My Blog

SAT 10 NOV 2007

Index futures? By Michael Pettis

One of the advantages of having so many of my students become traders in Hong Kong and the mainland is that I get to hear a lot of the rumors.  Two of my former students recently told me about a rumor that seems to be very current in the market, and I called a third who also told me that he had heard it and he thought it was reasonably credible.  The rumor is that last week the Social Security Fund was asked to sell off up to 30% of its A-share positions over the next 30 days.

 

The last time these kinds of rumors surfaced, I am told, was last May, just before the May 30 increase in the stamp tax that trashed the markets.  The interpretation that these guys are putting on it is that we may finally see, early next month, the introduction of index futures.  Since these instruments are not available to retail investors, who would probably use the futures as a way of taking leveraged long positions, but are likely to be used by institutions, who are expected to use this largely for shorting purposes, most people expect that the introduction of index futures will drive the market down. 

 

Among other things a number of investors told me that they plan to buy H-shares and B-shares, which are at a deep discount to the A-share market, and hedge market risk by shorting the index.  There will be lots of tracking error, but given the size of the discount most people are not terribly worried about it.

 

I have no idea if this true or not and of course make no representation that it is, but this does seem to be a common rumor, and even if it is not true it may affect market behavior in the near future. 

 

SUN 11 NOV 2007

Growth in PBoC liabilities

People often tell me that the many predictions over the years of a sharp adjustment caused by excess money growth in China and have never come true, so why should we think they are likely to come true now?  Actually I think China has in fact gone through some sharp financial adjustments, most importantly in the very difficult 1993-95 period, which we fail to notice in part because China had no financial system to speak of (it was still largely an arm of the MoF) and in part because China was still too small and isolated to have much of an impact on the rest of the world.  But the reason for concern now is that the real monetary expansion has been quite recent.  If you look at a graph of central bank liabilities to banks and bondholders, you can see that the real growth only started to occur at the very end of 2003.  

 

Before then total liabilities to banks and bondholders hovered just under RMB 2 trillion for two years, before suddenly shooting up to around RMB 4.5 trillion by the end of 2004, RMB 6 trillion by the end of 2005, just under RMB 8 trillion by the end of 2007, and roughly RMB 9.5 trillion today.  This nearly five-fold increase in less than four years is what should be generating concern today.

 

SUN 11 NOV 2007

Minimum reserve requirement is up (again) By Michael Pettis

As was widely anticipated, on Saturday the PBoC raised the minimum reserve requirement for Chinese banks by 50 basis points to 13.5%.  This is the ninth increase this year and I think at current levels the minimum reserve requirement is the highest it has even been in PRC history.   This increase is expected to take RMB 190 billion (or $26 billion) out of the banking system – equivalent to about half a percent of total deposits (RMB 38.3 trillion), and substantially less than one month’s increase in foreign reserves (running at about $35 billion per month).

 

Many analysts expect that if inflation numbers remain high the PBoC will be forced to raise interest rates again.  I think this will probably happen, but I also think there are many constraints on the PBoC’s ability to keep raising them, and these are going to get worse, not better.  Apparently a number of state-owned enterprises (SOEs) have started complaining that with rates having jumped 117 basis points this year, financing costs are up roughly 20%, and these SOEs may be putting pressure on the NDRC to ease up on interest rate hikes (the PBoC cannot set interest rates independently but must get approval from the State Council).  Although it is true that rising inflation undermines the real cost of the rate increase over the full life of the loans, increasing interest rates will nonetheless have the same cashflow effect as accelerating principle payments, and rising rates are straining cashflow for some of the less healthy SOEs.

 

I also heard this weekend from traders that concerns are rising that increasing interest rates are putting a lot of pressure on mortgage borrowers.  I haven’t seen figures, and anyway the accounting is notoriously unreliable – it is widely believed that information provided on loan documents is “exaggerated” —but apparently one of the consequences of rising real estate prices may have been that in the past Chinese home-buyers have taken out mortgages whose servicing costs are as much as twice as high as a share of household income than is normally deemed prudent (roughly 25%).  

