My Blog

SAT 3 NOV 2007

College unemployment By Michael Pettis

According to a Xinhua report, the Ministry of Education said today that by then end of September, of the 5 million students who graduated in July of this year, 1.44 million were still unemployed.  Last year at this time there were 1.24 million unemployed recent graduates.  It isn’t clear from the article if the rise in the number of unemployed students was caused by fewer jobs offered or more students graduating.

 

I would guess that rising unemployment among college students has to be one of the things that worries anyone concerned about social stability.  I suppose that it will increase pressure for the authorities to avoid doing anything that might slow employment growth in the medium term.  As China’s financial markets become more efficient at allocating capital, there should be a positive impact on the market’s ability to generate good jobs for college graduates, but until then let’s hope that student expectations about job prospects don’t turn negative.

 

As an aside one of my former Tsinghua students who graduated two years ago and went to work for China Mobile came by my office to see me today.  He told me that he and one of his classmates had just quit their jobs to start a company that reads and tracks bar codes.  They expect to sell their product to big retailers.  They received about RMB 1 million (about $150 thousand) from a Taiwanese investor to use as their start-up capital, and in exchange the investor received 40% of the company.  In one year, the investor may consider putting up another RMB 2-3 million (I don’t know on what terms).  The company currently has ten employees.  It doesn’t take a lot of money in China to fund a start-up.

 

The same Xinhua report said that of the recently graduated college students that found jobs this year, a little less than one-half of 1% started their own businesses.

SAT 3 NOV 2007

Oil price hike By Michael Pettis

Yesterday (this entry was written two days before I was able to get it published, thanks to the damned firewall) the prices of diesel and gasoline were raised by almost 10% and I believe the government is also planning raise the price of natural gas.  This was the first price hike since May of last year.  Obviously that should affect prices for a number of other products and services that are currently frozen, most obviously transportation and maybe electricity.  According to NDRC, the gasoline price increase could push up headline CPI by 5bps, which suggests, using a rough back-of-the-envelope calculation, that gasoline prices comprise 5% of the CPI basket.

 

The real impact on inflation is not likely to be so easy to calculate.  I guess there are at least three ways it can affect CPI prices.  The first, and most obvious, is by increasing the direct cost of any product that uses oil in its production or transportation, which is to say the direct cost of almost everything.  The second is its impact on profit margins – will rising costs force producers to squeeze their profit margins to maintain market share or will it force them to raise profit margins to protect themselves from increasing oil-price uncertainty?  Finally it may affect inflationary expectations, which is probably the thing that most worries the authorities.

 

My guess is that the next set of high CPI inflation numbers will be dismissed as the consequence of another “one-off” price increase (like with food in earlier months) that won’t really matter for underlying inflation.  The problem with this reasoning is that this particular increase is not a one-off reversible phenomenon but is rather the partial uncovering of previous hidden inflation.  This wouldn’t matter too much if inflation were wholly a consequence of a temporary and reversible increase in food prices but, as I have explained elsewhere, I am not very comfortable with that explanation.  It is still too early to say if we have seen a reigniting of inflation in China, but none of the numbers are comforting.

 

Two days ago I mentioned that oil had traded down from Monday’s record high of $93.80 to $89.75.  Not for long.  Today Bloomberg says it traded at $95.52.  Rising oil prices are increasing demand for biofuels, which has also driven up the price for soybeans and corn.  Bad news for China, but on the other hand wheat is up only a little after its biggest monthly fall in five years.

SAT 3 NOV 2007

RMB appreciation is speeding up By Michael Pettis

According to a Bloomberg article today, the RMB was up 0.56% last week, reaching 7.456 to the dollar.  This may not sound like a lot if you trade dollar/euro, but it is easily the biggest one-week jump in the US dollar value of the currency since it was suddenly revalued by 2.1% in July, 2005.  According to a Bloomberg article, RMB forward contracts imply a price of 7.38 by the end of this year and 7.25 by the end of the first quarter.  The article did not list the contract expiration date or a more precise RMB value, so my calculations may be slightly off, but this implies a 6.4% annual appreciation between now and the end of the year and a 7.0% annual appreciation between now and the end of 2008’s first quarter.  Implied annual appreciation during the first quarter of 2008 is 7.3%.

