My Blog

SAT 8 SEP 2007

Japan's monetary policy difficulties By Michael Pettis

William Pesek has an interesting September 7 column on Bloomberg which I excerpt below.  It discusses the difficulty of Japanes monetary policy management after years of low interest rates and an undervalued yen:

…Modern history knows of no other major economy holding short-term interest rates at, or near, zero for almost a decade. The BOJ has even gone further, adding additional yen to the financial system when zero rates failed to boost demand for credit.  Only now are the side effects of that policy becoming clear. Aside from a chronically undervalued yen, ultra-low Japanese rates are exporting bubbles around the globe.

 

"Overinvestment amid conditions of ample global liquidity was a major factor in causing the subprime issue," BOJ board member Atsushi Mizuno said Aug. 30. The market turmoil "is proof that keeping rates at levels that stray from fundamentals could actually cause instability."

 

He's right. For the good of the global financial system, Japan needs to normalize interest rates. While that won't sit well with the countless number of investors who borrowed cheaply in yen and put the funds in higher-returning assets overseas, it's necessary to restore sobriety to global markets...

 

... Japan's woes stem from risk-averse politicians who rely on easy money to avoid doing their part to modernize the economy. Rather than increasing competitiveness and entrepreneurship and utilizing the female workforce, the ruling Liberal Democratic Party depends on ultra-low rates.

 

Fukui's Choices  Fukui has two choices before his five-year term ends in March 2008. One, he can go boldly where politicians tell him not to and raise rates. Two, he can maintain the status quo, which means the BOJ will remain a creature of Japan Inc. and have even less credibility than it does today.

 

Economists will argue that higher short-term rates are the last thing Japan needs. Yet Japan's recovery is based on three artificial forces: negligible borrowing costs, an undervalued yen and the largest public debt in the developed world. Maintaining the status quo means Japan continues to muddle along below its potential.

MON 10 SEP 2007

Pesky school kids By Michael Pettis

From Reuters via today's South China Morning Post, this article doesn't need much comment:

Officials in Fujian province have told schools to caution students against dabbling in the stock market, warning that failed investments could fuel social instability. Students have followed pensioners, housewives and people from all walks of life into the stock market as prices have rocketed in recent months, despite experts’ warnings of a dangerous bubble.

 

"Local education departments and schools must instruct students to think twice before investing in highly risky stocks," the Beijing News said, citing a government notice in the southeastern coastal province of Fujian.  "[The regulation] is to prevent failed investments from affecting family and social stability," it added, warning students not to see the market as an easy way to make a living.

 

Teachers had a responsibility to help their students get a "correct view" about the stock market, the report said.  Financial officials have expressed concern the market may be overheating and warned the public to be careful about letting go of their money.

MON 10 SEP 2007

PPI numbers By Michael Pettis

PPI for August is up 2.6% year on year, versus 2.4% in July, driven largely by steel products and coal-mining -related costs.  This is not a particularly high number, but the trend is in the wrong direction and it doesn't do much to comfort those of us who are worried that the recent high food prices might be augmented by other factors in keeping inflation high for a at least few more quarters.  Tomorrow we get CPI numbers for August, and the consensus is that prices will have increased 5.8%, versus 5.6% in July.

MON 10 SEP 2007

Oh oh! CPI up to 6.5% By Michael Pettis

So much for expectations.  CPI for the month of August came in at 6.5%, well above last month's 10-year record of 5.6%, and also well above market expectations of 5.8-5.9%.  This is the highest monthly CPI number since December 1996. 

 

I have been a pessimist on inflation but I was still surprised that CPI inflation came in as high as it did.  I think it is going to be tough to keep this from affecting wage increases, and inflationary expectations generally are likely to become self-reinforcing. 

 

As expected, most of the increase was in food prices, which were up 18.2% and account for over one-third of the CPI basket.  I am not sure how the food price increases will initially play out for Chinese consumers, but it seems to me that there are only two possibilities.  They will pay for more expensive food either by reducing savings, or by reducing purchases of discretionary non-food goods (or of course some combination of both).  The former would of course do less damage to the economy, although it might put a little liquidity pressure on the banks.  The latter would not only shift domestic consumption, but it might also result in a little bit of upward pressure on the trade surplus as consumer goods not purchased (or imported) by Chinese would now be exported.

