My Blog

MON 26 NOV 2007

Europeans in China By Michael Pettis

The timing of the various European meetings in China with my own office move has made it hard for me to keep up my blog, but nonetheless the world hasn’t stopped providing interesting things to talk about.  As we all expected, President Sarkozy’s visit included a call for accelerated RMB appreciation – he asked for currency policies to be “harmonious and fair” which meant, he explained, that China needs to accelerate the appreciation of the yuan against the euro”. 

 

He wrapped this advice in the sort of words that the Chinese love to hear – “A great country must have a strong currency” – but warned against letting “imbalances accumulate to a point where we wouldn't be able to get out of them”.  I think this is a major point that needs to be made more often – if there is indeed a monetary imbalance, it is not just a current problem that at some point can be easily resolved with a revaluation.  Rather these imbalances can accumulate, making it almost impossible at some future point to resolve them without a significant, and potentially painful, adjustment. 

 

Nonetheless the advice was quickly rebuffed by Premier Wen who said China would continue its gradualist approach.  For Wen, as for many others in the leadership, I think there is a great deal of concern that a one-two combination of slowing US growth and a sharp appreciation of the RMB could seriously damage China’s export industry.  With rumors of rising urban unemployment (the figures are hard to check) and rising college unemployment, the Chinese authorities are in no hurry to jump onto any policy that can have an adverse impact on employment growth, especially a few months before the Great Coming-Out Party.

 

Two days after President Sarkozy made his comments, a group of European Union heavy hitters seemed to raise the ante.  According to Bloomberg “European Central Bank President Jean-Claude Trichet, Luxembourg Prime Minister Jean-Claude Juncker and European Union Monetary Affairs Commissioner Joaquin Almunia will argue that an undervalued yuan is ‘triggering protectionist tendencies’.”  The threat is not very hidden.  It seems that they will be telling Chinese officials that if something isn’t done to raise the value of the RMB against the euro, Europe may be forced by its own domestic political considerations to move unilaterally and raise trade barriers against Chinese goods.  The statement is all the more dire coming a day after a seemingly nasty dispute about Chinese product safety between EU trade commissioner Peter Mandelson and Vice premier Wu Yi, indicating that anti-Chinese feelings in Europe are rising.  This is clearly a worst-case scenario for China, especially as it will make it even easier for US protectionists to follow Europe’s lead.

 

I think there is no question that China needs to move much more dramatically on the RMB.  This is not just to appease the Europeans, but more importantly to protect its own economy from an out-of-control monetary policy that may lead to real domestic problems in the next year or two.  I think, however, that the Beijing authorities are still going to be reluctant to do anything dramatic.  So far, reducing unemployment still trumps moderating money growth as a policy preference.

 

But here’s a thought.  There are two ways the RMB can appreciate against the euro.  First, the RMB can appreciate more rapidly against the dollar.  Second, the dollar itself can begin to appreciate against the euro, dragging the RMB up with it.

 

China itself has been a very big factor in the dollar’s decline against the euro. What if the authorities were to permit a slightly faster rate of appreciation against the dollar at the same time that the PBoC announced that it was planning to accumulate more “cheap” dollars?  That would cause the dollar (and the RMB) to rebound, perhaps sharply, so appeasing the Europeans. 

 

Of course any significant move in the dollar would simply throw us back into the old game of a US deficit powering Chinese growth, which as we have already seen is not a stable outcome.  That’s the problem, without a serious decision to address RMB undervaluation, it is hard to see what can be done about global imbalances except shift them around a little.  But without a serious domestic economic or political threat, it is hard for the Chinese authorities to risk slowing the economy too much.

 

In the end I suspect that this will all come down to the inflation numbers of the next three or four months.  If inflation seems to moderate, or continues to be – at least in the short term – concentrated in food prices, nothing is likely to change before the Olympics.  But if inflation numbers over the next few months turn out to be alarming enough, Beijing might finally move to address the RMB.

