My Blog

TUE 15 JAN

The cause of China’s trade surplus By Michael Pettis

Prime Minister Manmohan Singh is currently visiting China and yesterday he too complained about China’s trade surplus.  There is still a debate about the structure of China’s balance of trade.  There are at least three reasons commonly cited to explain China’s massive trade surplus.  First, China’s control of the foreign exchange value of the RMB means that China is able to hold down the value of the RMB to well below its “correct” value, and so Chinese good are unreasonably cheap in foreign countries and foreign good unreasonably expensive in China.  This enforcement of savings on the population (or forced low domestic consumption) gives China a mercantilist advantage in trade.

 

The second argument also relates to China’s foreign currency regime, but in this case it is the abandonment of domestic monetary policy that is to blame for the trade surplus.  According to this argument, by locking itself into an undervalued and inflexible exchange rate, China has also locked itself into a monetary trap in which large trade surpluses and capital account inflows force domestic monetary expansion, which ends up largely as overinvestment and excessive expansion in industrial production.  Since the country’s production grows at a faster pace than its consumption, the country is forced into a large and growing trade surplus which further feeds the monetary expansion.

 

The third argument explaining the trade surplus cites China’s natural advantages, specifically an educated but very low-cost labor force capable of relatively high quality production at a fraction of the price required for the same labor in the US, Europe or Japan.  In this case China runs a trade surplus largely because it can produce the same things as the rest of the world but much more efficiently.  There is a fourth, related argument, which claims that this Chinese “efficiency” is at least partly explained by its refusal to count costs correctly – specifically environmental costs are socialized, financial costs are subsidized, and labor exploitation is permitted and even encouraged by political constraints on the ability of workers to organize and protect their interests.

 

Although of course all these reasons partly explain the trade surplus, I am thoroughly convinced that it is the second argument that is the most important.  It would explain why overinvestment has become such a problem and why in spite of a rising RMB the trade surplus has continued to rise steadily over the past 2-3 years.  Because we tend to think of China’s trade surplus as coming largely out of trade with rich countries, the low-cost-of-labor argument has always seemed a plausible explanation for China’s trade surplus, but Prime Minister Singh made a point yesterday of calling on China to do something about the growing trade imbalance between the two countries.  It is worth remembering that China is also running large surpluses with countries that have lower per capita income and, presumably, lower labor costs (although to be fair India apparently suffers from a very weak industrial infrastructure, which adds to overall costs).  The fact that Singh is so unhappy with the trade relationship suggests that there is more to the matter than low labor costs.

 

The differences among the arguments of course are not just academic.  They will require and result in very different adjustment processes.  If the first argument is correct, then a policy of faster RMB appreciation (or faster appreciation plus inflation, as Geng Xiao, of the Brookings Institution, has argued) will largely correct the imbalance.  In the process it will result in a shift of Chinese economic behavior from savings to consumption, thus resulting in a much more rapidly rising standard of living for Chinese, and for the rest of the world as Chinese growth contributes to world demand.  It will not matter too much when the shift takes place, as long as it takes place fast enough to appease foreign anger and to forestall trade wars.

 

If the second argument is correct, the policy recommendations are more radical and the expected outcome much more pessimistic.  According to this argument China has locked itself into a system of severe monetary imbalances, and the longer this goes on the sharper the adjustment will be.  The best policy in this case is to force as quickly as possible an adjustment in the balance of payments that brings monetary policy back into control – by forcing either the trade surplus down or the capital account into deficit.  It may already be too late to adjust easily, and even if it isn’t if the authorities are too wedded to the ideology of gradualism to make a rapid adjustment, so in this case I expect that the end game will occur either in the form of runaway inflation, which would eventually cause a sharp contraction in the money base, or in the form of sharply rising inventory leading to equally sharp cuts in production, which is how overinvestment cycles classically ended in the 19th Century.

 

If the third argument is correct, there is little that can be done in the short run to reduce the trade imbalances but eventually rising wages and salaries (or greater domestic political pressure for companies to absorb the full cost of production) will eliminate China’s greater industrial efficiency.  In that case the world will simply have to learn how to adjust to the advantages and disadvantages associated with integrating a large country like China into the world trading system.

 

Needless to say I will be watching inflation and inventory levels closely, and hoping that the faster RMB appreciation does not spur massive speculative inflows.

 

TUE 15 JAN

China’s loan constraints are biting By Michael Pettis

I am getting very bullish about the growth of capital markets issuance, loan securitization and alternative forms of investment intermediation (both formal and “informal”) in China.  Yesterday the China Securities Journal reported that the PBoC had set the total new-lending target for the banking system this year at RMB 3.63 trillion, against last year’s RMB 2.9 trillion – this represents a fairly tough cap on loan growth (I think about 12% but I need to check).  This comes a week after their two-day conference in which the PBoC failed, surprisingly, to announce new loan quotas.  It seems that if there was a fight over the policy decision, that fight has been resolved.  Separately I read that Reuters claims that December inflation (which will probably be officially reported next week) is likely to come in at 6.5%, which is lower than November’s 6.9% but still much higher than expected (and for statistical reasons represents no real reduction in the rate of inflation).  Maybe this is the reason why the fight has been resolved in favor of tough constraints.