 

Just to give a sense of the numbers, if we assume that Chinese consumers spend 18% more on the roughly one-third of their consumption that consists of food, and if we assume that a further one-third of the basket consists of non-discetionary items (rent, education, medical bills, etc.), and finally we assume that as much as one-half of the increased food bills come out of savings, that means that the amount of money spent on non-discretionary non-food consumption must decline by roughly 10%.  These numbers are just my best guesses, by the way, and not based on data.

 

My back-of-the-envelope estimate is that this represents a reduction in demand for those items of about 1-2% of GDP.  At least part of this will probably show up in an increase in the trade surplus, which is currently running at roughly 10% of GDP.

 

I think it is pretty certain that the latest CPI numbers, unless they come down dramatically over the next two or three months (I am skeptical) must result in upward pressure on interest rates.  The PBoC has already said that they want to see positive real rates. 

 

But of course there is a problem with raising rates.  If we assume that deposit rates migrate up to around 5%, the combinaton of deposit rates and an expected appreciation of the RMB of 5% anually means that depositing money in a Chinese bank will earn 10% in dollar terms -- a pretty hefty yield even for most hedge funds, especially since it requires no special expertise or instruments with which to do it. 

 

I know that there are disagreements about the extent of hot money inflows, but I find it hard to believe that rising rates won't have an impact.  As crazy as it seems, reserve growth may actually accelerate in the coming quarters. 

TUE 11 SEP 2007

Little insider reaction? By Michael Pettis

One piece of good news that comes out of all of this is that the A-share market was up 1.48% yesterday, even though it is down 4.51% today, much of it on the back of the inflation numbers.  I have noticed that the market has usually done a suspiciously good job of anticipating government figures a few hours before they are released, but this time it seems to have been caught flat-footed.

 

Another obvious silver lining is that high inflation has the same impact as revaluing the currency.  The appreciation rate is still too slow, but the RMB's pace has effectively picked up.

 

TUE 11 SEP 2007

Second largest monthy trade surplus ever By Michael Pettis

China yesterday reported another sizable monthly trade surplus, with exports exceeding imports by $24.97 billion in August.  This was their second largest ever, exceeded only by June's $26.91 billion.  July's trade surplus was $24.4, the third largest ever.

 

A lot of commentators had suggested that June's record surplus was caused by the acceleration of exports due to the expected elimination of a tax subsidy on July 1.  With two of the three biggest trade surplus months on record coming immediately after June, I think it is clear that something else was driving the process.

 

My own reading was, and continues to be, that the trade surplus is the near-inevitable consequence of China's currency regime, in which rapid monetary expansion is both the cause and result of the trade surplus.  This monetary expansion feeds into higher industrial production through credit expansion, which exacerbates the trade surplus.  A rising trade surplus, of course, means more capital inflows and more monetary expansion.

 

This is why for three years I have insisted that the trade surplus will only grow, until some sharp adjustment -- one way or the other -- is made to interrupt the inflow of foreign exchange.  I expect that we will continue to see record or near-record levels in the foreseeable future, and I expect reserves to continue to mushroom.

 

One interesting thing that came out of the numbers is that European trade is growing quickly.  Total exports to Europe were up 31% year on year to $23.0 billion (or just over one-fifth of total exports of $111.3 billion).  Imports from Europe were up 21% over last year to $10.2 billion (or just over one-ninth of total imports of $86.4 billion). 

 

This means that the trade surplus with Europe of $12.8 billion has grown by 40% in the last year.  This is still substantially less than China's trade surplus with the US, but the US trade numbers have been improving overall with the weakness in the dollar, and this will probably continue.  I am not sure that Europeans have the capacity to absorb large trade deficits for a very long time, and I expect that trade frictions with China are going to rise. 

 

For the record, the trade surplus for 2006 was $177.5 billion, and the trade surplus for the first eight months of 2006 was 53% of that, or $94.4 billion.  For the first eight months of 2007 the trade surplus has been $161.7 billion, about 71% greater than last year's number. 

 

A simple extrapolation suggests that this year's trade surplus could be as high $300 billion, although I think that the slowdown in the US will moderate that number.  Still, a trade surplus of at least $250 billion is highly likely. 

 

All this means that reserves will grow in 2007 at a substantially higher rate than last year's astonishing $247 billion, even taking into account the $200 billion transfer to the new sovereign wealth fund.  The growth rate of industrial production is still to high but has moderated in recent months because of pressure on the banks to lend less.  This kind of pressure, however, rarely seems to work for more than a few months.  I expect by the end of the year industrial production will be roaring back, and with it there will be even more upward pressure on the trade surplus.

