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Some new numbers on money supply have come out.  Total M2 is 38.4 trillion RMB, having grown 18.5% from last July.  In June it was up 17.1% year on year, and the PBoC claims it is trying to cap growth at 16%.  M1 is also up substantially year on year -- 20.9%.

There were 231.4 billion RMB of new loans in July, bringing the total for this year to 2.77 trillion RMB.  According to the South China Morning Post today this is equal to 87% of all of last year's loans.  During the first seven months of 2006 total new loans amounted to 2.34 trillion RMB, so new loans year to date are 18% higher this year than last year.

Total loans in the banking system are 26.75 trillion RMB, so loan growth year to date has been 11% for the first seven months of the year (or 21% on an annualized basis, if we were to assume the same level of new loans over the rest of the year).  I don't have July month-end numbers but my estimate for 12-month GDP is 19.9 trillion RMB (roughly $2.6 trillion), so that total loans are equal to about 135% of GDP.

What these very dry numbers indicate is that, at least for people like me who believe that monetary policy in China is in trouble, things continue to deteriorate.  Money growth is excessive (and sterilization is pretty ineffective) and loan growth is worse.  This expansion in credit ends up mostly in the expansion of productive facilities, and so growth in production will continue to outstrip growth in consumption.

A country's trade surplus is simply the excess of its production over its consumption, so as production surges, China's trade surplus is stuck on "accelerate".  This means that the trade surplus will continue to stay high, or grow, sucking in even more money into China which the PBoC must monetize, so causing further money supply and loan growth, which brings us right back to the beginning of the process. 

Of course as these numbers grow, the pressure for speedier pace of revaluation (or a sudden maxi-revaluation, which is what I expect eventually to happen) also increases, and speculative inflows add to the pressure. 

I should point out that speculative inflows are not necessarily, or even mainly, caused by the proverbial nasty speculator.  Last night a friend who works in the Spanish consulate in Beijing told me that since her salary is set in dollars (neither she nor I could figure out why the Spanish consulate in Beijing would set salaries in dollars), the appreciating RMB was eroding her purchasing power and, in order to protect her income, she was trying to convert as many dollars as possible into RMB. She, and millions of people like her trying to protect their savings or income (and me too, I should add), are one of the biggest sources of speculative inflows.   It would be hard to stop this without causing a great deal of hardship.

Brad Setser has an excellent and very thoughtful posting on his blog, called The Balance of Financial Terror (see it at http://www.rgemonitor.com/blog/setser/209711)

In discussing whether or not China can change its policy of accumulating dollars, he says  "China would be better off financially if it let the RMB appreciate substantially, stopped financing the US and took large losses now rather than continuing to finance the US, adding to its stock of dollars and adding to the scale of its future losses.   A bank that is lending to a failing company reduces its ultimate loss by cutting the company off and taking its lumps now, not by covering ever bigger losses with new loans to avoid “turmoil.”  China is in a similar position.  The US isn’t a failing company, but China is lending to the US on terms that imply very large financial losses for China."

Well said, and spoken like a trader.  One of the arguments often made, by those arguing that China should not revalue, is that any appreciation in the RMB would imply a loss on the value of its dollar holdings.  Aside from the fact that the local currency value of foreign reserves doesn't matter except to the extent that the central bank may become insolvent, which is not the case in China (this is because reserves can only be used to purchase foreign assets, so what matters is not the value of dollars in RMB terms but rather the value of the dollar in terms of China's basket of external debt and foreign imports), it doesn't make sense to protect a losing position by adding on more losing assets. 

If the dollar is undervalued relative to the RMB, rather than try to protect it from adjusting by accumulating more dollars at the current RMB price, the PBoC should raise the price at which it buys them (i.e. revalue the RMB).  Otherwise it is simply adding to its underwater position, which doesn't make sense if you are concerned about the value of your holdings.

This leads to a whole discussion about whether the existing trade relationship between the US and China is harmful for the US and/or China.  I would argue that it benefits the US moderately and in some ways it actually hurts China, but because of concerns about the impact of export growth on reducing unemployment, China is stuck with the system, at least for the near future.

The way I see it, there are three different areas of concern that many Americans and Chinese have about the existing trade and capital flow relationship between the two countries.  These are the current costs and benefits of the relationship, the balance sheet implications, and the question of sustainability.

As far as the current costs go, the way I see the relationship is that China is exchanging massive amounts of goods for US financial assets.  Thanks to the undervalued RMB it is delivering those goods at a very low price and taking in assets at a very high price (by keeping US interest rates low).  The US gets the benefit of high consumption at bargain prices.  It does not pay the associated cost (of low savings) because, although its savings rate is low, and although most countries' invesment rates are constrained by their domestic savings rate, the US has such an open financial system that its investment rate depends on global savings, not domestic savings.

For the US this is a good trade -- buy cheap and sell dear.  Of course this does not mean that everyone in the US benefits, and it is perfectly reasonable for Americans to demand that costs and benefits are shared fairly, but eliminating this relationship may help some parts of the country at the expense of the country overall.

For the Chinese, this trade relationship is in some ways less beneficial, but they have locked themselves into policies that allow them little room to manuever.  Rising unemployment is a great concern for the leadership, and they are essentially willing to give away the shop in order to keep employment growth in the near term -- one way of looking at it is that they are paying to trade Chinese unemployment in the short term for US unemployment in the short term (which is maybe one way of defining mercantilism).  Unfortunately however their currency regime has locked them into an out-of-control monetary policy that may eventually require a very sharp, and perhaps ugly, adjustment.

The second area of concern as I see it is the balance sheet implications of this relationship, and it is the national balance sheet that determines how a country reacts to shocks and how financial shocks are transmitted into the real economy.  From the Chinese point of view, the balance sheet consequences are complex, and not very good in my opinion.  At first everything seems rosy -- the Chinese are accumulating huge amounts of reserves, with little external debt, so they are absolutely protected from the possibility of a financial crisis, right?

Wrong.  We make a serious mistake when we assume that crises are, by definition, currency or external debt crises.  Some are, most aren't.  In the 19th century the US had a whole series of financial crisies -- one nearly every ten or fifteen years -- but none of them involved external debt to a significant extent except perhaps in 1837, and all of them, including the 1837 crisis, were primarily caused by breakdowns in the domestic financial system. 