 

Meanwhile new loan issuance in November and December dropped substantially to RMB 87 billion and RMB 48 billion.  For all but the last three months of 2007 new loan issuance has ranged between RMB 200 billion and RMB 600 billion.  This drop is not as dramatic as it seems because new loan issuance is often low at the end of the year, and surges again in the first quarter, but it does suggest that the PBoC is a lot more serious than it has been about constraining credit growth.

 

If they are able to keep it up will it matter to the economy and to their fight against overheating?  Probably not.  Companies are flush with cash, stock and bond issuance are likely to rise, and I expect that as long as China is forced to monetize large capital and current account surpluses money is going to flow into alternative forms of intermediation.  Still, so far it seems my skepticism that the PBoC would really be able to enforce slower loan growth was unwarranted.  The real test comes after the establishment of the new leadership in March.  Will we not see the traditional investment surge, or will the loan growth caps be ignored (or perhaps more likely, will the new provincial leaders discover the joy of financial engineering)?

 

WED 16 JAN

PBoC raises reserve requirements to 15% By Michael Pettis

In another wholly unsurprising move the PBoC announced a few hours after the markets closed today that it is raising minimum reserve requirements by 50 bps to 15%.  This is part of its very determined policy to reduce bank lending and so help constrain overinvestment and overheating.  Will it matter?  The only thing that matters, I think, is the extent of trade-related and capital inflows.  As long as they remain high China will have excessive monetary expansion and all the ills that come with that.  Raising minimum reserves will hurt banking profitability while hastening the process of bank disintermediation – no bad thing in the medium term, but not much help in addressing China’s out-of-control monetary policy.

 

On a related note I am no tea-leaf reader but I was intrigued by an article in today’s China Daily headlined “Yuan's rise less good, more bad for people.”  Unlike a spate of earlier articles telling us why it made sense for China to hasten appreciation, this article discusses how difficult it is for Chinese businesses with assets abroad to maintain the value of their assets given the rapid pace of appreciation in the RMB.  It also describes some of the problems faced by businesses that rely on dollar income.

 

In an effort to be fair, the article does say towards its middle that “Every coin has two sides, however. People traveling abroad spend much less now. Young people eager to study abroad would save money, too, for they have to pay less in yuan.  Also, Chinese investors would feel happy because they have to spend less money on the same overseas projects.  Some people back home stand to gain too because of the rising yuan. Car buyers, for example, can get an imported vehicle at a lower price.”

 

But the authors quickly return to the matter at hand by saying “But a rising yuan is a nightmare for Chinese exporters, especially the smaller ones. Tens of thousands of small- and medium-sized exporters face closure because of the rising yuan and scrapped or reduced export tax rebates.”  It goes on the present a pretty heavy case that the rising RMB is causing havoc among small businesses, who are unable to protect themselves.  Undoubtedly true, and perhaps an indication that we are beginning to see growing resistance to further appreciation.

 

WED 16 JAN

No surprise – QDIIs are a bust in China By Michael Pettis

A few months ago there was a lot of excitement among financial experts and monetary guys about a spate of very successful QDII public offerings in the Shanghai markets.  Until recently there have been restrictions on the ability of Chinese to invest abroad.  QDIIs allow Chinese investors to buy funds that only invest abroad, and it was hoped that via this mechanism Chinese wealth could be diversified and China could increase its capital outflows enough to help make domestic monetary policy a little more manageable.  The extent to which the initial offerings of QDII funds generated huge investor excitement and heavy oversubscriptions gave a lot of people hope that they would soon become a significant force in the market, and analysts seemed to settle on the number of $90 billion (I am not sure why) as the best estimate of the amount of QDII-related outflows to expect in 2008.

 

My own reading was that the QDII excitement said more about the frenzies associated with the domestic stock market bubble than about real understanding of investment abroad.  As someone who has been eagerly trying to bring money into China so as to capture the very safe and easy high dollar returns the RMB appreciation process had to generate, I had a hard time believing that there really could be significant interest in investing abroad.  You would have to make anywhere from 12% to 15% in dollars just to match expected RMB appreciation plus the bank deposit rate.  It never seemed likely to me that there would be significant outflows, and I expected that once QDIIs found themselves struggling to beat, or even match, the rate of RMB appreciation (which they needed to do just to break even), interest would quickly fall off.

