My Blog

TUE 19 FEB

Bad numbers, but China might still prefer to hesitate By Michael Pettis

After all the market-related anxiety I felt during the last few days in New York, I returned to Beijing yesterday expecting a little less gloom, but nonetheless I suspect that anxiety levels in the corridors of power in Beijing are probably higher than ever.  Yesterday the National Bureau of Statistics released PPI numbers for January and today it released the CPI numbers.  Regular readers of my blog will not be surprised when I say the numbers weren’t good.  According to the NBS release:

 

In January, Producers’ Price Index (PPI) for manufactured goods up by 6.1 percent from the same month last year; purchasing prices for raw material, fuels and power rose by 8.9 percent.  PPI for means of production increased 6.5 percent over last January. Of the total, PPIs for mining and quarrying industry increased 20.5 percent; that for raw materials industry and manufacturing industry correspondingly up by 8.5 and 3.8 percent; that for means of consumer goods grew 4.6 percent. Of which, price for foodstuff increased 10.4 percent; that of clothing and commodities rose 2.2 and 3.0 percent respectively, while that for durable consumer goods dropped 0.6 percent.

 

PPI numbers rose from October to December by 3.2%, 4.6%, and 5.3%, respectively.  January’s 6.1% indicates that upward price pressures continue stronger than ever.  Food prices were a big part of that, but notice that mining and the raw materials industry were also up substantially.

 

CPI was even more alarming.  A lot of debate during the last few weeks was whether we would see CPI hit 7% for January.  According to the NBS release today:

 

In January, consumer price index (CPI) was up by 7.1 percent over the same month last year, of which, urban area and rural area rose 6.8 and 7.7 percent respectively. The price of foodstuff, non-foodstuff, consumable and services expanded 18.2, 1.5, 8.5 and 2.6 percent respectively. CPI made 1.2 percent growth over that in December 2007.

 

7.1% CPI inflation for January is up from 6.9% in November and 6.5% in December (although remember that for statistical reasons the price jump in December is rally equivalent to the November rise – I discussed why in an entry last month).  The bulk of the increase was still caused by food inflation, but what worries me is that non-food inflation, while low (1.5%) is still rising, which it shouldn’t be if inflation were really caused primarily by a one-time food supply constraint – indeed it should be declining or even negative.  It is also pretty clear that inflation is starting to spread to other areas of the economy.  For those of us who have always been convinced that inflation in China is a monetary problem, and not a one-off food supply problem, the recent numbers, while not conclusive, only make us worry even more.

 

A lot of January inflation has been blamed on the effect of the recent weather crisis, but I believe that much of the weather-related price increases didn’t show up in January and are more likely to show up in February.  I should also point out that some Chinese analysts are warning that certain industries whose prices have been frozen (or for whom price increases are subject to approval) may have concealed the true extent of price increases, so the CPI number may actually understate inflation.  At any rate, according to the press, Deutsche Bank and Goldman are warning that inflation may go as high as 8-10% in February and March.  I am not sure how they get to those numbers, but regular readers of my blog know that I have always been much more easily convinced by the inflation pessimists than by the optimists.

 

So what can the government do?  Precious little, it seems to me.  There is still a fast and furious debate about tightening versus non-tightening.  On the one hand January’s numbers – rising inflation, the surge in bank lending, and the surprisingly high trade surplus – should argue for more tightening.  The government seems to have shifted policy from pro-growth until late last year, to slow-growth after October, and now back to pro-growth.  These rapid policy shifts are very damaging – they undermine credibility and, perhaps worse, they add unnecessary volatility since we never seem to wait around long enough to see what the impacts of the policy decisions have been – but there is a strong case that can be made that we need to shift once again to a slow-growth policy.

