Given the close trade and economic ties between the Hong Kong Special Administrative Region (SAR) and the mainland, analysts said, at least some of the investment might be speculative funds.

It very well might.  The article goes on to say that Ministry of Commerce figures indicate that since 1978, 40.7% of all FDI entering China, or $331.9 billion, was sourced through Hong Kong.   

FDI in the first half of last year amounted to $36.0 billion, if I remember correctly, so using these Ministry of Commerce numbers I calculate that Hong Kong accounted for around 33% of that total.  For the first six months of 2008 FDI amounted to $52.4 billion, and the Ministry of Commerce numbers suggest that Hong Kong accounted for 45% of the total. 

If I am doing my calculations correctly this implies that the increase in Hong-Kong-sourced inflows accounted for 69% of the total increase in 2008 year to date.  Given that last year HK accounted for only 33% of FDI, contributing 69% of what was a large overall increase means that Hong Kong investors are clearly playing a disproportionately large role in that increase.

Of course I can’t prove it, but for all the obvious reasons it is probably safe to say that most of the hot money coming into the mainland comes from Hong Kong, from Taiwan, and from Chinese family business networks, so the fact that Hong Kong accounts for such a disproportionately large share of the rise in FDI is, at the very least, suspicious.  I think this is clearly more evidence, if any is needed, that much of the money coming into China is speculative.

By the way according to the Ministry of Commerce release, investment abroad by Chinese companies more than doubled in the first half or 2008, relative to the same period in 2007, to $25.7 billion.  I think this is pretty impressive, especially given that investing abroad is a tough proposition when you have an undervalued and appreciating currency.  The release did not specify how much of this investment was funded abroad, but I suspect much of it was, so the domestic monetary benefits of this outward investment are probably pretty limited.

Meanwhile the local stock markets seem to be in a less gloomy mood than they have been during the past few months.  The two strongly positive days (Monday and today) and the two mildly negative days have left the SSE Composite – which closed today at 2910 – up 4.75% so far this week.  Part of the improvement is probably due to declining international oil prices, but given that financials have been the leaders, I think that most of the improvement comes from speculation that inflation may be easing, or at least that the authorities are likely to take pressure off the monetary side in their bid to promote growth.

By the way I heard confirmation today from another friend of the rumors to which I referred earlier this week – that the infighting between the two main policy-making camps has gotten so fierce and so visible that part of the purpose of the recent leadership meeting was to broker a compromise and calm things down.  Unfortunately given the apparent current tilt towards “growth” within the leadership, I do not think this controversy is going to die down, and I expect that rising inflation later this year will re-ignite it.

This week’s rising bank stocks prices don’t mean that there isn’t nervousness in atleast some quarters about credit risks.  According to Jamil Anderlini in today’s Financial Times (“China’s banks told to tighten mortgages”):

Chinese officials and government economists have warned domestic banks to tighten their mortgage lending criteria after the US government’s action to prop up Fannie Mae and Freddie Mac, the giant mortgage agencies.  

Liu Mingkang, China’s top banking regulator, has in recent days urged the country’s state-owned commercial banks to beware of risks in the real estate sector and ordered them to tighten loan approval processes.  Others among China’s policy community have also begun to express concerns about the health of the country’s banks amid signs a once-booming property sector has begun to slow

Jamil goes on to quote Yi Xianrong, at the China Academy of Social Sciences, as making the very sensible observation that “If financial institutions of Freddie Mac and Fannie Mae’s calibre could get into such a bad situation, then what does that mean for Chinese financial institutions?  The only reason we haven’t seen similar problems here is because property prices have continued to rise rapidly.” 

Needless to say I think Mr. Yi is absolutely correct, and I expect that he will have proven to be when and if ( and I really just mean “when”) we see a serious monetary or economic contraction.  He elaborates:  “Anyone can get a mortgage loan in China, no matter who they are. There is also a huge amount of speculation in the market and insider dealing when it comes to bank officers granting loans.”

In that context I heard from a normally plugged-in friend of mine that the authorities are planning to reshuffle the top positions in the big banks after the Olympics.  My friend tells me that the new leaders are likely to be more sympathetic to industrial and provincial leaders’ beliefs that slowing growth is a bigger worry than rising inflation.  If true, I think we can expect to see deterioration in the credit quality of bank portfolios, even as they take on more market risk.

