My Blog

SUN 18 NOV 2007

Acquisition sprees and loan growth

Amid the flurry of news items about Chinese acquisition plans abroad, there is an interesting piece by Geof Dyer in today’s Financial Times that may put things in a little perspective.

 

Normally, when companies have an extremely valuable currency with which to make acquisitions (relatively highly valued share prices), it makes sense for them to make acquisitions.  With several Chinese companies receiving valuations on the Shanghai and Shenzhen markets that make them far more valuable than better-managed companies abroad with significantly higher earnings, this should be a slam dunk for Chinese companies.  They should use their expensive share prices to make major foreign acquisitions, and so protect themselves from a deflation of the Chinese bubble while picking up higher-yielding assets.

 

The problem is that their currency, like the RMB itself, has limited value abroad.  Restrictions on foreign ownership mean that they cannot use their shares to swap directly into foreign holdings – foreigners cannot own their mainland-traded shares.  They also cannot raise enough cash directly.  The Chinese market itself is actually very small when you eliminate roughly 65% representing non-tradable shares, and almost another 20% representing tradable shares that are very unlikely to be traded.   That makes it difficult to sell enough shares domestically to use the proceeds to convert into foreign currency and buy foreign-listed shares.

 

Still, it would be great for domestic monetary policy if this were to happen.  The problem would be for local investors.  They would be buying overvalued domestic shares, which would then be converted into an overvalued foreign currency to buy foreign shares.  Local investors would probably take a double loss.

 

By the way once again we are hearing rumors of a lending freeze.  This seems to occur regularly every year around this time, probably because every year around this time, in spite of a desire by the financial authorities to slow lending growth, the amount of new loans year to date has blown out last year's total.  I am not sure we should take those rumors too seriously.  Every year in the fourth quarter loan growth slows somewhat, only to mushroom early next year.  As long as the currency regime is in place, lending growth will continue, and the only impact that any serious constraint on bank lending will have will be to force loan growth in the unregulated informal banking sector.

 

FRI 23 NOV 2007

China is selling dollars! (Again.) By Michael Pettis

I realize that this is old news, but I have been traveling for the past four days and so was not able to keep up with my blog very well.  Nonetheless I did want to return to Premier Wen’s comments earlier this week about the difficulty China is having in managing its reserves given the steep drop in the value of the dollar.

 

“We have never been experiencing such big pressure,” Mr Wen is reported to have said at a conference in Singapore, according to Reuters. “We are worried about how to preserve the value of our reserves.”  The market of course took this as a warning that China was going to shift its reserves out of dollars and into “stronger” currencies.

 

There is an irony here of course in that one of the main reasons for the steep drop in the value of the dollar against the euro (and against every other currency that floats freely) is that several Asian countries, led by China, insist on preventing the value of their own mostly undervalued currencies from rising against the dollar.  This means that the full adjustment for any imbalance must be made by those currencies that float – and as the main alternative currency, this means the euro.  The drop in the dollar is caused in part by a currency regime which China is still unable substantially to modify without creating a whole set of domestic problems, and which must necessarily result in China’s continued accumulation of dollars.

 

So what can China do to protect the value of its dollar hoard?  Precious little, it seems to me.  They cannot very well diversify out of the dollar.  If they were to do so, even at the margin, and if no one else were to take their place as the big buyer of dollars (and in so doing replicate China’s out-of-control monetary expansion), the US trade deficit would automatically decline. 

 

Since China’s trade surplus is structural, and caused primarily by its domestic monetary policy, with or without the help of US consumers the rest of the world would have to run the same (or, more likely, a growing) trade deficit with China, which means essentially that Europe would have to absorb the trade deficit that the US, until now, has been absorbing.  I think that this is politically and economically very unlikely.  Europe simply cannot begin to take on much more of the trade imbalance, and anyway as China accumulated euros instead of dollars, the growing European trade deficit would simply set the euro up for an equally violent fall.

 

So why signal so publicly a dilemma against which they can do nothing except make matters temporarily worse?  Perhaps they just want to make political points by pointing out that other countries have currency problems too (although surely they must know that at least part of the reason for the euro surge is their own doing).  If China were run by traders I would see something a little clever in these remarks.  The dollar is clearly undervalued relative to the euro and it is only a question of time, in my opinion, that the dollar begins to run up again. 

 

Could the Chinese be considering buying more dollars, and making these negative noises so that they can buy even cheaper (and then be hailed as heroes when they announce that they have stepped in to stabilize the dollar and save the world)?  I doubt it, but not because I think it is a stupid trade.  I just don’t think politicians or central bankers ever think like traders, and anyway continued dollar depreciation is likely to worsen trade relations between China and Europe without helping trade relations with the US.  That can’t be a smart move politically.

