My Blog

April 21, 2008

MON 21 APR

Inflation projections and manipulated stock markets By Michael Pettis

What is 2008 CPI inflation for China likely to be?  Merrill says in an April 16 research report that they except it to be 6.9%, and most other bank researchers say it will fall between 6% and 7%.

 

Are these numbers plausible?  For the first three months of the year, inflation has been running at an average month-on-month rate of nearly 1.3%.  This is the equivalent of 12.9% on an annualized basis – i.e. if the average inflation rate for the first three months remained the same for the rest of the year, inflation for the year would be 12.9%.  If we say we expect that inflation for the full year will come in under 7.0%, we are also automatically implying that the average monthly inflation from April to December will be less than 0.4%, or less than 5.1% on an annualized basis.  That is a pretty steep drop.

 

We can extend these projections a little further.  If we assume that month-on-month inflation declines from 1.3% for the first three months to 1.0% in April, we would need average monthly inflation from May to December to be less than 0.3%, or less than 4.2% on an annualized basis.  Finally if we assume that month-on-month inflation for May also turns out to be 1.0%, we would need average monthly inflation from June to December to be less than 0.2%, or less than 3.0% on an annualized basis.

 

I can play around a bit more with these numbers to make more generous assumptions.  Let’s assume that inflation for April and May come down sharply from the 1.3% it has averaged so far this year.  Specifically let us assume that in April monthly inflation turns out to be half of the average so far, or 0.6% (for an annualized 7.8%) and then in May we decline to a level equal to the monthly average for the whole year (assuming inflation for the year is 7%), also 0.6%.  In this case we would need for average monthly inflation from June to December to be less than 0.3%, or less than 3.7% on an annualized basis.

 

No matter how you look at it, even if we make relative generous guesses about declines in April and May inflation, to get inflation for all of 2008 to come in under 7% we are going to need a very sudden and sharp decline in the inflation rate.  This is of course possible, but I think it is going to be hard for CPI inflation to start the year at nearly 13% nonetheless to finish the second half of the year at well under 4%.  I also think it would be inconsistent with the kinds of GDP growth rates that everyone expects.  Such a dramatic decline would almost certainly come with a very sharp economic slowdown, right?  I am having trouble accepting the consistency of inflation and GDP projections.

 

My own guess is that by May year-on-year inflation will exceed 10%, and that thereafter it will be very hard to bring the inflation level down much below that number.  This may be the most extreme view out there for now, but within a month or two I suspect that quite a few people will be projecting 10% inflation for 2008.  The key is what happens to non-food inflation.  So far it remains low but has been accelerating steadily all year.

 

On a separate note the stock market traded up today, for the first time in nearly a week.  The real interesting thing is how it traded up.  Last night the China Securities Regulatory Commission said that shareholders selling more than 1 percent of previously locked-up shares within a month must do so in single block trades.  They could not just sell them piecemeal into the market (although if they sell less than 1% a month they can do so).

 

The move was transparently intended to prop up the market, which has all but collapsed in recent weeks – and has lost half its value since its November peak.  One of the things apparently weighing on the minds of investors is the possibility of a deluge of previously non-traded shares coming to market.  By presumably making it more difficult to dump shares, this move was supposed to reassure the market and signal the government’s concern.

 

Leaving aside the fact that this move really doesn’t do much as far as I can see, the important thing was the signaling effect, and sure enough the market responded exactly as expected.  Within minutes of the opening the market was up around 6%.  Very shortly after its stunning open, the selling started and it had given back much of its upward move by the midday break.  Selling continued through the afternoon and by the close of day the market was up by less than three-quarters of one percent.

 

Needless to say this is pretty bad news for the long-term development of the markets.  The whole thing was nothing more than a very naked attempt by the government to intervene in the market and as far as I can tell there is not a single fund manger or analyst in China who does not see it that way – every press report in the morning had fund managers saying explicitly that this was intended to shore up the market, even while a few of them warned that it would have no real impact..  

 

What’s the message?  The same as always.  The local stock markets have nothing to do with fundamentals and everything to do with current government intentions.  This constant changing of the rules of the game to suit the current political mood is not the right way to create a well-functioning capital market that allocates capital efficiently.  This fairly blatant manipulation only ensures that the market will remain undeveloped, and a haven for insiders and speculators, for longer.

 

The only thing new, as far as I can see, is how rapidly the credibility of government intervention in the stock markets is eroding.  The market soared at first by an astonishing amount not because of the real impact of the new measure, but simply because of what it signaled.  It then gave nearly everything back within hours.

 

This was hardly unexpected.  Serial attempts by governments to manipulate markets always results in an erosion of the government’s ability to do so.