 

Two reasons are generally given for the increase in appreciation rate, and both probably are true.  The first, and more cynical, reason is that there will be a meeting later this month between Chinese finance officials and their European counterparts, along with a meeting between France’s President Sarkozy and President Hu, and everyone expects the currency to be a very important topic of these meetings.  As they often do before such discussions, the Chinese authorities may be allowing the currency to appreciate to help deflect some of the expected anger.  One of the claims much beloved of journalists and China-watchers is that foreign pressure on Chinese authorities is almost always counterproductive, a claim about which I am extremely skeptical.

 

The second reason for the more rapid rise in the currency is that the inflation scare is ringing serious alarm bells in Zhongnanhai (the leadership compound), even while publicly the authorities still insist that inflation is a one-off temporary food thing.  Given the anxiety, it is striking to me that fuel prices were raised by nearly 10% last week and that there are rumors that other controlled prices may also rise.  This can’t help but feed into inflationary expectations.  I think the only thing that can easily explain the timing of such rises must be that the costs of the subsidies must be higher than the authorities are willing to support, although perhaps there is also a sense that they should get all the bad news out of the way as quickly as possible.

 

If market assumptions are correct and the RMB does begin to appreciate at 7.3%, with bank deposits yielding 3.8% you can earn 11.4% in US dollars if you can smuggle money into China and deposit it in a bank.  Even the most intrepid of my hedge fund friends in New York wouldn’t sniff at those kinds of returns, especially since the biggest risk is upside risk – a sudden maxi-revaluation.  There’s the problem – an obvious danger of speeding up the appreciation rate is that it might set off another wave of speculative inflows, thus pushing monetary conditions even more out of whack.  Poor PBoC – dammed if they do, damned if they don’t.

MON 5 NOV 2007

Inflation in China? By Michael Pettis

I have been asked again to guest blog on Brad Setser’s site (http://www.rgemonitor.com/blog/setser) and for my first entry I decided to summarize some of the inflationary concerns we have in China.  I am including that entry below.  I apologize if I repeat a lot of stuff from my earlier entries, but that is part of the summarizing.

 

In another week or so we are going to get the October CPI numbers for China and that will allow us to calculate inflation for the most recent month.  After three months of inflation numbers (6% on average) that significantly exceed the PBoC’s comfort level, everyone is going to be looking very closely to see what the new number may imply about the various issues bedeviling China.

 

To summarize CPI inflation behavior over the recent past, China’s CPI prices have been fairly stable until recently, rising by 2.8% in 2006.  Prices started to trend up in 2007, but not enough to create any alarm.  During the first five months of 2007 CPI inflation year-on-year (which tends to smooth out changes) hovered around the PBoC target of 3%, remaining on average under 3%.  In June, the year-on-year increase in CPI prices jumped to 4.4%, and then accelerated to 5.6% in July and 6.5% in August, before “moderating” to 6.2% in September.  For the first nine months of the year average CPI inflation has been 4.1%, well above the PBoC’s 3% target.

 

Much of the recent inflation has been blamed on the sharp increase in the price of food, which comprises about one-third of the total CPI basket, especially of pork, of which China is easily the world’s largest consumer.  Excluding cyclical components of the basket, price increases have stayed around 2% or less.  According to the authorities, food prices rose largely because of certain one-time events that created significant shortages – primarily flooding in the south and blue-ear disease among pigs.  They insist that these food price increases will reverse themselves over the next few months.  In that case what looks like inflation is really a one-off price shock that will soon work its way thought the economy unless it ignites inflationary expectations.

