My Blog

SAT 15 SEP 2007

Did US corporations "cause" the US-China trade imbalance? By Michael Pettis

This should be an unnecessary posting, but the topic has become so politicized that it has become hard to discuss without recriminations, and a lot of silly things are being said around it.  In the eagerness to assign “blame” for the US-China trade relationship, those in the it-ain’t-China’s-fault camp, and especially the Chinese press, love to point out that since a significant portion of Chinese exports to the US are from US multi-nationals, it must be US corporate policies, and not Chinese economic policies, that are to “blame” for the trade imbalance.  Bu this position makes no sense at all.

 

I don’t remember what portion of US exports are from US multinationals, but someone on Brad Setser’s blog (which, for those of my readers who don’t already read it, is something you should read regularly) claims that the number is 60-70% of total Chinese exports to the US.  This, he claims, proves that it is the fault of American corporations, and not Chinese policy-makers, that China is running a trade surplus with the US. 

 

Wrong – it proves nothing of the sort.

 

Imagine for a moment that the US suddenly passed a law making it illegal for any US corporation or subsidiary to own assets in China (and assume, unrealistically, that there were no other changes in the political relationships between the two countries).  Would the 60-70% of the Chinese trade surplus with the US immediately disappear?  Of course it wouldn’t.  The production and sale of those goods to the US would continue exactly as before, only now the facilities would be owned by Chinese (or Germans, or Japanese, or Brazilians or anyone else who took over the facilities).

 

Why?  Because the conditions that made it profitable to manufacture in China and sell to the US would not have changed.  Wages in China would still be low, infrastructure would still be solid, credit would still be excessive, and the RMB would still be seriously undervalued.  Meanwhile the US would still be a net recipient of capital, so that US consumption would still have to be higher than its production (i.e.it must run a trade deficit).  And Americans would still buy from China.  When Jones & Company manufactures a widget in China and sells it in the US, they do exactly the same thing that Zhang & Co. would do (ok, perhaps Jones & Co. knows a little more about marketing in the US and Zhang & Co. does a better job of getting a good deal in China, but you get my meaning).

 

China is running a trade surplus with the US in part because it has found itself locked into a currency regime that forces industrial production up without a commensurate increase in consumption.  The national origin of the exporter is irrelevant to the process and only reflects the importance of US corporations (especially in the US market) and the value both countries assign to the US-China relationship.  It does not affect the size of the trade relationship.

 

So does that mean I am in the blame-China camp?  No, because I do not think that the existing trading relationship is a serious problem for the US (although I do think it is a problem for China, as I have written many times before).  Since the US trade deficit is caused, in my opinion, not by the outrageous spending habits of Americans but because of the global excess savings – in most cases caused by specific savings-inducing policies in a number of countries – I do not believe that the question of what will happen when foreigners finally decide that they are “tired” of financing US excess consumption is an interesting question.  For me a better question is to wonder what will happen when China and Japan are “tired” of domestic policies that generate large savings (and so large trade surpluses), or what will happen when OPEC is “tired” of high oil prices.  Many things will happen, and they won’t necessarily result in the collapse of the US empire (which has anyway been collapsing unsuccessfully for nearly 90 years – since the early 1920s if I remember correctly, and most dramatically in the face of the Japanese onslaught of the 1980s).

 

Furthermore, and this may be a little more controversial because it requires some focus on long-term demographic trends, I think the US trade deficit is a necessary precondition for a world which will need to pay for a US trade surplus some time in the future.  The US economy and financial markets sometimes act, and have acted for many years, as a kind of residual that absorbs the various needs and requirements of the global economy in the aggregate – changes in the US force changes in the world, and vice versa.  In Europe, Japan and Russia today, and in China in about five years, we will begin to see a significant deterioration in the dependency ratios (as part of the aging process) that will require very heavy economic adjustments.  It is hard to overstate how dramatic and challenging these adjustments will be, and I frankly am a little pessimistic about the resulting prospect for all four countries.

