My Blog

MON 11 FEB

China’s adjustment isn’t being made any easier By Michael Pettis

Yesterday’s Financial Times says that US wheat inventories fell to a sixty year low and may even force the US to import wheat this year.  Apparently it had sold too much wheat last year and now will have to replenish stocks.  That news drove prices for certain varieties of wheat up nearly 11% last week and 50% so far this year.  There are also estimates that India, the world’s second largest wheat consumer, may have to import significantly more wheat than in the past, beginning in April this year.

 

One way of bringing wheat prices back down, according to analysts, is if higher prices in India and China cause farmers to allocate land away from cotton production to wheat production.  Price controls in China may make that process very difficult.  I am no grain expert, but the recent trend of shortages and rising grain prices is becoming monotonous and bodes poorly for China’s fight against inflation in 2008.  With food prices rising so quickly, even an annual RMB appreciation of 9-10% will not bring the price of foreign food imports down in local currency terms.

 

Next week we will get January’s CPI and PPI inflation numbers.  I doubt they will be good, but I suspect that inflation doves will insist that the distortions caused by the winter weather crisis make them useless in determining policy changes.  Next month’s CPI numbers are also likely to be distorted, by the spring festival.  That means it won’t be until mid-April, when we get the March numbers, that we might have sufficient evidence of persisting inflation to affect policy choices.  Of course that is the time the new provincial and municipal leadership comes into power, and so there may not be a lot of appetite for economic tightening anyway.

 

Separately Peter Mandelson, the EU’s trade commissioner, made some fairly aggressive claims last week in a speech at Cambridge University about rising European protectionist ire aimed at China.  Mandelson has the reputation of being a hard-core free trader, but his comments suggest that he is finding it increasingly difficult politically to explain away Chinese trade policies to his European constituents.  The whole shifting of Chinese trade surpluses from the US to Europe never had much chance, in my opinion, of being sustainable.  Thanks to its more flexible economy and financial markets, and perhaps a different attitude towards globalization, the US is able to accept and absorb these kinds off imbalances much more easily than Europe.  This means, I think, that unless the dollar rises strongly against the euro, it will be difficult for China to slow the rate of appreciation of the RMB without causing rising anger in Europe and maybe even trade-related moves.  China might want to do so should it suddenly become worried about a rapid drop in exports to the US caused by a slowing US economy.

 

Rising global inflation, the potential US slowdown, its impact on the rest of the world, and the accompanying credit crunch are seriously complicating China’s policy options.  A few years ago when former Brazilian central bank governor Arminio Fraga visited Beijing, one of the points he tried to make to government officials with whom he met, he told me, was that the best time to make difficult adjustments to the currency regime was when local and external conditions were great, as they were at the time, otherwise the financial authorities might find themselves in the position of being forced to make adjustments when conditions were much more difficult.  It seems like an obvious point, but bears repeating often.

 

WED 13 FEB

China’s mystery value does NOT enhance its creditworthiness By Michael Pettis

Yesterday at an investor meeting someone made the point that the lack of transparency in Chinese accounting may actually act to reduce the riskiness of the system.  If this is true, it is pretty good news for investors banking on government credit. 

 

What’s the total amount of central government debt in China and how is it structured?  We don’t really know.  What is the amount of municipal and provincial obligations guaranteed by the central government?  We certainly don’t know.  How much did banks lend against real estate?  We have some figures but it is widely believed that an awful lot of real estate loans are not correctly classified as real estate loans.  What is the breakdown within the banking system of new loans, and what about old non-performing loans?  We have some information but not nearly enough to give us a real sense of how much bad debt there currently is and, perhaps more importantly, how vulnerable new loans are to a slowdown.  There is a lot of mystery embedded in the national balance sheet.

 

Asking about the creditworthiness of the central government is not a trivial question.  China is in a reasonably good fiscal position and government expenditures only barely exceed revenues.  In addition most estimates put total current debt of the government at around 30% of GDP, which everyone agrees is fairly low and should cause little concern to anyone looking at the government’s ability to service debt. 

 

More importantly from a financial stability point of view, most government obligations are very safe and optimally structured – they consist of medium- and long-term, fixed-rate, local currency bonds.  In my book on financial vulnerability in developing countries I make a point about stressing how important this kind of debt is in protecting countries from the threat of financial crisis because of the way they dissipate the impact of adverse shocks.  In a crisis anything that causes interest rates to rise substantially (say a burst of inflation) would automatically reduce the existing debt burden, thus acting to stabilize the financial system.