 

Still, it is easy to argue against a policy shift and it seems that many in China seem to be doing exactly that.  The weather crisis and the possibility of a sharp US slowdown add enough uncertainty to the picture that an equally strong case can be made for taking a wait-and-see attitude before acting further.  Given the government’s ideological and institutional commitment to gradualism, a good reason to do nothing would be warmly welcomed.  Add to this the fact that new leadership will be announced in March, and one can imagine a lot of future newly-promoted provincial and municipal leaders eager to give their bailiwicks a big fiscal boost at the beginning of their watch.

 

Not surprisingly the analyst community is split on will-they-or-won’t-they.  Some are expecting a rapid return to interest rate hikes, reserve hikes, and tougher lending constraints, while others think that the authorities are unlikely to move before March or April, until we can get the first set of economic numbers uncontaminated by the effects of the weather crisis and the Spring Festival, and after we have a better sense of whether or not the US economy is likely to slow enough to affect the Chinese economy in a significant way.

 

Either way I don’t think it will matter.  I continue to believe that China’s problem is a monetary problem, and that the root cause of the problem is the massive amount of the trade and capital account surpluses that need to be monetized by the PBoC.  Until these inflows are eliminated, tightening policies will be as ineffective in the future as they have been in the past.

 

In principle the more rapid appreciation of the RMB should be one way to affect inflows, but in practice, of course, it is not.  Rapid appreciation stimulates speculative inflows, and as long as this money creation continues to feed China’s investment boom, industrial production will keep surging and the gap between production and consumption will continue to keep the trade surplus abnormally high.  None of the tightening measures being discussed – even if they are implemented – will do anything to get China out of its monetary trap.

 

WED 20 FEB

Should we expect a one-off jump or more gradual appreciation of the renminbi? By Michael Pettis

In a recent report Jonathan Anderson of UBS explains why he doesn’t think China will adjust the currency via a large one-off revaluation.  As regular readers of my blog know, I have been arguing since early 2007 that there is a high probability that the financial authorities will eventually be forced into a one-off (15-20%) revaluation, although I am uncertain about the timing. 

 

If they do revalue, they probably won’t want to do it too close to the Olympics because of their low appetite for uncertainty before such an important event, so that leaves them a very short time frame in which to do it – perhaps over the next two months.  However with all the uncertainty over the US economy, and with the new leadership being approved in the next NPC (which begins March 5), I think it is unlikely that they will choose to do it then.  On the other hand, the longer they wait, the worse the monetary and associated imbalances become.

 

Although I disagree with him, I wanted nonetheless to list Anderson’s arguments because I think his are often the strongest arguments against a revaluation.  I hope I am not violating copyright laws (although if I am, my excuse is, why not? around here everyone else does…), but here are excerpts from Anderson’s piece on why a one-off revaluation does not make sense:

 

1. It would hurt the wrong people…As we've also discussed numerous times, the problem behind the trade surplus is not overly competitive exports per se ... but rather imports, or more specifically the sharp drop in import demand over the last few years as rising domestic heavy industrial capacity has taken over market share at home and in some cases (e.g., steel) pushed surplus production abroad.
 
In this environment, the optimal solution for the Chinese authorities is to (i) raise costs for overinvested heavy industrial sectors in order to force out marginal players and rekindle import spending, without (ii)
overly penalizing traditional labor-intensive export manufacturers, who are the single largest employer of poor rural migrants.  What's the best way to achieve these aims? The short answer is to let the renminbi strengthen steadily, but not in big discrete jumps.

2. The timing is getting worse. Even if the authorities had been thinking about a one-off move before, it's unlikely they would still be considering it now on the heels of the painful weather-related disruptions in transport and power supply in January and February. Not only will Q1 2008 data point to a visible slowdown at home; most available data have also come off sharply over the past month or two, and the Chinese senior leadership has expressed public concern about the potential impact on mainland exporters. In short, this is not an environment where it would make sense to try an abrupt change of tack on currency policy.

