The PBoC has raised minimum reserve requirements for the seventh time this year, after three increases last year, from 12% to 12.5%, which is expected to drain about $25 billion from the banking system (equal, by the way, to a little more than two week's reserve inflows). In a televised speech two days ago premier Wen Jiabao said the government needs to prevent the economy from overheating. Yesterday Zhou Xiaochuan, the PBoC governor, said in a speech that the central bank hoped to see positive real interest rates, although he also made the very reasonable comment that inflation is not just what has happened this month but must be measured over a longer period of several months.
I am not very optimistic that inflation numbers will come down dramatically in the near term, so I interpret this to mean that rates are going to go up quite a bit over the next few quarters. But here is the conundrum. If rates do go up sharply, the speculative profit from investing in China also goes up and, perhaps more importantly, the incentive for Chinese to invest abroad goes down. This measn that capital inflows are going to get worse, not better.
If you believe, as I do, that it is the monetary expansion caused by the currency regime that is at the root of China's money problems, it is hard to see how this can possibly help. I believe the PBoC is very worried about capital inflows and the currency regime, but it is an indication of how much inflation terrifies the government that they are willing to do something that just six months ago seemed almost inconceivable -- increase the incentive for speculative inflows.
I am convinced more than ever that until the government allows a rapid increase in the value of the RMB -- and perhaps the least damaging way would be to engineer a sudden, maxi-revaluation of around 15% -- there will be no good way of dealing with the problems. I was interviewd on CCTV's Dialogue Thursday on the subject of inflation and one of the things both my co-guest, Tang Min, the Deputy Secretary General of the China Development Research Foundation, and I agreed is that the combination of rising inflation and previous and current excess money growth -- which in the past had been deflationary thought its impact on expanding industrial production -- was something new, and it wasn't clear what impact it might have on subsequent inflation. If inflation keeps up, as I suspect it might, it may be tough for the PBopC to engineer sufficiently high positive real rates anyway.
...Commercial lenders earn only 1.89 percent in interest on required reserves, compared with a benchmark one-year deposit rate of 3.6 percent. That means banks pay the price for China's refusal to let the yuan strengthen faster to make exports more expensive and ease the inflow of money, according to Paul Cavey, an economist at Macquarie Securities Ltd.
"In the long term, the banks will be the biggest victims of the exchange-rate policy,'' Cavey said in Hong Kong. ``With a more flexible currency, China wouldn't have to move so often to absorb the liquidity.''
China has resisted U.S. pressure to allow the yuan to strengthen more quickly. The currency has gained 9.8 percent versus the dollar since a fixed exchange rate was scrapped in July 2005. The yuan closed 0.15 percent higher at 7.5384 against the dollar in Shanghai today...
I think Paul Cavey makes an important point and it indicates one of the dilemmas facing China. One of the few tools available to rein in money growth is to raise minimum bank reserve requirements. This hasn't had much effect in the past because banks had so much liquidity that they ran excess reserves anyway, but little by little the PBoC is eating away at the excess.
Of course the problem is that the banks lose money on reserves because their return is lower than their cost of funding. Reducing their profits reduces the amount of capital they have to absorb NPL losses. Fitch estimated earlier this year that total losses on existing NPLs would likely amount to 50% more than total capital and reserves, and this does not take into account the recent explosion in lending and the impact of a possible economic slowdown or contraction. If interest rates rise, as I discuss in the previous entry, this exacerbates the problem by accelerating principle payments, for reasons I discuss in an entry on August 22.
Therein lies the problem. One the one hand, it is crucial to strengthen the financial sytem before allowing the currency to aprreciate much, because one of the great risks is the possibility that an adverse shock may lead to a breakdown in the banking system. On the other, postponing the currency adjustment actually weakens the banking system in a number of ways.
The current issue of the Economist has an article on global food prices, which I excerpt below. It underscores the difficulty China is going to have in reining in food inflation. It seems that help will not be coming from abroad.
THE long cycles of agriculture are seldom associated with gripping suspense. But on September 12th farmers, grain traders and investment managers around the world will be awaiting news that is generating greater excitement the higher grain prices rise. The monthly report of America's Department of Agriculture (USDA) is so sensitive that department staff go into what they call a “lockup” period for days in advance, often working all night just before its release.
Prices of global wheat futures hit records during the first week in September, about double what they were a year ago. Corn (maize) prices have also surged. Consumers are already paying higher prices, forking out more money for products ranging from bread to noodles—although the cost of something in the shops has many components in addition to the price of a commodity. Wheat, for instance, accounts for only about 5% of the cost of an average loaf of bread. But although a jumble of subsidies clouds the precise picture, a long period of higher food prices is beginning to show up in inflation numbers around the world...
...Crop prices are increasingly intertwined because they influence what farmers decide to plant. Higher wheat prices are driving up the price of corn, which is even more sought-after as an animal feed when wheat is too pricey to be a substitute. Corn prices are also pushed up by growing demand for biofuels. In America, one of many countries encouraging the use of such alternatives, biofuel distilleries account for about one-fifth of the corn crop—thanks in part to subsidies. The lack of acreage for other crops, such as soyabeans, pushes their prices up too.
Given the price volatility, the upcoming USDA report is keenly awaited. The data's impact was particularly acute earlier this summer when the department reported that farmers planted 19% more land with corn this year than last, while soyabean acreage fell by 15%. Markets briefly sent prices of these two commodities in opposite directions. The report covers all the big exporting and importing markets. No one else does such a comprehensive job and it is hard to guess the outcome. However, dearer food is likely to be on the menu for some time yet.
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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December, 2007
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