My Blog

July 11, 2008

The Shanghai stock market capped yesterday’s 1.5% decline with a further decline today of 0.7%.  It’s still been a great week, up nearly 8%, but the party, at least for a while, seems to have ended.

At least one government official is, alarmingly enough, wondering if there are ways to manage the process better.  According to an article in today’s China Daily:

It's necessary and urgent to set up buffer funds to confront big speculators and stabilize the mainland market, a senior official said.  Jiang Lianhai, head of Jilin provincial securities regulatory bureau, published an article in Shanghai Securities News yesterday, which pointed to the necessities, functions and capital resources of launching a buffer fund. Later, an official from China Securities Regulatory Commission reiterated the view in an interview with China Daily.

In the article, titled "The capital market with Chinese characteristic calls for a buffer fund", Jiang said that in recent years, international hot money has flooded into China's stock market and real estate sectors. Some international speculators are planning to buy cheap stock when the market is sluggish and close out in a high price. "If the government does not have an effective tool in hand, it will be dangerous."

One of my Peking University students sent me the article, highlighting the last two sentences.  His sardonic comment: “Nothing can be worse for China than to allow foreigners to make money.”  

He was being sarcastic, of course, and I am glad to see that my students are sophisticated enough to laugh at this kind of comment (a very widely held view here, by the way), but it is a little dismaying that a senior government official would say something that even an undergraduate would find so silly.  There is plenty of evidence that hot money inflows are driven mainly by Chinese at home and abroad, but even if that weren’t the case, foreign buyers during a time of market collapse are a force for stability, and the fact that they may profit shouldn’t be a driving factor in determining policy.

But I digress.  Here is what today’s South China Morning Post says about the article:

A senior official at the mainland's securities regulator has come out in favour of setting up a fund to help stabilise the volatile stock market, the first time a government official has openly advocated the controversial idea.  In an unusual and bold move that may press top decision makers to consider the issue, Jiang Lianhai, the head of the China Securities Regulatory Commission's Jilin branch, wrote an article in Modern Bankers magazine calling for the launch of a non-profit-making fund.

The government had no reason to stay on the sidelines of the troubled stock market, and its intervention could help stem destabilisation of investments, Mr Jiang said.  Unlike their more outspoken counterparts in the west, mainland securities officials rarely comment on policies, to avoid media attention that might not sit well with leaders.

We have heard these rumors before, in 2006 I think, before the market took off, but this is the first time a government official has made the point.  It may be a good short-term political move to bail out middle class investors, but these kinds of comments only reinforce the pessimism of those of us who do not expect to see a well-functioning capital market in China for many more years.

On a separate note, Paul Cavey of Macquarie has an excellent new research piece out on China called “China’s great Monetary Con” in which, among other things, he torpedoes the idea that Chinese monetary policy is tight.  His piece starts out:

Macquarie analysts. Global investors. Ordinary people. Everybody believes China’s monetary policy is tight. As a result, the market has sold off, and savings rushed into the banks. But why? Rates have fallen further behind inflation. The stronger currency has been offset by bigger capital inflows. Reserve requirements have been hiked, but credit growth has hardly slowed.

The only thing that has really changed is rhetoric, notably the announcement of a “tight” monetary policy. The impact of what has been purely a rhetorical shift suggests Beijing has more credibility than the Fed. Neither the US nor China has much ability to raise rates, but while attempts to talk up the USD have floundered, verbal threats in China have bought money back to banks.

With rhetoric a lot less disruptive than real policy changes, conning investors – more politely, the guiding of expectations – is a key central bank tool. As an example, China’s talking down of CPI will probably work. With households putting their money away, domestic inflation will indeed likely ease.

I have often referred in my blog to “tight” (quotations included) monetary policy in China, but after reading Paul’s piece I wonder if I may have been a little aggressive in assuming that everyone would know that what I meant by those quotation marks is that I don’t believe monetary policy in China is tight at all, or for that matter has been tight during any of the nearly seven years I have lived here.  China has a very loose monetary policy, and this was an inevitable consequence of the combination of ample global liquidity, an undervalued currency, and the country’s ongoing decision to manage the dollar value of the RMB, which almost automatically precluded its ability to manage domestic monetary policy.

How can I say that money is loose, not tight?  Except for the assurances of the central bank there is no other good evidence that money is tight:  Interest rates are negative, inflation is rising, and credit growth is actually very high and growing from a high base.  Remember that officially credit growth is supposed to be limited to 16% this year (from 18% last year), which already doesn’t seem particularly tight, especially given the high base, but this growth limit doesn’t apply to the policy banks, the informal banks, and to dollar loans, and all of these, to the extent that we can measure, have surged.