SASAC already announced yesterday that “China will restructure centrally administered state-owned enterprises after the Beijing Olympics”, according to Xinhua.  Perhaps this has something to do with the fact that profits at centrally administered SOEs are down 10.3% in the first half of 2008 (compared to up 30.9% last year).  I am not much of an expert on the industrial sector, and I don’t have a lot to say about this, but I was interested to see that Dong Tao at Credit Suisse says that this may indicate inflationary pressures:

We believe the weakened profit growth at the SOEs is a major concern. It suggests continued rising production costs and increasing pressures caused by the government’s caps on fuel prices and power tariffs.  Besides surging prices of raw materials, rising inflation expectations are leading to an acceleration in wage growth, in our view.  In addition, the continued losses in the oil refining and power production sectors have led to a further deterioration in fuel and power supplies. This may force Beijing to raise fuel prices and power tariffs again after the Olympics.  The shift in the source of inflation is of real concern, and we do not rule out the possibility of a second round of inflation as cost pressures continue to build.

The move will also safeguard the country's economic safety, protect ecological environment, optimize develop and reform mechanism, and prevent industrial monopolization, said the National Development and Reform Commission (NDRC) in a circular on Friday.  Projects that are not approved by the government, provide fake application materials, or use foreign exchanges improperly, will be punished.

Local governments will also investigate and supervise foreign enterprise-involved programs, including joint ventures, exclusively foreign-owned firms, bilateral cooperation projects, mergers and acquisition programs.  Meanwhile, regional economic regulators should look at the projects, monitor foreign exchange inflow channels, and enhance finance management of foreign enterprises.

With so many new, and economically intrusive, steps being taken to control hot money, it seems to me that the authorities are seriously worried about hot money, but in fairness I have to add that some analysts claim that their conversations with Chinese authorities suggest that while the authorities are watchful, they do not seem to be terribly concerned about hot money.  It is worth pointing out that there is no unanimity on the subject among China watchers. 

My friend Xinxin Li of The Observatory Group, for example, in his July 17 report, says that policy-makers think the market is overstating the hot money problem:

¨     Policymakers deem that the continuous capital inflows will not be as destructive as they were to other Asian economies in the 97-98 financial crisis.  They are largely not associated with China’s asset prices at present and there is no signal that hot money may flow out massively in the foreseeable future.  

¨     In Beijing’s view, hot money can be devastating only if some extreme scenarios occur to the Chinese economy, such as a financial crisis or war.  The current probabilities of these extreme cases are very small.  In addition, due to China’s strict capital controls, it is technically difficult for speculators to convert RMB back to foreign currencies and flee away from China.   

¨     Therefore, its major negative impact at present is the PBoC’s sterilization costs. Policymakers tend to downplay the role of hot money in China’s monetary creation, and do not view speculative inflows as a major driving force of China’s rising inflation and over‐investment.  

He concludes his report by saying:

In contrast to various market estimates, Beijing’s policymakers believe that the impact of hot money flows on the Chinese economy is limited and controllable.  They tend to use stricter capital controls to address continuous inflows, but are reluctant to allow a faster appreciation of the RMB.

He does say this in the context of their view that “the CASS report on $1.75tn hot money was irresponsible and misleading.”  According to Xinxin, SAFE was subsequently told to “ensure a right public understanding of the facts.”  In my opinion any claim that the sum of hot money in China amounts to $1.75 trillion is excessive, and I agree that the truth is likely to be a lot less dramatic, but if Xinxin is right about opinion among policy-makers (and he has had great information in the past), I would caution that when markets and policy makers disagree on the nature and size of a problem, it is not obvious to me that policy-makers have had a better track record of getting it right.

More specifically, many of the analysts and policy-makers insist on seeing the capital inflow problem exclusively in the context of the 1997 crisis, in which case the danger is that sudden outflows overwhelm the country’s foreign currency reserves, so that the currency is forced to depreciate, setting off massive financial distress in a corporate sector saddled with too much foreign-currency debt. This is also very close to the classic Latin American style financial crisis, except that in the latter the currency mismatch is usually on the government, rather than corporate, balance sheet.

This may be the wrong model.  I would argue that the danger for China is not a 1997-style crisis but rather a much more “American” form of financial crisis (I am thinking of the US in the 19th Century, but perhaps the current crisis is not so different), in which excess monetary expansion leads to severe overextension of the financial system and a vulnerability to a sudden contraction. In that case an unstable and risky banking system becomes the danger, not foreign debt, and the rapidity of hot money flows can lead first to financial imbalances and then to rapid financial contraction.