 

But one thing is almost certain – these adjustments will have to be paid for by liquidating foreign claims, and the only market large enough in which to accumulate these claims is the US.  During this process the US will probably switch from being the world’s largest debtor to becoming a major net creditor in order for these countries to adjust.  By the way this isn’t unprecedented.  At the beginning of WWI the US was, as now, the world’s largest debtor nation.  By the end of the war it was the world’s largest creditor – because the European belligerents liquidated their claims against the US to pay for the war effort.  The adjustment required by aging countries will be far more costly economically than WWI, but fortunately spread out over a longer period of time.

 

SAT 15 SEP 2007

China and the savings glut (2) By Michael Pettis

Separating these three factors may unnecessarily imply different operating processes, but of course they are all intertwined and part of the same process.  At any rate because of these three processes, and undoubtedly others, the Chinese economy was focused primarily on producing and hoarding.  But for this policy to work for such a large economy, it needed the rest of the world (i.e. the US, whose markets were huge, whose financial system was extremely flexible, and whose consumers proved very easily convinced) to play along, and the China-US balance of payments relationship was the obvious result.

 

China has now found itself stuck in a savings trap.  The currency regime has been so successful at boosting the trade surplus that the trade surplus has run out of control and every attempt to rein it in has failed.  Unfortunately the currency regime has put into place a self-reinforcing system in which rising trade surpluses cause too-rapid expansion of the money supply, which is funneled by the banking system into greater industrial production, which causes further upward pressure on the trade surplus.  It is difficult for China to escape from this trap without a sharp adjustment in the currency, but aside from the continuing need to boost employment, one of the consequences of the currency regime and its subsequent impact on monetary conditions may have been the creation of a very shaky banking system and overinvestment into both production and speculative assets.  Since all of these are funded by the banking system, any sharp adjustment, aside from the adverse short term impact on employment, could have significant unintended consequences for the country’s very rigid and opaque financial system.

 

Much of the argument about the impact of the currency regime on China’s trade surpluses or the US trade deficit misses the point.  Many economists argue that China should not revalue because revaluing the RMB would have no impact on net US-China trade.  They say that since 40% of China’s exports are reprocessed imports, a change in the value of the currency would simply net out in the final export prices for a large fraction of Chinese exports.  They also argue that China competes largely with other Asian countries, so even if a revaluation caused its export prices to rise significantly, the only effect would be to shift its trade surplus to other Asian countries, which would leave the US and European trade deficits with Asia unchanged.  Finally, since China is the dominant player in many of its foreign export markets, it has sufficient pricing power that a rise in its export prices would have a minimal impact on its sales volumes, and in fact could actually cause the monetary value of its exports to rise further.

 

In spite of the fact that all but the first of these arguments are intellectually dubious for a number of reasons, and in fact really argue in favor of a currency revaluation (after all, if raising the value of the RMB will have little impact on China’s export volumes, and may even boost them, why not revalue and so improve China’s terms of trade?), they miss the main currency argument.  China is running a rising trade surplus because, by definition, it produces more than it consumes, and production is growing faster than consumption.  The root cause of the excess and growing Chinese production – as I see it, anyway, and have repeated ad nauseum in my blog – is China’s out-of-control monetary expansion.  This is itself caused by the rising trade surplus and augmented by FDI, attracted by the impact of an undervalued currency on real assets, and hot money inflows, aimed at taking advantage of the expected currency rise.  A revelaution will not reduce the trade surplus because of its direct impact on export prices.  It would reduce the trade surplus if it caused a reversal of capital flows sufficient to eliminate the monetary expansion that is at the root of the growing surplus.

 

As long as China is locked into this system, the trade surpluses will not go away.  Until there is a sharp adjustment – voluntary on the part of the financial authorities in the form of a maxi-revaluation, or involuntary in the form of a banking or investment crisis, which I fear is increasingly likely – it is not possible for China to get out of this trap.

 

In China consumption levels are not nearly enough to absorb the level of production needed to maintain employment (unemployment is actually rising, especially among college graduates).  This is just another way of saying that Chinese savings are too high.  This is also just another way of saying that China must run a trade surplus, and if China must run a trade surplus, and if it invests almost all of its reserves directly or indirectly (as in when it purchases oil stocks) in US assets, it is almost inevitable that the US run a trade deficit.  The only logical alternative would be for Europe or Japan to replace the US in that role, and for structural and political reasons I think this will be difficult.