This is where China is running a significant risk.  China's brutally mercantilist trade policies coupled with its rigid currency regime may be condemning it to a sharp increase in non-performing loans, industrial overcapacity, and rising (hidden) government debt.  This creates all the classic balance sheet vulnerabilities.  A sufficiently large adverse shock could quickly lead to an unravelling of the national financial system, which is very fragile and is completely dominated by rigidly managed banks with little transparency, weak governance, and almost no experience in risk management.

Analysts who point to China's huge reserves as proof that it can buy its way out of a crisis simply do not get it.  A domestic financial crisis cannot be fixed with foreign currency reserves.  Aside from the fact that foreign currency cannot be spent domestically, these reserves are the asset side of the PBoC balance sheet, and they are balanced by domestic borrowings.  Any spending of reserves would result in a net increase in PBoC debt.  Since a domestic crisis will almost certainly involve concerns about excess government debt levels (which I suspect are already much higher than most of us realize), it is unlikely that they can spend themselves out of a crisis because that will mean increasing total debt.

If you need more convincing that record levels of central bank reserves are not the obvious antidote to financial crisis, consider the US in 1929.  Several year of massive trade surpluses and capital inflows -- turning it into the world's leading creditor nation and leading it to accumulate, in Keynes' words, "all the gold in the world" -- were of no avail in protecting it from the Great Depression, which started as a domestic financial crisis (and never involved external debt at all).

If the balance sheet implications for China of the current system are worrisome, the balance sheet implications for the US are less dire.  Brad Setser in the same blog entry quotes a statement by Larry Summers in which he says "There is surely something odd about the world’s greatest power being the world’s greatest debtor."

But there is nothing odd about this at all.  Any country that acts as a safe haven for foreign savings, or provides great investment opportunities, runs the risk of becoming a net capital importer.  Any country that is a net capital importer must run a trade deficit, and if it consistently runs a trade deficit it can become a large net debtor to the rest of the world.  Just before WWI, for example, the US was the world's largest debtor nation because for generations European investors were eager to finance US development in order to share financially in the benefits of US growth (and in so doing they forced the US into a trade deficit position for much of its history).

This would be a worry if the accumulation of debt led either to an inability to repay or to balance sheet instabilities that made the US vulnerable to a crisis.  Neither is the case.  Total external debt may seem like a largish number when compared to GDP, but of course this is the wrong comparison.  Either total external debt should be measured against total external and net domestic assets, or net external debt servicing costs should be measured against GDP.  I am not sure what the value of total assets is in the US, but I am certain that it completely dwarfs external debt.  The World Bank estimates total US wealth as of 2000 to be nearly $150 trillion ("Where is the Wealth of Nations", World Bank: 2006).  Similarly, net payments (what Americans pay foreigners on foreign investment in the US minus what foreigners pay Americans for investments abroad) are very low and tiny compared with the ability of the US to finance it.

Moreover the US has a well-structured balance sheet and a very flexible financial system.  Unlike many other countries, including China, it's external obligations are mostly structured in what I call in my book "correlated" obligations, such that events that triggered payment difficulties would automatically lessen the burden of those payments.   This significantly reduces the possibility of exploding debt that is a fundamental factor in every debt crisis.

If the US were a corporation it would be a triple-A-rated company with the added benefit that it could print the money to pay off most of its obligations if it ever needed to.  At any rate if you believe, as I do, that the US trade deficit is not "caused" by excess US consumption (except by definition, of course) but rather by excess foreign investment, it would be hard to imagine that the US faced a financing crisis. 

The third area of concern is the question of sustainability, and I promise this will be my last entry on this accursed subject (at least for now).  One of the things that worries most obervers about the US trade deficit, even if they think it is currently manageable, is whether it is sustainable.  If the US runs trade deficits equal to 5% or more of GDP forever, they worry, at some point external debt levels will accumulate to the point where the US will be unable to pay, except at a terrible cost to domestic consumption and wealth.

This is true arithmetically only as long as the total value of US assets grows less than the amount of the US current account deficit.  I have no idea if this is or isn't happening, but it seems to me that one of the consequences of foreign investment in the US historically has been that total US wealth always climbs faster than foreign claims on US wealth, and I see no reason to assume it isn't still happening.  If this is indeed happening there is no reason why US trade deficits cannot go on forever, as they have for most of our history.

But they won't go on forever anyway.  I already mentioned that on the eve of WWI the US was the world's leading debtor nation, and it is worth noting that it was the world's leading creditor nation four years later.  How did that happen?  Obviously enough the European belligerents had to liquidate their US investments profitably accumulated over generations in order to pay for the war.  They then ran substantial trade deficits with the US during the war, resulting in a massive accumulation of US claims against them.

I think something like this is going to happen in the next few decades -- not because of war but because of something that will have any equally dire economic impact.  Europe, Japan, China and Russia all face severe demographic crises which will probably entail rising consumption levels and flat or declining production as their working populations decline as a share of total population.  That means they all are likely to run long term trade deficits at some point in the future as they work themselves through their crises.

The US on the other hand is the only major country, besides India, that doesn't have a serious demographic crisis looming (it has a pension crisis, with which it is often confused, but that is a different thing).  With its deep markets and flexible and safe financial system, it is the only country against which the others can accumulate claims, and these claims will be worked out in the form of increased US export in the future.

By allowing these countries to accumulate claims against the US (i.e. by running trade deficits with them), the US is actually helping to create the necessary conditions which will allow for a smooth transfer over the next few decades.  It is also worth pointing out that foreigners' trade surpluses with the US today are what will finance their trade deficits in the future, and as these countries age the goods and services they will need -- including health, technology, and information-related services -- are precisely the things that the US does better than anyone else.

When does this future take place?  It's hard to say, but it is worth noting that after watching its dependency ratio deteriorate sharply from the 1950s to the 1970s, China saw a dramatic improvement in its dependency ratio from the mid-1970s until now (as the one-child policy eliminated the young from the number of dependents).  This improvement in the dependency ratio will reverse itself around 2010 and begin to deteriorate dramatically as the shortage of children becomes a shortage of workers.  So worrisome are the numbers that several China scholars have called for even higher foreign reserves to help China pay for this future demographic crisis and have warned that a declining working population will soon place significant wage pressure on manufacturers.