 

WED 28 NOV 2007

The RMB declined today By Michael Pettis

After many days of strength, as of noon today the RMB declined by 0.15%, to 7.3949 to the dollar.  Is this simply a random event or are the Chinese financial authorities warning European officials to stop pushing on the RMB front? 

 

If it is the latter, it is likely to be a wasted warning.  Domestic pressures in Europe are going to continue to grow, and I expect the European trade deficit with China to rise even further over the next few months.  If we have more dollar weakness and a slowdown in the US economy, the European economy is going to have a real tough time adjusting, and already high unemployment is likely to rise.  Anti-Chinese feelings are already high in Southern Europe, and are likely to spread, and even in Germany there is a bit of a chill in the relationship thanks to Chinese anger at Merkel’s meeting with the Dalai Lama.

 

At this rate it is hard to see how China will be able to avoid a nasty dispute with Europe over trade – a French engineer I spoke with last night brushed off the nuclear and Airbus deals that China recently signed with France, saying that Sarkozy should not bow to such transparent ruses.  I wonder how many people in Europe see things in the same way.  At any rate there is almost no one left, even in China, who does not think the RMB is not seriously undervalued.  Fortunately there also seems to be a rising consensus in China that the RMB is not just a problem for China’s trading partners; it is an even worse problem for China.

 

Even though it makes sense for domestic reasons to adjust the currency more quickly, without serious foreign pressure I think Chinese authorities are still going to refuse, largely because of concerns about the possible adverse impact on domestic unemployment.  I think they are making a huge mistake, however.  China’s out-of-control monetary policy is already very likely to lead to domestic grief, and if we keep this pace of reserve accumulation up for another year, I think the chances of an ugly adjustment become extremely high.

 

Ironically, if US and European pressure is successful in forcing a currency move (trade sanctions would be disastrous for China’s export sector), it may still be too late to avoid a crisis anyway, only in this case the two countries would almost certainly be blamed for forcing the ensuing crisis onto China – in the same way the claim is often mistakenly made that the US “forced” Japan into the 1980s bubble.  In both cases domestic monetary policy was the culprit, but foreign pressure will be blamed.

 

WED 28 NOV 2007

Why IPO prices should surge, and what happens when they don’t By Michael Pettis

China’s largest heavy truck maker, Sinotruk, raised $1.2 billion in an IPO today in the Hong Kong market.  After its launch, however, the share price immediately fell by 16%.  This was the second China-related IPO in recent weeks whose price performance was so negative – last week Sinotrans Shipping raised almost $1.5 billion but saw its share price drop 13% after launch.

 

With these two exceptions, in the past months most China-related IPOs have seen their prices surge dramatically – in some cases by well over 100% – in the first day or two after launch.  One of the questions commonly asked in my finance class at Peking University is how do we justify the huge price run-ups we have seen in recent mainland IPOs.  Doesn’t that mean that the issuer got a bad deal by leaving too much cash on the table?  This is the same question that was often asked during the US internet bubble, when IPOs routinely shot up in value on the first trading day.

 

Aside from answers which imply fraud and insider activity, the only satisfactory answer I can give is based on the structure of the demand for and allocation of shares in any primary offering.  Basically, when an investor puts in a bid for a part of an IPO, his bid is firm (and in China 100% backed by cash), but there is no guaranty that he will receive the amount he bid.  If the deal is very “successful”, that is if it is vastly oversubscribed, the investor may get allocated as little as 1-2% of the amount he bid.

 

Basically that means that the buyer has given a put option to the arranger of the deal.  If I put in a bid for 100 shares, for example, I have given the arranger the right to sell me any amount from zero shares to 100 shares.  Of course the more successful the deal, and consequently the more allocation I want, the less I get, and vice versa.  If the deal turns out to have been overpriced, I am likely to get all, or nearly all, I asked for, much to my chagrin.

 

If investors are rational, this option should not be given for free.  In other words for me to justify giving the arranger the option I am granting him, I need to get paid, and the expectation of a run-up in share price after the IPO is what I am effectively being paid.  Imagine that there were no expected run-up in price.  In that case it would make no sense for me at all to participate in the primary offering – I should just wait until the deal is launched and then buy it in the secondary market.  This way I don’t take the risk of getting too little of an undervalued deal and too much of an overvalued one. 