At any rate, and leaving aside the question of whether or not the PBoC is very worried about hot money, will these new controls have much effect? Perhaps, but I would guess that there isn’t likely to have been much more than $20 billion that came in this year through the FDI account, whereas the actual amount of unexplained, and possibly hot, inflow is many times that amount.  Going after speculative inflows through the registered trade and FDI accounts may be relatively easy, but I am not sure that they justify the disruptions to real economic activity.

Where there does seem to be greater unanimity among economic analysts is that the pro-growth shift in thinking among the most senior leaders, towards concerns about an economic slowing, has been pretty complete, even if the PBoC and some of its allies in the NDRC and the National Bureau of Statistics are still worrying about excessively loose monetary policy.  Today’s South China Morning Post has an article by Carey Huang subtitled “Top leaders to meet over slowing growth” that says:

The nation's top decision-making body, the Politburo, will meet this week to consider major economic policy for the mainland for the rest of the year amid growing concerns over slowing growth, rising inflation and, in particular, a dramatic decline in exports as the global economy slows.  All the most senior leaders completed fact-finding missions to economic strongholds and key export bases early this week, according to reliable sources.

The fact that they are holding this presumably urgent meeting just two weeks before the beginning of the all-important Olympics suggest that they are very worried about the possibility of an economic slowdown, even while inflation continues to nag at them.  One argument making the rounds is that the political infighting between the pro-growth camp and the monetary alarmists has gotten ugly enough and visible enough that the leaders are trying to smooth things over and broker a compromise.  

This may be true, and it wouldn’t surprise me at all.  My impression, and that of many of the people I talk to, however, is that there is a real worry that the normal macroeconomic tools aren’t working and that policy-makers don’t know what to do. I expect we’ll see more piecemeal policies and tinkering on the side, especially with administrative measures, for the next few months or so.  I think it will still require a big increase in inflation to concentrate policy-making.

There is another piece of news that is several (four) days old but which I wanted to address.  According to an article in Bloomberg, “China's stockpile of unsold new vehicles rose about 50 percent in the six months ended June, hitting a four-year high, as automakers expanded production and sales growth slowed.”

I don’t want to make too much of this single data point, but I have often argued (and do again above) that China’s financial cycle is going to look more like the overproduction cycles in the US of the 19th and early 20th centuries than the sequence of events that led to Latin American financial crises or the 1997 Asian crisis.  If that is true, one of the classic events to watch for is a sudden run-up of inventory as excessively loose monetary conditions lead to overcapacity in the industrial sector.  So far, China’s exports markets have been able to absorb its periods of excess capacity, but as Chinese production gets larger relative to the world economy, and as global demand contracts, it will be harder and harder for the world to absorb Chinese overproduction.

I don’t think we have reached the point of worry yet, but rising inventories are one of the three main triggers I watch for as an indication of the beginning of trouble for the financial system (the other two are rising inflation and bank deposit withdrawals).

Second-quarter housing prices in 70 large and medium-sized Chinese cities rose 9.2 percent year-on-year, said the National Development and Reform Commission and the National Bureau of Statistics on Monday.  The rise was 1.8 percentage points less than in the first quarter.

One of the regular debates on this and other sites is over whether there really is a problem of excessive hot money inflows, as I have been arguing for over a year.  If stock market and real estate prices are collapsing, skeptics ask, then how can hot money inflow be excessive?  Where does the money go? 

Aside from the fact that there are many other places where hot money can go (commercial bank deposits, deposits in informal banks, and commodity hoarding are just three of the most obvious), I think we have to distinguish between slowing growth in real estate prices and declining prices.  There are declining prices in certain real estate sectors – for example in some of the major cities – but overall prices still continue to rise, even in spite of what seems to have been massive overbuilding.  It is hard to prove this, but the combination of overbuilding, hot money inflows, and all the gossip about SUVs carrying armed men in sunglasses and bags of cash suggests plausibly that hot money inflows have managed to keep up demand for real estate in what otherwise might have been a sharper supply/demand imbalance,.

Gregor Neumann, in the comments to Friday’s posting, cites a piece that argues that at least some property markets in China are seriously oversupplied, and yet we haven’t seen a real collapse in real estate prices anywhere.  I think we are seeing a tug of war between oversupply and excess monetary-based demand.  I am not a real estate expert and I hesitate to speak authoritatively on this very complex subject, but any time spent over drinks with my more expert friends in the real estate business leaves me very gloomy about the impact of an economic or monetary contraction on the real estate sector.