I would like to know your thoughts on (1) how you think the domestic "crunch" inside China will unfold; (2) assuming the U.S. imposes a tariff of some sort, will this trigger the "crunch;" finally, what is the Chinese end-game? i.e. how do they see themselves getting out of this dilemma?

A friend sent the following article which was published in New Century China.   

Political Risk of Inflation in China
Lian Jing
7 August 2007

The shift from high growth, low inflation to high-growth, high inflation this year was a major turning point for the Chinese economy. The authorities were initially reluctant to accept the fact, and attempted to fool themselves by manipulating the statistics, but of late have at last realized that to do so is not only pointless but also extremely dangerous. On July 26, Hu Jintao held a Politburo meeting to study the economic situation, and on July 30, the National Development and Reform Commission (NDRC) issued a circular ordering local governments to be allow price increases, but also not to interfere arbitrarily with market price increases, placing the local governments in a "dilemma."  

The great nervousness to this wave of price increases on the part of the PRC's highest authorities is fully justified. Both of the two major bouts of inflations in post-reform China placed the regime under great political pressure and risk, and that of 1988 was an important factor to leading to former Party General Secretary Zhao Ziyang's downfall. In order to quell the discontent of urban residents in the inflation of 1994, then Premier Zhu Rongji adopted a series of anti-market measures which sacrificed the interests of the peasants. The so-called "food basket" and "rice bags" projects not only wasted a lot of financial and fiscal resources, and had far-reaching and extremely negative effects on agriculture and rural development. An important reason why Zhu Rongji never paid the political price for this was that his policy had the support of urban residents, whereas the peasantry had after June 4 completely lost anyone to speak for them at the top..  

Will this renewed surge in prices promoted by food prices now place much political pressure and risk on the Party's higher levels? After all these years of  high growth and low inflation, has China's ability to withstand high inflation been strengthened or weakened? These two questions are clearly present in the minds of all familiar with China's reform process. On the surface, China's per capita income levels are far better than before, and the state is financially stronger than it has ever been. More importantly, however, the govern­ment has been engaged for some years in so-called "market-oriented economic reform," with state-owned enterprises both large and small taking on the appearance of "modern corporate institutions." Judging by these phenomena, China's capacity to endure inflation, particularly that promoted by food price inflation, should have been greatly increased. How­ever, as those who grasp the fine points of China's economy are clear, high inflation, particularly when mainly made up of soaring prices of food and basic consumer goods, will increase China's political risk.  

This is because, firstly, the number and proportion the poor who are extremely sensitive to the price of basic consumer goods, has greatly increased. In the 1980s and 90s, the peasants, who account for a majority of the population, were not sensitive to the price of food; it was city dwellers, in the main, who were: while they had iron rice bowls, many city people were "raising their chopsticks to eat, but laying them down to grumble." They had lots of gripes against the Communist Party, and food prices simply gave them an excuse to grumble. The situation now is very different. 200 million peasants have moved in to the cities, scores of millions of SOE workers have been laid off, scores of millions of farmers have lost their land, while at the same time a group of people have made fortunes through so-called "restructuring" and "land development." Given the polarization of incomes, simply sacrificing the rights and interests of the peasants to ease the political pressure of inflation is unlikely to be effective.  

The trouble is, in recent years, while the government has more money, there has been no improvement in its actual capabilities. Local governments seize on the slightest sign to fleece the masses of the fruits of their toil. Not long ago, the government of a county took advantage of rising pork prices and, copying what Zhu Rongji once did, took over the pork trade there, actually handing the profits to their own people, and as result triggering collect­ive protest among the county's butchers and meat traders. An overall decline in quality of the city's celebrated beef noodle soup was triggered by the Lanzhou municipal govern­ment's intervention in the price. Local governments, blinded by the lust for gain, achieve little but spoil everything, increasingly becoming a big problem in the minds of the central government. That is why the emergency circular was issued prohibiting the local governments' unauthorized intervention in the market.  

So will the current bout of inflation lead to comprehensive social and political crisis? This will be decided, not by the local governments, but by the central government's macro-regulation and control, if major mistakes are made in managing credit and exchange rates, such that China's economy changes from high growth, high inflation, to low growth, high inflation, it would be the Chinese leader's worst nightmare.  

The PRC leaders hence dare not slow down the growth rate, but in this way, many major social reforms must once again give way to unbalanced, frenzied growth. 

A lot of my trader and hedge fund friends in NY have berated me for arguing in my WSJ piece last week that, thanks to the emergence of sovereign wealth funds, we are not yet in the last inning of this current global liquidity boom, or at least they’ve teased me for my poor timing.

But the purpose of my article was precisely to address the current panic and to argue that this, too, will pass.  It is not impossible that the Fed completely screws up its response to the current crisis and throws the world into a long-term liquidity contraction that leads into economic contraction and long-term risk aversion, but I am pretty sanguine that they won’t do so, and if they don’t, and as long as the driver of the current boom – the recycling of the US trade deficit – doesn’t change, the underlying liquidity will not change either.

The point I want to make is that long-term liquidity booms are not smooth.  They are often pockmarked with panics and financial crises, but the point is that these are temporary shocks which are ultimately absorbed by the market with limited economic impacts.  After all, the great boom from the early 1850s to the crash of 1873 (which was followed by such a severe economic contraction that in the US the 1870s were referred to as the “great depression” until that term was usurped sixty years later) was interrupted more than once, most famously by the 1866 crisis in which Overend & Guerney, the world’s leading discount house, whose conservative practices had led it to be called the “banker’s bank”, was forced into liquidation.

The next boom, beginning in the 1880s and continuing until 1914, was also interrupted several times, most famously by the Argentine crisis of 1890, which nearly brought down the House of Barings (and which has been likened by Barry Eichengreen to the 1994 Tequila Crisis) and then again in the Panic of 1907, in which JP Morgan famously engineered a rescue.