 

TUE 11 SEP 2007

Tom Holland on inflation By Michael Pettis

Tom Holland has a good piece in today's South China Morning Post warning about the impact of inflation.  He writes:

...That means although food inflation is not yet spreading into other sectors, it could begin to soon. People will adjust their expectations of future inflation upward in response to higher food prices, and start demanding higher wages. That will push business costs up, and eventually result in higher prices. If there are strikes and demonstrations, rising food prices could lead to social friction.

 

At the same time, there are signs that price pressures may neither be temporary nor confined solely to food. Demand is rising for protein-rich and therefore resource-intensive foods just as agricultural land is being turned over to growing crops for biofuels and for industrial use.

 

Transport costs are rising, and both energy and water costs look set to climb as subsidies are reduced. The current focus on food safety - mainland officials claim they have shut 2,000 food-processing plants in the past three weeks - will inevitably add to production costs.  Elsewhere, costs are also rising. According to Jing Ulrich, chairman of Chinese equities at JP Morgan: "Inflationary pressures are also building in the manufacturing sector, where the costs of land, labour, raw materials, utilities and pollution are on the rise"...

 

 

TUE 11 SEP 2007

Good news on retail consumption, but bad timing By Michael Pettis

China's retail sales grew in August by 17.1% (to RMB 711.7 billion), after last months' 16.4% growth.  This was substantially higher than expected and the fastest pace in over three years.

 

We have certainly wanted to see domestic demand become more important to China's economy as a way of reducing its reliance on the export sector, so this is definitely good news from that point of view.  However if we are an inflation-battling mode, rapidly rising consumer demand is not going to help.

 

Part of the growth in expenditures can be explained by inflation (prices went up so people had to spend more), but it has been underpinned by rising wealth among stock and real estate market speculators, rising disposable income among households (up 14.2% in the cities and 13.3% in the countryside in the first half of this year), and higher minimum wages and expanded welfare payments.

 

For the first eight months of the year retail sales were up 15.7% over the same period in 2006, to RMB 5.6 trillion.

WED 12 SEP 2007

Industrial output up 17.5% By Michael Pettis

Industrial output grew at a slower pace in August, to 17.5%, from 18.0% in July.  The government had taken a series of market and administrative measures to slow growth down, of which I believe the most important has been, as it always has, instructions to banks to tighten credit to certain sectors  of the economy.

 

This has happened many times before.  When growth numbers get out of hand the authorities put pressure on the banks to reduce loan growth, and for a couple of months loan growth slows, followed by slower growth in industrial production.  Nonetheless at 17.5% growth is still too fast, and as long as industrial production grows faster than consumption, it will continue to put upward pressure on exports.

 

If you believe that the root cause of the excess growth in China is the self-reinforcing relationship between monetary expansion and the trade surplus, then you would expect this reduction to be temporary.  I do.  My guess is that we will see a continued moderation of the pace of growth for a few more months but, unless the world economy contracts, before the end of the year growth in industrial production will accelerate again.  FDI for the first eight months of the year, by the way, was $41.95 billion, mostly into the manufacturing sector.  This figure is 12.8% greater than the amount over the same period last year.  That doesn't suggest to me that lending to the industrial sector declined willingly.  

 

THU 13 SEP 2007

Good news on money outflows By Michael Pettis

China Southern Fund Management is on track to raise nearly $8 billion in one day for its overseas equity fund.  The fund will invest in stocks in ten different countries, beginning first with Hong Kong and the US. 

 

I hadn't expected there to be much interest among Chinese investors in investing abroad because the expected currency appreciation creates too much of a hurdle, so I doubted the recent market openings -- making it easier for Chinese to invest money abroad -- would have much impact on limiting reserve growth and monetary expansion.  The success of this fund will have no major impact, because $8 billion in outflows makes little difference for a country that may see reserve growth of as much as $400 billion this year, but it is a good start, and if it is succesful (a big if, given global market difficulties and booming local markets) it may lead to further outflows.

 

Some analysts were concerned that this kind of outflow might spell trouble for the domestic stock markets, but the Bank of Beijing's IPO on the same day attracted more than 30 times as much demand -- about $250 billion for a $2 billion deal. 

 

[Added two days later] Total outward direct investment in 2006 surged by over 40% from 2005 numbers to $21.2 billion.  This is a little less than a third of inward FDI.

THU 13 SEP 2007

Keidel on China inflation By Michael Pettis

Albert Keidel (http://www.carnegieendowment.org/files/pb54) has a September 2007 Policy Brief for the Carnegie Endowment on the risks of inflation in China titled “China’s Looming crisis – Inflation Returns”.  He argues that

China’s economy today looks much as it did before the inflationary catastrophes of 1988-89 and 1993-96, and as in the past, China today faces more than inflation.  If inflation gets out of control, draconian steps to suppress it could cause hardship and social unrest.