 

If you agree that Bernanke is right – the world is saving too much – then the argument that we need to boost US savings could be a very dangerous one.  A world with excess savings does not need its largest economy to save more.  Of course a sudden rise in US savings would quickly reduce the US trade deficit, but it would do so not by boosting US or global demand for US products but rather by depressing US demand for imports.  Since US exports are highly correlated with US imports, a reduction in US import demand would probably also lead to a reduction in US exports (the US sells the machinery used to make the goods that are sold to the US), meaning that total US imports would have to decline by more than the current trade deficit in order to bring it into balance, because US exports would also decline. 

 

Global and US consumption and production, in other words, would have to fall, and the US and the world must become poorer for the US trade deficit to go away.  It is no secret that one way of eliminating the US trade deficit would be for US consumption to collapse and unemployment to rise, and I worry that this is exactly what a boost in US savings means.  If you think that growing foreign claims on the US are such a severe problem that it is worth increasing unemployment in the short term to correct the imbalance, then you might still support boosting US savings, and the short-term consequences be damned, but if you are not worried, as I am not, it seems like too high a price to pay.

 

By the way, the reason a country should save is so that its investment needs are met.  The US is an exception.  Its financial system is able to draw on global savings for all its domestic investment needs.  I am not sure “excess” consumption is as much a problem for Americans as it would be for other countries, although I would never say this in polite company for fear of getting hit on the head with bricks by all the millions of puritans and contrarians out there.

 

The real problem in the US-China relationship is not in the US, I think.  It seems to me that China has the bigger problem.  China cannot afford an interruption of this system, but unfortunately it is locked into a series of what I think are unsustainable processes.  It cannot afford such rapid monetary growth but it has no easy way in which to turn it off.  It cannot continue to channel so much money into speculation and overinvestment, but again there is no way to slow things down.  Because the financial authorities are so reluctant to make tough decisions now, the decisions are very likely to be forced onto them by adverse events in the markets, and it is almost certain that these will come at the worst possible time.  China simply does not have the flexibility the US economy has, and its ability to absorb shocks is limited.

 

SAT 15 SEP 2007

China and the savings glut (1) By Michael Pettis

On September 11 Ben Bernanke, Chairman of the Federal Reserve, gave a very useful presentation at the Bundesbank Lecture in Berlin.  It can be read at http://www.federalreserve.gov, and I strongly recommend that my Peking University students all read it.

 

Bernanke argues, as he has many time before, that the world is experiencing a savings glut.  According to him a number of developing countries, especially China and the OPEC countries, along with Japan, are saving far more than they are investing.  That means inevitably that they must export capital and run trade surpluses.  As the US is usually considered the safest and deepest financial market in the world, the US is the recipient of the world's global excess savings.  The inevitable result is that the US must run substantial trade deficits as the counterpart to its capital surplus.

 

I have been a believer of this thesis for several years.  Unfortunately Bernanke’s position has become much politicized and there are arguments back and forth about whether his hypothesis is merely an attempt to "blame" the US trade deficit on excess savings by foreigners rather than excess consumption by Americans.  These sorts of arguments are idiotic.  The fact is that any deficit country must by definition have “excess” consumption over savings, and any surplus country must have ”excess” savings over consumption, and it is not at all obvious which way the causality runs.  At any rate in my opinion this global “imbalance” is probably a good thing in the long term because running trade surpluses against the US is the only way Europe, Japan, China and Russia will be able to pay for the very brutal demographic adjustments they must make over the next two to three decades – and make no mistake, these adjustments will be brutal.

 

But leaving aside the silly argument as to whose fault it is, does Bernanke's argument do a good job of explaining the current US-China balance of payments?  I think the answer is yes – in fact it seems to me that China is a particularly good example of Bernanke’s thesis.  China does save too much – even the Chinese authorities acknowledge this, and they have made repeated and unsuccessful attempts to boost consumption.  The resulting trade surplus with the US is the inevitable consequence of this excess savings.

