will resume its upward march against the dollar.  As I suggested nearly 18 months ago, China needs to revalue its currency sharply to regain control of its monetary policy, but a gradual rapid appreciation would inevitably undermine that goal by encouraging massive capital inflows.  This is what seems to have happened.

Comments (12) for "Market temporarily breaks be...

Michael, do you have a link to Andy Xie’s article? I couldn’t find it (at least in the English edition). There are so many interesting aspects in this post. If it is true, that local governments are dependent on land sales, then we are witnessing a power struggle between the central authorities (trying to reduce the amount of money that flows into real estate loans) and their local counterparts. But it is probably too late to keep yet another real estate bubble from bursting. There are too many reports about property developers struggling for money. This would also explain why we hear so many mixed messages from China lately. The richer parts need a growth strategy with more credit, but they don’t really care about inflation, as long as their profits grow faster than inflation. The poorer parts need stability to catch up or a least not fall further behind. Inflation eats up their money too fast. The economic inequality makes it very difficult to decide which monetary policy will lead to a sustained development. By Gregor Neumann - 9/2/2008 9:11 PM

Man, you are absolutely right. By applying your option framwork taught in class, I predict that SSE will drop down more after breaking the 2300(or 2500) which is generally accepted as government's policy bottom. I short the FTSE/Xinhua 25 ETF and bought Ultrashort FTSE/Xinhua 25 ETF, of course online mock trading, so far the return is excellent! Actually, your theory has been proved to be quite correct when we see that SSE went staight down from 3300 (a very strong market believed government bottom at that time) to below 2300 now. I figure that this time, it would less stronger than last time, thinking that market has been constantly disappointed by the government since this year. By Enze - 9/2/2008 9:36 PM

Has anyone seen the figure for China's international currency reserves as of July? The June number (1,81 trillion USD) was out mid-July - but I still have not seen anything for August. By Stefan, Tallinn - 9/3/2008 3:04 AM

they might have shut the "safe" door through which those numbers were being released... By Eduardo Guelman - 9/3/2008 3:44 AM

Gregor, the article was sent to me and I don't have a link. Power struggles between the center and the municipal and provincial governments are pretty common. There is even an old saying: The mountais are high and the emperor is far away. By the way Steve Roach has an article in today's FT warning about inflation. Enze, I don't know if there is as much consensus about 2300 as there was about 3000. If there is, any break could again be substantial, although I should say that below 2300 even I might start buying. Have fun in Mexico. See you back in school soon. Stefan, August reserve numbers won't be formally released (I think only quarterly reserve numbers are), but soon enough we should get a leak listing what reserves at the end of August were. These leaks have proven very accurate in the past. By Michael Pettis - 9/3/2008 5:04 PM

Michael, I think Steve Roach has some excellent points. He basically says, China cannot expect that growth is a solution this time. Many underestimate the influence of a growing money supply on prices and wages. And he is quite right to point out that most of the developed countries are in or near recession. So what is the source for further growth? http://www.ft.com/cms/s/0/87c8b6e6-79c8-11dd-bb93-000077b07658,s01=1.html I am currently re-reading Hyman Minsky's "Stabilizing an unstable economy" to get a better understanding of the recession in 1970s. So I agree with Roach that we see many parallels to present time China. But I fear that the effects of overinvestment and speculation today are even more severe and that the currency effects are unpredictable. As you have pointed out, the situation is closer to the 1930s regarding the huge trade surplus and the deflation in key markets. I think policy maker hope that both effects will annihilate each other. Deflation in the US will drive down commodity prices and in the end inflation in China. But I am not so sure, if this will happen. Rising internal costs plus shrinking external sales are a toxic mixture. By Gregor Neumann - 9/3/2008 7:12 PM

Michael Thanks. I expressed myself wrongly, I was looking for the end-July number. But I take it that the 1,81 tril. end-June is the last one available. Ok, then either a leaked end-August, or official end-Spetember should be the next one. By Stefan, Tallinn - 9/3/2008 8:47 PM

But it will interesting to see if we will have a decline due to dollar-strength and potentially hot-money outflow. By Stefan, Tallinn - 9/4/2008 8:14 AM

Disagree very strongly with Andy Xie. Having a large spread between deposits and lending means that the banks end up with lots of cash, which is going to be very useful when everything starts blowing up (and everything will eventually blow up). Think of it as a preemptive bailout. If the banks are cash rich, this will make it easier to wipe out the real estate losses. "Efficiency" is not I think a major issue right now. "Catastrophe prevention" is. Also, the central government is going to start picking up more of the tab for local governments. By Twofish - 9/4/2008 1:45 PM

There has been a move away from land sales to fund local governments. One problem is that for a local government to make money off a land deal, it has to short change the peasants that were working on that land, which causes a lot of protests, so in 2005-2006, the government tightened the restrictions on the sale of land. By Twofish - 9/4/2008 1:49 PM

There is an interesting analysis from Morgan Stanley on the financial situation of the Chinese property market. It is titled “Can the Property Sector Be Counted on as the Engine of Growth?” and is looking at different aspects like residential building, affordability, home-ownership rates. It’s a good read: http://www.morganstanley.com/views/gef/index.html#anchor6880 For this discussion, two quotes are especially interesting: "Investment in property and infrastructure combined account for close to 40% of total investment, with a roughly equal split between the two categories. Given its public goods nature, investment in infrastructure is usually carried out by the government and thus tends not to be influenced much by the cyclical conditions of the economy in the short run. However, in China’s reality, the infrastructure projects carried out by local governments are financed in a significant part by proceeds from land sales. The performance of land sales is, in turn, influenced by the property market: a buoyant property market boosts land sales and pushes up land prices. We estimate that proceeds from land sales may have financed at least 25-30% of investment in infrastructure in recent years." (...) Our positive view about the property sector underpins our overall constructive outlook for the Chinese economy, as reflected in our GDP growth forecasts of 10% in 2008 and 9% in 2009. Specifically, while we expect the contribution of growth from net exports to be close to nil in 2009, investment growth could still hold up relatively well, with only a moderation in real estate investment growth to be offset by some pick-up in infrastructure investment, reflecting easing in fiscal spending. Consumption growth will normalize around its secular growth trend after a mini-boom in 2007 boosted by buoyant consumer sentiment on the back of an extraordinary stock market performance. The timing of the potential easing in property sector policy will hinge on the pace of an export-led slowdown, in our view. Based on our global economics team’s forecasts for G3 economies, China’s export growth will likely decline substantially to around the single-digit level in 1Q09, which may trigger a major policy shift, in our view." By Gregor Neumann - 9/5/2008 6:36 AM

If the CCP does undersell the majority of its dollar assets in its foreign reserves, it will result in global economic chaos. Although Secretary Paulson of the U. S. Treasury said China, being the second largest holder of U. S. treasury securities, possesses less than the daily trading volume of these securities, Paulson had to give this confidence talk as a political figure. What Paulson said is true. However, once the underselling starts, through the exaggeration of media reports, the international“ hot money” ... By forexbacktestingsoftware.com - 9/21/2008 5:31 AM