 

This may not be as a bad thing as it sounds because Chinese do save at very high levels, but most, if not all, of the mortgages in China are adjustable-rate mortgages, and so increasing interest rates by 20% this year must have been painful, and may be squeezing a lot of homeowners.  This is not a new story, by the way, but perhaps the sub-prime crisis in the US has made people more sensitive to problems in the Chinese mortgage market.  As an aside, two weeks ago one of my Peking University students told me that in another finance class a student had asked the professor if China has sub-prime mortgages, and the professor replied the in China all mortgages are sub-prime.  He got a big laugh.  He is exaggerating, of course, but it is not hard to hear some pretty hair-raising stories.

 

The PBoC has not said anything explicitly about their own constraints in raising interest rates, but from what people are saying in the market these issues are, at the very least, being discussed intensely.  As I mention in a November 7 entry, short-term interest rates in the repo market and in the bills market China have reached unprecedented levels and one theory making the rounds is that the PBoC is allowing short-term rates to run up as a “backdoor” way of constraining liquidity. 

 

That may be because they think the standard tools of monetary policy – interest hikes, sterilization, reserve hikes, administrative measures – have not seemed to have had much effect.  It is interesting that in their half-year report, released a few weeks ago, SAFE (the State Administration of Foreign Exchange – the PBoC’s trading and reserve-management arm) admitted in the roundabout way beloved of central bankers that monetary policy isn’t working: “The PBOC conducted a combination of open market operations and reserve requirement hikes in the first half of this year. The PBOC has raised reserve requirements six times by a total of 300 bps, increased the benchmark RMB lending and deposit rates three times and also raised the benchmark deposit rate for foreign currencies. These measures eased the surging money and credit supply. However, the excess liquidity situation hasn't been changed fundamentally."

 

The RMB continues to appreciate at a much faster pace than usual – this week it was up by a record 0.6% (not counting the one-off July 2005 revaluation when the RMB was de-pegged), which means over the last two weeks it has gone up by nearly 1.2% (it is up about 12% since July, 2005).  Most traders and academics that I talk to are still unsure of whether this represents a real change in policy or just posturing before the various European meetings later this month.  My guess is that the meetings may have increased pressure but in the end it is the weakness of the dollar and the increasing perception that monetary policy tools are not working that are driving the faster pace of appreciation, and that this will continue even after Sarkozy’s visit on November 25.  

 

The weak dollar has certainly made it easier (and maybe politically necessary, vis a vis Europe) for China to revalue.  I suppose the authorities will experiment with a faster revaluation and see if it does set off a renewed inflow of speculative capital.  I believe that it will, in which case the authorities may backtrack and slow down the rate of appreciation, but I think the authorities will eventually be forced to move to Plan B – a one-off maxi-revaluation.  More and more Chinese economists (although still a tiny minority) believe that this is where we are headed.  The idea was unthinkable six months ago but a recent poll showed that 5% of Chinese economists now favor a one-off maxi-revaluation and there are strong rumors that the idea was even proposed at the State Council level (and soundly rejected).

 

Don’t forget that on Tuesday we are supposed to get October CPI inflation numbers.

 

MON 12 NOV 2007

October trade numbers By Michael Pettis

October’s trade surplus came out and the number is both good news and bad news.  The bad news is that at $27.1 billion, this is the highest monthly trade surplus on record, surpassing slightly the previous record, last June’s $26.9 billion.  The good news is that it is not as bad as the $30 billion surplus many expected (indeed the South China Morning Post called the number “surprisingly small”). 

 

Exports grew by 22.3% year on year, to $107.7 billion, which was in line with forecasts, but imports surprised on the strong side, growing by 25.5% year on year to $80.7 billion.  Although part of the higher import bill was because of higher oil and commodity prices, and another part was probably caused by increased commodity imports to fuel the expansion in industrial production, at least some were crediting import growth with government programs to boost consumption – according to the Financial Times, Li Yushi, vice-director of a Ministry of Commerce think-tank in Beijing said “The strong growth in imports should be attributed to China’s encouraging policies and the strong domestic economy.”  I am not sure how we would disentangle the impact on consumption of government programs from the wealth effect caused by the bull stock and real estate markets, but there you have it.