 

There has been a series of decisions made at both the macro level and at individual levels that explain the high savings rate in China, and these decision lead inexorably to the accumulation of US assets (through central bank purchases). Of course if China is running a large capital account surplus with the rest of the world, it must run an equally large trade surplus, and as the only country capable of absorbing such large flows, it falls to the US, with its very open financial markets, to absorb China’s trade surplus (excuse me for fudging the distinction between a trade surplus and a current account surplus, but in this case the distinction is unnecessary).

 

Of the three most obvious reasons leading to this decision towards excess savings, in my opinion, the first and most obvious arose as a consequence of the Asian Crisis in 1997. China’s policy-makers, like those of many other countries, were horrified by the impact of the crisis on the affected countries.  Unfortunately; also like many other policy-makers, they may have drawn the wrong conclusion about the cause of the crisis.

 

The Asian Crisis, like all financial crises, was caused because of serious mismatches in the national balance sheets that left the afflicted countries vulnerable to shocks that could quickly cause their balance sheets to unravel.  These mismatches create what looks like a virtuous circle when conditions are good, but they quickly become vicious circles when conditions change.  In the case of Korea, Thailand, Indonesia and Malaysia in 1997, this mismatch occurred in the form of having used highly liquid external capital for many years to fund less liquid domestic assets.  As long as capital poured into these countries, as they did until 1997, the result was a boom in which both sides of the balance sheet improved simultaneously – domestic asset values rose while real appreciation in the value of local currencies eroded the cost of external debt.  The process led to imbalances in asset values, however, which ultimately would cause capital to flow out – to devastating effect on the national balance sheets.

 

The incorrect lesson learned was that it was too much external debt and the lack of foreign currency reserves which left a country vulnerable to crisis (this lesson, of course, merely seemed to reinforce the lessons of earlier crises in Mexico, Brazil and elsewhere). The policy conclusion was that countries should limit highly liquid forms of capital inflow and systematically run trade surpluses to build the necessary reserves to protect them from the risks of future outflows.  Unfortunately in their haste to implement policies that encouraged trade surpluses, financial authorities in China and elsewhere may have put into place the policies that led to equally severe, but largely domestic, balance sheet mismatches.  (I strongly believe that next big round of global financial crises will be domestic banking crises.)

 

The second obvious cause of Chinese macro policies to boost savings was its very Asian reliance on export growth, and import constraint, to achieve sustainable growth in employment.  Since exports are the excess of production over consumption, in a growing economy boosting net exports is the flip side of raising the total amount of savings.  I think Joan Robinson’s investment multiplier explains how this happens.  As Chinese authorities channeled investment into infrastructure and production facilities aimed at developing the export sector, the resulting increase in national income was separated into high savings and low consumption, and the growing difference between production and consumption was exported.

 

This decision to boost exports had particularly Chinese reasons.  While most state-owned enterprises, which had dominated the economy until very recently, were inefficient and had too many useless workers, the export sector could take advantage of China’s natural advantages – cheap but dependable labor, a relatively strong infrastructure, and highly concentrated economic policy decision-making – to fuel an export boom that would absorb workers. 

 

Among the policies put into place to support export growth was an undervalued currency within a rigid currency regime – it had to be rigid to reduce uncertainty among exporters.  This export-orientation was exacerbated by the decision to join the WTO which, in my opinion was not about the benefits of free trade (the Chinese government has no natural predisposition to free trade) but rather about the need to use external constraints to open up the domestic markets, which were subject to a host of impenetrable trade barriers among provinces.  In that sense I liken joining WTO to Argentina’s use of a currency board (an external constraint) to force discipline on the spending habits of provincial governors.

 

The third obvious source of excess savings was the transformation taking place in China that significantly increased uncertainty as it reduced the social safety net.  As the cost and need for education rose, as medical services collapsed except for those with money, and as it became clear that there would be no protection for those that retired or were put out of work, worried Chinese families put an increasing portion of their rapidly rising income into savings, in an attempt, not yet wholly successful given the pace of the safety net collapse, to protect themselves from uncertainty.

