My Blog

December 10, 2007

MON 10 DEC 2007

Oh-oh! M2 growth is 18.5% and PPI is up – CPI comes out tomorrow By Michael Pettis

On the National Bureau of statistics website (stats.gov.cn) they have just released the PPI report.  For November the cost of manufactured goods rose 4.6% year on year – much higher than expected.  The biggest price increases occurred in mining and quarrying (15.1%), the foodstuff component of consumer goods (9.1% – consumer goods overall rose 3.7%), and raw materials industry (6.8%).  On their website the PBoC also released money supply and credit information – M2 was up 18.5%, above expectations and well above the PBoC’s target.

 

Tomorrow we should get CPI inflation numbers and most commentators believe that it will equal or surpass last month’s 6.5%.  What is worse we should probably see price rises in far more than the food component, which has been the main source of CPI inflation in the past.  This shouldn’t be a surprise.  I was never comfortable with the idea that “temporary” increases in food prices could exist without deflationary (or at least disinflationary) pressures on the non-food component of the CPI basket, but inflation in the non-food section, although relatively low, was rising.  For surging food prices to co-exist with rising inflation in non-food items has always suggested to me that the inflationary pressures were at least partially structural, and not just cyclical.

 

By the way there seem to be continued fuel shortages, which suggest that there may be further pressure to raise fuel prices again.

 

MON 10 DEC 2007

Cooling China

My students can't afford a subscription to the Wall Street Journal and they asked me to post the Op Ed piece I wrote in today’s paper.  Here it is:

 

For all the energy U.S. and European politicians have exerted pressing Beijing over the yuan, internal economic problems are the greater concern for Chinese policymakers. And whether or not Beijing realizes it, a policy move last week to clamp down on bank lending may hasten the day when China is forced to revalue its currency.

 

China’s financial authorities face two contradictory policy demands. They need to rein in out-of-control growth before it sparks rampant inflation. They also need to maximize job creation to avert social unrest that might stem from growing income inequality. And they are running out of policy tools.

 

Beijing has tried for at least three years to moderate growth, but with minimal success. In 2007 alone, the People’s Bank of China (PBoC), China’s central bank, raised its benchmark loan rate five times, to 7.29%. It also raised the minimum required capital reserve for commercial banks nine times, to 13.5%, the highest level in the PBoC’s history. Administrative measures have been introduced to limit bank lending, reduce price subsidies, redirect investment, and talk down speculative and investment activity. Last week, Beijing rolled out its next-to-last big gun, a Draconian administrative cap on new credit.

 

Still, GDP growth this year is expected to hit 11.6%, well above the already high 10% forecasts at the beginning of the year, and the fifth consecutive year of double-digit growth. Inflation has risen steadily to 6.5% in October from 2.2% in January, and there are reasons to believe that next year inflation might get worse. Most of the other warning indicators — expansion of the money supply, credit growth, speculative activity in the local stock and bond markets, increases in fixed asset investment and industrial production — are well above official targets.

 

Earlier measures have failed because they have skirted the underlying reason for China’s problem: its currency regime. Because the PBoC rigidly fixes the foreign exchange value of the yuan within a narrow trading band, it has lost control of domestic monetary policy. China’s money supply is determined primarily by the net inflow of foreign exchange on its capital and current account. Because the value of the yuan is set so low, China runs a large trade surplus, whose magnitude is further exacerbated by large amounts of foreign direct investment and speculative inflows.

 

These large inflows must be converted by the PBoC into local currency or central bank bills, so that the fantastic rise in China’s foreign reserves is matched by an equally large rise in its domestic money supply. As the money supply surges, it encourages massive increases in fixed asset investment (up 27% so far this year), which in turn causes industrial production to surge. Since China cannot consume as fast as it produces, the balance must be exported, thus forcing ever greater trade surpluses and locking the country into a self-reinforcing cycle of monetary excess. Until this mechanism is broken there is little China can do to control its economic overheating.

 

Beijing is still reluctant to consider a dramatic revaluation. Instead, last week’s meeting of the Central Economic Work Conference, an annual meeting of key policymakers, recommended a sharp clamp-down on credit growth. Banks will reportedly be permitted to increase their total loan portfolios next year only by an amount equal to this year’s lending increase. This is expected to bring loan growth down to 13% next year from 15% in 2007.