He makes several interesting points. One point, which has not been sufficiently understood in the press or even by many research analysts, is that even though the 18% rise in food prices (which comprise one-third of the CPI basket) accounts for most of the CPI inflation, and this rise was driven largely by shortages on the supply side (especially pork), this doesn’t mean inflation isn't real.  

 

If prices for any particular good rise because of supply constraints the result is not inflation.  As spending shifts away from other goods to take into account the higher prices of the good in short supply, the shift will cause deflation in those other goods, and so the net effect on inflation will be zero or very low.  The rise in pork prices because of supply constraints, in other words, should be mitigated by the decline in other prices.  In China that did not happen.  Prices rose 6.5% in August.

 

This suggests that core inflation of just under 1% would have been higher if it had not been for the effect of rising food prices – without the mysterious pig disease, pork prices would have been lower but everything else would have been higher.  This is not to dismiss the distinction between core (or non-cyclical) prices and prices of goods that vary greatly as supply and demand adjust.  Food prices and farm production are certainly cyclical, but in this case I think it may be many quarters before the cyclicality works in our favor to bring prices down.  The point is to dismiss the idea that Chinese inflation was "only" food inflation, and that once food prices adjust we will be back to where we started..

 

A second point Keidel makes goes to the heart of an argument I have had many times.  I have been often told that in China bank runs are impossible because people have no alternative investments, and with nowhere else to put their money, why would they ever take their money out of the banks?  Aside from the fact that when you worry about the safety of your bank your first urge is to protect your liquidity, not to find an alternative investment, there are many things you can do with money.

Value-losing deposit rates early in both the 1988-89 and 1993-96 inflation bouts sparked heavy bank withdrawals and accelerated consumer spending – pushing inflation pressures to the crisis point.  In 1988, as inflation rose far above deposit rates, cash rushed out of the banks and into a panic buying spree that stripped many stores bare of their goods.  The resulting inflation took two years to tame….

 

…This same sequence erupted at the outset of the 1993-96 inflationary period.  Early, moderate inflation – again triggered by high food prices – rose far above bank deposit and lending rates.  Chinese citizens quickly began withdrawing cash and spending it, and corporations pounced on bank loans that were cheaper than inflation to splurge on investment projects.

Basically Chinese savers withdrew depreciating currency from the bank and exchanged it for hard goods that retained their value.  I was told by a Tsinghua professor that during the last major bout of inflation it was almost impossible to buy cigarettes, whiskey, and white goods in Beijing.  Depositors, by the same logic, would withdraw their savings even without inflation concerns if they were ever to become nervous about the liquidity of the banks.

 

The third interesting point is Keidel’s argument that the authorities must immediately raise domestic interest rates substantially to choke off inflation.  He says:

Some Chinese officials worry that raising domestic interest rates will attract unwanted speculative foreign capital.  This should be a secondary if not third-order concern.  China’s short-term capital account is still heavily, if imperfectly, regulated.  The scale of speculative inflows is manageable.  The central bank has ample resources to pull foreign cash inflows out of the economy by selling either treasury bills or its own bonds.

Here I disagree with Keidel.  As my regular blog readers know, I think the monetary expansion caused by the currency regime is at the heart of China’s imbalances, and I do not believe any solution which does not address this problem can work.  Higher interest rates will drag in more speculative capital and the PBoC is unable to sterilize them in a meaningful way simply by selling bills, which are a near perfect substitute for cash.  The resulting monetary expansion will make inflation worse, not better.

 

Unfortunately the solution must involve an adjustment in the currency regime.  Perhaps the RMB must appreciate at a much faster pace, as many believe, or the PBoC must engineer a one-off maxi-revaluation, as I believe, but without an adjustment of the currency that reverses reserve accumulation, China’s monetary problems are not going to go away.  Nor will inflation.

 

FRI 14 SEP 2007

Interest rates are up again (yawn) By Michael Pettis

The PBoC announced today that interest rates are up again for the fifth time this year. The one-year lending rate will be raised from 7.02% to 7.29%, a nine-year high.  The one-year deposit rate will rise to 3.87% from 3.60%. 