 

So if we think of the bidder as granting an option, post-IPO pricing surges are not unreasonable.  Of course the more oversubscribed the deal, the greater the required pricing surge.  After all, I wrote an option on 100% of the shares I bid, but since I can only get a profit on the shares I am actually allocated, and I expect to get allocated very little unless the deal suddenly turns into a dog, the lower the expected allocation, the greater the expected pricing surge must be.

 

The initial post-IPO pricing surge, in short, is what investors are getting paid for providing an option to the arranger, and it is the arranging banks that enforce this payment.  By the way if this is true, we would expect post-IPO surges to be greater for more volatile assets (option premiums are higher on more volatile assets), and also greater the more oversubscribed the deal is expected to be (the premium on the full bid must be paid as a percentage a very small allocation).  Both predictions seem to conform well to the empirical evidence.

 

The recent slew of surging IPOs may make us forget that the risk provided by bidders in an IPO can be very substantial.  Imagine that I bid in a very hot deal but get allocated only 5% of my bid.  If the deal subsequently rises by 80%, this may seem like a huge profit, but it is actually a much lower return on my total capital at risk.  I have effectively received a profit equal to 4% of the nominal value of the options I granted, or 4% of the capital I put at risk. 

 

If the deal had turned out to be a dog, I would have been likely to get allocated a large part or even the full amount of my bid.  In the case of Sinotruk, I would have probably have been allocated all or most of my bid.  Assume that I got allocated50% of my bid (I have no idea of what the actual average allocation was), the 16% loss would mean that the options I granted immediately lost 8% in value.

 

The two recent unhappy IPOs indicate how risky the IPO market can be for investors.  In China, IPO investors typically bid for far more than they want because they expect to get allocated a very small portion of their bid.  In fact there is anecdotal evidence (and corroborating evidence in the performance of short-term interest rates) that many IPO buyers borrow as much money as they possibly can to finance their bids, and expect to sell quickly to repay their loans.  Should any IPO suddenly turn bad, however, these bidders are likely to be left with an excessively large investment in a plunging asset, and they will need to raise money quickly to pay off the debts incurred to buy the IPOs.

 

With the two recent badly-performing IPOs in the Hong Kong markets, I think the risk of poor performance in Shanghai or Shenzhen has risen substantially.  This may translate into unacceptably large losses for some unfortunate investors.

 

WED 28 NOV 2007

Quarterly loan quotas By Michael Pettis

According to a report I just received from Credit Suisse the PBoC has apparently begun asking commercial banks to submit quarterly loan plans for next year in order, ostensibly, to smooth out loan activity.  In the past, loan quotas were made on an annual basis.  Banks would then rush to make loans early in the year because they wanted to maximize interest income, but the result would be that roughly 40% of the annual quota (and typically more) was lent in the first quarter, and nearly all the rest by the third quarter. The banks then asked for quota increases and the authorities, faced with the prospect of a total loan freeze, would grant the new quotas.

 

Not surprisingly, credit growth always exceeded the PBoC’s already high annual targets.

 

Will this new tactic work?  I am skeptical, but I guess it depends on how you define success.  It may reduce excessive loan growth, but will it reduce the problems associated with excessive loan growth?  If we assume that the source of China’s explosive growth in industrial production, fixed asset investment, the trade surplus, and the speculative investment bubble is the unconstrained eagerness of Chinese bankers to lend money to their friends, then a measure to enforce a little discipline on those bankers can’t help but be a good idea.

 

But if the problem is uncontrolled money growth fueled by the country’s currency regime, than I am not sure how quarterly loan quotas are going to make much of a difference in the underlying problem.  It may discourage bank lending, but what about other effects?  Where does the money go?  If the commercial banks continue to gain deposits, they will have to put the money to work somewhere, and if they can’t lend the money they will be forced to purchase government bonds from the market.  This will keep interest rates low and of course will deposit the cash, which was otherwise to have been lent, into the hands of the previous owners of the government bonds, who will then be forced to something with the money.  Either way bank profitability should decline.