3. …The central bank still has a long way to go before it runs out of options for managing a more gradual scenario…Equally important, FX reserve pressures have been fading over the past six months following the "scare" in the first half of 2007, when inflows jumped sharply (see Chart 2 above). The trade surplus was essentially flat through all of last year on a seasonally adjusted basis and could actually begin to decline in 2008, and as we show below, the strong portfolio capital inflows of a few quarters ago seem to be drying up as domestic equity and property markets fall.

4. No need for emergency inflation fighting. One of the most common arguments in favor of a large up-front revaluation is that the PBoC now needs emergency measures to fight inflation. But this argument makes no sense to us, for the following two reasons. First, as we've stressed continually over the past months, there's no indication whatsoever from the data that current headline inflationary pressures are structural in nature. …As of end-December "core" non-food CPI is perfectly stable; all of the increase in headline CPI in 2007 has come from food, and nearly all of the pressures within food have come from meat and eggs prices alone. This is hardly a picture of widespread, spiralling inflation (the picture may change temporarily in January and February as weather-related shortages lead to price spikes, but this effect should soon fade as well).

And second, there's no rationale behind expectations that renminbi strengthening would help moderate domestic food price increases – for the simple reason that is not a significant importer of food.

5. Fading speculation worries. Another very common argument is that can't successfully pursue a gradual renminbi strategy, since letting the currency appreciate by 8% to 10% per year would bring in a flood of speculative capital and overwhelm the PBC's ability to control the money supply. And in the first half of 2007, it seemed that this was precisely the case: "hot" money was visibly returning to the mainland once again in large amounts, and the central bank was forced to slow down the pace of exchange rate appreciation so as not to encourage further speculation.

However, over the past six months those pressures have faded. As it turns out, the main driver of capital inflows was not exchange rate expectations but rather the booming equity and property markets.

 

I have a lot of respect for Anderson, and like reading his stuff, although I have to say that I often disagree with his predictions and this is one case where I disagree, largely because I think he misses the main point except at the very end, where he partly addresses it.  Whenever people point out to me all the reasons why a one-off revaluation is a bad idea, I have no disagreement.  It is a bad idea.  If China is forced into a one-off revaluation, it will not be because this is a “good” policy choice that will leave the economy in better shape than it was before the policy was implemented.  It is almost certainly a bad policy choice, but unfortunately the alternatives may all be worse.  By waiting so long on adjusting the currency China has found itself in a trap where it must choose between the least bad options.  I have discussed this often in my blog and don’t want to beat this thing to death, but I do think it is worth making a few points.

 

Clearly China cannot go back to the old days of a pegged exchange rate or the painfully slow appreciation it experienced until last summer.  That leaves only two more options – the current strategy of much more rapid appreciation, or a one-off revaluation.  There are such serious problems with the rapid appreciation option that in my opinion by a process of elimination we are left with the last one.  What are the problems?  At least three, I think:

 

1.        The current appreciation strategy postpones the resolution of the monetary problem for perhaps another two years, during which time the imbalances caused by explosive money growth can only get much worse.  Another two years of this kind of reserve growth is almost certainly a terrible idea.  As it is, China’s monetary regime should have been altered in 2003 or 2004, and because it wasn’t, we have spent the last three years with explosive monetary growth.  By October of last year all the gradualist ideology and wishful thinking in the world (and there has been a lot of both) could not prevent the economic authorities from recognizing that China had built serious imbalances thanks to its out-of-control monetary policy, and if these weren’t addressed there was a risk of a very sharp adjustment.  That is why the October Economic Conference resulted in the abrupt policy shift.  It is hard to imagine that another two years of this can be anything but disastrous fro China.

 

2.        Anderson disagrees, but there is some evidences that hot money inflows are indeed high and likely to rise, although masked partly by complexities in the way the PBoC accounts for reserve accumulation and by over- and under-invoicing in the trade accounts.  The trader in me finds it hard to believe, in any case, that a low-risk 10-14% return in dollars for bringing money into China will not cause large speculative inflows, even if there are capital controls.  If it takes another two years to get to where we want to go, the impact could be hundreds of billions of dollars of additional monetary expansion because of speculative inflows.  This is the opposite of what we need.

