My Blog

March 24, 2008

Today’s China Daily quotes remarks made by a senior advisor to the PBoC on RMB stability and the need to fight hot money inflows, which he delivered at a conference held over the weekend (“Advisor: China needs stable yuan to fight hot money”). I thought his comments were very interesting:

China needs a relatively stable exchange rate and should not use another one-off currency revaluation to curb inflow of overseas speculative capital, Fan Gang, an adviser to the central bank, said in remarks published on Monday.  “In order to reduce the inflow of speculative money and prevent speculation on a bigger magnitude, China is in greater need of a relatively stable exchange rate policy,” Fan was quoted as telling a weekend forum in Beijing.

Fan opposes the use of another one-off revaluation of the Chinese currency, or yuan, according to the Shanghai Securities News. Widespread expectations that the yuan would register further sharp gains against the dollar have been encouraging inflows of speculative money into the country.

Aside from the fact the financial authorities and their advisors continue warning about hot money inflows, I was intrigued by the fact that Fan had clearly been thinking about a one-off revaluation and was, at least in public, opposed to it.  Of course his public “opposition” might simply be caused by concern that any widespread belief that the government might engineer another one-off revaluation would spur further inflows – the article points out that he himself argues that expectations of a sharp RMB appreciation have been encouraging inflows of speculative money.

The skeptic in me wonders however if the problem for Fan is a one-off revaluation, or just widespread expectations of a one-off revaluation. In the latter case, we would expect the authorities to deny that a one-off revaluation is coming, whether or not they thought it was.  I remember Lopez-Portillo’s widely repeated claim in 1982 that “We will defend the peso like a dog”, which earned the Mexican president opprobrium (and, funnily enough, barking sounds whenever he subsequently appeared in public), when the currency was catastrophically devalued just weeks later, and of course in July 1997 the president of Thailand promised to defend the baht only days before it was devalued.  Watch what they do, in other words, not what they say.

What interested me most about his speech is that by now it seems that the option of a one-off revaluation is clearly one of the policies on the table, and it is being widely discussed, even if distastefully.  About a year ago when I first suggested that the government was moving, almost inexorably, in the direction of a maxi-revaluation, I pointed out that although at the time the prediction might seem unthinkable, even laughably wrong, I expected the consensus to shift fairly quickly– I said that within six months I expected the idea would be much more generally discussed, and probably within a year it would be one of the central policy options under discussion.  The direction and force of China’s monetary problems seemed to rule out most other solutions.

I still do not believe that the policy of a sizable and sudden one-off revaluation is a widely-supported option, but things certainly still seem to be moving in that direction.  I expect that if hot money inflows prove to be a persisting problem over the next month or two, or if inflation stays high in March and April and especially if inflation shifts away from food and towards other goods and services, both of which I expect, it is going to be increasingly hard to dismiss the idea of a more radical and efficient solution to China’s monetary problems.

Talking about hot money, this is what China Daily reports about Fan Gang’s take:

More overseas speculative capital is expected to flow into China in 2008 and next year as a result of the US subprime mortgage crisis, which has sharply driven down the US interest rates and the value of the dollar, Fan was cited as saying.

The credit crisis would drive more capital to high-growth countries such as China and India, he said, adding that it remained a key challenge and priority for China to resolve the problem of excessive liquidity in its banking system.

Excess liquidity really is a challenge, but I am not sure they are dealing with it to any serious extent.  The problem lies with net currency inflows, and the only way to address that is to address the currency regime.  Still, for all the hot money and persisting inflation, the authorities are talking bravely about their ability to control monetary conditions.  Over the weekend Vice-Premier Li Keqiang, China’s new financial tsar, spoke about economic stability and financial management.  According to the South China Morning Post:

The central government has the confidence and ability to take effective austerity measures to avoid wild swings in economic development, Vice-Premier Li Keqiang said yesterday, in his first public speech in the new post. “Under the circumstances of a complex world economy, China's fast and stable economic development is particularly important," he said at a forum held in B over the weekend.

Mr Li, who is tipped to succeed Premier Wen Jiabao when he retires in 2013, said the government would keep macroeconomic controls at a reasonable level in accordance with “new situations and new problems”.

It seems to me that we are still in an area of policy complexity and even confusion.  The government wants to constrain overheating and inflation, and they are also hoping to maintain economic stability (i.e. stable employment growth), but it is not clear that these two policy goals are compatible.  The former needs more rapid currency appreciation and a sharp contraction in credit conditions, while the latter would be adversely affected by those policies.

I interpret “new situations and new problems” to mean that they will maintain “flexibility” in their fight against inflation, or to put it in a much less ambiguous way, unemployment trumps inflation as a problem.  I was not the only one to see the official comments that way.  According to the same article, “Ha Jiming, chief economist of China International Capital Corp, said the comments showed Beijing's determination to maintain economic stability.”