 

China imported this year about 13-14 million tons of crude oil a month.  A quick Google search tells me that there are 7.2 barrels in a ton, so China imports about 100 million barrels a month.  Working backwards, if we assume that the 100% of the difference between actual and expected import levels was caused by higher oil prices, China’s oil bill would have had to have increased by $30 per barrel – not very likely.  I don’t know how China imports oil, how much is purchased spot and how much forward, and what the timing of the forwards are, but very roughly I would guess that rising oil prices account for about one-third of the import increase, unless China does all of its buying in the spot market (which I doubt), in which case the recent accelerating oil price increases would have doubled this share.

 

The surplus in the first ten months of this year was US$212.4 billion, up 59 per cent from US$133.6 billion in the same period last year. The surplus for all of last year was US$177.47 billion.  On a straight line projection, it suggests that this year’s trade surplus will exceed last year’s by over $100 billion.  Among the comments in the various press reports I have read I see that some analysts believe that the lower-than-expected number takes pressure off China in its discussions with Europe and the US, but I am not sure I agree.  It is hard to dismiss a record trade surplus by saying it could have been even higher.  At any rate year-to-date Chinese exports to Europe and the US grew by 30.7% and 15.5% respectively.  The China-US trade surplus in October was $15.4 billion for the US versus $13.9 billion with Europe.  This will make the European discussions later this month a little testy.

 

As regular readers know, I believe that the level of industrial production is the key indicator of future trade performance, and since that number has been high and rising, I expect more record or near-record trade surpluses over the next few months.

 

MON 12 NOV 2007

Finanacial Times recommends maxi-reval By Michael Pettis

Yesterday the Financial Times published an editorial on inflation in China (“Inflation: China’s least wanted export’).  They made the by-now-consensus point that inflation in China can no longer be dismissed as a one-off food price increase, that it is structural and reflects China’s lack of monetary control.  The last paragraph in particular interested me:

 

There must now be a low, but non-zero, probability that China opts for a one-off revaluation of the renminbi in order to ease its domestic monetary problems. That would be the right move. The adjustment would be easier both for China and for the rest of the world if the renminbi had not been kept so low for so long. But the pain of unwinding global imbalances will only get worse the longer they are left.

 

In February when I told my finance class at Peking University that China would be forced into a one-off maxi-revaluation, I told them that this opinion might have seemed crazy, but it would gradually move from the “crank” corners of economic discussion towards the consensus view over a year or so (although I think that if the actual revaluation doesn’t happen in late 2007 or very early 2008, fear of ruining the Olympics, which begins August 8, will prevent it from happening until late 2008, which may be way too late).  The need for a maxi-revaluation is still not a consensus view by any means, but I think it is clearly becoming more respectable.

 

MON 12 NOV 2007

CPI inflation for October is 6.5% By Michael Pettis

Finally the numbers are in.  The CPI was up 6.5% in October.  This matches CPI inflation for August and, with that exception, is the highest monthly CPI inflation number since the 7.0% recorded in December 1996. On the one hand October inflation slightly exceeded the consensus forecast of 6.3-6.4%, but on the other hand it is below the 6.8-7.0% that some people (including me) were worrying about.

 

But is it really below 7%?  The non-food component rose just 1.1% last month from a year earlier, the same pace as it did in September, whereas food prices were up 17.6%.  I asked Oliver Shang, my assistant, to check whether the weighing of the components in the CPI basket have changed recently.  According to him, at the beginning of the year small changes may be made in the composition of the basket, but major changes are only made every five years or so.  That worries me, because it suggests that the composition of the basket hasn’t adjusted during 2007 to take into account price changes, and this might underreport the inflation actually felt by the average Chinese family.