But for today we should be cheerful.  A great start to the week saw the SSE Composite run up 2.99% today to close at 2861.  Financial companies led the rise after CITIC reported better-than-expected earnings, although you might not have guessed it from Xinhua’s article headlined, “Slump hits CITIC’s profit rise”, which said that the collapsing stock market had slowed first half profit growth to 13.3%.  Over the weekend meetings among senior officials suggest that the authorities are still tilting towards an economic slowdown as the more serious of two problems (the other being, of course, inflation) and so most of us continue to think we are less likely to see dramatic tightening moves in the immediate future.  That is likely to be good generally for financial and real estate companies.

The stock market was also helped by an article in China Securities Journal that said that regulators would slow approvals for stock sales in order to ensure “stable and healthy” markets.  This doesn’t come as a big surprise, but because it does indicate continued government concern about the performance of the market this year, people see it as yet another signal that the government will intervene to stabilize the market..

On that subject the current issue of Caijing has a very interesting article, in which they say “A report that criticized regulatory intervention in the securities market appeared briefly July 16 on the official Web site of the Shenzhen Stock Exchange (SZSE) before being quickly removed.”  The article goes on to say:

The 129-page report, compiled by the research arm of SZSE, said China's “securities regulatory bodies intervene too often and distort normal market operations.” The report also said misplaced regulatory clout partially contributed to widespread illegal activity on the mainland bourses in Shenzhen and Shanghai.   

An anonymous source at SZSE told Caijing that exchange officials had asked the Web manager to remove the report the night of July 16 because “further review is needed about the content, and it will be published in the future when the timing is right.”

The now-you-see-it, now-you-don't report shed light on what the authors said are four major factors behind illegal market behavior last year: legislation, the market, participants and regulations. The report said the China Securities Regulatory Commission (CSRC) had expanded its jurisdiction with little oversight, and now oversees a wide range of issues including professional standards, business approvals, IPO regulation, and investor education. Meanwhile, CSRC gave itself the right to make rules as well as supervise the nation’s bourses, and had assumed a bailout role during market troubles.

The report said the current securities market is “overburdened with administrative regulations.”  According to the report, CSRC's overbearing control contributed to irrational swings in the stock market, since administrative commands often hindered market mechanisms and poor implementation of regulations -- included some laws flawed from the start -- disrupted market order. Gray legal areas also leave the market open to exploitation.

There was also a call for better supervision of regulatory bodies and the media. The report suggested a securities court and arbitration bodies that could interpret existing laws, strengthen law enforcement and launch class action lawsuits.   The report also said lax law enforcement, not a clean market, is the reason why China has been reporting few insider trading cases.

None of these criticisms are new or surprising, of course, and I have made the point dozens of times on this blog that the overbearing administrative measures used by authorities to control the market actually have the effect of increasing speculative behavior and volatility.  What this report suggests is that there is a real attempt internally to roll back government heavy-handedness, although I am pretty skeptical that it will succeed.  The article also suggests how powerful, important and perhaps even necessary to China’s further development Caijing is, that they can openly discuss a report that seems to have been suppressed almost immediately upon publication.

Finally, following up on last Thursday’s post, today’s South China Morning Post says “Chongqing starts to ration power.”  Chongqing is one of the largest cities in China and the world, and one of four cities in China separated from their provinces and granted provincial status as municipalities (the others are Beijing, Shanghai and Tianjin).  Within China people often think of Chongqing as a sort of Chicago, the large urban and industrial gateway to the west.  According to the article, brownouts and declining coal stocks have forced the city to join more than a dozen other provinces in rationing power.  This has been a long, hot summer, and it isn’t over yet.

Cui Enze, one of my Peking University students currently completing a summer internship at Van Eck in New York, was nice enough to sleuth out the CPI numbers for me on the National Bureau of Statistics of China website.  According to him, this is the breakdown of the food and non-food components of CPI:

Without the actual index numbers, it is hard to extract much information from this series except to note the obvious – that non-food inflation is low but rising.  If I make a simplifying assumption that non-food inflation last year ranged from zero to 1%, it implies that non-food inflation year to date is probably running at an annualized pace of 2-3/4% to 3-3/4%.  This is not particularly high in itself, but remember that these numbers are being held down by price controls and, more importantly, that if Chinese monetary policy were consistent with low inflation, the surge in food prices should have caused at least some deflation in non-food prices.