In the past several months, we heard a lot about tackling inflation, but now the top leaders are saying to find an appropriate balance between curbing inflation and economic development,” Mr Ha said.

An “appropriate balance” is a little hard to define, but the anecdotal evidence suggests to me that unemployment is the key factor.  But even if it weren’t, I see no evidence that they have the tools really to constrain monetary growth.  By the way Gene Ma of ISI-CEBM sent me a research report today that has some very interesting numbers.  I don’t want to suggest that the folks at ISI-CEBM are as pessimistic as I am about monetary policy, but according to them, the PBoC was able to mop up 77% of foreign currency inflows in 2006 by net new selling of sterilization bonds and hiking minimum reserve requirements. 

In 2007, although net reserve increases jumped from $247 billion to $463 billion, the total amount of net new sterilization bonds and minimum reserve hikes took out only 72% of foreign currency inflows.  I am not a big believer in the effectiveness of either measure in constraining underlying liquidity growth, but even if I were, it seems to me that in the face of much larger inflows they have become less, not more, effective.  The “un-mopped” portion of inflows was 2.3 times as high in 2007 as in 2006, which would be a bad thing even if like me you didn’t think the mopping up was very effective in the first place.

Meanwhile there is a new problem in the fight against inflation.  Last week I discussed reports of fuel shortages in China.  Here is what the South China Morning Post had to say today (“Beijing under pressure as fuel shortage spreads”):

Fuel shortages at petrol pumps have spread from southern China to key economic centres in eastern and western parts of the country, pushing Beijing into a quandary as it faces mounting pressure to raise retail petrol prices amid its biggest battle against inflation in a decade. The shortages came as state leaders including Premier Wen Jiabao reiterated that Beijing would not waver from its goal of wrestling down inflation, which surged to a 12-year high of 8.7 per cent last month, even as Mr Wen conceded that it would be hard to reach the 4.8 per cent target for this year.

In a report on Saturday, the Huaxia Times speculated that Beijing would raise state-stipulated retail fuel prices as soon as early next month, without citing a source, although some industry executives doubted it given the high level of inflation. In the past 21 months, Beijing has raised retail fuel prices once, on November 1, by 9 to 10 per cent.

As I understand it, domestic fuel prices need to be raised by about 25-30% for local refiners to break even.  According to the South China Morning Post article, Jiang Jiemin, CEO of PetroChina, China’s second largest refiner, “last week said its refining division could break even only at a crude oil price of about US$67 a barrel at prevailing domestic fuel prices.”  That is still well below the $100 or so price per barrel in international markets.

Because the authorities are so concerned about inflation, the decision to raise fuel prices is a difficult one.  This is because they worry that a fuel hike will, by causing a variety of prices to rise, feed into inflationary expectations and so help inflation to spread away from food and into other goods and services. 

But I don’t think this is what will happen.  If inflation is indeed a monetary problem, which I think it is in China, keeping fuel prices low will not help to combat inflation.  It will simply encourage the spread of inflation into other goods by transferring inflationary pressures away from fuel and into other goods. 

This is just the flip side of what has happened already – the recent food supply constraint caused by disease and bad weather, by forcing up food prices very quickly, has absorbed overall inflationary pressures and kept them from spreading into other goods and services as quickly as they might otherwise have done.  That is why non-food inflation has been low (and rising).

Too much money causes the average price level to rise.  When the prices of some goods rise very quickly because of specific supply constraints, as food did in China, the process actually puts downward pressure on prices for other goods and services since it causes consumers to divert spending from other goods and services into food.  However if prices of some goods like fuel are kept artificially low, rather than reduce inflation by lowering inflationary expectations, the policy simply transfers the inflationary pressure to other goods by diverting money spent away from fuel and to other goods and services. 

It all depends crucially, I guess, on whether Chinese inflation is a monetary problem or a one-off food problem – money or pork – and what the role of inflationary expectations is in the process.  This is a case where the wrong explanatory model can lead to very adverse consequences.

This has been a very long entry, but before closing I did want to add one last think.  Geoff Dyer has an interesting article in today’s Financial Times about a recent McKinsey Global Institute report, which I have not yet read, which predicts that within two decades 40% of urban dwellers in China will be migrants from rural areas.  Geoff summarizes like this:

On top of the existing 103m urban migrants, Chinese cities will face an influx of another 243m migrants by 2025, taking the urban population up to nearly 1 bn people.  In the medium and large cities, about half the population will be migrants, which is almost three times the current level.

These are extraordinary and very interesting numbers.  The challenges faced by Chinese cities in the next two decades are going to be huge.  One can almost predict that the success of China’s modernization will, to a large extent, depend on the success with which migrant workers are absorbed by Chinese cities.

Comments (9) for "The RMB and contradictory po...