 

Caps on loan growth have failed before, thanks to lax enforcement, although most reports suggest that this time authorities are far more determined. Whether that is likely to happen during the run-up to the Olympics remains to be seen, but there is reason to believe that even if the authorities were successful, loan caps would have only a minimum impact on moderating underlying conditions. The measure would only force excess monetary expansion into other conduits for funding rapid economic growth.

 

Domestic measures to slow the consequences of monetary expansion will not work if the underlying monetary expansion continues unabated. The newly proposed curbs on Chinese credit growth, if they are effective, are only likely to fuel growth in the local stock and bond markets and to push money into the informal banking sector, where conditions are flexible and restrictions ignored.

 

The outcome of last week’s Beijing conference suggests a shift in the balance of power away from those determined to maximize employment growth and toward those concerned about the dangers of monetary excess. But the credit clamp-down suggests Beijing still hopes to address China’s economic imbalances without touching the currency regime. If and when last week’s measure fails to produce the desired results, the need for yuan revaluation will come even more sharply into focus.

MON 10 DEC 2007

Slower loan growth does not necessarily equal lower FAI By Michael Pettis

Does the market believe the declared loan tightening measures?  After the announcement Saturday afternoon that the PBoC was raising the reserve ratio 1% to 14.5%, Shanghai opened down Monday (my assistant told me that it opened more than 1% down, but I am not smart enough to get the intra-day info off the SSE website) but quickly recovered, and then kept moving up to close the day nearly 1.4% in the black. Just another uneventful day, I guess.

 

As I said in yesterday’s entry, I am not too optimistic that the renewed determination to limit credit growth is going to be very useful.  A serious attempt to reverse the monetary excess of previous years and to wring out inflationary expectations is going to require, like it or not, a real reduction in the rate of economic growth.  That means a reduction in the rate of employment growth, too, and with unemployment edging up even with the ferocious growth we have seen in the past three years, that translates into rising unemployment, likely to be worse among the young.  I am not sure whether the senior leaders really have that much appetite for an increase in unemployment, especially in an Olympics year.

 

In an Op Ed piece I wrote for today’s Asian Wall Street Journal (“Cooling China”, see entry below) I said:

 

Caps on loan growth have failed before, thanks to lax enforcement, although most reports suggest that this time authorities are far more determined. Whether that is likely to happen during the run-up to the Olympics remains to be seen, but there is reason to believe that even if the authorities were successful, loan caps would have only a minimum impact on moderating underlying conditions. The measure would only force excess monetary expansion into other conduits for funding rapid economic growth.

 

Several people have asked me what I meant by saying that the new measures “would only force excess monetary excess monetary expansion into other conduits”.  

 

The Chinese economy is a very large, very complex system with many moving parts, huge inefficiencies, and different ways of doing things, and given the furious expansion that has taken place in a system chock-full of regulators, bureaucrats, restrictions, rule changes, and conflicting directives, it should be no surprise that one of the great strengths of Chinese businessmen is that they have learned to be very flexible and to find ways around the thousands of irritations that buffet them on a daily basis.

 

This entails a huge diversion of resources to non-productive uses, and since the goal of much of this activity is to get around stultifying government-imposed restrictions, not surprisingly it also complicates the attempt by the central government to impose discipline on the economy.  If there is a ferocious demand for capital by rapidly expanding companies, and a huge supply of capital caused by the lack of a domestic monetary policy, successful attempts to interrupt the ability of commercial banks to intermediate the process might simply reduce the importance of banks as intermediators.  In today’s Financial Times Henny Sender (“China Loan Curb Hits Businesses”) shows one way how this might happen::

 

…Working capital has become a problem for many businesses in China as, worried about the possibility of an overheating economy, the government in Beijing has tightened controls on bank lending.

 

…In response, many companies are finding ways to circumvent the measures.

 

…In a complicated game of cat and mouse, as regulators try to close down loopholes, borrowers and intermediaries seek to locate others in their search for funds. For example, leasing companies have escaped the clampdown on lending. So if a company is unable to finance the purchase of equipment from the banks, it can turn to leasing companies instead.