 

If the banks act in ways to discourage deposits, are those deposits likely to end up in informal banks who are, according to a lot of anecdotal evidence, a fairly large segment of the banking market and are largely unregulated?  Or will the money go into direct investment.

 

I am not sure how this plays out, but it seems to me if the problem is unconstrained money growth caused by massive capital and current account inflows, then the only way to address the problem is by reducing those inflows.

 

THU 29 NOV 2007

CIC minimum return By Michael Pettis

Lou Jiwei, the CEO of the CIC, spoke at a banking forum in Beijing yesterday.  According to the South China Morning Post he “calculated that CIC needed to earn at least 300 million yuan a day just to break even because of the 5 per cent interest rate on the special bonds used to finance it.”

 

A 5% coupon on its RMB funding plus an expected annual RMB appreciation vis a vis the US dollar of anywhere from 7% to 10% means that the CIC needs to earn 12 1/2 to 15 1/2% percent in US dollars just to break even.  If they are successful they should immediately leave China and set up a hedge fund in Greenwich, Connecticut.  I am pretty sure I could help them raise lots of money.

 

THU 29 NOV 2007

Rumblings over November inflation By Michael Pettis

According to today’s newspapers six independent fuel stations on the mainland that have been illegally selling fuel at prices above the subsidized levels mandated by the government have been fined.  I don’t know how prevalent this is but I am pretty certain that even if it is very widespread these higher fuel prices will not show up in the official CPI numbers.  Nonetheless Shanghai Securities News says that according to a research report by Guohai Securities, CPI inflation for November is likely to be between 6.6% and 6.8%, which would be above its 11-year high of 6.5% in October.

 

I have already said in earlier entries why I think that official CPI is understating the real price increases for ordinary Chinese families.  First off, food prices have risen by 17-18% year to date, but food’s share of the CPI basket seems to have remained constant in the CPI calculations at roughly 33% of the basket.  Chinese families must be spending more on food now than they were at the beginning of the year, and if we adjust the food component up by just 10%, to 36% of the basket, that would have added 0.5% to last month’s CPI number.  Of course such a simply adjustment doesn’t correct for the bias, but it does suggest that inflation during 2007, especially since the big food price increases during and after summer, has been worse than what the CPI figures record, and with that real interest rates have been lower.

 

Second, inflation has had a much bigger impact on students and the urban working class than the numbers suggest.  They tend to spend more on food than the average family does.  That has a political dimension which lies outside the scope of my blog, but it does suggest why inflation is seen as such an urgent problem.

 

THU 29 NOV 2007

Reserves at $1.455 trillion

Growth in reserves continues to astonish.  Yesterday the NDRC announced that reserves had hit $1.455 trillion by the end of October.  This means they were up $21 billion for the month of October, after rising by $136 billion in the first quarter, $130 billion in the second quarter, and $101 billion in the third quarter, for a total of $388 billion year to date.  This compares with a huge $247 billion for all of 2006, and an already very high $209 billion for 2005 and $207 billion for 2004 (the $117 billion increase in reserves in 2003, a big number then, now seems almost insignificant).

 

We know that the trade surplus for the month was a record $27.1 billion, and FDI inflows were $6.8 billion, which implies that net other flows were a negative $13 billion, but it is hard to figure out how to think about that number.  There may have been an additional transfer to the CIC, and it seems that banks and SOEs (and even retail investors) are being encouraged to hold dollars offshore themselves.  The total amount of money that came into China in October through the current and capital accounts, in other words, is a lot higher than $21 billion and is probably even a lot higher than $34 billion (because of hot money inflows), but its impact on the PBoC’s balance sheet has been reduced by PBoC transfers to the CIC and by other capital account outflows.