Enze also sent me a separate note in which he alerted me to an article in this week’s Caijing

Just read news on the Caijing website that the CEO of a big private company (GoldenSun) in Yi Wu of Zhejiang province disappeared the other day.  The reason is that this company has 1.4 billion RMB outstanding debt which was borrowed through informal banks. Of the 1.4 billion, 800 million is principal and 600 million is interest not paid. The asset of this company has been audited or sold to repay part of debt.

This company had been borrowing through informal banks at an interest rate of only 2%-3% in 2005, but ever since late 2007, the interest rate has climbed as high as 12%, which brings a huge cash flow pressure to the private companies in Zhejiang. This year, several other owners of private companies in Yi Wu have fled because they can't repay the high interest.  As most of the small companies in Zhejiang are export companies, the RMB appreciation and rising price of raw materials have significantly reduced their profit margin.

I checked the English version of Caijing and saw the story, although it didn’t have as much information as the Chinese version which Enze cites.  It did say the following:

A source told Caijing that Zhang raised money through a local version of China’s informal “gao li dai” credit system, which lets private individuals lend cash at high interest rates to persons or companies through go-betweens known as “hui tou.”  The system flourishes thanks to legal loopholes.  In Zhang’s case, the hui tou allegedly included local officials and lawyers. Many lenders mortgaged homes to raise the money that Zhang borrowed over the past two years, the source said.

The article closes by quoting a Yiwu-area banker as saying: “More bosses will flee later this year.”  I suspect that these sorts of stories are going to become more common.

For now I don’t know how common these sorts of defaults are likely to be, but at least this article does address one question that comes up a lot.  I have often heard people assert that the informal banking system is not a significant source of banking risk because loans are too small to matter, even in the case of serial default.  But this story involves loans from the informal sector of significantly more than $100 million to one client.  This sounds like regular banking to me.

Another student, who wants to remain anonymous for obvious reasons, also sent me an interesting note today (it’s great to have such great students).  He is spending the summer as an intern at one of the larger and better city commercial banks in the southeast.  He tells me (with some editing on my part, largely to hide names):

We saw some weird stuff yesterday in the money market.  If you only looked at the money rate, it was a normal day, but in the real market, a Big Four bank unexpectedly ran out of liquidity, and they were asking for money eagerly from other banks.  Because this bank is a major money-provider in the market, small or city banks like us cannot lend them money at a very high rate (because of their power and "mianzi").  We worry that they may punish us later when we lack money ourselves, so most of us choose to say: "Sorry, but we also lack money."

It wasn’t until 3:30 in the afternoon, that the bank finally got the money it needed, but because of their lack of money, small banks also could not borrow.  Our bank was also caught in this trap and not able to borrow one cent before 3:30.

My student goes on to tell me that his money market traders told him that these sorts of liquidity squeezes have become increasingly common during this quarter.  I haven’t been able fully to figure out what this means.  It may simply be the expected consequence of the several hikes in minimum reserve requirements.  If so, this puts a little hair on the statement I cited yesterday by a banking regulator who warned that further reserve hikes were hurting the system. 

I wonder if anyone else among my readers saw something similar and can explain what happened or how common it is.  One of the few things I learned from my banking classes at Columbia Business School (and amply confirmed in my many years as a bond trader) is that problems in the banking system usually first turn up in the plumbing – the otherwise very unglamorous  money markets.  I always tell my finance students to keep an eye on the money markets, and I am glad to see that at least one of them has taken me seriously.

PPI numbers, also as expected, were much worse.  PPI prices rose 8.8% year on year in June, compared to 8.2% in May, 8.1% in April, and 8.0% in March.  I have already pointed out many times before that as the CPI numbers become increasingly tainted by price controls, more and more of us are looking at PPI to get a sense of underlying inflationary pressures.  I think any sense of relief prompted by the continued decline in CPI inflation will be held in check by the frankly very poor PPI numbers.  

On a related topic today’s Financial Times has an interesting article by Jamil Anderlini and Geoff Dyer with the rather worrying title "China on the brink of electricity shortfall."  

China faces its worst power shortage in at least four years as soaring coal prices and government-set electricity tariffs force dozens of small power plants to shut down rather than face mounting losses.  Nearly half of China’s provinces have started to ration electricity as the country enters the peak summer season, facing what analysts describe as its worst coal shortage.  

 

Analysts warn that this year’s electricity shortfall could be more severe than in 2004, when the country was affected by its worst power shortage in decades because of soaring demand for power as the economy boomed.  