Even the LDC lending boom in the 1970s was not without temporary panics – mostly famously the peso problem that resulted in a crisis in Mexico in 1975.  But the party did not really end until 1979-1980 when Volcker, in order to combat runaway inflation, engineered a major liquidity contraction that created deep recessions in the US and ultimately led to the LDC Debt Crisis, in which 32 countries were forced to default on or reschedule their debts and which resulted in the Lost Decade for Latin America.

The point is not that crises cannot happen during a major liquidity cycle, but rather that when they do, they lead very quickly to market recovery.  The liquidity cycle we are currently living through was interrupted big time in 1994, 1997-98, and in 2000, and yet we are still flying.  Unless the Fed seriously mismanages the current crisis, which I doubt, in retrospect this will not be looked on as the “big one” that ended the party.

My bet is that by October prices will have substantially recovered.  My feeling was reinforced by a New York Times article today that pointed out that insider activity suggests that corporate insiders and leaders are feeling bullish, not bearish, about the market. 

If all this excitement leads financial institutions to becoming more careful about their recognition of and accounting for risks, it will have been overall a good thing, but I suspect of course that the recovery will simply reinforce the behavior of excessive risk takers, and so will increase the overall riskiness of the market.  The party will definitely end, and probably in an ugly way, but not just yet.

The CPI numbers have come out and they are a lot worse than expected, and this should give us reason to worry.  I think the consensus was for CPI to come out to just under 5%, from 4.4% in June, although three days ago I had already heard the 5.6% number being bandied about.  This is the highest monthly number recorded since February 1997.

Most of the inflation occurred in food prices (non-food items were up only 0.9%), and so once again we are being told by an army of analysts that this is temporary and will soon reverse itself.  I suspect however that the same mistakes are being made about the supposed temporary nature of the series of record-breaking trade surpluses over the past three years.  In both cases I think they are the consequence of excess monetary growth, and so are a lot less temporary than we think (although of course the standard suspects also matter in the case of CPI -- livestock diseases and food shortages). 

At any rate if these rises persist, whatever the cause, the consequences will be destabilizing for the banking system if the price increases put pressure on depositors to find alternative ways of maintaining the value of their savings, or if the driving of real rates deeply into negative territory encourages (further) overinvestment. 

By the way there is reason to believe that the CPI number understates the non-food component of inflation.  Energy and power prices are subsidized, so we effectively have taken some payments out of the "inflation" box and put them in the "taxes" box, but the net effect on disposable income is ultimately the same.  I believe rents are not correctly included in the CPI number.  And finally, Stephen Green, of Standard Chartered bank, was reported to have said, according to today's FT,that "Anecdotally, some local governments are said to be under-estimating various price trends, and there is scepticism that service sector inflation is being accurately captured.”

It is always hard to prove that monetary growth is excesive, but China is now exhibiting nearly all the expected consequences of excess money -- explosive lending growth, asset bubbles, overinvestment and inflation.   In a recent article in China Securities Journal Zhang Tao, vice head of the international department at the PBoC, was reported to have said that “Economic growth is overly fast and it has been so continuously,” and he warned about rapid rise of gross domestic product, fixed-asset investment, inflation and lending, saying that they “may have entered a dangerous zone”.

Absolutely.

From today's South China Morning Post:

The China Securities Regulatory Commission (CSRC) is poised to allow trading in the mainland's first equity-based derivatives - likely to be stock index futures contracts based on the Shanghai-Shenzhen 300 Index as early as next month.  The move was expected after the investor watchdog issued licences this month to more than 40 brokerages to trade on the China Financial Futures Exchange, established in Shanghai in September last year.

Not a good idea, I think.  The main problem with the Chinese capital markets is not that they lack hedging tools, sophisticated instruments, or even good financial data (which they do lack).  It is that the investor base is completely unbalanced.  There is no way for fundamental investors or arbitrageurs to act profitably, but on the other hand there is plenty of useful information for speculators (insider activity, government intervention, fraud, sudden regulatory changes, etc.).

As a result, this is a wholly speculative market and for all the talk it hasn't changed much in the six years I have been here.  Giving a wholly speculative market derivative instruments that multiply leverage will only add unnecessary volatility to the market.

On the other hand, for those who are long B-shares (full disclosure: such as me), this is a great thing.  B-shares are so cheap relative to their A-share equivalents (more than 30% discount) that it makes sense for foreign investors to buy B-shares and short the index.  Of course there will be tons of tracking error, but with a 50% return to convergence, what's a little tracking error?

From today's South China Morning Post:

Retail sales, a key gauge of consumer spending, rose 16.4 per cent in the mainland last month compared with a year earlier, government data showed on Tuesday.  Sales totaled 699.8 billion yuan and compared with a 16-per cent rise in June, the National Bureau of Statistics (NBS) said in a statement.

 

Sales in the first seven months of the year increased 15.5 per cent from a year earlier to 4.9 trillion yuan, the NBS added. The economic planning agency has said it expected retail sales growth of 12 per cent for all of this year but a steady rise on the back of wealthier Chinese consumers is likely to push the figure higher.

This is good news in that it means that China may be slowly moving away from an investment- or export-driven economy to a more consumer-driven one.  On the other hand I am a little uneasy because this could also be one of the consequences of excess money growth, and could keep upward pressure on prices.

As an aside, I remember when rising inequality in the US was justified (in part) by the argument that the US needed to save more and that the rich saved more than the rest of us.  Now in China rising inequality can be justified by the need for Chinese to save less and consume more, and the rich do just that.  You got to love the rich -- always working for the common good.

According to my assistant Shang Ning, next week the MoF will sell RMB 600 billion of the expected RMB 1.55 trillion special issue bonds which will be used to fund the government-owned investment company.  There will be three issues, the first two of RMB 600 billion, followed by a third of RMB 350 billion.

The MoF will use the proceeds to buy FX from the PBoC, which will then deliver the dollars to the CIC, the new sovereign wealth fund which will manage excess reserves.  At some unspecified time in the future (I think one or two weeks) the PBoC will buy the MoF bonds from whomever purchased them at sale, and use them to manage liquidity through open market operations.  The net impact, when the dust settles, is that the PBoC will have exchanged dollar reserves for MoF RMB bonds.  If it sells any of these these bonds in its open market operations, the market will have exchanged PBoC bills for MoF bonds. 