TUE 18 SEP 2007

Appreciation in Chinese Yuan Versus Euro By Michael Pettis

This is a few days old but I was traveling until yesterday and not clever enough to figure out how to post it.  As the dollar weakens against the euro, dollar-pegged currencies like the RMB must necessarily also weaken, and the consequence involves major changes in the global balance of payments.

Sept. 14 (Bloomberg) -- European Central Bank President Jean-Claude Trichet and French Finance Minister Christine Lagarde urged Asian governments to let their currencies appreciate more to close disparities in global trade.  ``The yen and the yuan in particular are currencies whose level and spread pose a problem to global trade,'' Lagarde told reporters today after a meeting of euro-area finance chiefs in Oporto, Portugal. Trichet singled out China in saying it is ``desirable'' that Asian nations without floating exchange rates allow more movement in their currencies.

The concern among European officials is that, with the dollar at a record low against the euro, European exports stand to suffer if Asian currencies such as the Chinese yuan and Japanese yen don't gain more.  The calls for change come before European Union Monetary Affairs Commissioner Joaquin Almunia visits China next week for talks. While the yuan has risen against the dollar since the government ended a peg to the U.S. currency in July 2005; in the same period, the Chinese currency has declined versus the euro.

That is being reflected in trade data, with the euro region's trade gap with China expanding to 43 billion euros ($59.6 billion) in the five months through May, up 23 percent from a year earlier, according to the latest data. Updated statistics scheduled for release next week may show China surpassing the U.K. as the euro area's biggest source of goods.

If countries like China and Japan continue to run trade surpluses and accumulate reserves (i.e. produce more than they consume), the rest of the world must continue to run trade deficits.  Until now the US has absorbed most of these deficits, but if the dollar weakens because of reduced new purchases of dollar assets, one very likely result is that the deficit must shift to countries with stronger currencies – e.g. Europe.

 

The Europeans have two ways they can deal with this.  The less likely way is “import” Chinese monetary policy and buy massive amounts of dollars while expanding the domestic money supply – driving up capital inflows into the US would cause a balancing increase in the US trade deficit..  The more likely way, however, is to see imports expand at a faster rate than exports. – i.e. Euopre would run a growing trade deficit.  Given the rigidity of the European economy and high levels of unemployment, I don’t think there is an awful lot of appetite for the latter, and I expect we will see more pressure from Europe on countries perceived as running mercantilist policies to raise the values of their currencies.

 

TUE 18 SEP 2007

Maybe Chinese exposure to complex instruments is limited By Michael Pettis

I was in Hong Kong earlier this week and one of the things I like to do while there is to meet as many of my former students involved in banking and trading as possible.  On Sunday and Monday I had dinner and drinks with about twenty to thirty students and I met several others during my meetings at their banks.  I like to think that it is a testament to my teaching that many of my students are as skeptical and anxious as I am about financial systems in general, and are always looking for the bad news out there.  I am very close to some of these students and can usually rely on them to give me valuable information about things taking place in the financial markets.

 

Since many of them are involved in structuring and selling products to Chinese institutions, it was a good opportunity for me to glean perceptions and gossip about the exposure Chinese institutions may have to very complex insturments that may have suffered large – and as yet still concealed – losses in the recent market turmoil.

 

The results of our conversations were frankly quite comforting.  At least according to my students there isn't yet a major concern among bankers that there is lots of hidden toxic stuff out there in Chinese balance sheets waiting to be revealed at the worst possible time.  Conversations on the same subject with senior trader friends were also relatively placid (although many are increasingly worried about the Chinese banking system and about monetary policy).  This doesn't prove anything, of course, but as a general rule traders gossip about the existence of problems long before they are sprung onto the rest of the world, and there doesn't seem to be much worrying gossip just now.

 

THU 20 SEP 2007

China's sovereign wealth fund By Michael Pettis

Xinxin Li, of the G7 Group recently sent me a report on China’s newly created sovereign wealth fund.  G7 Group is a New-York-based research and consulting group partially owned by Xinhua that gives especially good information of the activities of various major governments and their impacts on financial markets.  He has allowed me to quote the following:

1) The Ministry of Finance has issued RMB 600bn STBs, the first batch of the approved RMB1.55 tn (equivalent to $200 bn), to finance the new CIC.  It is expected to receive another RMB100 bn by the end of September and the balance before year-end.