 

For all of this year the food component of the CPI basket has been set at just over 33% of the total.  But food prices have risen by about 15-20% since the beginning of the year.  Wouldn’t that mean that the average Chinese family spends more on food than it used to, even if we assume that higher food prices may have shifted consumption somewhat?  I recompiled the CPI numbers assuming that food’s share rose from 33% to just 36% (I assumed that there has been a lot of substitution and reduced food consumption), and I found that this would have driven CPI prices up by 7% year on year in October.  Is this right, or is my methodology mistaken?

TUE 13 NOV 2007

October CPI inflation rose to 6.5% By Michael Pettis

Finally the numbers are in.  China’s CPI was up 6.5% in October, up from 6.2% in September.  This matches CPI inflation for August and, with that exception, is the highest monthly CPI inflation number since the 7.0% recorded in December 1996.

 

On the one hand October inflation slightly exceeded the consensus forecast of 6.3-6.4%, but on the other hand it is below the 6.8-7.0% that some people (including me) were worrying about. (However you can read my previous entry to see why I think October inflation may actually be over 7 %.)  This is the third month of inflation over 6%, and I think that given the recent cut in fuel subsidies it is hard to see what can drive CPI inflation below 6% for the rest of the year.

 

I think by now it is pretty clear that this is no longer just a food thing, although some analysts continue to say that it is.  For example they argue that the non-food component rose just 1.1% last month from a year earlier, the same pace as it did in September, whereas food prices were up 17.6%. 

 

That suggests that food is still the primary force driving prices upward, although in a poor country where one-third of the CPI basket is food, I would think that rising food prices must affect wages and, through wages, the rest of the economy.  More to the point today we were also told that PPI was up 3.2% in October, compared to 2.7% in September (and 2.6% in August, 2.4% in July, and 2.5% in June).  Food prices were a big part of that, but oil and raw materials were up 4.8% and mining was up 5.4%, (4.5% and 1.2% in September), and this doesn’t fully take into account the 8-10% increase in gasoline and diesel prices that was passed late last month.

 

There is a lot of disagreement on where this will go.  Goldman Sachs have just changed their 2008 inflation forecast from 4.0% to 4.5%, whereas Credit Suisse keeps saying that it is going to be very hard to bring inflation down next year.  In explaining their forecast, Goldman said to its clients in a note today that “We believe the central bank will likely respond with additional tightening measures including strict control on bank lending and two more rate hikes before the end of this year.”

 

I have a great deal of respect for my Goldman Sachs friends, but I have to go with Credit Suisse’s Dong Tao on this one. Goldman, and everybody else for that matter, is right in saying that the high CPI inflation number is likely to lead to additional tightening measures, but given China’s monetary policies I cannot see how these tightening measures will work to reduce inflation.  The whole point of tightening will be to reduce consumer demand as a way of putting a lid on inflation.  But if consumer demands moderates, what will that do to the trade surplus? 

 

Of course it will rise even faster, and as the PBoC is forced to purchase the additional inflow, China’s money supply will expand even more quickly.  In addition, whether or not you believe that speculative inflows are a serious problem for China (I think they are), it is hard to argue that raising interest rates won’t have at least some positive effect on inflows.  PBoC tightening, in other words, is likely to increase current and capital account inflows.  The only market tools they have to attack inflation will, perversely enough, increase monetary expansion, and if you believe as I do that the root cause of Chinese inflation is excess money growth, that cannot be a viable solution.

 

I think China is stuck and can do nothing about domestic inflation without fixing the currency problem.  This gets to the nub of the reason why I think China will be forced into a maxi-revaluation (or at least a significant speeding up of the daily appreciation).  The authorities have no control over monetary policy and never will until they address the currency regime.

 

This pessimism of mine was confirmed, I think, by other October data.  M2 was up in October by 18.5%, a very high number, and more or less in line with monthly growth over the past four or five months (and at record levels since 2003).  Bad as this is, it was exceeded by the 22.2% growth in M1 in October (also at or near record levels since 2003).  With M1 growing faster than M2 every month since November of last year, (before than for several years either the two grew at near-identical rates or M2 grew substantially faster) depositors seem to be shifting money into more liquid facilities so causing money velocity to rise.