Many analysts say that, because this will ultimately result in an exchange of PBoC bills for MoF bonds, there will be no net liquidity impact, but I disagree.  I think that the use of these MoF bonds adds a useful arrow to the PBoC's meager quiver.  I do not believe that selling central bank bills, which are a near perfect substitute for money, is a very effective way of mopping up liquidity in China.  Selling these MoF bonds into the market, with their much longer maturities (I have heard ten years), will have a greater impact.

By the way the PBoC must buy the bonds indirectly because according the the central bank law the PBoC cannot directly subscribe to a sale of government bonds.  This law was written to protect the independence of the PBoC -- mainly to prevent the PBoC from being forced to monetize government debt.  I have heard rumors that the intermediary will be the Agricultural Bank of China, but I am not sure if this is true.

The unkind among us might wonder why allowing the PBoC to use this little trick to circumvent the rules guaranteeing independence should not make us wonder more generally about the independence of the PBoC.

More numbers have been released.  In today's South China Morning Post we read that:

Mainland industrial output slowed more than expected last month after tax changes made exports less attractive, suggesting to some economists that the country’s politically sensitive trade surplus may shrink in coming months.

 

Factories churned out 18 per cent more goods than in July last year, down from 19.4 per cent growth in June, the National Bureau of Statistics said on Wednesday.  Economists had expected a rise of 19.2 per cent.

One correction -- I think a Bloomberg poll had economists forecasting an 18.5% rise, but in either case it is lower than June's number and lower than forecast.  Is this reduction in the growth of industrial output a good thing?  In one sense yes.  It is clearly better, as I see it, for the growth rate to move down rather than up. 

According to my model China is caught in a trap in which the rising trade surplus increases the domestic money supply (since the PBoC is forced to act as the residual buyer of net capital inflows).  This increase in money supply expands production either directly, by increasing investment, or indirectly, by supporting rapid loan expansion, which in China is far more likely to go into production than into consumption.

Since a country's trade surplus is simply the excess of its production over its consumption, anything that causes faster growth in production relative to consumption will increase the trade surplus, which starts the whole process all over again.  The system is exacerbated by FDI, which comes into China to take advantage of cheap asset prices, and hot money inflows, which enters China to speculate on high returns (including the expected gain on currency appreciation).

If you agree with that model, you would probably also agree that anything that caused a decline in the industrial output growth rate is a good thing and helps ease China out of this trap.  But before we celebrate let me quote something I wrote in the June 2007 issue of Far Eastern Economic Review.  I was discussing 2007 first quarter numbers:

Industrial production was up 18.3% over the same period last year, a 10-year record (versus an already high 16.7% for first quarter 2006). With this level of growth in industrial production, it is unrealistic to expect a narrowing of the trade surplus any time soon, and if the trade surplus doesn’t narrow, neither money growth, loan growth, nor investment is likely to slow down.

So July's lower number (18.0%, versus 18.5% growth for the first seven months of 2007) is certainly better than what we have been seeing, but it is not a number we should be too happy about.  Industrial output is still growing at very high levels -- well above its average for the past four years.  In addition, it may be that the growth slowdown was caused by the reduction in loan growth that we have experienced over the past three months (compared to the first quarter).  This suggests that administrative measures to reduce credit expansion are working, but I am very skeptical about the effectiveness of administrative measures except in the very short run.

We will need many more months of declining growth rates before we can relax.  Tomorrow fixed asset investment numbers come out.

Also from today's South China Morning Post:

The United States trade deficit narrowed in June from May, despite a politically sensitive record gap with China, as a weak dollar buoyed exports, the government said on Tuesday.  The trade deficit shrunk 1.7 per cent to a four-month low of US$58.1 billion (HK$453 billion) in June, the Commerce Department said. That overturned economists’ consensus forecast that it would increase to US$61 billion.

 

The better than expected performance in June came despite surging oil prices and in the context of a soft dollar that made US exports a comparative bargain.   But Americans showed no signs of a waning appetite for cheap Chinese-made goods, despite protests from some US legislators that China was keeping its yuan currency undervalued to maintain an unfair trade advantage. The gap with China, which holds the lion’s share of American imports, expanded to a record US$21.16 billion in June from US$20.02 billion in May, the Commerce Department said.

 

Chinese lenders

Black-market banking

Aug 9th 2007
The Economist

Worried about illicit lending, China discovers a big underground bank

JUST over two years after a big unlicensed bank was last found in China, another surfaced this week. Last time the bank was based in Shanghai and operated in a small number of provinces. This time the illegal bank, which is based across the border from Hong Kong in Shenzhen, is on a far grander scale. It did business in every province of the country and its clients included state-owned enterprises and foreign multinationals. It appears to have been operating unnoticed by officials for up to eight years. In the Shenzhen area alone, it was reported to have done 4.3 billion yuan ($544m) of unspecified transactions in the year and a half to May.

According to the State Administration of Foreign Exchange, the bank's clients had been borrowing mostly to buy fuel, cover deposits for land-use fees and pay export duties. But, as often happens, most of the lending was really for companies to make speculative investments in property and shares. This is what appears to have led to the bank's downfall.

The authorities in Beijing, worried about the surge in the stockmarket and property prices in the past two years, have been trying to cool things down. They had suspected that part of the frothiness in the markets was the result of too much illicit lending. Their investigations appear to have uncovered the bank's existence.

Such banks are surprisingly common in China—although this one is a whopper. A government-funded study by the Central University of Finance and Economics cited by the South China Morning Post last year found that they lent as much as 800 billion yuan a year. Some of this goes to legitimate business. Underground banks provide as much as a third of the loans to small and medium-sized enterprises (SMEs) and 55% of the loans to farmers. SMEs and farmers are generally poorly served by the larger state banks and frequently have no option but to turn to these illegal institutions.

The state's efforts to reduce legitimate lending to cool the economy mean that illegal borrowing is likely to have grown. But the success of underground banks is also partly down to the returns they provide. With state banks offering savers paltry rates of interest, the under-the-counter ones simply offer more for deposits.

Of course, they pay better because they earn more. Most of the money these banks lend is for risky investments. As much as 90% of it is used for speculative trades in financial markets.