 

The CIC can be though of as a sort of “second” central bank although dollars held by the CIC are not, strictly speaking, monetized in the same ways that dollars held by the PBoC are.  Because it was (or will be) fully funded by an RMB-denominated bond issue, the money creation associated with CIC holdings are fully “sterilized”, and they are sterilized by the issuance of long term MoF bonds, not central bank bills.  These MoF bonds still have an expansionary monetary impact, but clearly they are much less money-like than central bank bills, and the effective substitution in the market of these MoF bonds for PBoC bills (the PBoC has indirectly purchased the bonds but plans to use them as part of its open market operations) will reduce money creation somewhat.

 

If other entities are holding more dollars, this is also good for China because the domestic monetary impact of the foreign currency inflows into China is limited, but we should be careful not to assume that in this case the monetary impact is zero.  For example, if banks are holding more of their reserves in dollars, the PBoC has clearly been spared the problem of buying those dollars and so monetizing them, but at the same time those dollar holdings may free up RMB holdings in the banks that can now be used for loan purposes. 

 

In that case I think the positive monetary impact (i.e. the fact that the PBoC did not have to create currency or bills to buy them) might be negligible – foreign currency inflows are still likely to cause an effective increase in domestic money.  In general for any company or individual, and not just for the banks, if holding dollars abroad becomes a substitute for holding RMB investments domestically, I would guess that the monetary impact of dollar inflows is still positive and may be substantial.  They do not necessarily need to show up on the PBoC’s books for them to affect domestic monetary conditions.  I wonder if any of my readers might have any better insight and chime in here.

 

I don’t know if there is still a lot to transfer from the PBoC to the CIC before the end of the year (altogether $200 billion were to be transferred this year, and I am guessing that at least one-third was already done), but even if there is, total reserve growth at the PBoC plus the CIC will easily exceed $500 billion this year and may even exceed $600 billion.  At 17-20% of GDP, this level of reserve growth cannot help but be a serious problem for domestic monetary policy.

 

THU 29 NOV 2007

Decoupling? Not according to the stock market By Michael Pettis

The headline in today’s South China Morning Post put it succinctly enough:  “HK and Shanghai surge 4pc on rate-cut hopes”.  Suggestions Thursday evening by Fed Chairman Ben Bernanke that US rates might be lowered again lifted markets around the world, and China was no exception.  Shanghai surged 4.16% to 5003 and Shenzhen climbed 3.06% to 1257 (Hang Seng was up 4.06% and Nikkei-225 was up 2.38%).

 

Not long ago there was very little correlation between the mainland markets and overseas markets, but in the past few months the mainland markets have been very affected by events abroad and correlation has surged.  Since there aren’t a lot of direct links between mainland and foreign capital markets, thanks to capital restrictions, local markets must be concerned about fundamental economic links between foreign and local economies.  They don’t seem to believe in the de-coupling thesis.

THU 29 NOV 2007

Global food prices still rising By Michael Pettis

At $11.14 a bushel, which it reached yesterday in Chicago, soybean prices have risen to their highest level since 1973.  Not only do high global prices directly affect the price of food in China – as the world’s largest importer China imports 40% of all tradable soybeans – but 80% of the crop is apparently processed into food for livestock, so high prices will impact the price of pork, beef and lamb.  An article in today’s Financial Times suggest that there may be more upward pressure on prices because of bad weather in Brazil and lower acreage in the US.  Corn prices at current levels imply that soybeans might need to go up another 10% or more before US farmers start shifting out of corn and back into soybeans.

 

The Chinese government had temporarily (until December) reduced their soybean tariffs from 3% to 1% in order to encourage imports and so keep local food prices down, but price increases in the international markets are already greater than any reduction in the tariff and are likely to go up even more.  None of this is good news for domestic inflation.

 

FRI 30 NOV 2007

Will QDII make a difference to monetary policy? By Michael Pettis

Yuan Li, a spokesman for the China Insurance Regulatory Commission, said yesterday at a conference that the twenty mainland insurers that have received QDII licenses are expected to invest mostly in Hong Kong stocks.  The insurance companies together have about $400 billion of assets, and since July they have been permitted to invest as much as 15% of their assets abroad – before that it was 5% (although my understanding is that none of them are anywhere near their limits).