 

Logan Wright, of Stone & McCarthy, in a recent uncirculated report finds even more to worry about in looking at October numbers for the composition of bank portfolios.  Not only is loan growth at near-record levels on a seasonally adjusted basis (loan growth in October tends to low or even negative, whereas this year it is up by RMB 136 billion), but banking deposits actually declined in October.

 

More alarmingly from the perspective of the central bank is the data on banking system deposits, which reveal that absolute levels of overall deposits in the banking system fell on a month-on-month basis for the first time since July 2001. Renminbi deposits in the banking system fell by 449.8 billion yuan, and total deposits fell by 434.2 billion yuan. Renminbi deposit growth fell sharply to 14.9% year-on-year from 16.8% in September and 16.5% in August…

 

…Household deposits are now rising at only a 3.7% rate year-on-year, and these deposits have traditionally been the primary source of banking system liquidity. Interestingly, enterprise deposits, which have been rising much more rapidly in recent years, declined month-on-month as well, by 194.7 billion yuan. Enterprise deposits are still growing at a 22.7% rate year-on-year, and this constitutes the bulk of the growth in banking system deposits throughout 2007, meaning that the banking system is becoming even more dependent upon the profits of Chinese enterprises and the macroeconomy as a whole. We should caution that this is only one month of data, and a somewhat distorted one at that, being October, but the central bank is unlikely to be pleased with the flows of deposits out of the banking system and into the equity market, given its previous statements about the importance of maintaining positive real deposit rates.

 

It is hard not to look at all of this and not conclude that the fears that some of us had as far back as 2003 – that China’s currency regime was locking it into a monetary trap – were unjustified.  Monetary conditions have played out almost exactly as expected.  In my opinion, as this thing continues to unfold the logic of a maxi-revaluation will only become clearer, but it is probably too late to undo all the damage.

 

WED 14 NOV 2007

Zhou calls for positive real interest rates

On Wednesday Zhou Xiaochuan was interviewed by a newspaper published by the PBoC, of which he is the governor, in which he insisted that the PBoC would stabilize inflationary expectations, curb excess liquidity and pull real interest rates out of negative territory.  One-year deposits at 3.87% and inflation for the past year has three months has been 6.4%.  He also said, probably in reference to October’s seasonally high growth in credit, “We must implement appropriately tight monetary policies, continue to take comprehensive measures, improve and innovate in policy tools, and appropriately step up macro controls in order to maintain reasonable credit growth.”

 

I don’t want to read to much into these particular tea leaves, but from what Zhou has said and from what I am hearing elsewhere it seems to me that a number of recent issues have caught Zhou’s eye.  First, most obviously, CPI inflation is not moderating, and there is reason to fear that it might be spreading.  Second, the RMB 449.8 billion drop in RMB banking deposits in October may be indicating an acceleration of capital flows into the stock market – in part because of a few very large (and crazily successful) IPOs but also perhaps because of negative real interest rates.  Third, new loans expanded by RMB 136.1 billion in October, which is an historical high for a normally very weak month.  Clearly commercial banks are still eager and able to expand their loan books in spite of several minimum reserve hikes and lots of moral suasion.

Zhou has already said last week that the first priority of the central bank was to curb inflation and maintain price stability.  Maintaining employment would take a back seat in monetary policy.  Xinxin Li of the G7 group has this to say:

"- The PBoC is inclined to define the current problem as an overall inflation pickup, and the conclusion is it is a monetary phenomenon caused by accumulated effects of external imbalances and money supply growth… 

"- By comparison, the National Development and Reform Commission (NDRC, the economic planning committee) still sees the CPI jump as a supply shock of food and commodities.  By denying a full-scale inflation, the NDRC may have more flexibility to increase energy and utility prices, which are still heavily subsidized by the government. On November 1, the widespread shortage of diesel and gasoline finally forced the NDRC to increase the refined petroleum price by 10%.