 

3.        Finally, and this is a problem that almost no one to my knowledge has discussed, but there is serious a problem with the end game that needs to be addressed before we get there.  A gradual appreciation, unlike a one-off revaluation, creates no credible signal that we have reached the upper limit of the appreciation path.  If the RMB appreciates for two years at 8-10%, how do investors and speculators know when we have reached the "correct" level and stop speculating on additional appreciation?  In past cases, sustained currency appreciation develops its own momentum, and often a currency will switch from heavily undervalued to heavily overvalued (Japan in the 1980s?).  This could well happen in China, and it would cause a whole new set of problems that would be very difficult to control.

 

Notice that none of my reasons for a one-off revaluation are positive reasons.  I came to the conclusion that China would be forced into this policy only because I was forced to conclude that every other policy would fail.  In other words it is only by a process of elimination that I arrived at this conclusion.  That doesn’t mean, of course, that the financial authorities will necessarily come to the same conclusion I did, but it does suggest, at least to me, that if they don’t, China’s financial system and near-term economic prospects face some very ugly adjustments.  A one-off revaluation is a bad idea, but everything else is worse.

 

WED 20 FEB

China Daily on inflation By Michael Pettis

Yesterday the China Daily published an interesting editorial on inflation that may indicate what the concerns are among at least part of the leadership. Here it is in total:

 

Early reports of shocking price hikes in areas hardest-hit by the bitter snowstorms might have made it relatively easy for the public to swallow a 7.1-percent consumer inflation in January. Given the severity of the supply shock caused by the worst snowy weather in at least half a century, a short-term acceleration of inflation at this level, though the highest in a decade, is still an acceptable result of the Chinese government's efforts to curb overall price rises.

 

Had the authorities not tried hard to increase food supplies and introduced stopgap price controls on a number of daily necessities before the snowstorms, the consumer prices may have gone through the roof. On back of a 6.5-percent headline inflation in December, it took a lot of endeavors to limit growth of the consumer price index to 7.1 percent in January when both snowstorms and the coming Chinese New Year were significantly pushing food prices up.

 

However, while they can breathe a sigh of relief for managing to cope with short-term inflation factors, policymakers should not stop fixing their eyes on long-term inflation.  Aggressive price measures that the authorities have adopted will continue to take effect and thus slow price hikes in the near future. But the country's inflation outlook may worsen in the long run if the structural imbalance in the economy cannot be properly and promptly addressed.

 

The acceleration in inflation has so far been predominantly driven by food. But that does not mean the current round of inflation will be short lived if the supply of food can be raised.  While food prices surged by 18.2 percent year-on-year, non-food price inflation remained low at 1.5 percent in January. The slow rise in non-food prices is rather a source of increasing inflationary pressure than a reassuring check on further inflation.

 

The surge in producer prices which jumped 6.1 percent in January, the fastest growth in more than three years, indicates that rising energy and food costs are considerably pushing up manufacturing costs.

Besides, the enforcement of higher environmental and labor standards will add to companies' costs. Hence, non-food price inflation is already in the pipeline. The complexity of China's growth prospects this year makes it very difficult for policymakers to fight an all-out war against inflation. A tightening monetary policy is essential to preventing serious inflation. But it may also risk slowing the growth of the Chinese economy by too much as a US slowdown or recession weighs increasingly heavily on the country's export sector.

 

The policymakers should certainly be forward-looking and prepare for the possible downturn.

Yet, an inflation rate above 7 percent currently warrants more concerns over entrenched inflationary pressures than worries about a temporary farewell to double-digit economic growth.