Even the growth of monetary aggregates, which in yesterday’s entry I explain why I don’t consider too seriously, is high, again especially considering they are also growing from very high bases.  My student undergraduate Liu Bing kindly interrupted his internship at Van Eck in New York to send me the following data.  In May the year-on-year growth in M_O, M₁, and M₂ were, respectively, 13%, 18% and 18%.  For reference purposes, according to Deutsche Bank, M₂ is expected to be 164.0% of GDP this year, up from 156.3% last year.  That is a pretty high base from which to grow.  The growth in PBoC liabilities, by the way (and this is the indicator that most impresses me), was 31% in May, from an already astonishingly high base.

So far none of these numbers seem to indicate anything approaching “tight” monetary conditions.  Perhaps the reason why many people believe, according to Paul, that Chinese monetary policy is tight is conflated with concerns about an economic slowdown. 

These two issues are very different.  I think it is possible for China to have excessively loose monetary policy and for the economy nonetheless to be at risk of a slowdown.  In fact I think both are highly likely.  Next Monday I have been invited to speak on CCTV’s Dialogue, the country’s main current events program, on the topic of stagflation.  I have found that this program often discusses issues that are being widely debated among the country’s leadership and analyst community, and in the five shows I have done this year, stagflation has been one of the main topics of discussion (the others being inflation and the currency regime). 

Clearly stagflation is a problem that worries a lot of people, and with reason.  Yesterday Human Resources and Social Security Minister Yin Weimin said, according to an article in today’s South China Morning Post, that the country was facing “unprecedented pressure” on employment.  Among other things the article cites a release on the ministry’s website that claims that the record 5.6 million students graduating this year (there were 4.9 million last year) are competing for jobs with 0.7 million of last year’s graduates who still have not been able to find a job.  That means that even as the number of graduates has increased by 13% from last year to this year, nearly 15% of last year’s graduates are still unemployed, a year after graduating.  You don’t need to be a political scientist to wonder about the political implications of rising student unemployment.

Because of recent years of overinvestment and overproduction, with the attendant massive misallocation of capital, I think it was inevitable that China’s sizzling growth rates would have to decline, especially given a global economic slowdown.  As I’ve discussed many times this seems to be causing officials to shift focus away from monetary concerns and towards growth concerns.  I am not smart enough an economist to say what polices the government can and should implement to shore up growth and prevent rising unemployment, but I am pretty certain that monetary loosening is not the answer.  This will only postpone a slowdown slightly while increasing the riskiness of China’s balance sheet and so making the subsequent contraction more damaging.

Logan Wright and I have a piece in next Monday’s Financial Times that partially addresses why.  Our argument is that not only has monetary expansion continued at an alarming rate, with reserve accumulation doubling again so far this year (at the rate of nearly 30% of GDP), but, more importantly, the composition of that reserve growth has made the process much more volatile.  Logan’s numbers show that two and three years ago, the trade surplus, FDI and interest income accounted for 80-90% of reserve accumulation.  This year, even ignoring the huge amount of hot money likely to be buried in those numbers, they account for less that 40%.

One of the things that I have argued repeatedly, including in my book, is that it is not just aggregate debt levels or capital flows that matter to instability but, more importantly, the structure of those debt levels or flows (i.e. whether they are counter- or pro-cyclical).  For example it doesn’t make sense just to look only at raw debt levels – i.e. the ratio of debt to assets – to understand the vulnerability of a system to breaking down.  What is just as important, perhaps even more important, is whether the value of the debt is positively or inversely correlated with the value of the assets.  Argentina in the beginning of 2001, for example, had debt to GDP levels of only around 53%, which doesn’t seem high, but because the combination of its very rigid exchange rate regime (which is always highly pro-cyclical) and the fact that most of its debt was denominated in dollars, its balance sheet was too inverted to allow it to withstand any but the gentlest of shocks.

Unstable balance sheets, in other words, are not just balance sheets with lots of debt, but they are also balance sheets with lots of highly pro-cyclical “volatility machines” imbedded in them.  These self-reinforcing processes in the balance sheet improve good times and exacerbate bad times, and they do so in a very mechanical way that can sometimes dumbfound observers.  South Korea’s astonishing crack-up in 1997-98, for example, was almost wholly a function of the way domestic corporations were forced by their very unstable balance sheets to respond to the unexpected won depreciation. 