2) A seven-person executive team has been formed, representing all the interested parties.  The Chairman of the Board is the vice secretary general of the State Council (China's Cabinet) Lou Jiwei, who invited the current deputy head of the National Social Security Fund (China's national pension fund) Gao Xiqing to be the CEO of the CIC.   The team also includes vice finance minister Zhang Hongli, the head of Central Huijin, Xie Ping, and a representative from the NDRC.  The PBoC is supposed to send a deputy governor to join the team, but the appointment is still pending.  A possible candidate is the current deputy governor Su Ning.

3) This structure reflects the inter-ministerial nature of the CIC: it is not only a SWF seeking high investment returns, but a coordinator among different government agencies on China's overseas investment.
 
4) The CIC will have three major departments in terms of investment functions.  Central Huijin, the former investment arm of the PBoC, will be integrated into the CIC and continue to capitalize domestic financial firms. Another existing institution, China Jianyin Investment, will mainly operate in the area of managing domestic assets and disposing of non-performing loans.  In addition, the CIC will establish a new department for overseas investment.  The takeover of Central Huijin and Jianyin will make the CIC a big agency with about 1000 employees.

However, the CIC is quite different from what the global market was expecting, in terms of investment strategy and the pace at which it will operate overseas.  At the initial stage, it will focus on domestic issues rather than picking where it left off, so to speak, seeking overseas ventures similar to its Blackstone investment.  Why?
- Seemingly, its investment strategy is very flexible with only two criteria: its foreign currency investments cannot be exchanged back into RMB; and it must be profitable.  However, this ambiguity gives other government agencies excuses to tap into the CIC's foreign reserves, and lobbyists already are lined up at the door of Lou Jiwei's office.
- Very likely, the CIC will cooperate with the State Assets Supervision and Administration Commission (SASAC) and invest in 16 state-owned enterprises to fund their overseas expansion plans.
- The CIC has domestic policy responsibilities, e.g., pushing forward restructuring and capitalization of domestic financial firms.  As expected, it will inject up to $60 bn to two state-owned banks: the Agricultural Bank of China and China Development Bank.  Consequently, its available funds for foreign investment will be sharply reduced.
- At the same time, the CIC has to compensate the PBoC for its previous capitalization of domestic financial firms though the Central Huijing.  The PBoC is asking a "reasonable" price -- RMB500 bn ($67 bn).  This means, the CIC will limit its overseas investment further to roughly $70 bn.
- But the CIC is unlikely to use even this limited capital for overseas direct investment (ODI).  The State Council made it very clear that, "given its initial stage and the sensitive timing of the international financial market", the CIC will mainly outsource its foreign reserve management to the State Administration of Foreign Exchange (SAFE) and specialized financial institutions, at least in the short-term.
- Its portfolio will include non-dollar currencies, foreign stocks and high yield bonds, but strategic investment in commodities is not a priority yet.

All of a sudden, the CIC appears to be embracing a very conservative and gradualist investment strategy, in contrast to its audacious investment in Blackstone.  The unstated reasons behind this shift are both external political pressure and domestic criticism on the Blackstone deal.
- During German Chancellor Merkel's visit to China at the end of August, Chinese officials promised her that the CIC had no intention of buying a strategic stake in a big western company in the near future.  Clearly, that was a response to the growing worries from European countries about potential takeovers by foreign SWFs.  Many US officials also expressed the same concerns in their visits to China.
- Furthermore, Blackstone's share price has dropped below $24, or 20% below the CIC's purchase price.  This has aroused public criticism and political backlash.  Some critics accuse the CIC of recklessness, poor execution and bad-timing.  Others wonder why the investment was approved before the CIC had either a basic investment strategy or a risk management framework.

 

THU 20 SEP 2007

What is the PBoC doing to repo rates? By Michael Pettis

Dan Rosen was the first to alert me to the fact that short-term rates in China have soared in recent days.  The benchmark rate is the 7-day repo rate, which hit a pre-September high of 4.77% in April.  Today, however, it went to 6.69%.  The one-year repo rate, which had peaked at 4.45% in April was even more volatile, reaching 7.21% today.