With stockmarkets around the world jumpy, China's stockmarket bubble continuing and 3-4% of the broad money supply estimated to be flowing underground, it is no wonder the authorities are alarmed. So many unregistered institutions risk the savings of millions being suddenly washed away.

The Economist article on illegal banks (see below) has caused a lot of discussion among a group of China scholars with whom I regularly communicate.  Consultant Anne Stevenson-Yang sent the following note:

I met one of these gao li dai in [a coastal city]. The company was partly owned by the [local] government, the proprietor said. He charged local companies 5-7 percent MONTHLY for loans of between $1 and $5 million, and he said that Ningbo had about 50 other companies lending at that level and hundreds making loans under $1 million.

 

The gao li dai take deposits at a guaranteed 1.5% monthly and, to secure the loans, take guarantees of the personal assets of the company proprietors. You can imagine what happens if you don't pay. One interesting part of the conversation was his comment that the PBOC "opens one eye and closes the other" because officials recognize that the banking system is ill equipped to extend short-term loans to private companies that need to get shipments out the door, and that most of the companies legitimately need short-term financing and legitimately repay the loans.

 

Everyone in the room agreed that the business would be either regularized or outlawed, or both, in about two years' time.

1.5% a month (18% a year if this is simple interest, nearly 20% if it is compounded) for depositors is certainly a lot higher than inflation, currently running around 5%, and even better when measured against bank deposit rates of around 3%.  Loans at 5-7% per month are equal to anywhere from 60% annually (5% per month simple interest) to 125% annually (7% per month compounded).

At these lending rates the business opportunity must be extremely profitable (and very short-term) to justify borrowing.  If these loans are mostly "legitimate" business loans, then it is clear that some parts of the Chinese economy are very profitable.  It does lead me to wonder however about how much of this money goes to stock market and real estate speculation.

My concerns have to do with systemic implications.  First of all, I think the informal banks are not the only banks making illegal stock loans.  There is strong anecdotal evidence that pawn shops too (and these are not what you and I might think of as pawnshops -- some have hundreds of branches) are making illegal loans for real estate and stock speculation.

As I see it there are at least two problems.  One is that these illegal (informal?) banks are part of the financial and money creation system, and their activity is like that of any other bank except that they are unregulated and unrecorded.  This wouldn't be a problem if they were small, but if it is true that they made RMB 800 billion in loans in 2006, as the article says, their lending is sizable compared to the RMB 3.2 trillion made last year by the formal banking system, so they matter a lot.

If nothing else we would need to adjust our estimates of Chinese loan growth to account for the lending growth of the illegal banks.  Since the rate of loan growth in the legal banking sector is constrained by the government, I would assume that for banks that are not similarly constrained, loan growth is probably higher -- just a guess, because I don't know for sure, but it seems plausible.

The second problem is the impact of lending on speculative activity.  Normally we can estimate the volatlity of the stock and real estate markets and their vulnerability to sharp downward movements by the amount of self-reinforcing mechanisms in, among other things, the ownership structure.  One of the biggest sources of this volatility is margin lending, since rising prices lead to greater borrowing capacity and falling prices lead to margin calls and forced selling.  Margin lending, in other words, is highly pro-cyclical, and this automatically adds volatility to the system.  

If there is a lot of margin out there it could lead to real problems if there is a sustained decline in the market.  I say sustained because I'll bet the margin activity is not as automatic as it might be in the US.  If your stocks decline to below the limit I suspect you won't get the "put up money by 5 p.m. or we sell at tomorrow's open" phone call that you would in the US.  There may be a little more flexibility.  But if stock prices stay below the limit for some days or weeks I'll bet that it is harder to negotiate for breathing space, and there would ultimately be forced selling.  Since my understanding is that a lot of homes have been put up as collateral, the selling might even extend to real estate.

All I can say for sure is that when markets are frothy, the lack of information never seems to be a serious problem -- we just sort of assume the best case.  As soon as the markets get into trouble, however, this lack of information will suddenly become a very nasty problem, and the extent and impact of illegal and unrecorded banking activity will suddenly become one of our favorite things to worry about.

Kellee Tsai, who wrote an invaluable book on the informal banking sector in China (Back-Alley Banking, Cornell University Press, 2004), responded to the Economist article with this:

While it may be true that the funds in the particular Shenzhen-based bank
discussed in the article were primarily being used for speculative
investments, I do not agree with the assessment in the second to last
paragraph, "As much as 90% of [the money in these banks] is used for
speculative trades in financial markets." 

 

The allocation of funds varies considerably by locality.  It is not surprising to hear that the large (busted) underground banks based in Shanghai and Shenzhen were focused towards the real estate and equity markets, but in most of rural and urban China, underground banks and moneylenders are simply brokering funds between savers seeking higher returns and individual borrowers who need capital to run their businesses.  Occasionally these arrangements degenerate into ponzi schemes or get distorted by bad (OK, "speculative") investments, which generates substantial local press coverage and a short-term wave of regulatory crackdowns. 

 

But I have found that most informal financial institutions are remarkably well run because they face hard budget constraints and their owners are quite saavy in making sound credit decisions.  Finally, for conceptual and typological clarity, I wish the article had distinguished between illegal investment funds and underground banks serving SMEs.  There are many different types of informal finance.

 

China move starts corporate bond surge

By Jamil Anderlini in Beijing

Financial Times

Published: August 15 2007

Listed Chinese companies are lining up in their hundreds to sell corporate bonds and pay off bank loans after the securities regulator issued formal rules governing the nascent sector.  The regulations, first circulated in draft form two months ago, greatly reduce the formal requirements for listed Chinese companies to sell bonds for trade on the Shenzhen and Shanghai stock exchanges.

A quota system that kept annual corporate bond issuance below Rmb100bn ($13.2bn) last year has been abolished and listed companies are now permitted to repay bank debt with bond proceeds for the first time. Companies with high levels of debt, particularly in the power, property and transport infrastructure industries are expected to be the first to sell bonds under the new regime, with China Yangtze power reported to be preparing an Rmb8bn issue.

But bonds will appeal to all corporations in a country where bank lending rates are set artificially high by the central bank to ensure profits and stability in the state-owned banking sector. Interest rates in China’s bond market are generally 2-3 percentage points lower than bank loans.