 

QDIIs have been a hot topic since China Southern Fund Management launched the first successful mutual fund QDII on September 12.  They expected to raise RMB 15 billion during the just-over-two-week subscription period to fill their QDII quota, but on their first day of subscriptions they received RMB 50 billion in orders (and closed subscriptions that day).  SAFE subsequently doubled their quota to RMB $4 billion.

 

Two weeks later China Asset Management received orders of RMB 60 billion for the launch of their own QDII, whose quota was then also doubled, to $5 billion.  The first QDII launch was actually in October of 2006, by Hu’an Fund Management, but they were only able to $200 million of their $500 million quota.  This year’s crop was a lot more successful.  By the way not everyone in China can be a client of a mutual fund QDII.  The minimum investment is RMB 300,000 (about $40,000), so it leaves out nearly all of China’s many small investors. 

 

I am not sure of the exact numbers but I think that there are ten approved QDIIs, not counting the insurance companies (eight fund management companies and two securities firms, CICC and China Merchants), and by the end of the year there will be around three more approved, to raise altogether about $20-30 billion.  Next year most commentators expect there to be another $90 billion in funds raised to invest abroad through the QDII program – there are around fifteen fund managers and three securities firms that are slated to get approval.

 

In principle this is an unalloyed good thing.  Not only does it help internationalize Chinese markets and give Chinese firms experience managing money in other markets, but anything that reverses capital outflows helps the PBoC manage the huge inflows China is experiencing through its trade and capital accounts.  Money leaving China this way is netted out of the inflows that have to be converted into currency or central bank bills, and that is a huge relief for a central bank struggling to moderate its wild money expansion.

 

However given the currency situation in China I wonder how these QDII funds can possibly keep their clients happy.  Because of the minimum investment size QDII clients are supposed to be sophisticated and knowledgeable about the benefits of diversification, but with the RMB expected to rise by anywhere from 7% to 10% over the next year (with only upside risk), and deposits earning nearly 4%, QDIIs are going to have to be very profitable to jump the low-risk 11-15% hurdle they will have to make in dollars just to break even relative to RMB bank deposits. 

 

Diversification is a good thing, of course, but if all it means is that investors lose money, it is hard to see why anyone would want it.  At any rate from what I understand most QDII money is going to Hong Kong stocks, and the Hong Kong stock market has become pretty highly correlated with the mainland stock markets, so it is unlikely that they will provide much of a hedge, although on the other hand there is a built-in currency hedge for the Hong-Kong-listed stocks of mainland companies.  A rising RMB should translate into an automatic rise of their net asset values in HK dollars, which may then result in an automatic increase in their HK share prices.

 

If QDIIs are conservatively managed they are most likely going to underperform local investment alternatives.  In that case instead of more money pouring into QDIIs next year I wonder if we won’t see disgruntled investors begin to withdraw their investments as their returns significantly underperform simple bank deposits.  We may see net redemptions next year, rather than more money going into QDIIs.

 

On the other hand If QDII managers feel compelled to beat the currency-related hurdle to keep their investors, there is the danger that they stretch a little too far for yield and take some ugly risks.  If as a manager you expect prudent investing will lead to redemptions, does that create an incentive to go out too far on a limb?  I think it might, at least in some cases, and I don’t doubt there will be some dodgy ideas peddled to fund managers.  However a nasty performance for one of these QDIIs could sour the whole market, at least in the short term. 

 

It is hard to see why investors should be taking money out of the country much longer when the best game in the world seems to be to bring money into China, especially as the pressure for RMB appreciation increases.  If QDII investors do reverse their earlier decision, the monetary benefits of the QDII program could actually reverse next year as investors bring their money back home, and with reserves expected to grow anyway by another huge amount, this reversal will only make matters worse.  This might not necessarily apply to the insurance company QDIIs, who may have a different set of incentives, but even for them several quarters of underperformance should at least retard the growth of their QDII appetite.