 

I am not sure I agree with this explanation.  My understanding of price increases caused by one-off supply shocks is that the increase in the price of a particular product is not inflationary.  As consumers are forced to spend more on that particular good, they divert spending from other goods and so exert downward pressure on the price of those other goods.  In a frictionless world, a price increase caused by a sudden or unexpected supply constraint should have zero net impact on inflation because it would be perfectly matched by deflation in other goods.  This seems to be what happened in Hong Kong.  The big rise in food prices in Hong Kong over the past few months was met by a drop in the price of most other goods, so that overall inflation has been very low (well under 2%).  Hong Kong may not be a great comparison because food comprises a much smaller share of the CPI basket, but the point is that one-off supply shocks are not automatically inflationary.

 

Of course we do not live in a frictionless world, and so it may be possible for a significant price rise in an important good to cause a temporary net increase in average prices, but I would imagine that the main source of friction might be downward price-stickiness cause by some kind of money illusion.  If that is the case, we might not expect a big rise in Chinese food prices to cause a sufficient decline in non-food prices to counterbalance it, but at the very least if the prices of non-food items were anyway rising too, the rate of increase would decline. 

 

That has not happened – structural inflation in China is positive and has actually inched upwards in the past few months.  PPI inflation has also risen recently, from 2.6% in August to 4.0% in September, and this has been caused almost exclusively by non-food items – steel and cement being the main culprits.  None of this is consistent, in my opinion, with the argument that inflation is a temporary problem caused by a series of one-off supply constraints.  At any rate price shocks are spreading – the government recently increased gasoline and diesel prices (which are subsidized) by 8-10% and there are rumors that more subsidized prices are going to be relaxed.

 

It is probably no surprise to people who know me to hear that my argument is that the problem is the currency regime which has locked China into an overly expansive monetary policy.  At first monetary expansion tended to be deflationary because in China it led to overinvestment, not excess consumption (the banking system channels monetary growth primarily into loans to the industrial sector).  At some point, though, all this money growth runs the risk of creating not just asset inflation (which we clearly already have) but also CPI inflation, and maybe this is what is beginning to happen.

 

Whether or not inflation is rising is never a purely academic debate but in China it has a particular urgency for at least two reasons.  First, previous periods of inflation – which usually begin with food price inflation – have led to bank withdrawals and the threat of social instability.  With one-year deposits at 3.8%, it will be increasingly difficult to convince depositors to leave their money in the bank if inflation stays at 6% or more, and deposit withdrawals are likely to end up in even more stock and real estate speculation.

 

Second, there are a number of constraints on the ability of the PBoC to raise interest rates sharply, and with nominal rates quite low, real rates in the official banking system in China may be very low or even negative (I specify the “official” banking system because there is strong evidence of a large and active “informal” banking sector paying much higher rates – my friend Dan Rosen has told me that he has even seen these rates quoted in some local newspapers).  If inflation rises too quickly and if the ability of the PBoC to raise lending rates is constrained by fears of accelerating NPLs, declining real rates caused by inflation may increase overinvestment and capital misallocation. 

 

By the way I have heard people argue that one good thing about rising inflation is that at least it helps to solve the currency undervaluation problem – if China’s inflation is higher than that of its trading partners, the net result is the equivalent of a further appreciation of the RMB.  Besides the fact that this would be too slow a way to adjust the currency, it is not necessarily true – the one is only like the other if real interest rates are allowed to adjust automatically, and of course they are not.  Also it should be remembered that even if real rates are constant, rising nominal rates have the effect of accelerating principle payments, and so inflation can place cash-flow pressures on borrowers if interest rates fully or partially adjust.  All of this can hurt an already weak banking sector, and I am definitely not one of those who believe that the banking sector is finally in good shape. 

 

There is really nothing good about rising inflation in China, although perhaps China, which has acted like a hyper-charged proxy for the rest of the world, is simply experiencing an exaggerated version of the inflation that seems to be emerging in the rest of the world too.  Most of my conversations here suggest that at least some people in the PBoC are extremely worried.

