My Blog

November 8, 2007

THU 8 NOV 2007

Comments By Michael Pettis

I have been getting some great comments on some of my entries, but I have not responded to any of them.  This is because my blog is still blocked in China, and although I can read the blog using a proxy, I cannot post on it without great difficulty.  My entries are all posted by one of my favorite students, who is spending a year in California, but it would be too complicated for me to ask him to post my responses to comments.  Apologies.

THU 8 NOV 2007

Mr. Sarkozy goes to Washington By Michael Pettis

Amid the adulation he received during his speech to the joint session of Congress, I noticed that Sarkozy remembered to bring up two subjects – the dollar and the RMB.  He criticized dollar weakness saying that the world’s leading exponent of free trade “should be the first to promote fair exchange rates”.  He also said “The yuan is already a problem for everybody. The dollar should not remain simply a problem for others. If we are not careful, monetary disorder risks descending into economic war, of which we would all be victims.” 

 

Clearly the value of the euro against Europe’s (or at least France’s) main trading partners is weighing on his mind.  He is supposed to visit Beijing, Shanghai and Xian (the home of the terracotta warriors) from November 25 to 27 and amidst agreeing on a Chinese order for two nuclear reactors (worth around ($9 billion) I expect he will discuss currency issues.

 

THU 8 NOV 2007

The declining US trade deficit By Michael Pettis

In Monday’s Financial Times, there is an Op-Ed piece by George Shultz and John Taylor on the US trade deficit (“The silver lining in America’s subprime cloud”).  They say:

 

The good news is the recent reversal of the steady upward climb in the current account deficit. During the past three quarters for which we have data the deficit has been cut by $119bn, falling from about 6 per cent of gross domestic product to 5 per cent, and the adjustment appears to be continuing.

 

Why the reversal? One explanation is the implementation of policies that these same international policymakers agreed to at recent past meetings. The basic economic principle that led to these policies is that the US current account deficit is caused by the gap between saving and investment. Accordingly, a three-pronged strategy was called for – reducing the US budget deficit to decrease government dissaving, raising economic growth abroad relative to the US in order to stimulate US exports and increasing the flexibility of exchange rates, especially in China, to facilitate the adjustment.

 

You can see the strategy being implemented now. The budget deficit has come down sharply to 1.2 per cent of GDP, well below historical averages and less than in most other countries. World economic growth – especially in emerging markets – has been strong, even as US growth has slowed. And China’s exchange rate has become more flexible – appreciating by 10 per cent since the peg was abandoned. Forward markets project further appreciation. All these policies are expected to reduce the current account deficit, but they take time – too much time to explain the sharp reduction in the current account in the past year.

 

So there must be other forces at work too. Because the current account deficit equals saving minus investment, these are logical places to look. Herein lies the silver lining. The housing turmoil has indeed cut a chunk out of investment – residential investment has fallen by $81bn in the three quarters during which the current account deficit declined, and even more compared with the peak of the housing boom earlier last year.

 

Hence a good part of the current account reduction can be directly attributed to the decline in residential investment. Moreover, the decline in housing prices is starting to increase the personal saving rate, as home equity loans are drying up and people are recognising that their housing wealth is not as large as they had expected. When asset prices were rising, households could spend what they earned and still see an increase in their net worth. Sometimes spending even exceeded income. Now, consumption is falling relative to income, so there is more household saving.

 

I worry that if the current global trade imbalance is caused not so much by US over-consumption but rather by excess Asian savings, the second prong, “raising economic growth abroad relative to the US in order to stimulate US exports” is far more important than the first, “reducing the US budget deficit to decrease government dissaving”.

 

If there is a sharp US slowdown (something about which, by the way, I am not wholly convinced) accompanied by a rise in US savings, I think the world’s balance of payments will indeed adjust, but how?  I am not optimistic that faster growth abroad is likely in the face of a sharp US slowdown – I am not a believer in the “decoupling” theory given that the US trade deficit in the past decade has risen, not dropped, as a share of global GDP.  The world still depends on US demand, and I suspect that if there is a US slowdown and a declining trade deficit, they will bring with them a global slowdown.  If the US raises its savings rate, that global slowdown could be even sharper. 