This is part of the problem with the inflation numbers.  We are exchanging higher prices for shortages, and although one is as much an indication of inflationary pressure as the other, only the former shows up in the CPI and PPI numbers.  These kinds of shortages (and there are many more) are masking very real inflationary pressures, but earlier experience, such as those of the US in the 1970s, suggest that shortages are only a temporary way to mask inflation.  I expect price increases will have to occur soon.  

In general I don’t think the numbers today are going to help the economic policy-makers reach any kind of firm conclusion one way or the other.  GDP growth has slowed, according to today’s release, but a slowing to 10.1% growth in the second quarter (from 10.6% in the first), although slightly lower than expectations (and the lowest in three years), shouldn’t be enough to strike terror just yet., especially since, worryingly enough, fixed asset investment surged, by 26.8%, compared to 25.6% in the first five months of the year.  This suggests that if the economy is moderating, it is not because of a decline in the overinvestment problem.  

None of us really expected this batch of numbers to do much to clarify policy-making, and that is more or less what happened.  That won’t stop the lobbying, of course.  The Ministry of Commerce and its allies are stepping up the pressure to limit RMB appreciation, even though it is very hard to conclude from the numbers that Chinese exports are suffering because of currency appreciation.  In fact export growth is remarkably strong given the slowdown in global demand and the high price of commodities.    

I suspect the debate about whether or not to further "tighten" monetary conditions will also rage on.  In his article on the data release Dong Zhixi in today's China Daily put it this way:  

These concerns may be part of the reasons why the finance committee of the National People’s Congress, China's parliament, pledged on Wednesday to maintain its tight monetary policy for the rest of the year.  However, watchers sensed a softening of words in its description of the fight against inflation. The committee said curbing price pressures would be a "prominent task" in the months ahead, instead of "top priority," phrasing that economic leaders repeated in the early months of 2008.  

 

Analysts believe policy makers are trying to find a balance between inflation and economy growth and are gradually shifting towards preventing a major economic slowdown.  

In that context Bloomberg has an interesting article today, although it is a little hard to evaluate its importance.  In a piece called "China Regulator Warns Against Further Bank Tightening", the article says:  

China’s banking regulator told policy makers that forcing banks to increase reserves has hurt the industry's ability to repay debt, according to a person with knowledge of the matter.  The People's Bank of China raised its reserve ratio requirement to a record 17.5 percent last month to rein in loan growth and inflation. The China Banking Regulatory Commission has warned against ordering further increases, the person said, declining to be identified as he isn't authorized to speak publicly on the matter.  

 

China's push to remove funds from the banking system resulted in the slowest loan growth in more than two years last month. The risk is that more banks will fall below the minimum requirement for short-term financial strength, the person said.  

Amid all the economic data, the stock markets continue to be depressed.  The SSE Composite drifted more or less steadily downward today, to close at 2685, down 0.78% for the day.  So far I haven’t heard too much angry noise coming from investors, perhaps because last week was pretty good (up nearly 8%), but I did read with some dread a report on today’s Bloomberg that says “Pakistan investors stormed out of the Karachi Stock Exchange, smashed windows and cursed regulators after the benchmark index fell for a 15th day, the worst losing streak in at least 18 years.”

Several things drove the decline.  The market is still very worried about the threats of a slowing economy and rising costs, and their impacts on corporate profits.  On the positive side, this has seemed to suggest in the past that the authorities would loosen up on money and credit conditions.  But the market is also nonetheless very concerned that the financial authorities will maintain a “tight” monetary policy – i.e. raise interest rates, hike minimum reserve requirements, or otherwise constrain lending growth.  According to today’s China Daily, “Chinese shares declined for the second day on Wednesday, led by property developers and banks on concerns they would be further pressured by the continuing tightening monetary policies.”

There continues to be a lot of confusion about government intentions.  Recent statements by several very senior leaders seemed to suggest that they were downgrading inflation as their top concern and turning more worriedly to slowing economic growth.  I still think this to be true, but the RMB has continued to rise and we continue to hear very hawkish statements about inflation and the currency.  We get a bunch of economic data tomorrow, and I hope these new numbers will provide us with a better sense of what is happening in China.

As an aside I had lunch with a group of investment bankers today to discuss monetary policy and financial risk.  At one point, perhaps a little impatiently, one of them turned to me and said, “Look. I am a very direct woman. I just want to know if the stock market will go up or down before the Olympics.”