 

I think there are at least two very interesting points about this article (besides the fulsome but perfunctory praise about how well the authorities have handled the inflation problem so far).  First, the author seems less than confident that inflation is merely a short-term food problem.  Clearly he is worried that the inflation genie has already been let out of the bottle and that inflation is spreading to other parts of the economy.

 

Second, he acknowledges the complexity of the economic issues surrounding financial policy-making, but he says emphatically that “the country's inflation outlook may worsen in the long run if the structural imbalance in the economy cannot be properly and promptly addressed.”  As I understand it, “structural imbalance” almost always means the currency regime and the associated monetary consequences.  I am not sure what “properly and promptly” mean, but interest rates have been rising, reserve requirements have been rising, and the currency is appreciating more quickly.  Either he means something else must be done, and soon, or he is arguing that the recent hints of a policy reversal (actually a lot more than just hints) are ill-considered and Chinese policy-makers must go back to the grim spirit of the October Economic Conference. 

 

Either way I read this as suggesting that the internal policy debate is fierce and far from resolved.

 

THU 21 FEB

Does the PBoC think hot money is a problem? By Michael Pettis

Yesterday I quoted extensively from a UBS report that argued very strongly against the likelihood of a one-off revaluation of the RMB.  Much of my discussion concerned why I think that although I agree with some of the author’s points, I do not believe they are relevant to the case.  I had planned to write in today’s entry about one of his arguments which was in fact relevant but with which I disagreed – that there was no evidence that hot money inflows have become a problem for monetary policy.

 

When I checked Brad Setser’s blog (which I do every day and strongly recommend to anyone interested in central banks, global monetary policy, and international capital flows) I saw that he had beaten me to the punch.  In his very extensive entry he summarizes the argument proposed by UBS and others that, based on residual reserve growth (after things like the trade surplus, FDI, and other non-portfolio inflows are subtracted from the total increase in reserves), hot money inflows do not seem to be a serious problem.  He counterpoints these with the arguments of folks like Morgan Stanley’s Stephen Jen that hot money inflows have actually been very high, adding his own and Logan Wright’s calculations that suggest headline reserve growth may significantly underestimate effective reserve growth, and so underestimate the residual.

 

Brad Setser seems to come down on the aside of arguing that hot money inflows are indeed a concern for the monetary authorities and, needless to say, I strongly agree with his assessment.  Since it is an excellent post there is no need for me to belabor the point when I can simply cheat and recommend that anyone who is interested read it himself at http://www.rgemonitor.com/content/view/245201.

 

I do however want to add two things to his argument.  First, in today’s Bloomberg I read the following article:

 

Yuan Declines on Speculation China Seeking to Deter Speculators

Feb. 21 (Bloomberg) -- The yuan fell, snapping a five-day gain, on speculation China is seeking to deter speculators betting on faster gains in the currency. The central bank set a weaker foreign-exchange reference rate for trading, making it the only loser of the 10 most-active Asian currencies today outside of Japan. The People's Bank of China pledged to boost the currency's flexibility in a five-year plan released this week. China may ``flush out speculators from time to time, before allowing the yuan to appreciate again,'' said Nizam Idris, a currency strategist with UBS AG in Singapore.  

 

This is the second time in recent weeks the PBoC has suddenly reversed RMB appreciation, supposedly to “flush” out speculators. They have been doing this regularly in the past few months. 
 
Leaving aside the usefulness of their actions (if everyone knows the RMB is headed up, why should a small one- or two-day reversal worry anyone?), I would wonder why the PBoC is bothering with all this if they didn’t believe there were significant hot money inflows.  One could argue that they are trying to teach Chinese corporations about currency volatility so as to prepare them for the brave new world, but since purchase and sale contracts are usually priced forward, I doubt it would have much impact.  This action seems to be aimed at speculative inflows, and if the PBoC thinks speculative inflows are a problem, should any of us disagree?