"- The position of the National Statistics Bureau (NBS), another government agency capable of macroeconomic projection, is closer to the NDRC's view. It is quite optimistic on the inflation outlook and believes that the CPI will moderate gradually in H1'07."

The outcome of this policy disagreement is not at all clear in the short run.  My guess is that the PBoC needs higher CPI inflation numbers to strengthen its case for speeding RMB appreciation, although another few months of record trade surpluses and increasing anger from the US and Europe may also do the trick.

THU 15 NOV 2007

Industrial growth up 17.9% for October By Michael Pettis

Finally we have a piece of somewhat good news.  Industrial production was up only 17.9% year on year in October, down substantially from September’s 18.9% year-on-year rise.  Not only is this well below last month’s number, it is also well below expectations, which were for an 18.3-18.5% rise.

 

But we shouldn’t get too excited by the decline.  September’s growth in industrial production was extremely high, and the October growth rate may be a partial rebalancing of that number.  The October figure is more or less in line with August’s 17.5% and July’s 18.0%.  

 

Also it seems to me that in past year we saw these numbers moderate around this time of year before bouncing back up again early in the next year.  This may have something to do with the reduction in credit expansion we normally see in October, including this October.  For the first ten months of the year total factory output was 18.5% higher than for the same period in 2006.

 

FRI 16 NOV 2007

Cap on bank deposit withdrawals in Shenzhen By Michael Pettis

In Shenzhen, a city in Guangdong near the Hong Kong border, the local branch of the PBoC has issued instructions to local banks to limit cash withdrawals. Individuals are allowed to withdraw no more than RMB 30,000 (about $4,000) a day, RMB 50,000 a week, or RMB 200,000 a month from their bank accounts.  The limit for companies is RMB 100,000, RMB 200,000 and RMB 500,000 respectively.

 

The reason for this restriction is to slow down the flood of money leaving the mainland attempting to take advantage of the relatively lower share prices at which Chinese companies sell in Hong Kong.  I think H-shares (Hong-Kong-traded shares) trade at roughly half the price of A-shares (Shanghai- or Shenzhen-traded shares).  Of the RMB 195.6 reduction in deposits withdrawn across the mainland in the year to date, about half comes from Shenzhen, giving pretty good circumstantial evidence that this money is being withdrawn to be invested in Hong Kong.

 

I am not sure how effective these measures will be.  It is pretty commonplace here that bank records are so weak that little information travels from branch to branch, and even less so from bank to bank.  If you open two accounts at two different banks you can probably transfer half your money to one of those accounts legally and then legally withdraw the full amount permitted from each account.  The only ones who won’t be able to do this are depositors who have too little money to afford the hassle and cost of opening two accounts, but I doubt they are the big source of speculation anyway.

 

One thing though, this is good practice for dealing more generally with bank runs.

 

FRI 16 NOV 2007

US slowdown and Chinese investment By Michael Pettis

Two related stories in today’s Financial Times point out one of the most worrying economic risks facing the world today.  The first is a report by China’s National Bureau of Statistics that fixed asset investment (FAI) in urban areas was up 26.9% (to RMB 8.9 trillion) during the first 10 months of the year compared with the same period last year.  This is the highest it has been in over a year.  Market expectations were for an already high 26.3%, in line with last month’s figure of 26.4%.

 

In an entry yesterday I pointed out that the slowing down of the growth of industrial production was one of the few good numbers that had come out in recent months because rising industrial production is what powers growth in the trade surplus, and China desperately needed to bring the trade surplus down.  Although most economists were expecting continued moderation in the industrial production growth rate, I was (surprise!) less optimistic because September’s number had been so high and October’s trade surplus was at a record level, so it seemed to me that the dynamics driving this money-creating machine were stronger than ever.

 

The very high FAI numbers deepens my concern.  All of this investment is likely to increase production, and if Chinese consumption does not keep pace (and it seems that it cannot), the excess must increase the country’s trade surplus and so its money growth.