Well, I am a pretty direct man.  I really don’t know.  Predictions about the direction of the stock markets are usually anchored in some notion of value, but in purely speculative markets like those of China, notions of value, even coming from someone as subtle as Warren Buffet, don’t really mean much except over a very long horizon.  In the immediate term, the markets are going to be affected almost wholly by government action, abrupt changes in monetary conditions, and sentiment.  I am not sure I would want to predict any of those things.  Overall, however, I am not very bullish.  I understand that a lot of investors are still desperately hanging onto losing positions begging for a chance to recoup their losses so that they can bail out.  This kind of trading strategy usually limits the upside and drags out the downside.  If forced I’d rather be short than long, but in fact I’d rather be in cash.

On a separate note eagle-eyed Jonathan Lerner sent me the following very interesting article from today’s Bloomberg:

Xia Says Yuan Should Rise Quickly, Then Level, Journal Reports

By Zhang Dingmin

July 16 (Bloomberg) -- Xia Bin, a former official at the People's Bank of China, said the nation's exchange rate policy should be aimed at disrupting expectations of continued currency appreciation, the China Securities Journal reported.

Xia said the government should allow the yuan to rise against the U.S. dollar to “a certain level” in a “relatively short” period of time, then keep it stable and allow for depreciation when the dollar strengthens, the newspaper reported today. Xia now heads the financial institute of the State Council's Development Research Center.

I searched Bloomberg and Xinhua and wasn’t able to find it, so I can’t link it.

There has been mixed news on the whether or not inflation is still the top worry.  There have certainly been a lot of statements that suggest that the authorities are very worried about a slowdown, and even some suggestions that they are willing to put the fight against inflation on hold, but a statement released by the NDRC yesterday, in which they said that “upward pressure on prices remains strong” seemed to dampen at least some expectations that the government would loosen up on the monetary side.

I am still a monetary pessimistic.  I think the balance of opinion, or at least the opinion that matters, is tilted towards putting inflation-fighting on the back seat and worrying more about a possible slowdown.  I am worried that our inflation respite is going to be temporary, and certainly the data on money inflows doesn’t make it easy to be optimistic about the ability of the PBoC to control inflation.

On the other hand today’s Sydney Morning Herald has a very interesting article by John Garnaut (“Chinese calls for yuan rise to ease inflation”) that was sent to me by Jonathan Lerner, and I haven’t seen any other reference to the story.  The article starts out:

A GROWING number of top Chinese economists are advising their Government to consider a currency revaluation to fight persistent inflation and destabilising "hot money" capital inflows.  “The Chinese currency should be revalued as China's productivity is increasing," Professor Fan Gang, a member of the central bank's monetary committee, wrote in a paper that he was to present to the China Update conference in Canberra before being held back for a last-minute meeting with the Prime Minister, Wen Jiabao.

In recent years currency revaluation has been a taboo topic among Chinese policy makers.

The article goes on the quote He Fan, the assistant director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, telling Garnaut that “They don't need to say they are floating the exchange rate but they can at least test the market's view. With a one-off appreciation by 10 or 15 per cent, maybe the market will believe that's the end of the story. But maybe the market will still not be satisfied.”

There have been more and more think-tank and quasi-official comments recently about the one-off appreciation, and I suspect that the debate is fairly intense.  Yesterday evening I was with another senior think-tanker, who I have met several times on Dialogue and who has a very sophisticated view of the Chinese economy.  He told me flatly that the only hope of protecting China from the ravages of hot money was to peg the currency.  Since pegging it at these levels would be problematic for many reasons, he said that the PBoC should “surprise” everybody by first revaluing, and then pegging.  He told me that he thought the revaluation should be 5-10%, but agreed that this might be too little.

The Sydney Morning Herald article goes on the describe something that I think is extremely important and has perhaps been under-emphasized in the debate – the destabilizing impact of excessively loose monetary policy on the banking system.  Referring to the pressures on bank profitability caused by PBoC strategies to mop up liquidity, the article says:

Mr He said the main state-owned commercial banks were already devoting between 30 per cent and 40 per cent of their assets to such loss-making endeavours. This was creating "ugly" bank balance sheets and encouraging the banks to recoup profits with "dangerous" lending policies that might ultimately jeopardise financial stability and the Government's efforts to clean up non-performing loans

In his paper, Professor Fan writes that analysts have "correctly and convincingly" highlighted "structural distortions caused by repressed interest rates and an undervalued currency" which "may also lead to economic, financial and social problems".  His comments are significant because Professor Fan was previously a staunch defender of the status quo. Nevertheless, a one-off revaluation is unlikely in the near term because China's export sector is suffering from a downturn in their major developed-world markets and struggling to cope with rapidly rising input costs.