As the won depreciated and the need to hedge their dollar debt grew, they were forced to sell won assets (in a rapidly declining market) and use the proceeds buy increasingly expensive dollars, thereby exacerbating won depreciation further and putting even more balance sheet pressure on them to continue the process.  This kind of process can go on for a long time before it finally works itself out, usually in bankruptcies and enormous financial distress, leaving observers shocked at the sheer irrationality of markets that cold so far overshoot any reasonable “equilibrium”.  But the process was not one of reverting to fundamental equilibrium, but rather of unwinding imbalance in the balance sheets, and so fundamentals have nothing to do with it.  Overshooting can occur, and will occur to the extent that balance sheets are very unstable.

So it is not only the sheer size of capital inflows into China that are worrying, but the increasingly pro-cyclical nature of those inflows that are exacerbating the problem.  If we wait too long to repair the balance sheets, the ultimate adjustment will be far greater and more damaging than anyone expected because of forced adjustments. 

By the way, FDI numbers were released today.  FDI inflows for the first six months of 2008 were $52.4 billion, up 64% from last year’s $31.9 billion.  I suspect that around $20 billion of this represents either disguised hot money, or an acceleration of future expected investment, which from the PBoC money-creation point of view is not a whole lot different.

Comments (12) for "Money is way too loose, not ...

Your student makes a good point about the Chinese hating the thought that foreigners might profit at the expense of China. Even though I would agree with you that a lot of the hot money actually comes from mainland and overseas Chinese it is westerners who will be blamed. Preventing these evil foreign speculators from making a profit is likely to override sensible policy decisions. By David Oliver - 7/10/2008 8:38 PM

When the reserve rate is about 18% and the interest rate in informal banking is 30% to 100% a year, I would not call that there is "loose" money. And 1997 Asian Crisis is precisely why China should try to hold the currency stable as long as possible. Any great appreciation under current situation would seriously hurt Chinese businesses further. Then the worsen returns combined with the profit-taking-money-outflow would compell RMB to depreicate, at a time they need to hedge the foreign debts. The the South Korean scenario would happen in China. Foreseeing this, your highest prority is to keep a certain level of growth. Global economic conditions are out of control of anybody. The only viable option left is to stabilize exchange rate to migrate the negative impacts from falling demand. You hope that demand destroyed elsewhere could bring down the commodity prices. And U.S. Fed would raise rate before you blink. oh, BTW, populism is popular everwhere now. I do not think you want to have a contest about who is meaner than whom on bashing foreigner at this blog. By fatbrick - 7/11/2008 12:29 AM

Michael thanks for your thought-provoking post. Two comments. 1) You argue that "foreign buyers during a time of market collapse are a force for stability." Maybe this is true, but isn't it a little rosy? Doesn't it ignore the downside impact that foreign buyers could have in creating a collapse via capital flight, ala Thailand 1997? 2) In discussing the tight/loose issue, I think one needs to carefully distinguish between monetary policy and monetary conditions or just money, terms that you seem to use interchangeably. Beijing has undertaken measures in recent months (raising the reserve requirement ratio, for example) that do qualify as a tightening of monetary policy. However, whether or not this leads to a de facto change in the relative looseness or tightness of monetary conditions is another question. So did Paul Cavey torpedo "the idea that Chinese monetary policy is tight," or did he show that money is actually looser than is often said, despite tightening policies undertaken by the government? From the perspective of Western monetary policymakers, a 17.5% RRR would be quite tight indeed. Look forward to your feedback... By Nick Consonery - 7/11/2008 2:16 AM

Prof. Pettis: Regarding Jiang Lianhai's suggestion that there should be a stabilisation fund (consonant with remarks from officials in Taiwan and Vietnam, if I remember correctly), how similar would establishment of such a fund be to a more indirect injection of capital in the markets (vis-a-vis a $30 billion non-recourse loan, swapping treasuries for illiquid undesirable crap, stimulus checks, foreclosure moratoriums, etc.)? Aren't we talking about different ways to grease the wheel here? How confident are you in the United States as a "well functioning capital market" given the much larger scale intervention there? Am I comparing apples to oranges? Nick Consonery: With respect to your second point about loose monetary conditions v. loose policy, I rather appreciate Prof. Pettis' demarcation of "tight." Policy is loose, as Prof. Pettis says. He mentioned real interest rates, as controlled/influenced by the central bank, are negative. That is policy, not happenstance. It is also policy to control the exchange rate of the RMB v. USD. How do you suppose they accomplish that? Maintenance of the USD/RMB is policy. Several other things are listed in the body of the post. I would suggest that the measures taken so far to "tighten" are largely symbolic and an attempt to appease critics while continuing to push the pro-growth agenda. By matt - 7/11/2008 5:46 AM