MON 5 NOV 2007

Export orders are down. Imports too. By Michael Pettis

Consistent with expectations that a weakening US economy will cause a decline in China’s trade surplus, the latest PMI figures show the new export orders index down by 1.5% for October.  Confounding those expectations, however, the new import orders index was down even more – it declined by 2.1%. 

 

In an October 23 entry (“A slowing US won’t fix China’s trade imbalance”) I suggested that if it is China’s monetary policy that is driving the trade surplus, rather than “excess” US consumption, a slowdown in the US economy would not necessarily result in a reduction in China’s trade surplus since this was driven by the excess of production over consumption, and this excess was largely a function of China’s monetary policy (or lack thereof).  One month’s numbers don’t prove anything, of course, but if this is true we would expect any slowdown or decline in exports to be matched by an equivalent decline in imports.  So far that looks like it may be happening.

 

I need to think this through a bit more, but I guess that if US demand does fall, we would either see lower Chinese export prices, so that Chinese exports would displace those of other developing countries, or either a decline in import demand caused by lower consumption or a buildup of inventory.

 

By the way a recent research piece by Credit Suisse claims that from the beginning of 2001 to the beginning of 2005, the RMB depreciated in real trade-adjusted terms by about 16%.  After that it began to appreciate in fits and starts by about 8% by early this summer before giving back about 3%.   

WED 7 NOV 2007

Emerging markets inflation roundup By Michael Pettis

I just received today’s Emerging Markets Economic Daily from Credit Suisse, in which they discuss the outlook and their expectations for a number of macroeconomic and political indicators. Here is what I noticed.  In the Argentina section, they say “Inflation indices published by INDEC show that inflationary pressures may be increasing”.  In the Brazil section, they talk about a favorable inflation scenario but add that “continued rise in prices of agricultural products should ensure maintenance of high IGP-DI inflation in October.”  In the Chile, Mexico and Venezuela sections they don’t mention inflation, but I know that inflation has been a big problem in Venezuela.

 

In the Russia section they say “The very unfavorable inflation data for October mean that even the latest official forecast of 10.5-11.0% for year-end may be exceeded.”  For South Africa they quote the SARB as saying “The most important challenge for monetary policy makers is to ensure that inflation is bought back under control.”  For Turkey they warn of “the aftermath of a worse-than-expected CPI inflation reading for October.”  For Ukraine they start by saying “October CPI inflation was extremely high, raising a risk that inflation may exceed 14% in December.” 

 

In the China section they say “China still faces upward pressure on retail fuel prices.”  In the Korea section they talk about excess monetary expansion but add that “a policy hike can probably be deferred, especially if headline CPI inflation does fall back below 3% year on year in November as we expect.”  For Malaysia they do not discuss inflation.

 

Of the twelve countries they discuss, in seven they warn about inflationary pressures, in one they think inflation is in good shape, and in four they say nothing about inflation, although I know that for at least one of them inflation has become a serious problem.

WED 7 NOV 2007

Why have the PBoC’s borrowing costs gone up? By Michael Pettis

Logan Wright, who writes research reports for Stone & McCarthy, consistently writes some of the most interesting stuff on Chinese financial markets – at least for those of us boring enough to think that reading about changes in short-term interest rates is a great way to spend an evening.  He has a new report out today (“China: A Rise in PBoC Paper Yields – What Does It Mean?”) that addresses one of those arcane things that China-watchers like me and Dan Rosen get all excited about.

 

We’ve all noticed that yields on central bank bills have risen quite a lot lately – two years ago 1-year yields were below 2%.  They climbed steadily, until about a year ago, and then for about six months until March of this year, they were more or less stuck at 2.80%.  Since then they’ve kept climbing until, as Wright says, “yields on 1-year bills spiked again this week, with the central bank selling 8.5 billion yuan in paper at a yield of 3.7990%, up 19.35 bps from last week's yield of 3.6055%, which was up 15 bps from the previous week. This week's result marks an all-time high for 1-year yields.” 