“The regulators want to gradually move to the US model where a large amount of credit risk is moved from the bank balance sheets to the capital markets,” said Zhang Zhiming, director of asset allocation research at HSBC in Hong Kong.  “There is likely to be huge interest from listed companies because, even if they don’t need additional funding, they will still be attracted to save money by switching from bank loans into bonds.”

The reforms were made possible by a decision this year to shift control of corporate bonds from the National Development and Reform Commission, the country’s conservative central planning agency, to the more liberal market-oriented China Securities Regulatory Commission.  State-owned banks, which account for more than 90 per cent of corporate financing, are not the only sector that will be affected by the move.

In the last seven months of 2005, Rmb142bn of short-term corporate paper with maturities of less than one year was sold in the inter-bank market. Total issuance hit Rmb292bn last year, and Rmb180bn so far this year.

The opening of the corporate bond market is good news for many reasons.  The most important reason is that people living in Beijing whose only real professional experience is in the primary and secondary international bond markets will soon enough find great job opportunities that won't require them to leave mainland China.  As a member of this group, I can only applaud the foresight of the financial authorities.

But there are other reasons why this is good news.  Chinese companies rely excessively on the banking system for new financing -- between 95% and 97% of new financing comes from banks, depending on which period you measure.

This is a problem because it means that the Chinese economy is hostage to adverse developments in the banking system.  Given the huge (and probably growing) amounts of non-performing loans, the rigid and opaque governance structure, weak risk management, and lack of credit experience, it doesn't take much to imagine ways in which the system could seize up and contract. 

As in Japan in the 1990s -- except probably to an even greater extent -- a contraction in China's banking system would immediately be transmitted into the real economy by the inability of companies, especially vibrant, young companies, to obtain financing.  The consequences of a banking crisis in China, even a small one, would be pretty awful in my opinion.

The more independently-operating moving parts a financial system has, the better it is able to withstand adverse shocks.  This is one of the great, and not enough acknowledged, strengths of the US financial system.  When one part of it breaks down, another part almost immediately expands to replace its financing function, and so the transmission into the real economy is broken -- remember how the MBS market grew exactly when S&Ls were going under, or how the junk bond market exploded just as money center banks were reeling from the energy and LDC shocks?  These were not a coincidences. 

By the way this is also, perhaps, a reason to applaud the existence of informal and illegal banks in China -- to the extent that their business is uncorrelated to overall conditions in the Chinese banking system (although it is not clear that they are), the more active they are the more flexible China's financial system is.  This flexibility is extremely important, and a functioning corporate bond market will diversify corporate funding in a way that will provide flexibility and so limit the impact of a banking contraction.

A corporate bond market brings other advantages.  The lending decision made by Chinese banks are, often enough, driven not by economic considerations but by political ones (not to mention considerations of what economists politely call "rent seeking").  This is unlikely to change for quite a long time, if ever, and it goes a long way in explaining why the capital allocation mechanism -- one of the more, if not the most, important functions of a financial system -- works so poorly in China.

A functioning bond market would presumably do a better job of allocating capital because the management structure and the mark-to-market requirements would force fund managers to behave differently that loan managers.  This can only help China achieve more sustainable long-term growth.

There are things to worry about however.  One impact of a rapidly developing bond market is that money will have to be diverted from the banking system as part of the disintermediation process.  Another would be a migration of better credits from the banking system to the corporate bond markets.  Declining liquidity and deteriorating loan portfolios are exactly the opposite of what the banks need.

But it makes sense to put all of this in context.  Let us assume that right now that bond and equity markets together account for 5% of total financing, and further assume that bond market financing grows at three times the rate of bank lending and equity issuance.  After five years, if we assume that loans grow at anywhere from 10% to 20% annually (they are currently growing at over 20%, but must slow down), bond markets will still only account for 5% to 8% of total new financing.  This is a good thing, of course, but it will be many years before bond markets really matter.

Fixed asset investment -- investment in such things as factories, power plants, roads, and new buildings -- was 26.1% higher at the end of July 2007 than it was at the end of July 2006.  This is good news relative to June's 28.4% rise, but all the caveats we discussed in the rise in investment output (see entry for August 14) apply here too.  The July number is barely below the too-high 26.7% achieved in the first half of the year.

By the way, even if the numbers do come down dramatically, it seems to me that, like credit expansion and money expnasion, FAI is both a stock and a flow problem.  Previous bouts of exess investment pile up unnecessary production facilities, inventory, and so on, and in order for the economy to adjust fully, it is not enough to slow down to some theoretically reasonable pace commensurate with sustainable growth.  I would argue that FAI would have to grow below this "reasonable" pace in order to allow the economy to absorb the previous excess production (or write it off).

There is an article by Gilian Tett in today's Financial Times ("Fearful banks make liquidity grab") that discusses the sudden recent drying up of liquidity that occurred in the midst of what seemed like a world of endless liquidity:

When a panic hits a population – say, bird flu or flooding – they are apt to hoard baked beans or bottles of water. So too, in the supposedly sophisticated arena of high finance. For as the markets have embarked on their recent roller-coaster ride, one reason for the swing is that investment funds have suffered painful losses that are forcing asset sales.

 

But another crucial factor – indeed the key issue now – is a massive, old-fashioned grab for liquidity. For just as households might stockpile baked beans, banks are currently trying to stockpile funds, either because they have to meet repayment demands from investment vehicles or, most perniciously, because they fear these demands are looming soon...

 

...And, just as a frenetic stockpiling of baked beans tends to fuel panic, the very fact that banks are grabbing for cash is making investors even more nervous, particularly in the dollar market where many investment vehicles have raised funding in recent years, even if they are based in Europe (ironically, because the dollar market was supposed to be ultra-liquid.)

Why would I refer to an article about how suddenly and unexpectedly liquidity can collapse in a blog dedicated to China, where we have so much liquidity that the insolvency of the banking system can be largely ignored?  No reason.  I'm just being perverse.

But I have to say that references to sudden panics like "say, bird flu or flooding" hit a little close to home.  Could a health, weather, or environmental panic ever lead to a financial panic in China by, say, undermining credibility in the authorities? After all the only thing holding up the banking system is generally confidence that the goverment wouldn't let anything bad ever happen.