 

But still, that doesn’t mean that there is nothing to worry about.  Last March the Inter-American Development Bank published Living with Debt - How to Limit the Risks of Sovereign Finance by Eduardo Borensztein, Eduardo Levi, and Ugo Panizza, and one of the most interesting points the book makes is that the surge in debt that precedes a financial crisis rarely occurs because of the accumulation of massive fiscal deficits, as we are likely to assume, but rather because of a sudden conversion of contingent liabilities onto the government’s balance sheet. 

 

The two most likely sources of these contingent liabilities have typically been unhedged external debt, when a rapid depreciation of the currency suddenly causes the value of external debt to rise relative to the value of domestic assets, or a surge in non-performing loans on bank balance sheets that forces the government to intervene and assume the liabilities of the banking system.  China, which has been vigorously fighting the 1997-Asian-Crisis war, is almost immune to the former risk, but it doesn’t take an alarmist to see that the latter risk is a real possibility, especially given the explosion in bank lending during the best-of-times period of 2003 to the present.

 

Right now, my best guess is that if various contingent liabilities were correctly accounted, total liabilities of the government would exceed 50% of GDP, and could be much larger – some estimates put it at 80% of GDP, which is not implausible.  If there were a significant downturn the number would probably get worse – it is almost a certainty that non-performing loans in the banking system would rise in an economic downturn.  How much is anyone’s guess, but it is not implausible to assume the possibility of a sharp rise in non-performing loans. 

 

When these are combined with the non-performing loans still residing on the bank balance sheets (some correctly identified, but perhaps many of them still hidden) and the loans transferred onto the asset management companies created for that purpose, who are technically bankrupt but explicitly guaranteed by the MoF, total debt of the government may jump substantially, and this debt is not nearly as well structured as the existing bond obligations of the government.  In fact, as I explain in my book and elsewhere, these types of debt exacerbate external shocks and so can be as toxic for the government as external debt, or Mexico’s famous Tesobons, in case of a domestic crisis, because like external debt their value tends to expand just when the country can least afford it.

 

I brought this up yesterday at an investor meeting and received a comment, in the form of a question, that I have heard many, many times before – and from some fairly sophisticated sources.  Since the government has been able to hide the true extent of its liabilities quite well, why should we assume that in a contraction we will suddenly get access to this information and, if we don’t ever know, why should it matter?  The hole on a borrower’s balance sheet is only a problem if we know it is there.  China’s lack of transparency actually reduces the risk of bad information spooking investors.

 

It is always frustrating to get this kind of comment, especially now when the sub-prime crisis has made it very obvious that sometimes the lack of information is worse than unhappy information.  After all it wasn’t the extent of the potential sub-prime losses, even assuming the worst possible case, that scared the market but the fact that no one knew where these losses were hiding.

 

Information does matter, especially when we need it most.  Based on many years of trading, I can say one of the few rules of financial markets I know is that when markets are buoyant and liquidity plentiful, transparency and high-quality information is of little use – in fact since we tend to assume the best, no information just means no bad information, so buy, buy, buy.  However when things go badly, investors change tack suddenly and begin to assume the worst.  In this case no information means nothing but bad information.

 

It’s always dangerous to make predictions but one thing I will predict with great confidence is that when things turn badly in China – when economic or monetary conditions are contracting – the lack of information that emboldens investors today will force them into panic selling.  Lack of transparency is only a blessing in the irrational state of a bull market.  However it becomes a source of new irrationality in a declining market. 

 

This, by the way, is not a new observation at all.  On my flight to New York I was reading Russell Napier’s Anatomy of the Bear and came across this June 15, 1932 quote from the Wall Street Journal: “During the roaring days of the bull market, lack of full information about a company gave its securities a certain mystery value.  The long depression has done a good deal to eliminate mystery value from consideration of the worth of a security.”

 

THU 14 FEB

January new lending and new money soars in China By Michael Pettis

After declining strongly in November and December, to I think around RMB 60-70 billion a month, new lending in January soared to RMB 804 billion.  This is the highest monthly figure in years and more than twice the very high monthly average for 2007 (RMB 303 billion).  It also blows out the monthly average for the first quarter of 2007 (RMB 474 billion), the former record period for new lending.  To make a quick back-of-the-envelope comparison, even if February and March new lending plummets to the December level, the first quarter of 2008 will still see more new loans than the average quarter last year.  I think we may see a new quarterly record set.