 

Given recent inflation numbers this might not seem surprising – increases in inflation are often followed by increases in short-term yields – but the PBoC has generally been wary of raising its cost of borrowing and has tended to limit auction size to keep rates under control.  This is one of the reasons that it has not sterilized as much of the money creation that we would have expected (even assuming that under China’s monetary conditions selling central bank bills is an effective sterilization tool).  Wrights says:

 

One of the reasons we assumed that the central bank limited upward pressure on yields in the past was because of the importance it attached to maintaining the interest rate gap between Chinese and U.S. interest rates. Clearly, the central bank is no longer as concerned about the interest rate gap as a hedge against capital inflows, and a recent SAFE report claimed that asset prices were a more significant factor compelling capital inflows than bets on yuan appreciation. With today's rise in yields, the interest rate gap between PBOC 1-year paper and 1-year US LIBOR is only 80 bps. With the gap shrinking, China's capital controls are likely to be tested, and we expect "unofficial capital inflows" to rise in the months to come. Rather than give in to the rising pressure on the yuan, we simply expect foreign exchange reserves to rise faster than they have previously…

 

…Another reason we assumed that the central bank limited upward pressure on yields was a concern about rising sterilization costs. These costs will definitely continue to accumulate as the central bank allows interest rates and interbank yields to rise, but they are still relatively marginal in terms of the central bank's balance sheet.

 

Wright suggests three possible explanations for the PBoC’s willingness to let rates rise.  First, the PBoC may be worried that bank lending is expanding too quickly in part because banks have little interest in taking on very low-yielding central bank paper, and by allowing rates to rise they are simply acknowledging the need for higher rates if they want to issue a lot more paper.  Banks have extended RMB 3.36 trillion in new loans in the first nine months of this year (about $450 billion, or 16% of all of last year’s GDP of RMB 20.94 trillion), compared to RMB 3.18 trillion in all of last year.  Even if loan growth slows (and it did for much of the third quarter), it is hard to imagine that the volume of new loans won’t equal 17-20% of 2007 GDP.

 

Medium and long-term RMB-denominated loans are growing at a 23.9% rate, while RMB deposits are growing at only a 16.8% rate, with most of that growth among enterprise deposits; household deposit growth rates are decelerating as depositors shift funds into the equity market. Last year, net issuance of PBOC sterilization paper was 1.034 trillion yuan. So far this year, net issuance has only been 645 billion yuan, despite a surge in capital inflows from the trade surplus. In addition, net issuance has been negative for the seven months since the end of March, reflecting poor market demand for PBOC paper under expectations of monetary tightening.

 

The second reason Wright suggests for the run-up in rates is to prepare the market for more aggressive rate hikes, and I think this is his favored explanation.  If inflation numbers for October continue to suggest difficulty in reining inflation in, some people expect that the PBoC will be prepared to act with more vigor, and letting rates rise is their way of preparing and signaling to the market.

 

Finally, Wright suggests that the PBoC may be trying to contract monetary expansion surreptitiously even though they may be under pressure not to do so.  By tightening interbank rates they don’t have to raise one-year benchmark deposit and lending rates.

 

The logic behind this may be political in nature. Before 2006, the widespread conventional wisdom in China was that raising interest rates was relatively difficult from a political perspective, because state-owned enterprises depended heavily on working capital loans extended at the benchmark lending rate or 10% below that lending rate, and these SOEs resisted higher costs of capital through their channels of influence in the Ministry of Commerce and the National Development and Reform Commission (NDRC). After all, the PBOC is not an independent central bank, and requires the approval of the State Council before raising interest rates.