 

But wouldn’t it be a good idea to buy dollars now?  I know, I know, everyone with any sense knows the dollar has only one way to go – down, down, down until it is worth no more than the paper on which it is printed – but allow me for just a moment the conceit that we haven’t yet arrived at the global apocalypse, that the US isn’t collapsing into a bigger version of Haiti, and that if there is value in buying US assets there will at some point be buyers of US assets.  My mother, for example, a very astute French woman who owns a profitable business in Spain, has made a lot of money buying things that were in her opinion a little too cheap. 

 

During her last visit to New York she was shocked at the prices – she couldn’t believe how well Americans lived and at how cheap everything was compared to in Europe, and this was months before the big dollar move downward.  She is now converting some of her bank deposits from euros to dollars, and many of her friends -- other business owners with money in the bank -- are planning to do the same. I am sure others will do so too.

 

So, aside from the fact that my mom thinks it would be stupid for China to start selling cheap dollars and buying expensive euros, China simply cannot diversify out of dollars in a meaningful way.  The global balance of payments must balance, and unless we think that Europe (or Australia maybe? India? Brazil? Canada?) can absorb the kind of trade deficit that the US has for the past several years, China cannot both continue to run its currency regime the way it has AND diversify out of dollars.  The math does not work.

 

As an aside, Barry Eichengreen recently posted (November 19) on his blog an argument as to why the eurozone must survive as a monetary union.  I am a huge Eichengreen fan (his Golden Fetters is a must-read book) but I am not nearly as optimistic as he is about the long-term survival of the euro.  Monetary unions have a history of working during periods of great global liquidity, but nearly all of them have broken down when the underlying liquidity dried up.  To me, the internal problems facing the euro (can Italy really give up the ability to monetize its debts? after its huge liquidity-induced run can Spain accept the costs of monetary adjustment? will the lack of labor mobility and even capital mobility undermine the adjustment mechanisms needed for such a diverse region?) are still large and still unresolved.  Until we go through a period of real monetary stress – several years of persistent inflation or a severe monetary contraction – we can’t really argue one way or the other.  One thing is for sure, as long as there is a need to argue that the euro cannot fail, there are reasons to be concerned.

 

 

FRI 23 NOV 2007

Hot money coming and going By Michael Pettis

How much money has been flowing illegally from the mainland to Hong Kong?  No one really knows, of course, but there has been an awful lot of noise about the subject recently, culminating in the decision last week by the Shenzhen branch of the PBoC (and Wen Jiabao’s subsequent reversing of the decision) to limit bank withdrawals, in an effort to slow down money flows out of Shenzhen and into Hong Kong.  

 

Prime Minister Wen did say that the amount of money illegally flowing out of China is “huge”, and several people who know a lot more about this than I do say that roughly half of this is going to Hong Kong to take advantage of relatively cheap share prices of Chinese companies that trade there (the so-called “H-shares”).  HSBC’s Steven Sun even says that there have been suggestions that as much as RMB 120 billion ($16 billion) flowed into Hong Kong just in September, although he dismisses the number as being way too high.

 

At the same time there has been an increasing debate during the past few months about hot money inflows into China.  Some analysts still argue that this is not a serious problem for monetary policy, and so will not act as a constraint on the ability of the PBoC to manage domestic interest rates and the rate of RMB appreciation. 

 

I disagree.  At any rate I think these arguments are a lot weaker than they were even three months ago, and I don’t think they were very strong back then either.  Research group CEBM argues in their November 19 report that hot money inflows are becoming once again a real PBoC concern and declining US-China interest rate differentials are making things worse.  Based largely on educated guesses about the balance of payments figures, anecdotal evidence, and statements from financial authorities that seem to indicate real worry, my working assumption for a long time has been that net hot money inflows are high enough severely to limit the ability of the PBoC to manage monetary policy.  Nearly all domestic tightening measures will simply have the perverse effect of increasing money inflow and so reversing the intended impact of the tightening. 

 

So it seems that absolute flows out of China are high enough to cause a lot of concern among authorities, even to the extent of causing them to take the anxiety-inducing step of limiting bank withdrawals.  Net inflows are also high enough to cause significant concern.  This suggests that gross flows coming from and going into mainland China are probably very high – and certainly high enough to suggest that we shouldn’t place too much confidence in the ability of capital controls to protect the integrity of domestic Chinese monetary policy. 

 

In and of itself this shouldn’t be surprising.  Capital controls for such a big and rapidly changing country like China were never going to be easy, and of course the longer they are in place the more easily subverted they tend to be.  Tomorrow I will try to say a little more on the subject based on as-usual invaluable sleuthing by Logan Wright of Stone & McCarthy.