 

The sudden relaxation (to put it mildly) of new lending constraints might be a panicked but limited reaction to the effect of the storm in January, or it may signal that the government has more generally reversed course and has begun easing again.  Much of the lending was short term (51%).

 

Money supply growth also surged in January.  M2 was up 18.9%, compared to the 16.5% consensus as reported by Bloomberg.  M0 was up 31.2% from last January.  This is not as surprising as it seems since a lot of people took out cash for the Spring Festival holidays, and of course a lot of commentators are saying just this.  Still, I am still haunted by the image of the man in the old-fashioned shower jerking the faucet back and forth as he alternatively scalds himself and freezes himself.

FRI 15 FEB

China’s trade surplus was higher than expected (again) By Michael Pettis

According to today’s Bloomberg, “China's trade surplus jumped more than economists estimated in January, a sign that the world's fourth-biggest economy may keep powering global growth as a recession looms in the U.S.”  Data released by the Chinese authorities yesterday showed a trade surplus of $19.5 billion for January.  This is below December’s $22.7 billion (which tends to be swelled by Christmas shipments), but it is 23% higher than last January’s $15.9 billion.  More importantly it was also higher than the consensus estimates, of just under $17 billion.  Exports rose by a very high 26.7%, to $109.7 billion for January, while imports increased by 27.6%.

 

Although the number surprised substantially on the upside (yet again), a number of analysts tried to downplay or explain away the higher-than-expected surplus, and to predict (yet again) that things will improve.  “Such strong export growth is unlikely to be sustained. I think it’s abnormal,” said Li Yushi, vice-director of a think-tank under the Ministry of Commerce, according to an article in today’s South China Morning Post. “Many exporters are in difficulties due to rising costs and the yuan’s appreciation, and export momentum will ease in coming months.”  Analysts focused on the seemingly strong growth in imports and noted that part of the increase in exports might have been an anticipation of the early Spring Festival, which this year came eleven days earlier than last.  The need to get work done before the holidays kicked in left exporters rushing to fill orders in January that might normally have been filled in February.

 

While this may be true of exporters anticipating the holidays, it should also be true of importers, and the net figure still should not have been so high.  Anyway since the date of the Spring Festival was widely known by economists I don’t see why its impact should have been unexpected.  What is more, this trade surplus, high as it is, still understates the strength of Chinese exports and overstates the rise of imports.  According to Mark Williams, of Capital Economics, “the value of imports was also inflated by the high cost of oil imports last month. We estimate that this alone accounts for 12 percentage points of the growth in imports. If oil prices had remained flat, January’s surplus would have been in the region of $28bn rather than $19.5bn, not far off an all-time high in the oil price-adjusted data.”

 

When the trade surplus numbers started coming down at the end of last year, I wrote in my blog (January 11, “December's trade surplus declines to $22.7 billion”) not to take the decline too seriously. 

 

Many analysts are suggesting that we may have seen a cresting of export growth and perhaps even the trade surplus.  I am skeptical.  I think recent export-related cooling measures, plus the surge in oil prices, may have brought the trade surplus down temporarily, but the figures are still very high and money growth is still excessive.  Once the initial cooling measures on exports wear off (not to mention when the anti-inflationary cooling measures on consumption kick in) we will get back to the old dynamics of an expanding money supply leading to expanding industrial production leading to expanding exports. 

 

My reasoning was that as long as there was excess money creation it would feed into rising industrial production via rising investments, and as long as industrial production climbs faster than consumption, China’s trade surplus must stay high or rise.  I think it is going to be very hard to see a real decline in the trade surplus until we see either a sharp rise in forced domestic investment (rising inventory levels) caused by a significant falling off of foreign demand, or until the currency regime is fixed, either by a lot more appreciation or by a lot more inflation.  China’s trade surplus is part of the monetary trap in which it finds itself caught.

 

Talking about trade, the US also reported trade figures yesterday.  The US trade deficit shrank in 2007, for the first time in five years, by 6.2%.  This was partly explained by a reduction in the growth rate of imports (5%) and partly because of a sharp rise in exports (12%).  The lower-than-expected trade gap may cause the fourth-quarter GDP growth numbers to be revised upwards.  It also underscores how risky the current strategy may be of significantly relaxing the fight against inflation and overheating because of concerns about a collapse in US demand.

 

So far, just as I and all the other monetary alarmists have been predicting, there hasn’t been much moderation in China’s growth numbers.  In spite of the recognition in October of how flawed Chinese economic policy-making had been over the past several years in its failure to take into account out-of-control monetary policies, it seems that we have gone right back to the old days.