 

Over the past two years, the NDRC has been calling for higher interest rates to limit the risk of overheating, and containing the rise in inflationary pressure seemed to be a larger political priority than caving to the demands of the state sector, whose profitability was rising rapidly. However, after five hikes in lending rates totaling 117 bps so far this year, state-owned companies may be getting a little squeamish regarding the prospect of future rate hikes and the impact on costs. According to some sources, the PBOC has conducted surveys of enterprises and found growing resistance to the rate moves conducted so far this year. With three rate hikes in the last quarter, and relatively conservative companies suddenly confronting borrowing costs that are 72 bps higher in a short period of time, this is not entirely surprising.

 

Whatever the reason, rates have gone up dramatically and it is clear that something has to change.  The PBoC is behaving as if they are worried about something, and that something obviously has to do with China’s monetary conditions.

WED 7 NOV 2007

More on overheating? By Michael Pettis

My assistant Oliver Shang tells me that the wholesale price of pork is up 1.9% in the last week, and has been trending upwards during the whole period since the last CPI release.  He says that other food prices, including vegetables, are also up a little.  What with this and the increase in gas prices two weeks ago I think people are expecting October CPI inflation to come in higher than August’s 6.5%.  Some people are claiming that it will break 7%.  I agree.

 

As an aside, according to Wednesday’s South China Morning Post, Cheng Siwei, vice-chairman of the Chinese People’s Political Consultative Conference, parliament’s top advisory body, said that Beijing needed to dampen international expectations that the RMB would keep rising.  In the same speech he caused a stir when he said that China should “balance” its reserves between the euro and the dollar.

 

According to Cheng, this “mindset” – international expectations that the RMB would keep rising – was more dangerous than a stronger RMB itself.  I think I understand why he is saying it, but I also think he underestimates how serious the RMB problem really is (and he can’t seem to resist the Chinese temptation to explain a domestic problem as somehow being caused by the “international” community). 

 

To the extent that his is a common perception within the government, I think the outlook for policy isn’t good.  If they believe that the “problem” of the RMB is not the impact of the currency regime on monetary policy but rather that China will be subject to damaging speculative inflows because of “international” perceptions that the RMB must rise, this may lead authorities to focus more on changing those perceptions by introducing volatility to the RMB’s appreciation, rather than adjusting the currency regime. 

 

By the way his comments make me skeptical of claims by some analysts that speculative inflows caused by faster appreciation are not a serious problem.

 

Finally, according to another article in Wednesday’s South China Morning Post:

 

Premier Wen Jiabao has mounted a rare public defense of his macroeconomic policies, which have been criticised both within the Communist Party and overseas. In an uncharacteristically assertive manner, Mr Wen arranged an interview with a group of Hong Kong reporters yesterday during his visit to Russia. The premier said the criticism directed at his economic policies was ill-founded - the strong and stable growth vindicated those policies.

 

"Everybody agrees that China's economy has been doing pretty well for the past five years and actually it's one bright spot [in the global economy]," said Mr Wen, who has been in charge of the economy since 2003. "If that's the case, then to label [our] macroeconomic controls as ‘toothless’ contradicts both fact and logic."  Mr Wen's management of the world's fourth-largest economy has been a subject of heated debate. Overseas media and analysts have said his macroeconomic controls have been ineffective in cooling the sizzling economy and run the risk of damaging the mainland's long-term growth

 

I have a lot of sympathy for Wen and think overall he has done a great job on a number of fronts, but I think managing the competing interests affected by economic and monetary policy isn’t easy and he is going to be criticized no matter what he does.  The options facing China are pretty limited and not terribly enticing.  Still, it is very interesting that he felt the need to defend himself while in the middle of his Russia visit.  It suggests to me that there must be real nasty debate and even some internal strains, reaching all the way into Zhongnanhai, the leadership compound in Beijing.