 

Just a few minutes ago before I could post this entry I received an angry and impassioned email from one of my former Chinese students who is now an FX swap trader in Shanghai for one of the largest global investment banks (with the Subject heading “China Market SUCKS”).  I found his email very interesting and perhaps very relevant (it’s great that so many of the best young traders in the Chinese markets are my former students).  He allowed me to excerpt his email, with a few clarifications and some editing to eliminate trader’s slang:

 

Some officials from SAFE called the only two onshore money market brokers yesterday after the market closed, and told them verbally that they must stop brokering FX swap onshore immediately.  The reason they gave verbally (and only verbally, no written notice) is that FX swap is an FX instrument (because an FX forward = an FX swap + an FX spot trade, so that if the FX swap price changes, an FX forward’s price will follow – how silly this is!).  They said that the foreign exchange market is so important to China that it is highly co-related to national security, and because of the brokers’ activity, the market is too volatile and out of the control of SAFE.

 

By closing down the broker shops, they hope the onshore fx swap market will be more stable, and easier to monitor, and China’s financial market, or at least China’s FX market, will be safer!

 

Here is what we got today after this new rule, which is nothing surprising to traders.  Since banks are only allowed to trade by calling each other direct and no one really knows what is happening and where the real market is, every bank quotes very wide bid/offer spread, and during whole morning only five trades were done in the market.  If any big flow hits the market, which is very likely because no corporate is willing to hold long USD forward position, the market will be more panicked than ever as it lacks liquidity.

 

Well, at the end of day, I am surprised to find out how little they know about this market (how can a FX swap be an FX instrument?!) and that how rapid policy can be changed in China (as this verbal notice came to everyone as a surprise).  More importantly, it shows how desperate they want to control the market in their good hands, and maybe it shows they feel that they are in the threat of losing control.

 

Very honestly I am not sure why SAFE is doing this and what they expect to accomplish, but it seems they are very concerned about what is happening in the foreign exchange markets.  There have rumors for a long time (actually, much more than rumors) of corporations using the market to speculate on RMB appreciation, and maybe this is a way to try and control the market.  At any rate I welcome any of the readers of this blog, especially traders and especially my former students, to write to me either online of offline and explain what they see happening. 

 

THU 21 FEB

Victor Shih on China’s credit boom By Michael Pettis

On of my favorite China experts is Victor Shih, a political science professor at Northwestern University and an expert on financial and economic policy-making within the Chinese leadership.  Yesterday the Asian Wall Street Journal published a piece by him called “China's Credit Boom”, which is well worth reading.  In case any one has missed it I am reprinting it below.

 

China's Credit Boom 

 

The rest of the global economy may be experiencing a credit crunch, but not China, where easy credit has fueled a spectacular run-up in real estate prices and stock markets. Despite a cascade of State Council decrees restricting bank lending this year and a high-profile Politburo meeting in November that focused on the risk of inflation, bank lending last month grew by over 800 billion renminbi ($112 billion) -- equivalent to 22% of the total loan quota that Beijing's technocrats meted out to state-owned banks for 2008.

 

This rate of credit expansion is similar to the rate last seen in the second quarter of last year, when China's economy grew by nearly 12% from a year earlier. And it comes just as the Party is trying to ratchet down inflation, which in January hit 7.1% year-on-year on consumer prices.

 

Technical factors don't fully explain why the monetary base grew with such fervor in January. The lunar new year holiday took place earlier this year than usual, driving up demand for cash. However, new year cash spending usually means withdrawing one's savings, not borrowing from banks. A severe winter snow storm forced the central government to release tens of billions of renminbi in funds to pay for emergency spending. But this amount would be a blip in the Chinese monetary landscape, which runs into the trillions of renminbi in a given quarter.

