My Blog

November 7, 2007

WED 7 NOV 2007

Emerging markets inflation roundup By Michael Pettis

I just received today’s Emerging Markets Economic Daily from Credit Suisse, in which they discuss the outlook and their expectations for a number of macroeconomic and political indicators. Here is what I noticed.  In the Argentina section, they say “Inflation indices published by INDEC show that inflationary pressures may be increasing”.  In the Brazil section, they talk about a favorable inflation scenario but add that “continued rise in prices of agricultural products should ensure maintenance of high IGP-DI inflation in October.”  In the Chile, Mexico and Venezuela sections they don’t mention inflation, but I know that inflation has been a big problem in Venezuela.

 

In the Russia section they say “The very unfavorable inflation data for October mean that even the latest official forecast of 10.5-11.0% for year-end may be exceeded.”  For South Africa they quote the SARB as saying “The most important challenge for monetary policy makers is to ensure that inflation is bought back under control.”  For Turkey they warn of “the aftermath of a worse-than-expected CPI inflation reading for October.”  For Ukraine they start by saying “October CPI inflation was extremely high, raising a risk that inflation may exceed 14% in December.” 

 

In the China section they say “China still faces upward pressure on retail fuel prices.”  In the Korea section they talk about excess monetary expansion but add that “a policy hike can probably be deferred, especially if headline CPI inflation does fall back below 3% year on year in November as we expect.”  For Malaysia they do not discuss inflation.

 

Of the twelve countries they discuss, in seven they warn about inflationary pressures, in one they think inflation is in good shape, and in four they say nothing about inflation, although I know that for at least one of them inflation has become a serious problem.

WED 7 NOV 2007

Why have the PBoC’s borrowing costs gone up? By Michael Pettis

Logan Wright, who writes research reports for Stone & McCarthy, consistently writes some of the most interesting stuff on Chinese financial markets – at least for those of us boring enough to think that reading about changes in short-term interest rates is a great way to spend an evening.  He has a new report out today (“China: A Rise in PBoC Paper Yields – What Does It Mean?”) that addresses one of those arcane things that China-watchers like me and Dan Rosen get all excited about.

 

We’ve all noticed that yields on central bank bills have risen quite a lot lately – two years ago 1-year yields were below 2%.  They climbed steadily, until about a year ago, and then for about six months until March of this year, they were more or less stuck at 2.80%.  Since then they’ve kept climbing until, as Wright says, “yields on 1-year bills spiked again this week, with the central bank selling 8.5 billion yuan in paper at a yield of 3.7990%, up 19.35 bps from last week's yield of 3.6055%, which was up 15 bps from the previous week. This week's result marks an all-time high for 1-year yields.” 

 

Given recent inflation numbers this might not seem surprising – increases in inflation are often followed by increases in short-term yields – but the PBoC has generally been wary of raising its cost of borrowing and has tended to limit auction size to keep rates under control.  This is one of the reasons that it has not sterilized as much of the money creation that we would have expected (even assuming that under China’s monetary conditions selling central bank bills is an effective sterilization tool).  Wrights says:

 

One of the reasons we assumed that the central bank limited upward pressure on yields in the past was because of the importance it attached to maintaining the interest rate gap between Chinese and U.S. interest rates. Clearly, the central bank is no longer as concerned about the interest rate gap as a hedge against capital inflows, and a recent SAFE report claimed that asset prices were a more significant factor compelling capital inflows than bets on yuan appreciation. With today's rise in yields, the interest rate gap between PBOC 1-year paper and 1-year US LIBOR is only 80 bps. With the gap shrinking, China's capital controls are likely to be tested, and we expect "unofficial capital inflows" to rise in the months to come. Rather than give in to the rising pressure on the yuan, we simply expect foreign exchange reserves to rise faster than they have previously…

 

…Another reason we assumed that the central bank limited upward pressure on yields was a concern about rising sterilization costs. These costs will definitely continue to accumulate as the central bank allows interest rates and interbank yields to rise, but they are still relatively marginal in terms of the central bank's balance sheet.

 

Wright suggests three possible explanations for the PBoC’s willingness to let rates rise.  First, the PBoC may be worried that bank lending is expanding too quickly in part because banks have little interest in taking on very low-yielding central bank paper, and by allowing rates to rise they are simply acknowledging the need for higher rates if they want to issue a lot more paper.  Banks have extended RMB 3.36 trillion in new loans in the first nine months of this year (about $450 billion, or 16% of all of last year’s GDP of RMB 20.94 trillion), compared to RMB 3.18 trillion in all of last year.  Even if loan growth slows (and it did for much of the third quarter), it is hard to imagine that the volume of new loans won’t equal 17-20% of 2007 GDP.

 

Medium and long-term RMB-denominated loans are growing at a 23.9% rate, while RMB deposits are growing at only a 16.8% rate, with most of that growth among enterprise deposits; household deposit growth rates are decelerating as depositors shift funds into the equity market. Last year, net issuance of PBOC sterilization paper was 1.034 trillion yuan. So far this year, net issuance has only been 645 billion yuan, despite a surge in capital inflows from the trade surplus. In addition, net issuance has been negative for the seven months since the end of March, reflecting poor market demand for PBOC paper under expectations of monetary tightening.