 

The second article in the Financial Times has the headline “US slowdown threatens Chinese export growth”.  It reports that China’s commerce ministry has warned that a slowdown in the US economy could create a sharp enough drop in China’s exports to create what they called a “turning point” for economic growth.  According to the article the PBoC estimates that every 1% drop in US GDP growth would be accompanied by a 6% drop in Chinese export growth – scary indeed, given that exports account for one-third of Chinese growth, and are probably the healthiest part of that growth.

 

Of course this might just be the typical Chinese posturing before a series of important meetings (with Secretary Paulson, President Sarkozy and ECB Governor Trichet) later this month in which the currency is sure to come up, but perhaps it is also true.  I think I am less pessimistic than most about a sharp slowdown in the US economy, but I confess to being well out of my depths and I recognize that my expectations come with a very wide standard deviation. 

 

The question is what happens if we have both furious Chinese investment and a stalling US economy.  High levels of Chinese investment will lead to high levels of industrial production.  My simple calculus says that since this will result in a growing excess of production over consumption, and since the difference must be equal (give or take a few smaller accounts) to the trade surplus, the result must be a rising Chinese trade surplus.

 

But if US GDP (and that of the rest of the world in the aggregate) slows, and global consumption slows with it, how does this work?  One effect might be that Chinese exports simply displace the exports of other low-income (or even some middle- and high-income) countries – China, in effect, exports unemployment to its neighbors.  This would be accomplished by lowering prices, and thus lowering corporate profitability (which might affect the banking system).

 

Another possibility is that China counteracts a global slowdown by increasing domestic investment further (I don’t think it is likely to increase consumption).  I guess there are three ways this can happen.  First, corporations can invest more in productive facilities.  Second, the government can invest more in infrastructure, education, health, etc.  And third, corporations can be forced to invest by increasing inventory.

 

I think we would all agree that the third possibility would be a disaster.  Rising inventories would simply signal that we are in the early stages of an old-fashioned over-production crisis, like those the US used regularly to experience in the 19^th Century.  Unless the global economy quickly turned around and started absorbing those inventories, the process would have to be followed by a sharp drop in investment and employment.  (In that context there is a monograph, written by Richard Chew of Virginia State University, called “Certain Victims of an International Contagion: the Panic of 1797 and the Hard Times of the Late 1790s in Baltimore”, that may give some interesting insights on China’s transition from export-led growth to domestic demand-led growth.)

 

The first possibility is better, but not a lot more.  If corporations invest even more in production facilities, we would effectively be simply doubling the bet, and hoping that global growth emerged quickly enough to absorb the future increase in inventories.  Doubling a bet is only fun if you win the bet the second time around – if not, the outcome is even worse.

 

The second possibility, that the government expands investment in infrastructure, is probably the least damaging, but it would involve a significant re-orientation of the economy (good in the long run) and a significant increase in debt.  This last may not seem like a big deal, but I think real government debt levels are much higher in China than people think (at least 60% of GDP if contingent liabilities through the banking system are included), and I would not be totally happy about seeing it rise too quickly.  Still, it is probably the least damaging outcome, at least in the short run.

 

So, my prediction?  If the US slows down, expect to see a run-up in Chinese government debt or a rapid ruin-up in Chinese corporate inventory, or both. 

 

FRI 16 NOV 2007

Can export crisis lead to internal development? By Michael Pettis

I was taken to task in my previous posting for having hurried over the idea that China might respond to a US and global slowdown by exporting unemployment to its neighbors, but I agree that it is a real possibility and even likely to happen.  In fact if China is locked into an overproduction cycle, declining global consumption will probably result in both a build-up of inventory AND an export push that unsettles its neighbors and competitors.

 

That is why I mentioned Richard Chew’s article on the 1797 crisis.  He argues that before the crisis the US was an export machine, heavily dependent on its export sector for its booming domestic economy (sound familiar?).  The global slow-down of the period totally derailed the US economy and caused a great deal of damage in the short-run, but in the long run it forced the US to re-orient its economy towards its own internal development and domestic demand.  This clearly was key for the subsequent economic rise of the US.