As an aside, on August 9 David Barboza of the New York Times did have an unsettling little article ("Virus spreading alarm and pig disease in China") on the spread of this new disease.  He says:

A highly infectious swine virus is sweeping China’s pig population, driving up pork prices and creating fears of a global pandemic among domesticated pigs.  Animal virus experts say Chinese authorities are playing down the gravity and spread of the disease.

 

So far, the mysterious virus — believed to cause an unusually deadly form of an infection known as blue-ear pig disease — has spread to 25 of this country’s 33 provinces and regions, prompting a pork shortage and the strongest inflation in China in a decade. More than that, China’s past lack of transparency — particularly over what became the SARS epidemic — has created global concern.

 

An editorial in today's South China Morning Post says:

Another big unknown is whether countries in the region will, despite a slowing US economy, benefit from China's rise as a growth engine. After almost 30 years of largely uninterrupted growth, the mainland has become a powerful economic force in its own right. Much of its growth still depends on exports, particularly to the US, but such dependency has decreased.

Likewise an article in today's New York Times makes the argument that:

"We’re no longer in a world where the United States sneezes and the rest of the world catches a cold,” said Nariman Behravesh, chief economist with Global Insight, an economics research firm in Waltham, Mass. “You’ve got strong growth overseas, and it’s been kind of like a lifeline to the United States from the rest of the world.”

 

But in Asia, where growth has been strongest in recent years, many countries are still worried that American troubles could drag them down as well. Experts say those nations are less interested in extending a lifeline to the United States than in discovering whether they have reduced their ties to the American consumer.

 

Countries in Asia, particularly China, have started chafing at their dependence on the thirst of Americans for imported goods, on the sway of the American dollar around the world and on American financial institutions.

 

It is true, Asian business executives and economists say, that fundamental economic changes have limited Asia’s need for American consumers and financial markets. But it is still not clear, they say, how much effect the current financial turmoil is likely to have outside the United States.

 

"Definitely the reliance on the U.S. economy, particularly from the Asian economies, has lessened a bit over the last five to seven years,” said Sanjay Mehta, the chief executive of Essar Shipping of India. “There will be an impact — I don’t see that there will be no impact — but less of an impact than we saw in 2001 and 2002, when the Internet bubble crashed.”

I think the idea that the rest of the world has become less reliant on US growth is based on looking at individual numbers, not aggregate numbers.  For most countries, exports to the US have declined as a share of total exports over the past ten years, and most analysts have interpreted this to mean that their economies are less sensitive to US demand.

But it could also mean simply that globalization has made trade spread out more.  If China, for example, shifts from exporting shoes directly to the US, to exporting shoes to Italy, which then exports them to the US after some processing, it may look like China's dependency on the US consumer has diminished, but of course very little has changed.

Perhaps it makes more sense to look at US imports as a share of world GDP to gauge the world's ssensitivity to the US.  This has risen over the past ten years, suggesting that the world is more, not less, senstive to changes in US demand.

My market-following assistant Shang Ning writes today: 

I understand that on Aug 16th, RMB 100 Billion ($12B) of new central bank notes have been issued. Eleven major commmercial banks and city commmercial banks have been ordered to buy the notes because of their too-rapid loan growth. The coupon is 3.69% (which is below the market rate) and maturity is 3 yrs.

Nice summary in Bloomberg, from which I excerpt the following.  It is interesting to see that bank economists are sounding increasingly alarmed.  This may simply be because chaos in the markets always tends to encourage apocalyptic views among bankers, but it may also be a belated recognition that all is not well, and conditions can change brutally quickly.

China May Raise Rates by Sept. 30 to Cool Growth

By Nipa Piboontanasawat and Patricia Chua

 

Aug. 17 (Bloomberg) -- China will probably raise interest rates by the end of September to cool the economy after inflation accelerated to a 10-year high and record trade surpluses pumped cash into the financial system.  Rates will increase this quarter for the fourth time since March, 11 of 16 economists in a Bloomberg News survey said yesterday after the final economic data for July. Most expect the benchmark one-year lending rate to rise to 7.11 percent from 6.84 percent. The deposit rate is likely to be raised to 3.6 percent from 3.33 percent...

 

...The trade surplus may reach $250 billion this year from $177.5 billion in 2006, according to economists surveyed separately this month. A fourth rate increase will compare with two last year.  "China is coping with a bigger inflow of liquidity," said Stephen Green, senior economist at Standard Chartered Bank Plc in Shanghai.

 

Consumer prices jumped 5.6 percent in July from a year earlier, the biggest increase since February 1997, as the costs of pork, eggs and poultry soared. M2, the broadest measure of money supply, rose 18.5 percent.  "With inflation higher, monetary policy has not been significantly tightened and real interest rates have not changed dramatically," said Isaac Meng, senior economist at BNP Paribas SA in Beijing...

 

...The key CSI 300 Index of shares has climbed more than 130 percent after more than doubling in 2006. The value of China's listed shares is $2.8 trillion and larger than last year's gross domestic product. In July, housing prices jumped 19.4 percent from a year earlier in Shenzhen and 10.4 percent in Beijing. 

 

Household savings fell in July by 9.1 billion yuan ($1.2 billion) from the previous month. China this week reduced a tax on interest income to 5 percent from 20 percent to make deposits more attractive.  The People's Bank of China will order lenders to set aside more money as reserves at least once more this year, 11 economists said. Most expect the required reserve ratio to rise to 12.5 percent from 12 percent.

 

The central bank has already told commercial banks to increase reserves on six occasions this year, compared with three times last year. Chinese lenders extended 2.8 trillion yuan of new loans in the first seven months, 18 percent more than a year earlier.  Fixed-asset investment in urban areas increased 26.6 percent in the first seven months from a year earlier, close to the 26.7 expansion in the first half. Industrial production rose 18 percent in July, down from 19.4 percent in June...

 

...The nation's foreign-exchange reserves, the world's largest, soared to a record $1.3 trillion at the end of June, 42 percent more than a year earlier. The trade surplus surged 81 percent in the first seven months to $136.8 billion.