 

More convincingly, major borrowers are pressuring banks to lend out as much of the credit quota as possible. Companies want to take advantage of low real interest rates and lock in cheap cash for the remainder of the year. Although large firms, many of which are powerful state-owned entities, are undoubtedly exerting pressure on banks, State Council loan ceilings precisely seek to minimize the effect of firm pressure by coordinating all banks simultaneously to cut back on lending. However, bankers called the technocrats' bluff and proceeded to lend with gusto. In effect, they are daring Beijing technocrats to enforce the credit ceiling and risk a widespread liquidity shortage in the latter part of the year.

 

This is an unusual game of chicken. China's major banks, all of which are majority state-owned and run by managers appointed by the Communist Party, are simply ignoring decrees issued by the highest authorities.. In a state-dominated banking system, this is as unexpected as mid-level managers blatantly acting against the wishes of both the CEO and the board of directors. Formally the technocrats have the full backing of the ruling Communist Party and can dismiss any banker at any time. However, senior state bankers do not behave as if they take the threat of removal seriously. They've stared down such threats before, anyway -- in China, elite political discord has often compelled banks to disobey formal decrees.

 

Politics may be at work here. First, the increasingly vocal National People's Congress, China's rubber-stamp legislature, is slated to open its new session at the beginning of March. Many top technocrats, including central bank governor Zhou Xiaochuan, will receive new appointments. Others will simply be reappointed to their posts. Thus, technocrats may hesitate to enforce loan ceilings because they do not want to anger regional and industrial lobbies represented in the NPC that want easy credit. But although the NPC formally votes to appoint ministers, in reality, their appointments are decided by the Politburo Standing Committee -- the same body that voted to support retrenchment policies in November. Thus, the technocrats should not feel threatened by the NPC, even though the NPC may not prefer retrenchment.

 

There are plentiful historical precedents for these kinds of politically driven loan surges. In the 1980s and '90s, feuding elite factions cheered their provincial followers to borrow heavily from the banks. Banks, knowing that elite politicians in the Communist Party's Politburo supported loose lending, felt they had little choice but to open the monetary spigot. Likewise, because the technocrats knew that banks were lending due to elite political pressure, they could do little to punish banks. Both the technocrats and the banks served the same master -- the political elite in the Communist Party. This often led to serious inflation trouble until the faction with the most to lose from an economic crisis decided to support senior technocrats and crack down on lending, thus ending loose lending policy and stifling inflation.

 

Something similar may be happening today. When faced with rising inflation late last year, President Hu Jintao decided to support Premier Wen Jiabao's retrenchment policies. There were signs, however, that not every member of the ruling Politburo Standing Committee agreed with retrenchment policies. Days before the November meeting, for instance, Premier Wen announced on a trip to Singapore that lowering asset prices was a high priority. Yet, the Politburo meeting did not endorse this policy goal, strongly suggesting that some members of the top elite opposed it.

 

The most likely opponents of strict monetary policies are powerful "princeling" officials -- children of the Communist Party's founders -- who have close connections with economic interests in China's big coastal cities. Some of these interests, which include manufacturers and real estate developers, have suffered from the tight monetary environment. Detecting elite discord on retrenchment policies, bankers are then emboldened to disregard central decrees, betting that their elite supporters would protect them from the wrath of the technocrats.

 

The Chinese government needs to continue monetary tightening by raising interest rates and the bank's reserve requirements. Furthermore, Messrs. Hu and Wen need to overcome internal opposition and make it clear to bankers that flouting central decrees begets serious consequences, including dismissal. Otherwise, they risk allowing inflation to spiral toward dangerous levels. In the opaque Chinese political system, strong signals, in addition to decrees and laws, continue to be necessary ingredients of credible policies.

 

Mr. Shih is a professor of political science at Northwestern University and the author of "Factions and Finance in China: Elite Conflict and Inflation" (Cambridge University Press, 2008).