Fatbrick, I think China's situation today is radically different from that of the Asian countries in the 1997 crisis, but the insistence on fighting that crisis is likely to be the main reason for a future crisis. A depreciation would not have hurt these countries (on the contrary, it would have been expansionary, as it was for the UK in 1991 and Brazil in 1999) except for the fact that they had terribly mismatched balance sheets which collapsed into conditions of financial distress when the currencies depreciated. China's problem is not one of excess foreign liabilities backed by limited foreign assets. It is almost the opposite. A better comparison is with Japan in the 1980s. The Japanese waited so long to allow the currency to adjust that their financial system became seriously overextended. When they finally began the adjustment process, they turned it into a powerful one-way bet, which unleashed capital inflow and a subsequent bubble. They should not have waited so long, and since they did, they should have adjusted much more quickly. China has waited too long. The only open question, in my opinion, is whether they will drag out the adjustment process too. Of course bashing China or any other country has no place on this blog and I apologize for any misunderstanding. As my PKU student’s reaction indicates, many Chinese understand full well that economics isn't a zero-sum game. By Michael Pettis - 7/11/2008 5:43 PM

Nick, of course foreign money can be destabilizing as well as stabilizing. My point is that although it makes sense to protect yourself from its potentially destabilizing impact, it doesn't make sense to prevent the latter. At any rate the best way to protect China or any other economy from the destabilizing impact is to ensure healthy balance sheets. As for your second point, I am not sure I agree. Nominally tightening measures that are significantly less than what would be required to maintain monetary neutrality would, in my definition, be described as "loose" monetary policy. If the PBoC does only half of what they would normally need to do, in other words, I would not describe them as running tight monetary policy. This is the same point I would make to Fatbrick's first comment. Even 20% minimum required reserves can be loose under certain conditions, whereas 6% minimum required reserves can be extremely tight under other conditions. Whether a specific monetary policy can be described as tight or loose cannot make sense independently of underlying monetary conditions. It would be like telling someone not to throw the ball too far or too near without reference to where the catcher was standing. By Michael Pettis - 7/11/2008 5:52 PM

Mr Pettis Your opinion: When they finally began the adjustment process, they turned it into a powerful one-way bet, which unleashed capital inflow and a subsequent bubble. They should not have waited so long, and since they did, they should have adjusted much more quickly. China has waited too long. The only open question, in my opinion, is whether they will drag out the adjustment process too. Was there really any question that a bet on the RMB would be a one way bet? China , in that sense , has not waited too long, it didn't have the opportunity to liberalize the RMB any earlier, Without the necessary "protection" the Chinese economy would have gone the way of Argentina. London was forced into depegging for some of the reasons you said, but it had built up wealth over the centuries, and was never communist in nature; Labour is not even close to socialism , not even in its more radical days. Sad, but if you've looked closely at the British economy, apart from the banking industry, most other industries have not come close to regaining their shine. In contrast, without the time to build up its reserves and some economic fortifications, China won't stand a chance. Reserves might look huge but when the crunch time comes and the true health of balance sheets revealed, will they be sufficient? Upswings rarely cause as much upheaval as downswings, the biggest test for China has yet to come. It's just a guess but could the slight "bipolar" nature of emerging markets be due to the fact that potential holds so much promise that confidence once disappointed turns even more bitter? Asked the same question (different context) of an expert in behauvioural economics at a FT forum some months back, nopt sure if he really understood what was asked! By Judy Yeo - 7/12/2008 9:09 PM

Despite of all those loose-monetary condition evidence, negative interest rate, huge money growth, inflation, etc, micro evidence of a tight monetary condition is the "cold winter" for thousands of companies. Property developers are selling their stakes at a discount to acquire enough fund they need to finish the projects, thousands of enterprises went bankrupt or insolvent in the Yangtze delta region, and earlier this year, there is a report that NDRC hold a meeting with CEOs from major SOEs to warn them an at-least-two-year-period of tight monetary policy. I'm just wondering why the macro number and the micro suffer conflict with each other. If you can read in Mandarine you will see all reports about enterprises suffering from tight monetary conditions, and their surging borrowing cost because they borrow from illegal high interest lenders. This is just too massive to be just rhetoric. Oh btw, I'm one of your PKU students, too. ^_^ I'm gonna check out with the banking deposite data to see if the massive money growth are mostly within the banking system. They are not in the stock market, not easily available to enterprises (as I observed from mainland media and the fact that senior officers from central government flew to five most important provinces to check out micro conditions of the market), where are they? If you regard the cause behind the overheating of China's economy is basically misallocation of capital. Then that may also be something that the government is working on. A report from the popular website www.sina.com.cn said that Zhejiang province has scheduled to make undergroud lending legal by means of allowing private capital to set up small-amount lending financial companies (surely under some restrictions).The point that China should allow private capital to form banks to surpport small-middle size companies has already been long argued by economists like Li Yining in our school (GSM). By Cassandra Cheng - 7/13/2008 8:49 AM

