My Blog

April 19, 2008

SAT 19 APR

More evidence of increasing risks By Michael Pettis

This probably doesn’t need to be pointed out in my blog because I have been beating the idea to death, but sharp-eyed Logan Wright in his latest Stone & McCarthy report comes up with some pleasingly simple evidence that hot money is pouring into the country from every pore.  In his words:

 

Foreign direct investment in China has surged in the first three months of 2008, totaling $27.41 billion, up by 61.3% year-on-year. Paradoxically, however, the NBS's fixed asset investment data show a 6.5% year-on-year decline in the use of foreign-sourced capital as funding for fixed asset investment. In other words, 61.6% more money is flowing into China for investment purposes than the same period last year, but the use of that capital has declined by 6.5% year-on-year. While there will undoubtedly be some delays between the receipt of registered capital and the use of the funds, these diverging trends suggest that the foreign direct investment statistic includes some speculative capital inflows betting on appreciation of the yuan, which will continue to fuel monetary growth, requiring additional sterilization by the central bank.

 

FDI inflows surge but actual foreign investment drops slightly over the same period.  This doesn’t prove anything because we would need to look much more closely at the actual numbers and the timing of disbursements, and Logan himself acknowledges this, but for the two numbers to move in such dramatically different directions over the year is at the very least counterintuitive.  Unless you believe of course that a big part of recent trade and FDI flows are simply disguised speculative capital, in which case it makes perfect sense. 

 

The evidence is largely circumstantial, but by now there has been so much circumstantial evidence of hot money piling up that it is hard to avoid the conclusion.  By the way, if speculative money is looking for any way possible to enter China, and one of these ways would obviously be from over- or under-invoicing exports and imports, wouldn’t this also suggest that the speculative inflows hidden in the trade numbers have rising materially in the past few quarters?  If so, China’s real trade surplus is likely to be a lot lower than we think.  Perhaps the export-related slowdown is greater than we believe it to be.

 

Meanwhile the equally sharp-eyed Shirley Yam at South China Morning Post has also been digging away at some numbers and has come up with interesting results.  In today’s edition she wonders about the much-repeated claim among many of the mainland’s larger firms that “profits and profit margins have dropped because of raw material and fuel cost increases.”

 

Displaying a journalist’s cynicism she decides to look at a number of companies to check to see if their margin declines have really been caused by commodity price increases or other factors over which managers have no control.  “Is this the sole reason, or just a convenient excuse for inefficient management to pass the buck?” she asks.  As she explains in her article,

 

This is an increasingly relevant question given the global business environment has turned from deflationary to inflationary where raising costs is the norm.  I read through the 2007 annual reports of 10 major state-owned enterprises. The results were disappointing.

 

It turns out that the companies she examines have all seen distribution expenses, administrative costs and staff expenses shoot up much faster than revenues – two to eight times as fast.  Rather than enjoy economies of scale they seem to be suffering massive diseconomies of scale.

 

This kind of thing worries me not because I care about the how managers choose to spend and/or waste money.  It worries me because boom times like the one we have enjoyed in China since 2003 often lead to rigidities and excesses in corporate activity and balance sheets that make it very difficult for them to survive sharp turndowns, and this is precisely one very common such type of rigidity. 

 

Corporate costs can grow much more rapidly than revenues while still allowing the company to show significant increases in net profits as long as revenues are surging, as they have been for Chinese companies in recent years.  In case however of a slowdown and a decline in revenues, or at least a sharp reduction in revenue growth, it can take a long time for management to get rising costs under control.  The result can be a collapse in cashflow, profitability, and perhaps creditworthiness.

 

This is likely both to increase the risk of a sharp, adverse financial adjustment (as companies ability to withstand a downturn is seriously weakened) and to increase the adjustment cost if such a downturn takes place (deteriorating creditworthiness immediately increases financial distress costs and causes corporates to engage in systemically adverse behavior).  

 

Readers of my blog might easily accuse me of always focusing on the worst case scenario and always looking for problems.  Perhaps that is because as a former bond trader I tend naturally to pessimism – after all bond prices tend to have limited upside and nearly unlimited downside, so it pays to worry about the downside more than the upside.  But as someone who has experienced too many financial crises and who has written extensively about the history of capital flows and financial crises, I am also pretty sure that when things go wrong nearly everything goes wrong at the same time.  This is not a coincidence.  It is simply the way unstable balance sheets work, and during boom times companies tend systematically to build risky balance sheets – by, among other things, letting costs get out of control.