 

The second reason Wright suggests for the run-up in rates is to prepare the market for more aggressive rate hikes, and I think this is his favored explanation.  If inflation numbers for October continue to suggest difficulty in reining inflation in, some people expect that the PBoC will be prepared to act with more vigor, and letting rates rise is their way of preparing and signaling to the market.

 

Finally, Wright suggests that the PBoC may be trying to contract monetary expansion surreptitiously even though they may be under pressure not to do so.  By tightening interbank rates they don’t have to raise one-year benchmark deposit and lending rates.

 

The logic behind this may be political in nature. Before 2006, the widespread conventional wisdom in China was that raising interest rates was relatively difficult from a political perspective, because state-owned enterprises depended heavily on working capital loans extended at the benchmark lending rate or 10% below that lending rate, and these SOEs resisted higher costs of capital through their channels of influence in the Ministry of Commerce and the National Development and Reform Commission (NDRC). After all, the PBOC is not an independent central bank, and requires the approval of the State Council before raising interest rates.

 

Over the past two years, the NDRC has been calling for higher interest rates to limit the risk of overheating, and containing the rise in inflationary pressure seemed to be a larger political priority than caving to the demands of the state sector, whose profitability was rising rapidly. However, after five hikes in lending rates totaling 117 bps so far this year, state-owned companies may be getting a little squeamish regarding the prospect of future rate hikes and the impact on costs. According to some sources, the PBOC has conducted surveys of enterprises and found growing resistance to the rate moves conducted so far this year. With three rate hikes in the last quarter, and relatively conservative companies suddenly confronting borrowing costs that are 72 bps higher in a short period of time, this is not entirely surprising.

 

Whatever the reason, rates have gone up dramatically and it is clear that something has to change.  The PBoC is behaving as if they are worried about something, and that something obviously has to do with China’s monetary conditions.

WED 7 NOV 2007

More on overheating? By Michael Pettis

My assistant Oliver Shang tells me that the wholesale price of pork is up 1.9% in the last week, and has been trending upwards during the whole period since the last CPI release.  He says that other food prices, including vegetables, are also up a little.  What with this and the increase in gas prices two weeks ago I think people are expecting October CPI inflation to come in higher than August’s 6.5%.  Some people are claiming that it will break 7%.  I agree.

 

As an aside, according to Wednesday’s South China Morning Post, Cheng Siwei, vice-chairman of the Chinese People’s Political Consultative Conference, parliament’s top advisory body, said that Beijing needed to dampen international expectations that the RMB would keep rising.  In the same speech he caused a stir when he said that China should “balance” its reserves between the euro and the dollar.

 

According to Cheng, this “mindset” – international expectations that the RMB would keep rising – was more dangerous than a stronger RMB itself.  I think I understand why he is saying it, but I also think he underestimates how serious the RMB problem really is (and he can’t seem to resist the Chinese temptation to explain a domestic problem as somehow being caused by the “international” community). 

 

To the extent that his is a common perception within the government, I think the outlook for policy isn’t good.  If they believe that the “problem” of the RMB is not the impact of the currency regime on monetary policy but rather that China will be subject to damaging speculative inflows because of “international” perceptions that the RMB must rise, this may lead authorities to focus more on changing those perceptions by introducing volatility to the RMB’s appreciation, rather than adjusting the currency regime. 

 

By the way his comments make me skeptical of claims by some analysts that speculative inflows caused by faster appreciation are not a serious problem.

 

Finally, according to another article in Wednesday’s South China Morning Post:

 

Premier Wen Jiabao has mounted a rare public defense of his macroeconomic policies, which have been criticised both within the Communist Party and overseas. In an uncharacteristically assertive manner, Mr Wen arranged an interview with a group of Hong Kong reporters yesterday during his visit to Russia. The premier said the criticism directed at his economic policies was ill-founded - the strong and stable growth vindicated those policies.

 

"Everybody agrees that China's economy has been doing pretty well for the past five years and actually it's one bright spot [in the global economy]," said Mr Wen, who has been in charge of the economy since 2003. "If that's the case, then to label [our] macroeconomic controls as ‘toothless’ contradicts both fact and logic."  Mr Wen's management of the world's fourth-largest economy has been a subject of heated debate. Overseas media and analysts have said his macroeconomic controls have been ineffective in cooling the sizzling economy and run the risk of damaging the mainland's long-term growth

 

I have a lot of sympathy for Wen and think overall he has done a great job on a number of fronts, but I think managing the competing interests affected by economic and monetary policy isn’t easy and he is going to be criticized no matter what he does.  The options facing China are pretty limited and not terribly enticing.  Still, it is very interesting that he felt the need to defend himself while in the middle of his Russia visit.  It suggests to me that there must be real nasty debate and even some internal strains, reaching all the way into Zhongnanhai, the leadership compound in Beijing.