 

FRI 22 FEB

NPLs for the big commercial banks rose last quarter By Michael Pettis

As if keeping time with Victor Shih’s article (see previous entry) Standard & Poor’s warned yesterday that non-performing loan ratios in China have risen, and added that corporate defaults in 2008 may increase because of tighter credit controls and weakening demand from a slowing U.S. economy.  NPLs for the major commercial banks (the big five plus the 12 joint-stock banks) stood at 6.63% of total loans at the end of September 2007, and rose to 6.74% by the end of December.  This may seem like a small increase in the ratio, but remember that this increase occurred during what can only be described as optimal times – the economy grew at well over 11% in the 4th quarter, the country was flooded with new money, inflation increased faster than interest rates (which causes debt payments to decline relative to revenues and asset values), loans expanded rapidly (which should push the NPL ratio down), and equity issuance surged.

 

We can only guess what will happen if Chinese borrowers are hit by a combination of rising interest payments, slowing external demand and credit constraints.  There are already good reasons to suspect that the NPL ratios seriously underestimate the true extent of NPLs, and of course it is well know that most of the improvement in the NPL ratio during the last five years (the NPL ratio was around 20% in 2003) occurred because of the huge increase in loans outstanding – total loans outstanding grew by over 16% in 2007.  The question is whether that increase in loans, made during what can only be described as a party atmosphere, doesn’t include a large amount of future bad loans.  Bad loans, as old bankers always point out, are usually made during good times.

 

In that context I should bring up an interesting (and alarming) article from yesterday’s Spiegel titled “German State-owned Banks on the Verge of Collapse”.  The opening paragraph says:

 

The German government has had to bail out state-owned banks with taxpayers' money after their managements recklessly gambled away billions on subprime investments. But if a state-owned bank were to go under, the consequences could be disastrous for the whole economy.

 

The article describes how the state-owned banks, “one of the key pillars of the country's banking system”, had engaged in such reckless lending behavior during the boom years of the recent past that they were almost wholly unable to withstand last year’s credit contraction.  A number of the largest banks have been forced to their knees, and there is an increasing risk that a few major defaults could bring the whole system down.

 

It is a nightmare scenario that the government financial supervisory authority now believes is increasingly likely. Germany's public-sector banks speculated far more heavily than private banks in American subprime mortgage securities. Now these banks' beleaguered executives are calling on the government to bail them out from a disaster of their own making.

 

For Wolfgang Reuter, the author of the piece, a major cause of the crisis was the skewed incentives created by state ownership and effective state guarantees.

 

Ortseifen and Matthäus-Maier are perfect examples of the fatal mix of amateurism, greed and political protection that is symptomatic for many of Germany's state-owned, partially state-owned and public sector banks. It is an environment that can only thrive in the shadow of the state -- and that has drained more than €20 billion from the public treasury within the last decade.

 

Until now, the government has always been there to pick up the tab in the end. Fully aware of this safety net, the executives at state-owned banks gambled with their employers' assets as if there was no tomorrow. Munich-based BayernLB did it with stocks in Singapore, Bankgesellschaft Berlin with real estate investments, and WestLB with holdings in British companies.

 

Anyone who is not responsible for bearing the consequences of the risks he or she takes can easily turn into a gambler. And the bets kept increasing in recent years, getting more and more public-sector banks into financial hot water. Now the banks find themselves lacking the assets they need to weather the turmoil of an international financial crisis.

 

I bring up the German experience to make two points.  First, the speed in which a banking system can unravel after many years of what seemed like robust growth is often astonishing, and the way in which the unraveling takes place is almost always unexpected.  Second, state ownership is no guarantee of safety.  In fact in the German case it seems that state ownership may have exacerbated the poor lending decisions.

 

I shouldn’t need to make the last point, but I cannot remember how many times I have been assured that the difference between Chinese banks and non-Chinese banks is that unlike the latter, Chinese banks are state-owned, and that fact makes a banking crisis in China nearly impossible.  Wrong on both counts.

 

You can read the Speigel article at http://www.spiegel.de/international/business/0,1518,536635,00.html