THU 8 NOV 2007

Comments By Michael Pettis

I have been getting some great comments on some of my entries, but I have not responded to any of them.  This is because my blog is still blocked in China, and although I can read the blog using a proxy, I cannot post on it without great difficulty.  My entries are all posted by one of my favorite students, who is spending a year in California, but it would be too complicated for me to ask him to post my responses to comments.  Apologies.

THU 8 NOV 2007

Mr. Sarkozy goes to Washington By Michael Pettis

Amid the adulation he received during his speech to the joint session of Congress, I noticed that Sarkozy remembered to bring up two subjects – the dollar and the RMB.  He criticized dollar weakness saying that the world’s leading exponent of free trade “should be the first to promote fair exchange rates”.  He also said “The yuan is already a problem for everybody. The dollar should not remain simply a problem for others. If we are not careful, monetary disorder risks descending into economic war, of which we would all be victims.” 

 

Clearly the value of the euro against Europe’s (or at least France’s) main trading partners is weighing on his mind.  He is supposed to visit Beijing, Shanghai and Xian (the home of the terracotta warriors) from November 25 to 27 and amidst agreeing on a Chinese order for two nuclear reactors (worth around ($9 billion) I expect he will discuss currency issues.

 

THU 8 NOV 2007

The declining US trade deficit By Michael Pettis

In Monday’s Financial Times, there is an Op-Ed piece by George Shultz and John Taylor on the US trade deficit (“The silver lining in America’s subprime cloud”).  They say:

 

The good news is the recent reversal of the steady upward climb in the current account deficit. During the past three quarters for which we have data the deficit has been cut by $119bn, falling from about 6 per cent of gross domestic product to 5 per cent, and the adjustment appears to be continuing.

 

Why the reversal? One explanation is the implementation of policies that these same international policymakers agreed to at recent past meetings. The basic economic principle that led to these policies is that the US current account deficit is caused by the gap between saving and investment. Accordingly, a three-pronged strategy was called for – reducing the US budget deficit to decrease government dissaving, raising economic growth abroad relative to the US in order to stimulate US exports and increasing the flexibility of exchange rates, especially in China, to facilitate the adjustment.

 

You can see the strategy being implemented now. The budget deficit has come down sharply to 1.2 per cent of GDP, well below historical averages and less than in most other countries. World economic growth – especially in emerging markets – has been strong, even as US growth has slowed. And China’s exchange rate has become more flexible – appreciating by 10 per cent since the peg was abandoned. Forward markets project further appreciation. All these policies are expected to reduce the current account deficit, but they take time – too much time to explain the sharp reduction in the current account in the past year.

 

So there must be other forces at work too. Because the current account deficit equals saving minus investment, these are logical places to look. Herein lies the silver lining. The housing turmoil has indeed cut a chunk out of investment – residential investment has fallen by $81bn in the three quarters during which the current account deficit declined, and even more compared with the peak of the housing boom earlier last year.

 

Hence a good part of the current account reduction can be directly attributed to the decline in residential investment. Moreover, the decline in housing prices is starting to increase the personal saving rate, as home equity loans are drying up and people are recognising that their housing wealth is not as large as they had expected. When asset prices were rising, households could spend what they earned and still see an increase in their net worth. Sometimes spending even exceeded income. Now, consumption is falling relative to income, so there is more household saving.

 

I worry that if the current global trade imbalance is caused not so much by US over-consumption but rather by excess Asian savings, the second prong, “raising economic growth abroad relative to the US in order to stimulate US exports” is far more important than the first, “reducing the US budget deficit to decrease government dissaving”.

 

If there is a sharp US slowdown (something about which, by the way, I am not wholly convinced) accompanied by a rise in US savings, I think the world’s balance of payments will indeed adjust, but how?  I am not optimistic that faster growth abroad is likely in the face of a sharp US slowdown – I am not a believer in the “decoupling” theory given that the US trade deficit in the past decade has risen, not dropped, as a share of global GDP.  The world still depends on US demand, and I suspect that if there is a US slowdown and a declining trade deficit, they will bring with them a global slowdown.  If the US raises its savings rate, that global slowdown could be even sharper. 