 

I am always branded a pessimist because I think a financial crisis is inevitable in China, but I think that this is just common sense – in fact China will have not one but many crises (and has had in the past two decades).  The history of any developing country, including China’s own history, makes that evident. 

 

But actually for me it is crucial that China make the same change that the US did after 1797 and reorient itself towards its own huge internal market, and as in the US I think it will probably take an export-led crisis to force the change – and the sooner the better.  Crises are painful, but they often result in necessary changes that permit long-term development, and there is no question in my mind that the current Chinese model has outlived its usefulness.

 

Of course there is one big difference between the US and China.  Americans were far more favorably disposed to the legitimacy of their government in 1797 than most Chinese are today (and yet still faced one major and many minor secession crises).  Most Chinese support their government, but that support is very brittle, and it doesn’t take much to break it.  This was made pretty clear to me during the SARS crisis.  The foundation of the support anyway is a nationalism that can as easily turn against the government as support it. 

 

So the question, more for the political scientists than for me, is whether a serious financial crisis that leads to an economic crisis can also result in a political crisis.  I was very interested four years ago when a professor at Tsinghua who advises senior Party officials told me that foreigners focus too much on the June 4, 1989, crisis (which of course followed a period of inflation) when, according to him, the real crisis that nearly brought the Party down was the 1993-94 inflation crisis.  I don’t fully understand why he thought so, but was impressed that he did.

 

One response to my entry suggested that China is still desperately poor and so could easily benefit from a massive spending program in the case of a US slowdown.  That is certainly true.  I travel a lot through China and it is probably only because I grew up in developing countries that I am not shocked by the level of poverty in some places.  But the government doesn’t need a US slowdown to justify that spending, and if it hasn’t done as much as it should that may be because the problem is huge and there is no real support for it -- poor farmers, frankly, are not nearly the political threat that poor city dwellers are.  In addition, if China is indeed facing a major adjustment caused by a drop in exports, the banking system may suddenly become a big concern again, and that won’t be the right time to engage in increasing government debt.

 

FRI 16 NOV 2007

Can the PBoC use state shares to sterilize? By Michael Pettis

I am guest-blogging on Brad Setser’s blog again and after one of my postings there has been an interesting discussion about selling shares as a form of sterilization. Since it is not clear that the PBoC can sell enough bills to sterilize its massive money creation, and anyway it is not clear that central bank bills are far enough from money to reduce liquidity in the system, one argument has been that the government should sell its shares in tradable companies and deposit the proceeds at its account at the PBoC. This would have the same effect as if the PBoC used equity rather than bills for its open market operations. 

 

I think so far the consensus is that, in principle, for the state to sell its shares in traded companies and deposit the money at the PBoC makes perfect sense and would be a great way to sterilize money creation. In practice, however, selling enough shares to have a material impact might cause serious problems in the stock market, and in addition there could be political resistance and governance issues that would need to be resolved.  
 
Although there has been some discussion of privatization as a way to slow the stock market bubble, as of yet I see no evidence that the government has seriously considered the possibility of using stock sales for sterilization – usually when policies are being considered we get rumors and feelers put out. In part that may be because outside the PBoC and a few other smaller offices there is still no sense that monetary policy may be out of control, and talk of sterilization makes the eyes of all but the hardened bunch who read my and Brad's blog glaze over.  
 
It may also be that the political difficulties of doing so are so great that China's political leaders know it is a non-starter.  It is true that if Hu, Wen and Wu get behind a direct order, it is hard to resist (although often is anyway), but the impression I get from my friends in government and academia is that the recent 17th Plenum was not a love-fest, and my CPC students and colleagues often tell me about the rumors they have been hearing about who is out to get whom.  
 
Given the probable factional fighting I think no one in the leadership has any strong desire to alienate powerful provincial leaders or local bosses. Forcing through a decision, no matter how sound, might not be anyone's first priority. Look at the anti-corruption drive of the last four years, which was widely supported in principle and just as widely opposed in practice. Only the official press believes it has been anything but a failure, even though it clearly was a central concern of Hu's and Wen's. 
 
In China, as anywhere else, politics can trump common sense.