 

…The cash crunch is particularly dire for smaller and private companies because Chinese banks favour their larger, state-owned clients. So when the bankers have to cut back credit lines to meet Beijing’s rigid new quotas, they first turn towards what amounts to the bottom of the corporate food chain.

 

I suspect that if the credit growth capping measures are successful, we are going to see a growth in financial “ingenuity”.  Informal banks and “non-bank” banks (as we used to call them when I was in business school) will increase their activity, and even the bond market will help take up the slack.

 

Not to end this on a note of pessimism, I see that one English newspaper is speculating that the Blackstone Group, perhaps with the help of the CIC or other Chinese institutions, may be preparing for a bid on Rio Tinto (which would involve at least $150 billion).  Encouraging outward expansion creates its own set of problems for the Chinese economy, but it does have one great advantage (besides the obvious one of heating up the market for China-based investment bankers just when I am thinking of returning to the market) – it does reduce the pressure on domestic monetary expansion.  But unless outward investments mushroom to frightening levels, none of this will really matter to overheating until the currency is fixed.

 

MON 10 DEC 2007

CPI is up 6.9%, trade surplus at a near record By Michael Pettis

The CPI numbers came in today, and as I expected they didn’t look good.  Most of the news services reported consensus expectations ranging from 6.7-6.9%, with the actual CPI inflation coming in at the high end – at 6.9%.  During the previous three months it was 6.5%, 6.3% and 6.5%, respectively.  Year to date prices have risen 4.6%, versus a target of 3%.  If we assume that 2007 inflation will be 4.7% for the full year, it will be the highest recorded number since 1996.

 

Food was up 18.2%.  Since major adjustments in the composition of the CPI basket occur only every few years, and minor adjustments only at the beginning of the year, food still officially comprises 33% of the food basket.  By now I would assume it must make up a larger share of the total basket than it did in January.  Raising food’s share by 10% to 36-37% of the basket adds about 0.5-6% to headline inflation.

 

Total inflation excluding food was 1.4%.  This may not seem like much, but it is the highest number all year, and substantially higher than the 1.1% last month.  What’s more, it suggests to me that we cannot take much comfort in the argument that inflation is primarily a one-off food problem.  If that were the case, we should see deflation, or at least disinflation, in non-food items, rather than increasing inflation.  I expect inflation numbers will not improve in the next few months and in fact will begin to spread into other categories as food inflation subsides.  By the way, I understand that there continue to be fuel shortages in parts of China, which increases pressure for reducing the fuel subsidy.  My understanding is that the NDRC is eager to convince senior authorities to approve more pricing deregulation, but I guess this will probably hinge on how well they are able to convince those authorities that inflation is just a food problem.

 

Here is one more reason to worry that inflation is likely to be sustained: the trade surplus for November, at $26.28 billion, was lower than October’s record $27.1 billion but still the third highest on record.  As such, it continues to act as a great source of monetary expansion.   

 

November’s trade surplus was 14.7% higher than last November’s trade surplus, and reflects a 22.8% rise in exports since last November and a 25.3% rise in imports.  The numbers are not good, but at least they are moving in the right direction in one sense.  Exports for the first 11 months were up 26.1%, versus imports, which rose 20.5%.  I don’t know if this is a seasonal effect, but it seems that later in the year import growth has sped up relative to export growth.

 

There is not a whole lot to say about any of these numbers because they do little more than confirm the story of the past three years: China is stuck in an expansionary monetary policy and nothing the authorities have done to extricate themselves has had any effect, nor is it likely to until they address the currency problem.  Most newspapers that reported today’s batch of numbers added that Chinese authorities announced last week that that China was switching its monetary policy from “prudent” to “tight”, but this announcement misses the point.  

 

China does not have a monetary policy.  It has an exchange rate policy, and as a consequence domestic monetary policy is largely a residual.  In one sense it seems to me that they are finally addressing the underlying monetary problem by encouraging capital outflows, but this is simply another, albeit more powerful, way to avoid addressing the fundamental problem.  Encouraging more and larger-scale outward FDI may take some pressure off the PBoC, but it runs the risk of pushing Chinese companies to invest outside of China before they are ready.