 

Past globalization cycles have all been underpinned by some event that caused a significant expansion in global liquidity, and for a long time I have been arguing that the combination of asset securitization (especially mortgage securitization) and the recycling of the US trade deficit has been the source of the liquidity expansion that has underpinned the latest globalization cycle.  If over the next two or three years we begin to see the unwinding or slowing of both, my theory will certainly be tested.

 

THU 8 NOV 2007

Small banks getting squeezed by IPOs By Michael Pettis

My invaluable assistant Oliver Shang tells me that according to a blog written by a banker at Dongguan City Commercial Bank, a small bank in Guangdong, short term interest rates are getting so high for some of the smaller banks that they are turning to alternative sources of funding to cover the period of deposit withdrawal during big IPOs. 

 

As I have written in earlier entries, big IPOs on the local exchanges are a real problem for the smaller banks, because they tend to be heavily oversubscribed (by as much as 100 times or more) and potential buyers have to deposit the full amount of their order with their brokers, even though they are unlikely to get more than 1-2% of their order filled.  As a result money is drawn from banks all over China and deposited with brokers, who then deposit the money in their own bank accounts, which are likely to be the largest banks.  The net effect is a drain of deposits from smaller banks, who already rely more heavily than big banks on purchased money to fund their loan book, to larger banks.

 

In order to keep their funding intact, the small banks enter into the short-term money markets to borrow against the withdrawn deposits, driving money market rates up substantially.  The PBoC does attempt partially to accommodate, but they do so mostly by not rolling over maturities due around the IPO dates, and they never do enough to eliminate the cash squeeze.

 

According to the banker-blogger, repo rates have become so high for the smaller commercial banks that some of these banks, including his own, are unwilling to finance in the repo market, and instead they choose to sell assets, mostly short-term assets, to raise liquidity.  The reason they do so is because large IPOs freeze money for at most four or five days, whereas the repo markets have become so tight that as much as two weeks before a big IPO, 14-day, 21-day, and 1-month repo rates all rise substantially.  Since the banks do not want to be locked into high-cost funding for so long (especially as large IPOs have become quite frequent) they prefer to raise liquidity by selling short-term paper.  This is apparently at least one reason for yields on short-term assets to have become so volatile recently. 

 

Unfortunately for the small banks the market is a learning machine.  Repo rates have started rising long before large IPOs because market participants are now used to the liquidity squeeze that precedes them, but as banks turn to selling short-term paper to get around the repo market, the prices of these assets are also dropping earlier and earlier before the IPO date.  This means that the small banks are effectively funding at high rates for longer and longer periods.

 

I believe the next scheduled big IPO is by China Railway Engineering Corporation.  Money for purchase orders will be frozen from November 21 to November 23.  They expect to issue 3-4 billion shares and may raise RMB 20 billion or more.  If past experience is any guide, we may see as much as RMB 2 trillion ($270 billion) or more in orders.

 

THU 8 NOV 2007

CPI inflation projection by PBoC By Michael Pettis

My assistant tells me that the PBoC has just published its 2007 Q3 Report.  I have not been able to find it in English on their website but I guess they may not have released the translated version yet.

 

According to the report, the PBoC expects GDP growth to be no less than 11.0% for 2007.  It has raised its CPI inflation projection for 2007 to 4.5%.  I calculate this to mean that it expects average inflation for the last three months of the year to be 5.6%.  On Tuesday we are supposed to get October CPI numbers, and a lot of people are expecting inflation for the month to exceed 7%.  If it is equal to 7.0%, we would need average CPI inflation over the last two months to be 4.9% in order to reach the target of 4.5% for 2007.

 

For those who want to do the calculations themselves, the monthly CPI numbers from January to September are 2.2%, 2.7%, 3.3%, 3%, 3.4%, 4.4%, 5.6%, 6.5%, and 6.2%.