 

According to a report today by Credit Suisse, China’s first four QDIIs have seen the prices of their mutual funds decline by about 12% since their launches.  Credit Suisse also claims that “poor investment performance has substantially slowed subscriptions for newly launched mutual funds.”  I can’t say I am surprised, and  I very strongly doubt interest will pick up much later this year.  The only serious foreign investment is likely to be strategic or state-directed.  Excluding the desire to hide ill-gotten gains, why else would anyone want to take money out of China right now?  I am trying to bring as much as I can in.

 

THU 17 JAN

Can stagflation hit China? By Michael Pettis

FRI 18 JAN

Chinese provinces will help with price controls By Michael Pettis

As we race towards the Spring Festival holidays there is normally a dearth of news and new measures to report.  This is somewhat still the case in 2008, but financial authorities have been a little more active than they usually are at this time of year.  Two days after the NDRC announced national price controls on grain, food made of grain, edible oil, meat, milk, eggs and liquefied petroleum gas, they sent a circular requesting that local governments formulate their own price control plans in accordance with the new rules. 

 

I am not sure how much leeway local governments will actually be giving in the fight against inflation, but I would hope that it is not too much. Local governments often go to excesses to show Beijing whatever they think Beijing wants to see, and I am afraid a not-very-good plan, price controls, can become a lot worse if enforced too eagerly and too aggressively.  Local government officials are likely to be far more eager to prove to Beijing that nominal prices have not risen much than to ensure that local residents are protected from the consequences of inflation.

 

We are still waiting to see what the CPI numbers for December will look like and I guess we will get them around the middle of next week.

 

FRI 18 JAN

Chinese banks aren't yet home free By Michael Pettis

I have been told that the CBRC posted on its website today (it is not yet on the English website) a piece stating that in 2007 they had discovered RMB 860 billion is “irregularities”, without specifying what those irregularities are.  I am very curious to know if that means false accounting of new loans – for example to get around restrictions on certain types of real estate and stock-related lending.  Separately, according to the China Daily, the CBRC has urged commercial banks to be more circumspect in granting car loans.  For years there have stories about problems in car-loan portfolios and, according to the article, in 2004, the last year for which there is information, banks registered over RMB 100 billion of non-performing car loans (the market more or less really got going in 2001).  The new CBRC circular suggests, I guess, that non-performing car loans continue to be a problem.

 

Interestingly enough I had dinner with a group of institutional investors last night who were completing an investor tour of China.  I asked them if on this trip they had discovered anything new worth noting.  One of them responded that the most important thing for him was a series of meeting culminating in a meeting with a large electronics manufacturer, in Shanghai I think I remember his saying, whose facilities were enormous but whose profit margin was about 1%.  He told me that these meetings convinced him that there was a lot of overcapacity in the industrial sector, which suggested that in the case of a demand slowdown we might see a sharp cut back in production.

 

It also suggests that these companies don’t have much room either for higher interest rates or a reduction in revenues.  From there the conversation turned to the health of the banking system and its ability to withstand an economic contraction.  With annual loan growth of 15-20% (and sometimes higher) over the past few years, there is a lot of uneasiness about how vulnerable loan portfolios are to a turndown, and whether we would see a sharp rise in non-performing loans under the circumstances.  I think it is all but inevitable that we will.  The question is how bank lending and SOE borrowing would respond to a sharp rise in non-performers.  On the one hand the government could simply force banks to maintain credit lines instead of hoarding liquidity, which is the normal response to a sharp rise in bad loans.  On the other, this might have a negative impact on government credibility.

 

Although in the case of a slowdown there are likely to be lots of little worries, such as high default rates on car loans (not to mention student loans), the biggest thing to worry about, as in many other banking systems, is what happens to property prices and real estate developers.  Chinese banks have officially a great deal of exposure to property developers and property, and there is a lot of anecdotal evidence that there official exposure significantly understates the real exposure.  Property prices have been up year to date by about 10.5% nationwide, but according to a research piece by Credit Suisse,

 

Property prices in China have started to decline on a monthly basis. Under the cumulative effect of credit tightening and administrative measures against property speculation, China’s property prices stared to show signs of moderation in December.  Not only major cities like Guangzhou (-2.8%) and Shenzhen (-0.2%) recorded monthly declines in the prices of their newly constructed residential units, 17 other smaller cities also recorded monthly losses. Jilin, Xian, and Beihai, for example, recorded a 1.5%, 3.7%, and 4.1% monthly drop in prices in December, respectively. Prices in major cities such as Beijing and Shanghai remained on the rise month-on-month, but have moderated from the pace seen in previous months. Across the nation, prices of new residential units rose by merely 0.3% in December, while prices of second-hand residences stayed flat. 

 

Credit Suisse (who have been pretty good on predicting prices in China) conclude by claiming that they expect a “sharper price correction” in January but do not yet anticipate a collapse of property prices.