My Blog

January 11, 2008

In a conference today, Shang Fulin, chairman of the China Securities Regulatory Commission (CSRC), said the country will encourage companies to sell more shares domestically.  The securities regulator plans to “expand the scale of fundraising in the capital market, increase the amount of tradable shares and push forward the listing of large companies and high-quality medium-sized companies.” 

For a while we have been hearing that one of the best ways the country can deflate the stock market bubble is by increasing the supply of shares.  This will allow it soak up some of the flood of money looking for a place to go, and will reduce the need for heavy-handed measures that the government now employs to knock down the market every few months.

This is almost certainly true.  China suffers from too much money looking at too few investment opportunities, and not surprisingly the result has been credit bubbles, real estate bubbles, stock market bubbles and much else.  The government’s main way of managing down the stock market – various administrative measures – is not only very inefficient but, as I argued in an entry last week, actually retards the development of a well-functioning stock market by undermining fundamental investment strategies and strengthening speculative strategies based on predicting government behavior.  But, as an indication of the quandary in which the government has found itself because of its slowness to address the currency regime, if the CSRC is really serious about increasing the selling of shares in the domestic markets it will seriously undermine attempts by the PBoC to control inflation and overheating by reining in lending. 

The PBoC hopes that by imposing caps on loan growth it can reduce China’s torrid pace of investment, which is seen as key to the overheating problem facing the country.  As I have argued earlier, we need to be skeptical about the effectiveness of these caps on loan growth because there are too many reasons why banks, corporations, and provincial leaders are going to resist.  In fact last week at the end of its two-day conference, for the first time in years, the PBoC was not able to announce loan growth targets for the year – probably because the policy was too controversial to resolve.

But even if it does succeed in reining in loan growth it won’t matter.  One of my recurring arguments is that if China’s lack of a domestic monetary policy is the real culprit, which I believe it to be, administrative measures such as capping loan growth will simply force money to flow through other channels into overinvestment.  Here, it seems, the CSRC is going to help prove my point.  By encouraging companies to sell more shares, they will take money away from the banks – who presumably aren’t able to lend it anyway – and pass it on directly to corporations who will then spend it on new investments.  The only difference is the structure of the corporate and banking balance sheets, but the money will still end up invested.

However this difference is not negligible, and this is a very important consideration.  If China is anyway going to suffer from an overinvestment crisis, it will be much better for China if corporate funding is raised in the form of equity rather than debt.  This reduces the financial distress costs to corporations after the crisis, speeds up their recovery, and perhaps most importantly of all, reduces the future growth of non-performing loans in China’s already shaky banking system.

So I agree wholeheartedly with the CSRC’s plan to encourage share sales, but not because it will help soak up liquidity and so reduce the consequences of China’s out-of-control monetary policy.  I think it will have no such effect, and only policies that directly address the accumulation of capital inflows can ever do that.  I think this is a good policy because it will significantly ease China’s recovery if it is forced into an ugly adjustment.

China is still trying to figure out what policies will help prevent a crisis.  I think it is just as important to figure out what policies will minimize the economic impact of a crisis if and when it occurs.

Comments (6) for "Should China try to avoid a ...

Michael I have read a lot of your stuff but am still sometimes surprised by the originality of your thinking. It hadn't occurred to me to make a distinction between polices to prevent crises and policies to minimize their impact, but of course there is a distinction, and in some caes the two may conflict. By Henry Zhang - 1/11/2008 4:00 PM

Professor Pettis, can’t selling equity be seen as a way to sterilize money creation? If the state sells shares they are taking money from the economy, are they not? Mr. Zhang, I have read Professor Pettis’s book and he discusses very forcefully the conflict you mention. If I may paraphrase his description of what happened in my country, when the Mexican government became concerned about capital outflows in early 1994 and the pressure it would put on the currency to depreciate, one of their strategies was to reduce the sale of peso Treasury bills and replace them with dollar-indexed Treasury bills (the infamous Tesobonos). This was done partly to indicate to investors their determination never to devalue the peso, because if they did, the cost of the Tesobonos to the government would be prohibitive. Their strategy to prevent crisis-proportion outflows by reducing their willingness to devalue meant increasing the cost of a crisis if it were to happen. But as the professor points out, investors evaluate both the probability and cost of a shock, and although the probability of devaluation might have seemed to go down as the government issued more and more Tesebonos, the cost went up (I think he calls this a “credibility Laffer curve”). At some point investors began to withdraw money because in their eyes the cost had gone up too much. In the end, the government forced the consequence that it was trying to avoid. Professor Pettis gives several other examples of this conflict. Professor, do you think the Chinese authorities are doing behavior of this sort? By Jaime Florida - 1/12/2008 1:11 PM

Mr Florida, imo the state-owned firms in China always reinvest much of the money raised from the stock market because of the incentive structure of their managers. By Tishop - 1/12/2008 8:41 PM

To answer Mr. Florida's question, what Michael is talking about is not the state selling existing shares it owns (in which the money passes from buyer A to seller B - the state - and never goes to the company), but rather companies being allowed to issue more shares to the public (presumably through allowing more companies to list). In this case the money goes to the company itself, not to the state, and fattens the company's bank account, not the state's treasury. Thus, there is no sterilizing effect. By Don Clarke - 1/13/2008 1:08 AM

Don and Tishop are right. There should be no sterilization effect if companies issue more shares and of course there will be no reduction in overinvestment if corporations use the money for investment or speculative purposes, which is highly likely. In fact a Mundellian argument might be that channelling investment through share issuance rather than through new loans, which increases the liquidity of tradeable shares (against loans, which don't trade at all) would have a mildly positive impact on total underlying liquidity. Jaime and Henry, thanks for your comments. To answer your question, Henry, the authorities might be engaged in a sort of "Tesobonos" effect in their attempts to rein in investment by capping loan growth, if the main consequence is simply to channel investment flows into less-easily-controlled forms of intermediation. It may be a stretch to compare the two, however. For the time being I see little that suggests we are aproaching the inflection point of any credibility Laffer curve. By Michael Pettis - 1/13/2008 3:56 PM

I still think China has its own monetary policy. With capital control, it is shelled from outside shocks, like in 1997 Asian Financial Crisis. The peg and fixed exchange rate system does make the monetary policy more difficult. It just takes more radical steps to add or reduce liquidity in the economy. By fatbrick - 1/13/2008 11:51 PM