 

Rates have gone up less than 1.4% this year, whereas monthly inflation has risen about 3-4%.  Of course these numbers are not comparable.  If the inflation numbers for June, July and August represent a temporary blip, annual inflation for 2007 will have gone up by around 1%, depending on what period you compare it with.  If inflation stays at these levels, however, or even if they inch back down to 4%, the rise in interest rates won't be enough to cause real rates to rise, or even to prevent real rates from declining.

 

Fixed asset investment surged 26.7% in the first eight months of 2007, a tad over market expectations.  Credit Suisse calculates this to be equal to a 27.3% increase year on year.  They also argue that this actually represents a moderating of FAI growth because of a statistical quirk.  I wouldn't disagree because loan growth has slowed in recent months, although from an extraordinarily high peak, and new loans are still way above the average of the last twelve months, and well above the equivalent for the summer months of 2006 and 2005.  Investment and credit numbers are improving, but they are still way too high, and my guess is that the improvement will reverse itself in a few months -- loan growth, for example, always seems to moderate around this time of the year but picks up again at the end of the year.

 

FRI 14 SEP 2007

Bank run in England By Michael Pettis

This entry is not directly about China, but it may have indirect bearing on China by suggesting how sudden, unexpected and indirect the sequence of events leading to a bank run can be.  Rapid growth, weak transparency, and major changes in business strategies that are not anchored in very strict risk management can be a powerful combination in bringing a bank down when the very good economic and liquidity conditions that underpinned its growth suddenly change, and as this English example shows, panic can quickly become “irrational”.  Not even a Bank of England rescue was enough to chase away depositors clamoring for their money. 

 

It always seems a little anachronistic to worry about bank runs, but we continue to have them – usually in ways that are very different from those of the movie “It’s a Wonderful Life”, but as Northern Rock shows, not always.  This is excerpted from Friday’s Financial Times:

The turmoil in global banking hit the streets of Britain on Friday as thousands of Northern Rock customers queued up to withdraw their savings from the UK mortgage lender after it was rescued by the Bank of England.  As regulators and politicians called for calm, Northern Rock – Britain’s fifth-biggest mortgage lender – scrambled to contain the fallout after it became the first British bank in decades to be bailed out by regulators. One person close to the situation said customers had withdrawn about $2bn Friday but Northern Rock declined to comment on the figure, which would amount to 4 per cent of its deposit base.

 

The rescue demonstrates the risks from a decade of financial innovation in the capital markets, which allowed a small regional lender to wield financial clout far greater than its network of 76 branches would suggest.  It also shows how the turmoil in the financial system that resulted from excessive lending to Americans with patchy credit histories triggered the failure of a bank with no direct links to the US mortgage market.

Saturday’s Financial Times had more on the topic:

Some had been up all night worrying, others had spent an hour travelling or battling jammed websites and all were determined to do one thing at a Northern Rock branch on Friday: get as much of their money out as they could.  “We are elderly and this is our life saving,” said Sheila Smith, who came with her husband, Arthur, to withdraw all their money from the bank’s Moorgate branch in central London. “We can’t afford to lose it.”

 

A 61-year-old retired health service consultant from Sidcup was following suit, having spent more than an hour getting into the city after a morning of failed phone calls to his local branch.  “I put all my savings in one basket and the best thing to do is to get out of this basket,” he said.  Michael Ribotham, 74, could not see any point in leaving his money in a bank with such big problems. “I’m not young and don’t have a chance to make it back again.’’

In another article on the same day, someone with the wonderful name of Scheherade Daneshkhu writes:

Could the problems affecting Northern Rock spread to other banks and building societies? That was the question on the minds of millions of homeowners on Friday.  The British Bankers’ Association moved swiftly to allay the fears of mortgage customers and savers. “Everyone should calm down and refrain from making simplistic comments in a very complex area which just cause unnecessary worry and concern,” it said reprovingly.

Finally in an Opinion piece John Gapper writes:

Actually, there is something to worry about, even if those queuing outside Northern Rock branches to withdraw their money on Friday were (understandably) over-reacting. The Bank of England does not bail out banks every day. The last comparable wobble was the secondary banking crisis of 1973-74, in which the Bank of England launched a “lifeboat” for troubled small banks and National Westminster Bank nearly foundered.

 

Here is the blurb to Margaret Reid’s book on that crisis: “Abundant credit in a liberalised financial system led by a government hell-bent on growth provided a hot-house atmosphere for a breed of self-styled financial entrepreneurs...Their reign was brief, foundering in a mix of political chaos, currency crises, rebounding interest rates, over-investment in property and the inevitable and dramatic change in that most fickle of ingredients – confidence.”