Cassardra, I agree, the situation is deeply puzzling. Internal and external view, micro and macro analysis paint very different pictures. Exports are still rising y-o-y, PMI is slowing. Currently China seems to produce less, but to sell more. http://blogs.cfr.org/setser/2008/07/11/chinas-june-exports-still-chugging-a-long-despite-all-the-talk-to-the-contrary/ Everybody is suspecting an inflow of hot money. This should push up prices for stocks and property, but both are declining. If there is massive speculation, it is not obvious, where it is taking place. http://seekingalpha.com/article/84742-china-s-impending-financial-crisis There seems to be a black hole in the market that is sucking up the money. Could it be inflation? Is there pressure to liquidate assets to pay your bills? Do we witness the aftershocks of a housing and property bubble? Is the money needed to pay back loans? Or to put it in a different perspective: Is it really hot money that is flowing into China? Could it be investments that are trying to return home? AChinese suggested that high inflation might reverse the effects of the so called savings glut. http://www.piaohaoreport.sampasite.com/china-financial-markets/blog/What-is-money-growth-in-China.htm As Judy said above: “When they finally began the adjustment process, they turned it into a powerful one-way bet, which unleashed capital inflow and a subsequent bubble.” I wonder, if we missed a part of it because of the massive trade surplus. So many questions :-) By Gregor Neumann - 7/13/2008 7:34 PM

Gregor and Cassandra, the idea that hot money inflows must result in rising stock and property markets is common but not well-supported. Excess money creation can increase the probability of markets being speuclative, but speculative markets work both ways, up and down. After all, the current liqudity boom in the US was able to take in the collapsing stock markets of 2000, and there are mnay other cases of individually collapsing markets within a liquidity growth cycle. Where does the money go? A lot goes into banks (deposits are growing quickly). Part of it goes into real estate, especially, it seems, in secondary cities. A lot is probably going into the informal banks. The government keeps launching anti-hoarding drives against "speculators" in grain, oil, and other commodities, so there must be a lot of this going on, and remember that buying several tons of rice and storing it is as much an investment as buying stocks or real estate. By Michael Pettis - 7/14/2008 3:45 PM

Michael, “but speculative markets work both ways, up and down.“ Good point. Perhaps we see credit deflation in action. If long term loans are reduced (in 2008 the total credit line in the US has been shrinking at an annual rate of 8 percent), it is a smart choice to hoard liquid assets. This will depress stocks and real estate and increase the supply of short term money. Companies may be tempted to use their existing credit lines to the max, because it is unclear, if they will get new loans in the future. Could this explain, why there is enough liquidity, but not enough credit? If the PBoC tries to sterilise the extra cash in the market, it will lead to higher FX reserves. Could the current boost of inflation just be a sign that money is looking for a new safe heaven? If credit is destructed, cash is king. Buying commodities (or food) is a hedge, if you think that credit supply will decrease. Mike Shedlock observes a similar trend in the US http://globaleconomicanalysis.blogspot.com/2008/07/tms-truer-money-supply.html BTW: As it seems, not only the production of shoes and clothing is going down. The shipping industry is reporting free capacity for transport to and from China. And steel exports and ore imports are down, too, says the Ton Mile Trader: “China exported 5.22 million tons of finished steel in June, a 6% m-o-m decrease from May's 5.56mt and 18% less than the 6.36mt exported in June 2007. Analysts had expected exports to exceed 6mt but a larger than expected drop in regional demand (usually down in the summer) resulted in Southeast Asian importers taking very little Chinese steel. Domestic steel demand in China is also falling due to the same seasonal lull as well as electricity shortages and high operating costs. Chinese iron ore imports, although still at very healthy levels, have now fallen two months in a row. China imported 37.8mt of iron ore in June , a decrease of 3% from May's 38.9mt and 12% less than the record 42.85mt imported in April. With the Olympics less than a month away and seasonal demand at a low, it's possible Chinese steel production and iron ore imports will come down for a brief period of time. http://www.tonmiletrader.com/home/2008/7/14/is-the-dragon-about-to-take-a-short-nap.html By Gregor Neumann - 7/14/2008 4:20 PM

One consequence of high oil prices is that shipping costs soar. This is putting a crimp in inernational trade. A good produced in China must be produced much cheaper than in Mexico to justify the additional shipping cost to the US. By Michael Pettis - 7/15/2008 1:51 PM