 

Past globalization cycles have all been underpinned by some event that caused a significant expansion in global liquidity, and for a long time I have been arguing that the combination of asset securitization (especially mortgage securitization) and the recycling of the US trade deficit has been the source of the liquidity expansion that has underpinned the latest globalization cycle.  If over the next two or three years we begin to see the unwinding or slowing of both, my theory will certainly be tested.

 

THU 8 NOV 2007

Small banks getting squeezed by IPOs By Michael Pettis

My invaluable assistant Oliver Shang tells me that according to a blog written by a banker at Dongguan City Commercial Bank, a small bank in Guangdong, short term interest rates are getting so high for some of the smaller banks that they are turning to alternative sources of funding to cover the period of deposit withdrawal during big IPOs. 

 

As I have written in earlier entries, big IPOs on the local exchanges are a real problem for the smaller banks, because they tend to be heavily oversubscribed (by as much as 100 times or more) and potential buyers have to deposit the full amount of their order with their brokers, even though they are unlikely to get more than 1-2% of their order filled.  As a result money is drawn from banks all over China and deposited with brokers, who then deposit the money in their own bank accounts, which are likely to be the largest banks.  The net effect is a drain of deposits from smaller banks, who already rely more heavily than big banks on purchased money to fund their loan book, to larger banks.

 

In order to keep their funding intact, the small banks enter into the short-term money markets to borrow against the withdrawn deposits, driving money market rates up substantially.  The PBoC does attempt partially to accommodate, but they do so mostly by not rolling over maturities due around the IPO dates, and they never do enough to eliminate the cash squeeze.

 

According to the banker-blogger, repo rates have become so high for the smaller commercial banks that some of these banks, including his own, are unwilling to finance in the repo market, and instead they choose to sell assets, mostly short-term assets, to raise liquidity.  The reason they do so is because large IPOs freeze money for at most four or five days, whereas the repo markets have become so tight that as much as two weeks before a big IPO, 14-day, 21-day, and 1-month repo rates all rise substantially.  Since the banks do not want to be locked into high-cost funding for so long (especially as large IPOs have become quite frequent) they prefer to raise liquidity by selling short-term paper.  This is apparently at least one reason for yields on short-term assets to have become so volatile recently. 

 

Unfortunately for the small banks the market is a learning machine.  Repo rates have started rising long before large IPOs because market participants are now used to the liquidity squeeze that precedes them, but as banks turn to selling short-term paper to get around the repo market, the prices of these assets are also dropping earlier and earlier before the IPO date.  This means that the small banks are effectively funding at high rates for longer and longer periods.

 

I believe the next scheduled big IPO is by China Railway Engineering Corporation.  Money for purchase orders will be frozen from November 21 to November 23.  They expect to issue 3-4 billion shares and may raise RMB 20 billion or more.  If past experience is any guide, we may see as much as RMB 2 trillion ($270 billion) or more in orders.

 

THU 8 NOV 2007

CPI inflation projection by PBoC By Michael Pettis

My assistant tells me that the PBoC has just published its 2007 Q3 Report.  I have not been able to find it in English on their website but I guess they may not have released the translated version yet.

 

According to the report, the PBoC expects GDP growth to be no less than 11.0% for 2007.  It has raised its CPI inflation projection for 2007 to 4.5%.  I calculate this to mean that it expects average inflation for the last three months of the year to be 5.6%.  On Tuesday we are supposed to get October CPI numbers, and a lot of people are expecting inflation for the month to exceed 7%.  If it is equal to 7.0%, we would need average CPI inflation over the last two months to be 4.9% in order to reach the target of 4.5% for 2007.

 

For those who want to do the calculations themselves, the monthly CPI numbers from January to September are 2.2%, 2.7%, 3.3%, 3%, 3.4%, 4.4%, 5.6%, 6.5%, and 6.2%.