Is it possible that hot money inflows overstated? Standard Chartered's Stephen Green believes there are three reasons that explain this: 1. Money is flowing back from the HK stock market. 2. There are more loans in dollars on the mainland. Borrowers can then convert these to Yuan by unofficial means. These dollars would then likely end up on the balance sheet of the People's Bank as forex reserves. Dollar loans increased by $12 billion in January alone. 3. Active onshore forwards trading. When a company sells dollars forward, its counter-party bank covers its risk by selling dollars spot market. These dollars, too, end up on the PBOC's books. By sam sherraden - 3/24/2008 2:24 AM

The following news article peripherally touches on unemployment while raising many questions. If there is a signficiant slowdown in China's economy secondary to deflationary forces sweeping the world, how will this likely impact companies owned by foreign entities? Will they have little to no ability to relocate or lay off workers? The Shanghai Daily has a story today stating that the Chinese government has accused Kraft Foods of violating a new Chinese labor law by moving its Chinese headquarters from Beijing to Shanghai without consulting workers. According to the story, sometime in January, Kraft decided move its headquarters in a restructuring effort after buying a snacks division of Danone company. The article goes on to say that the law requires companies to consult employees before major moves that affect worker interests. Apparently, more than half of the 340 Kraft employees will lose their jobs if they do not accept the relocation. Accordingly, the workers have formed a union and called for compensation and an apology. Unfortunately the article did not list the amount of the potential fine and compensatory damages likely to be levelled. Would anyone on this blog be able to knowledgeably comment on whether or not Kraft will likely take a significant hit over this oversight? Or if the costs are likely to be of very little consequence? Whatever the outcome, I am sure that giant international corporations are going to watch how Kraft is treated with great interest. By kevinfischer2002 - 3/24/2008 5:25 AM

Literally speaking, hot-money holders may one day walk away with China's currency reserve. They may today borrow in USD, save in RMB, and when that day comes when the tide turns, they may sell out and repatriate the USD. The Chinese will have to fight back with its currency reserve - losing it. Given the seemingly accelerating nature of hot-money inflows today - the end of this inflow-process could be near. By Stefan, Tallinn - 3/24/2008 7:11 AM

As an aside, not only do price controls on fuel transfer inflationary pressure to other goods and services, but they also have the contradictory effect of actually worsening the fuel shortages for at least two reasons: 1. The limited supply of fuel now goes to buyers who are first in line, rather than those who are likely to put it to the most economic use (i.e. are willing to pay more for it). 2. The incentive for fuel sellers to increase stocks is lessened or removed completely because their profits are restricted. This finger-in-the-dike stuff. The Chinese economic experiment is coming to its conclusion and although the results ought to cry out in favour of the free market, there is a good chance that they will instead be interpreted as evidence of the need for yet more government intervention. By k - 3/24/2008 12:29 PM

michael -- I agree that Fan Gang's comments indicate a more active debate on policy inside China, one where a new one-off reval is again on the table. My sense is that Fan Gang is a bit less keen on RMB appreciation than others involved in the Chinese monetary policy debate -- tho that impression is based entirely on my recollection of his comments at the Peterson institute's conference last fall. consequently, it isn't a surprise that he would favor a stable RMB. By bsetser - 3/25/2008 2:51 AM

traditional monetary policies responses are losing traction to tackle this stagflation pressure. In both US and China, it is now time for fiscal policiy to step in, luckily for China, there are still money in the pot and there is not an expensive war going on Inflation have to be contained while energy prices have to go higher. Government will finally make up their mind, take the pill and move to hike rate aggressively or indexing rates, while appreiating Rmb by the final 15%. Throwing Rmb500b urban tax cut / rural subsidy or roughly 2% GDP to households will largely dim the inflation - employment pressure on households Corporate tax cut in the similar amount should cushion capex Property-A share prices probabaly will plunge by 30% in the process, but these are collateral damange as Chinese economy is never asset based By isaac - 3/25/2008 9:59 AM

Stefan, the highest estimate I have seen for total hot money is about $500 billion, so hot money could all walk out tomorrow and still leave China with the biggest hoard of currency reserves in the world, and a lot more than what it would need according to even the most conservative estimate. Thanks for your comment Brad. I haven't met him or heard him speak, but clearly the topic is on his mind, whther he opposes or favors. Isaac, I am afraid you are soon going to challenge my position as the official pessimist. Are you as worried as I am about Chinese-stlye staglation (i.e. GDP growth under 9% and inflation well over)? By Michael Pettis - 3/25/2008 2:34 PM

Hello Michael Pettis, Thanks for such an informative blog on China's financial markets. I have a really basic question. Like one of your students, I could be shy or profess my ignorance. I'll do the lattar. If China does do a once off re-evaluation (say 20% as per your Feb 20 post), then will that make the Remninbi 20% stronger or weaker compared to the Dollar? I'm assuming stronger, but could not find it explicitly stated. Thanks, John By john gallo - 3/25/2008 4:09 PM

John, a revaluation will make the RMB stronger (worth more) against the dollar. Great blog entry, by the way, Pettis. By TR - 3/25/2008 7:47 PM