 

My first thought was that this was a reaction to some recent large IPOs, notably the China Construction Band deal which priced on Monday with $300 billion of demand.  Combine this with a 50 basis point increase in the bank reserve ratio last week, and the recent and planned sales of long-term MoF bonds to finance the sovereign wealth fund, and it seemed like the run-up in rates was caused by a normal excess demand for funds in the repo market.  This is how it was described last Thursday (September 17) in the South China Morning Post:

Traders dumped mainland bills and bonds on Thursday as a money market squeeze triggered by tighter policy and China Construction Bank’s huge Shanghai initial public offering worsened. “There’s panic selling - people are scrambling to raise funds,” said a trader at a Chinese bank in Nanjing. “Liquidity is much tighter today than yesterday.”

 

The money market has suffered half a dozen other squeezes this year during big initial public offers of equity, and each time short-term interest rates have quickly pulled back near their previous levels after the IPO has passed. But the current panic appears to be more serious because it is occurring at a time of unprecedented monetary tightening, and after Tuesday’s announcement that last month’s inflation jumped to a 10-year high of 6.5 per cent, several traders said.

 

Over the past week authorities have announced a reserve ratio increase, a 151 billion yuan issue of special bills and a plan to sell 200 billion yuan of special bonds to the market, while an interest rate rise is expected as soon as this week. That has left the market unsure about how much liquidity the central bank intends to leave in the market after the IPO is completed, and how far short-term rates will eventually come back down. “There are too many uncertainties about policy now. The special bond issue really scared the market,” said a trader at a leading domestic bank in Shanghai.

 

Trading volume has shrunk dramatically because of the squeeze but some individual bonds were quoted early on Thursday at yields at least several basis points higher than Wednesday’s levels, traders said. “Nobody is buying bills or bonds,” said the trader in Nanjing. The weighted average seven-day repo rate, the key measure of short-term liquidity, jumped to a fresh two-month high of 4.0173 per cent from Wednesday’s close of 3.8437 per cent. Traders think it could hit a multi-year high of 5 per cent in the next couple of days as subscriptions are taken on Friday and Monday for CCB’s IPO, which is expected to attract a record total of more than 2 trillion yuan in subscriptions.

The central bank appeared to be trying to ease the squeeze last Thursday by canceling its regular weekly issue of three-year bills. That means it injected RMB 140 billion into the market, against a net drain of RMB 145 billion last week.  But that wasn’t the end of the story.  Today, as Dan pointed out, the deals have been put the bed and the unsuccessful bids returned, but instead of coming down, rates have actually increased.

 

So what is going on?  Quite a lot, it seems.  Market rumors are that this is all part of a short squeeze engineered by the PBoC because of their worries about inflation and rising stock prices, which may be linked in their minds.  Instead of acting to balance short-term changes in the supply of and demand for funds, as they normally do, they are simply walking away from the short-term markets and allowing rates to rise sharply.  By causing such volatility in market and letting short term rates rise so sharply, albeit temporarily (money is expected to seep back into the market over the next few weeks), they are hoping to undermine speculative fervor and, by slowing down the stock market, even take wealth-effect pressure from consumption (and thus reduce inflationary pressures).

 

This squeeze might have a dampening impact on the stock market, but since margin buying is illegal, I am not sure how the transmission will work.  At any rate the market has been slow but not panicky in the last three days, and in fact was up 1.40% today.  I suspect high repo rates may dampen demand for new issues more than they affect secondary trading levels.  

 

There may also be a very negative and unintended consequence.  With the Fed having lowered rates by 50 basis points, this may not be the best time to raise short term RMB rates if the PBoC wants to discourage speculative inflows.  After all, if you can get 7% in RMB, plus 5% or more in expected RMB appreciation against the dollar, the resulting 12% return in dollars is high enough to make all but the wildest hedge funds pretty happy.  Of course anything that encourages more hot money into the country will simply exacerbate the very process that is at the root of the imbalances the PBoC is so desperate to end.

 

Will any of my former students or other readers of this blog who are active in the local money markets weigh in?  What exactly is going on?