One piece of good news that comes out of all of this is that the A-share market was up 1.48% yesterday, even though it is down 4.51% today, much of it on the back of the inflation numbers. I have noticed that the market has usually done a suspiciously good job of anticipating government figures a few hours before they are released, but this time it seems to have been caught flat-footed.
Another obvious silver lining is that high inflation has the same impact as revaluing the currency. The appreciation rate is still too slow, but the RMB's pace has effectively picked up.
China yesterday reported another sizable monthly trade surplus, with exports exceeding imports by $24.97 billion in August. This was their second largest ever, exceeded only by June's $26.91 billion. July's trade surplus was $24.4, the third largest ever.
A lot of commentators had suggested that June's record surplus was caused by the acceleration of exports due to the expected elimination of a tax subsidy on July 1. With two of the three biggest trade surplus months on record coming immediately after June, I think it is clear that something else was driving the process.
My own reading was, and continues to be, that the trade surplus is the near-inevitable consequence of China's currency regime, in which rapid monetary expansion is both the cause and result of the trade surplus. This monetary expansion feeds into higher industrial production through credit expansion, which exacerbates the trade surplus. A rising trade surplus, of course, means more capital inflows and more monetary expansion.
This is why for three years I have insisted that the trade surplus will only grow, until some sharp adjustment -- one way or the other -- is made to interrupt the inflow of foreign exchange. I expect that we will continue to see record or near-record levels in the foreseeable future, and I expect reserves to continue to mushroom.
One interesting thing that came out of the numbers is that European trade is growing quickly. Total exports to Europe were up 31% year on year to $23.0 billion (or just over one-fifth of total exports of $111.3 billion). Imports from Europe were up 21% over last year to $10.2 billion (or just over one-ninth of total imports of $86.4 billion).
This means that the trade surplus with Europe of $12.8 billion has grown by 40% in the last year. This is still substantially less than China's trade surplus with the US, but the US trade numbers have been improving overall with the weakness in the dollar, and this will probably continue. I am not sure that Europeans have the capacity to absorb large trade deficits for a very long time, and I expect that trade frictions with China are going to rise.
For the record, the trade surplus for 2006 was $177.5 billion, and the trade surplus for the first eight months of 2006 was 53% of that, or $94.4 billion. For the first eight months of 2007 the trade surplus has been $161.7 billion, about 71% greater than last year's number.
A simple extrapolation suggests that this year's trade surplus could be as high $300 billion, although I think that the slowdown in the US will moderate that number. Still, a trade surplus of at least $250 billion is highly likely.
All this means that reserves will grow in 2007 at a substantially higher rate than last year's astonishing $247 billion, even taking into account the $200 billion transfer to the new sovereign wealth fund. The growth rate of industrial production is still to high but has moderated in recent months because of pressure on the banks to lend less. This kind of pressure, however, rarely seems to work for more than a few months. I expect by the end of the year industrial production will be roaring back, and with it there will be even more upward pressure on the trade surplus.
Tom Holland has a good piece in today's SouthChinaMorningPost warning about the impact of inflation. He writes:
...That means although food inflation is not yet spreading into other sectors, it could begin to soon. People will adjust their expectations of future inflation upward in response to higher food prices, and start demanding higher wages. That will push business costs up, and eventually result in higher prices. If there are strikes and demonstrations, rising food prices could lead to social friction.
At the same time, there are signs that price pressures may neither be temporary nor confined solely to food. Demand is rising for protein-rich and therefore resource-intensive foods just as agricultural land is being turned over to growing crops for biofuels and for industrial use.
Transport costs are rising, and both energy and water costs look set to climb as subsidies are reduced. The current focus on food safety - mainland officials claim they have shut 2,000 food-processing plants in the past three weeks - will inevitably add to production costs. Elsewhere, costs are also rising. According to Jing Ulrich, chairman of Chinese equities at JP Morgan: "Inflationary pressures are also building in the manufacturing sector, where the costs of land, labour, raw materials, utilities and pollution are on the rise"...
China's retail sales grew in August by 17.1% (to RMB 711.7 billion), after last months' 16.4% growth. This was substantially higher than expected and the fastest pace in over three years.
We have certainly wanted to see domestic demand become more important to China's economy as a way of reducing its reliance on the export sector, so this is definitely good news from that point of view. However if we are an inflation-battling mode, rapidly rising consumer demand is not going to help.
Part of the growth in expenditures can be explained by inflation (prices went up so people had to spend more), but it has been underpinned by rising wealth among stock and real estate market speculators, rising disposable income among households (up 14.2% in the cities and 13.3% in the countryside in the first half of this year), and higher minimum wages and expanded welfare payments.
For the first eight months of the year retail sales were up 15.7% over the same period in 2006, to RMB 5.6 trillion.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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January, 2008
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