The idea of “dangerous” lending that is likely to be caused by excess control of parts of the system (their forced piling up of PBoC bills and minimum reserves) and by current monetary and credit conditions is something about which I have had a surprisingly hard time arguing, both with Chinese and with foreign analysts.  I am not sure why, since in most markets this is fairly well understood, and given the ongoing crisis in the US, the idea that seemingly smart banks can do some pretty dumb things during optimal times is getting quite a lot of newspaper coverage. 

None of this is new.  Hyman Minsky in particular, has long argued that it is impossible to protect financial systems from periodic crises because the very conditions designed to prevent instability are the ones that create the incentives for bankers to take excessive risk – usually in less well-monitored areas – that end up ensuring that at some point the system will go through a period of “adjustment” and distress.  The empirical evidence that loose monetary conditions and implicit or explicit credit guarantees lead to banking crises is also pretty ample.

I can’t prove it, of course, and no one will be able to prove it until we have our own contraction, but I would be willing to bet that over the last few years the banks and the financial sector in China have been engaging in behavior that will one day seem self-evidently dangerous.  That is both the biggest risk of a sudden revaluation and the strongest argument for doing it as soon as possible.

Speaking of monitoring the banking system, I saw another very interesting piece, this time in ChinaStakes.com (“Government Moves to Legitimize Underground Lending in Zhejiang”).  The title says it all, but here is what the article says:

In Zhejiang Province, with the most developed private companies and private capital in China, the government is trying to legitimize private capital, and set up small-sum loan companies to connect private capital with capital-hungry private companies.  The tight credit policy has driven many small and medium enterprises into hardship and even bankruptcy in coastal provinces like Zhejiang Province. Normally, formal banks, especially the state-owned banks, are reluctant to lend to private companies.

However, Zhejiang is also famous for its so-called underground banking, or back-alley banks as some analysts put it. The government has never issued lending licenses to them.  For some central bankers, like Wu Xiaoling, the former deputy governor of the People’s Bank of China, small-sum loans are an alternative under the current tight monetary policy in place in China.

So now Zhejiang is carrying out a pilot scheme for petty loan firms. If everything goes well, the first small-sum loan companies will start operations in September this year, and their experiences will help to set up more companies of this kind.  Zhejiang is the first province to react to the Guiding Opinions of the China Banking Regulatory Commission and the People’s Bank of China on the Pilot Operation of Small-Sum Loan Companies, which was released in May.

The article goes on to say:

The government has set strict limits for the establishment of small-sum loan companies in order to guarantee their development. According to the regulations in Zhejiang, investors in these loan companies should be chosen from private companies with regular management, sound credit, and are well-operated. The net assets of these companies should not be less than 50 million yuan (or 20 million yuan in less developed areas), and the asset liability ratio no higher than 70%. They should have made profits for three straight years and the total profits should be no less than 15 million yuan (or 6 million yuan in less developed areas).

The government has also banned these companies from collecting deposits or illegally raising funds from the public. Their loans should be dispersed to different businesses in small sums.

The “informal” banks are in many ways among the better-functioning parts of the financial system, although their dubious legal status means that it is probably hard for them to raise money and to collect on bad loans.  This of course raises their cost and forces them into otherwise non-economic behavior – for example I suspect that they tend to insist on short-term loans even when longer-maturities might be optimal – but at least their capital allocation process is probably better in many ways than that of the commercial banks.  Bringing them into the regulatory fold and improving their legal status will almost certainly improve China’s financial system.

Given that the trade surplus and FDI for the month were $21.3 billion and $9.6 billion, respectively, June’s $11.9 billion number is almost certainly going to cause some unnecessary excitement about flight capital.  June’s increase is the lowest monthly increase in a long time, and a lot less than the $54 billion average for the first five months of the year, but most of us were expecting June’s number to be a lot lower than average – in my July 9 entry I guessed it would be about $20 billion.  The main reason for this was June’s 100 basis point increase in minimum reserve requirements, which we believe was redenominated into dollars, thus bringing headline reserve growth down by about $45 billion.

That means the actual amount of net inflows purchased and monetized by the PBoC in June was actually around $57 billion, which is a lot lower than the $67 billion average for the first five months of the year, but this average number includes the two extraordinary months of January and April.  Excluding these, June’s numbers are fairly typical.  The table below shows what really happened, as far as I can piece it together: