My Blog

SAT 19 APR

More evidence of increasing risks By Michael Pettis

This probably doesn’t need to be pointed out in my blog because I have been beating the idea to death, but sharp-eyed Logan Wright in his latest Stone & McCarthy report comes up with some pleasingly simple evidence that hot money is pouring into the country from every pore.  In his words:

 

Foreign direct investment in China has surged in the first three months of 2008, totaling $27.41 billion, up by 61.3% year-on-year. Paradoxically, however, the NBS's fixed asset investment data show a 6.5% year-on-year decline in the use of foreign-sourced capital as funding for fixed asset investment. In other words, 61.6% more money is flowing into China for investment purposes than the same period last year, but the use of that capital has declined by 6.5% year-on-year. While there will undoubtedly be some delays between the receipt of registered capital and the use of the funds, these diverging trends suggest that the foreign direct investment statistic includes some speculative capital inflows betting on appreciation of the yuan, which will continue to fuel monetary growth, requiring additional sterilization by the central bank.

 

FDI inflows surge but actual foreign investment drops slightly over the same period.  This doesn’t prove anything because we would need to look much more closely at the actual numbers and the timing of disbursements, and Logan himself acknowledges this, but for the two numbers to move in such dramatically different directions over the year is at the very least counterintuitive.  Unless you believe of course that a big part of recent trade and FDI flows are simply disguised speculative capital, in which case it makes perfect sense. 

 

The evidence is largely circumstantial, but by now there has been so much circumstantial evidence of hot money piling up that it is hard to avoid the conclusion.  By the way, if speculative money is looking for any way possible to enter China, and one of these ways would obviously be from over- or under-invoicing exports and imports, wouldn’t this also suggest that the speculative inflows hidden in the trade numbers have rising materially in the past few quarters?  If so, China’s real trade surplus is likely to be a lot lower than we think.  Perhaps the export-related slowdown is greater than we believe it to be.

 

Meanwhile the equally sharp-eyed Shirley Yam at South China Morning Post has also been digging away at some numbers and has come up with interesting results.  In today’s edition she wonders about the much-repeated claim among many of the mainland’s larger firms that “profits and profit margins have dropped because of raw material and fuel cost increases.”

 

Displaying a journalist’s cynicism she decides to look at a number of companies to check to see if their margin declines have really been caused by commodity price increases or other factors over which managers have no control.  “Is this the sole reason, or just a convenient excuse for inefficient management to pass the buck?” she asks.  As she explains in her article,

 

This is an increasingly relevant question given the global business environment has turned from deflationary to inflationary where raising costs is the norm.  I read through the 2007 annual reports of 10 major state-owned enterprises. The results were disappointing.

 

It turns out that the companies she examines have all seen distribution expenses, administrative costs and staff expenses shoot up much faster than revenues – two to eight times as fast.  Rather than enjoy economies of scale they seem to be suffering massive diseconomies of scale.

 

This kind of thing worries me not because I care about the how managers choose to spend and/or waste money.  It worries me because boom times like the one we have enjoyed in China since 2003 often lead to rigidities and excesses in corporate activity and balance sheets that make it very difficult for them to survive sharp turndowns, and this is precisely one very common such type of rigidity. 

 

Corporate costs can grow much more rapidly than revenues while still allowing the company to show significant increases in net profits as long as revenues are surging, as they have been for Chinese companies in recent years.  In case however of a slowdown and a decline in revenues, or at least a sharp reduction in revenue growth, it can take a long time for management to get rising costs under control.  The result can be a collapse in cashflow, profitability, and perhaps creditworthiness.

 

This is likely both to increase the risk of a sharp, adverse financial adjustment (as companies ability to withstand a downturn is seriously weakened) and to increase the adjustment cost if such a downturn takes place (deteriorating creditworthiness immediately increases financial distress costs and causes corporates to engage in systemically adverse behavior).  

 

Readers of my blog might easily accuse me of always focusing on the worst case scenario and always looking for problems.  Perhaps that is because as a former bond trader I tend naturally to pessimism – after all bond prices tend to have limited upside and nearly unlimited downside, so it pays to worry about the downside more than the upside.  But as someone who has experienced too many financial crises and who has written extensively about the history of capital flows and financial crises, I am also pretty sure that when things go wrong nearly everything goes wrong at the same time.  This is not a coincidence.  It is simply the way unstable balance sheets work, and during boom times companies tend systematically to build risky balance sheets – by, among other things, letting costs get out of control. 

 

MON 21 APR

Inflation projections and manipulated stock markets By Michael Pettis

What is 2008 CPI inflation for China likely to be?  Merrill says in an April 16 research report that they except it to be 6.9%, and most other bank researchers say it will fall between 6% and 7%.

 

Are these numbers plausible?  For the first three months of the year, inflation has been running at an average month-on-month rate of nearly 1.3%.  This is the equivalent of 12.9% on an annualized basis – i.e. if the average inflation rate for the first three months remained the same for the rest of the year, inflation for the year would be 12.9%.  If we say we expect that inflation for the full year will come in under 7.0%, we are also automatically implying that the average monthly inflation from April to December will be less than 0.4%, or less than 5.1% on an annualized basis.  That is a pretty steep drop.

 

We can extend these projections a little further.  If we assume that month-on-month inflation declines from 1.3% for the first three months to 1.0% in April, we would need average monthly inflation from May to December to be less than 0.3%, or less than 4.2% on an annualized basis.  Finally if we assume that month-on-month inflation for May also turns out to be 1.0%, we would need average monthly inflation from June to December to be less than 0.2%, or less than 3.0% on an annualized basis.

 

I can play around a bit more with these numbers to make more generous assumptions.  Let’s assume that inflation for April and May come down sharply from the 1.3% it has averaged so far this year.  Specifically let us assume that in April monthly inflation turns out to be half of the average so far, or 0.6% (for an annualized 7.8%) and then in May we decline to a level equal to the monthly average for the whole year (assuming inflation for the year is 7%), also 0.6%.  In this case we would need for average monthly inflation from June to December to be less than 0.3%, or less than 3.7% on an annualized basis.

 

No matter how you look at it, even if we make relative generous guesses about declines in April and May inflation, to get inflation for all of 2008 to come in under 7% we are going to need a very sudden and sharp decline in the inflation rate.  This is of course possible, but I think it is going to be hard for CPI inflation to start the year at nearly 13% nonetheless to finish the second half of the year at well under 4%.  I also think it would be inconsistent with the kinds of GDP growth rates that everyone expects.  Such a dramatic decline would almost certainly come with a very sharp economic slowdown, right?  I am having trouble accepting the consistency of inflation and GDP projections.

 

My own guess is that by May year-on-year inflation will exceed 10%, and that thereafter it will be very hard to bring the inflation level down much below that number.  This may be the most extreme view out there for now, but within a month or two I suspect that quite a few people will be projecting 10% inflation for 2008.  The key is what happens to non-food inflation.  So far it remains low but has been accelerating steadily all year.

 

On a separate note the stock market traded up today, for the first time in nearly a week.  The real interesting thing is how it traded up.  Last night the China Securities Regulatory Commission said that shareholders selling more than 1 percent of previously locked-up shares within a month must do so in single block trades.  They could not just sell them piecemeal into the market (although if they sell less than 1% a month they can do so).

 

The move was transparently intended to prop up the market, which has all but collapsed in recent weeks – and has lost half its value since its November peak.  One of the things apparently weighing on the minds of investors is the possibility of a deluge of previously non-traded shares coming to market.  By presumably making it more difficult to dump shares, this move was supposed to reassure the market and signal the government’s concern.

 

Leaving aside the fact that this move really doesn’t do much as far as I can see, the important thing was the signaling effect, and sure enough the market responded exactly as expected.  Within minutes of the opening the market was up around 6%.  Very shortly after its stunning open, the selling started and it had given back much of its upward move by the midday break.  Selling continued through the afternoon and by the close of day the market was up by less than three-quarters of one percent.

 

Needless to say this is pretty bad news for the long-term development of the markets.  The whole thing was nothing more than a very naked attempt by the government to intervene in the market and as far as I can tell there is not a single fund manger or analyst in China who does not see it that way – every press report in the morning had fund managers saying explicitly that this was intended to shore up the market, even while a few of them warned that it would have no real impact..  

 

What’s the message?  The same as always.  The local stock markets have nothing to do with fundamentals and everything to do with current government intentions.  This constant changing of the rules of the game to suit the current political mood is not the right way to create a well-functioning capital market that allocates capital efficiently.  This fairly blatant manipulation only ensures that the market will remain undeveloped, and a haven for insiders and speculators, for longer.

 

The only thing new, as far as I can see, is how rapidly the credibility of government intervention in the stock markets is eroding.  The market soared at first by an astonishing amount not because of the real impact of the new measure, but simply because of what it signaled.  It then gave nearly everything back within hours.

 

This was hardly unexpected.  Serial attempts by governments to manipulate markets always results in an erosion of the government’s ability to do so.

 

TUE 22 APR

Stagflation revisited By Michael Pettis

In my January 17 posting I wondered whether China might experience stagflation in the near future.  In my piece I defined the stagnation part of stagflation a little differently than its normal definition.  Specifically:

 

In China a “stagnant” economy is not one in that is recession.  It is one in which employment growth fails to keep up with the growth of the labor population, which when I first came to China six years ago everyone assumed to be GDP growth below 7%.  Given the much higher growth we have seen in recent years and the still-upward pressure on unemployment, especially among university graduates, I suspect that the minimum level of GDP growth is probably much higher

 

I agree that the idea of stagflation in China seemed at the time a little farfetched given the country’s rocketing economic growth, and I received quite a few comments saying exactly that.  Still, it seemed to me that there was a real possibility that frantic efforts to cool the domestic economy, if they didn’t involve serious measures to constrain monetary growth (which, for me, is another way of saying adjusting the currency regime to cut net inflows sharply), could very easily lead to a sharp slowdown with absolutely no slowdown in money growth and so no slowdown in inflation. 

 

I noted in particular a comment by John Tamny, at Investors.com, in which he claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.”  This is because, he argues, inflation is monetary, and not necessarily affected by changes in aggregate demand. 

 

Since much of the tightening focus here in China is in the form of loan caps, administrative measures, and a more rapid appreciation of the currency, and the last of these simply means more hot money inflows and so more monetary expansion, one could make a very plausible case that the tightening can cause an economic contraction while having no impact on inflation, which would continue to rise.  Stagflation is not only possible, but in certain fairly plausible scenarios it is very likely.

 

Given my musings I found it very interesting that, according to today’s China Daily, a prominent Chinese economist is now making a similar warning.  According to China Daily:

 

While combating inflation and excess liquidity, the nation's financial regulator should also be wary of possible stagflation, the Shanghai Securities News quoted a noted economist as saying on April 20.

 

Speaking at a financial expert forum in Beijing, Tang Shuangning, chairman of the China Everbright Group and also a well-known economist, said the nation faces the threat of both inflation and stagflation. It is justifiable and necessary to adopt a tightening monetary policy in order to prevent the economy from going too fast, but monetary policy alone or improper use of it could cause a dilemma.

 

In order to address the problem, he suggests the government increase agricultural investment to secure food supply and stable prices. Therefore, it is necessary to combine monetary tools with other means such as credit and fiscal policies to support rural production.

 

I am not sure we have the same outlook.  It seems to me that what he is saying is a variation on an argument I hear a great deal.  China can sharply curtail monetary growth and make up for the resulting drop in demand by rapid fiscal expansion – and I think he suggests fiscal expansion directed at the agriculture sector.

 

I don’t completely agree.  I would argue that China actually needs to be a little careful about assuming that it has unconstrained use of fiscally expansion measures.  Why?  After all since Chinese government debt is low (around 20% of GDP, I think) and the fiscal deficit is also low (below 1% of GDP), isn’t there plenty of room for fiscal expansion?

 

I am not sure there is.  I think the ability to play the fiscal card is a likely to lot more constrained than we might think, for at least three reasons.

 

1.        I think government debt is a lot higher than the headline numbers.  There is almost certainly a lot of government-guaranteed municipal and provincial debt that is not recorded.  A few years ago a Chinese economist estimated that this kind of debt might add up to 10% of GDP.  I have no idea how much there really is and if his estimate would change today, but as someone with a lot of experience in developing countries I can only suggest that during a contraction these numbers always turn out to be much higher than originally expected.  In addition there are a lot of bonds on the balance sheet of the large banks issued by the AMCs.  This debt is guaranteed by the MoF but the non-performing loans the AMCs purchased in exchange for the bonds are almost certainly worth no more than a quarter of the value of the bonds.  That means that the AMC’s are bankrupt and their obligations should also be included as government debt. 

 

2.        In a contraction these numbers are likely to rise as contingent liabilities suddenly surge.  Specifically I expect that non-performing loans in the banking system are much higher than the official numbers (no big surprise here – nearly everybody pretty much thinks the same) and in case of a contraction they are likely to rise significantly.  I was told by a friend of mine who worked on the Japanese banking crisis that in 1990 the Japanese government had almost no debt.  By 2000, after ten years of cleaning up the banking system, its debt significantly exceeded 100% of GDP.  I haven’t verified these numbers but my only aim is to make the non-controversial point that in a serious contraction we might see an explosion of contingent liabilities.  In fact we almost certainly will.

 

3.        Finally, I am skeptical about the stability of the current fiscal deficit.  Aside from the fact that there may be a lot fiscal spending occurring indirectly and off-balance-sheet (a former student of mine from Tsinghua University who works for an SOE in another province assures me that this is the case, although he gave me no specific examples, so I am not sure), I believe that both fiscal expenditures and fiscal revenues have grown very quickly in recent years.  I need to check the numbers (and I will at some point) but I have been told by another professor here that the biggest reason for rapidly rising fiscal revenues has been corporate taxes (because the recent surge in corporate profits).  If this is true, a sharp contraction might automatically cause the fiscal deficit to surge even without additional spending, since corporate profits would almost certainly drop sharply and, with them, corporate taxes.

 

At any rate the China Daily article is headlined “Preventing Stagflation is also important.”  It certainly is. I am delighted that this debate is occurring, and I suspect that it is very much in the minds of the folks at the PBoC and the more-monetarist-oriented think tanks. 

 

I noted two other interesting pieces today.  Xinhua reports that the authorities are announcing new measures to crack down on “profiteers.”  They say:

 

China’s oil regulators are ready to launch a nationwide crackdown on wholesalers who sell to illegal filling stations and dealers in the wake of supply shortages…

 

…Illegal dealers and filling stations are believed to have aggravated the situation by hoarding oil and jacking up prices to drivers wanting to avoid the long queues at licensed stations.

 

Aside from the obvious point that shortages are a common consequence of price controls, it is clear that an inflation purist would insist that the long queues, from which people are willing to pay money to escape, are a form of reduction in the quality of good or service that is as much a component of inflation as higher prices, and so headline inflation is being disguised as waiting time.  Real inflation is higher than the official numbers, and Chinese motorists are paying this higher cost, but it is not showing up correctly in CPI.

 

The second additional interesting piece today is also from Xinhua.  It notes that according to Zhang Wei, a “senior official” from the China Council for the Promotion of Foreign Trade, China’s combined direct investments abroad amounted to $92.05 billion by the end of 2007.  Not a big number, but I think it is growing fast, and I suspect that the PBoC would like to see it grow much faster.

 

 

WED 23 APR

Food prices and energy shortages By Michael Pettis

I had lunch with a senior banker from a major Chinese bank today.  He is based in Shenzhen, across the border from Hong Kong in the southern province of Guangdong.  Among other things he told me that lines at gasoline stations are getting terrible, in part because a lot of Hong Kong residents drive to the mainland to fill their gas tanks.  Gasoline on the mainland is at less than the half global price, so this isn’t much of a surprise.  He also told me that he thinks actual inflation is higher than the headline CPI number.  That isn’t a big surprise either, I guess.

 

Finally we discussed concerns about a coal shortage, and I read in today’s Xinhua a confirming article that claims that coal reserves have fallen to a 12-day supply, which I think I understand from the Xinhua article is a record low level, even less than March’s already-worrisome 15-day supply.  The combination of low coal reserves and gasoline shortages means, I think, that it is going to be hard to keep a lid on energy prices.  I wouldn’t be surprised to see energy prices, which are controlled in China, rise in the next few weeks, even amid all the worry about spreading inflation. 

 

The fact is I don’t think that allowing energy prices to rise will increase inflation in China.  I think this widely-held idea is based on a misconception of the source of Chinese inflation.  The inflationary pressures here are monetary in origin, and just as rising food prices have absorbed much of this pressure and prevented it so far from spreading to non-food goods and services, frozen energy prices are causing upward pressure on non-energy prices.  And they are causing shortages too, of course.

 

Meanwhile there are two interesting, and disturbing, articles in today’s South China Morning Post on global and Chinese food supply.  One of them is subtitled “Supply jitters intensify as signs of shortage emerge in US, world’s breadbasket,” and this more or less describes the contents of the article pretty accurately.  Food production in the US, the world’s largest, as well as in other important producer countries such as Brazil and Argentina, is under severe pressure and causing escalating price rises.  In the US the culprits are partly weather and partly the diversion of crops for the increased production of bio-fuels.  Among other things the article mentions that there has been a spike of demand for wheat and grain in certain shops in Canada and the US, and that this spike may be a consequence of hoarding.  I find it hard to believe that there is hoarding going on in the US, but just the fact that they are talking about it is interesting.

 

In response a number of Asian governments are curbing rice exports, and officials at the Asian Development Bank are complaining bitterly.  According to the South China Morning Post, “With poorer nations struggling to find supplies, the Asian Development Bank criticised rice export bans, saying governments should instead use fiscal measures to help the poor.”  They quote Rajat Nag, the ADB’s managing director general, as saying “Banning of exports is no different from hoarding at a national level.”

 

Be that as it may, a lot of countries, including China, are limiting food exports in an attempt to keep prices low at home.  The second article from today’s South China Morning Post discusses the food prospects in China.  The article points out that China’s growing population, and its rising per capita income, are being accompanied by a sharp reduction in the amount of cultivated farmland as much of the best farmland falls to rapid urban development.  In one very important way this is a good thing, of course, because it means that Chinese wealth is growing and tens of millions of people are being lifted out of poverty.  But of course in the short-term it also means that there will be continued pressure on food prices, and this particularly hurts the newly urbanized poor.

 

“China is feeling the rising pressure to grow enough grain to feed its population,” said Wen Tiejun , dean of the School of Agricultural Economics and Rural Development at Renmin University.  However, China did have a fourth consecutive growth in grain output last year which met more than 95 per cent of domestic needs, Professor Wen noted.

 

Senior economist with Asian Development Bank, Zhuang Jian, said arable land for grain production had given way to rapid industrialisation. At the same time there was a growing population and changes in consumption habits that had widened the gap between supply and demand of grain.

 

They quote the ADB’s Mr. Zhuang as saying that “China is facing the most severe agricultural challenge [of any country] as the world's most populous nation sees the most severe imbalance between population and land.” 

 

A lot of these problems are problems of success.  As China develops it is natural that it turns away from agricultural production, although my understanding is that there is still a lot of room for China to improve its agricultural productivity, which in some areas is extremely low.  The point is that success brings with it a new set of problems, and unfortunately we are going through a stage where a series of different, and often unrelated, problems are converging upon each other.

 

One last thing.  I was pleased to see in today’s Financial Times that the Chinese securities regulators seem to be cracking down on insider activity among fund managers.  Fund managers apparently like to take personal account positions in stocks before their fund takes much larger positions, and of course this allows them to profit from their knowledge of the buying strategies of large players.  Two fund managers were punished yesterday, according to the article.

 

Such punishment, and the public release of details of such cases, is a common tactic – referred to as “killing the rooster to scare the monkey” – used by the regulator in the face of widespread irregularities and malfeasance in the country’s capital markets.  “The scale in China of corruption, poor disclosure, insider trading and market manipulation basically swamps the regulator’s limited resources,” said Fraser Howie, author of a book on China’s capital markets. “This is just how the market works and these guys were either unlucky or stupid.”

 

The CSRC issued a warning to fund management firms through state media yesterday that it was prepared to punish companies whose lax internal controls allowed managers to break trading laws and regulations.  It also ordered firms to monitor all communications of investment managers in the workplace.

 

I often lecture to my students about how damaging this kind of unethical behavior is to China.  It not only represents an unfair transfer of money from investors to cheaters, but much more importantly it is extremely damaging to the long-term functioning of the financial markets, and it helps ensure that Chinese capital markets do a terrible job of allocating capital efficiently.  Let more of them be punished.

 

THU 24 APR

Stock market rises 9.3% By Michael Pettis

Last night the Ministry of Finance and the State Administration of Taxation announced that the stamp tax on the purchase and sale of stocks would be cut from 0.3% to 0.1%.  Today, in response, the Shanghai Composite Index surged 9.3%.  According to an email earlier today from my teaching assistant Shang Ning, “the index opened up 7.98% today, and closed 9.29% higher.  A fucking crazy day, volume more than doubled over yesterday. At 1:30, the index reached its lowest level, roughly 5.6% up, and then it turned, shooting up.”  He’s been speculating on warrants and from the excited email message I think he may have made a couple of bucks today.  I should see if I can get him to pay for dinner tonight.

 

The cutting of the stamp tax was a widely-anticipated reversal of the move last year, on May 30, when in order to cool what seemed like a vastly overheated market, the stamp tax was raised from 0.1% to 0.3%.  The market fell 6.5% the next day, and lost another 6.5% that week, if I remember correctly, but not for long.  It quickly turned around and returned to its dramatic rise, surging another 75% or so to reach 6124 on October 16.  Government attempts to manage stock market prices in China do work, for a while at least.

 

Since its peak in October, however, the market has plummeted to just below 3000 on Tuesday, losing over half its value, and creating a great deal of concern for the government – China’s is the world’s worst performing stock market year to date.  The government is afraid both that the continued market slump may anger the newly-emerging urban middle classes and that it may translate into reduced consumption as savings are eroded (although according to Andy Rothman at CLSA at its peak the total market cap of traded shares was only about 36% of GDP, and is much less today). 

 

This was not the government’s first move to try to kick-start a rally.  On Sunday night, as I discussed in my Monday entry, the CSRC announced restrictions on the ability of owners of previously locked-up shares to sell their shares in the market.  This was designed to address fears of a selling overhang, and although it couldn’t have had much fundamental effect as far as I can see, it was transparently a signal that the government wanted the market to trade up.  Sure enough the market shot up nearly 7% in the morning before giving away nearly 90% of the gains over the rest of the day.

 

Since that announcement was not enough, the government made its next big signaling effort last night and reduced the stamp tax.  I have discussed in earlier entries that this was much-rumored during the past few months.  Because of the big negative impact of raising the tax last May, there was a very widely held assumption that lowering the tax would have an equally large but positive impact.  Actually, and evidence if any was needed that insider information is a main determinant of profitability here, the market was up 4.2% yesterday before the announcement was made.  Perhaps just a lucky guess.

 

No one doubted that this tax move represents fairly blatant signaling by the government.  Today’s Bloomberg quotes Wei Wei, an analyst at West China Securities Co, saying “It's a clear signal from the government that it thinks of the decline as overdone.”  And according to today’s South China Morning Post “internet chat rooms carried messages praising government officials believed to be responsible for the tax cut.” 

 

This is pretty typical of how most investors view the change in the stamp tax.  It has no real fundamental effect but it signals government intentions, and in China the main driver of the stock market is still perceptions of government intentions.  This is definitely not a good thing.  My friend Mark Williams of Capital international is quoted in today’s Financial Times as saying “The government’s continued efforts to manage the level of prices condemns the equity markets to further volatility.”  I am afraid he is right.

 

But how effective will this move be in keeping the market from sagging further?  Sunday’s move created a real frisson of excitement Monday morning, but it quickly fizzled out.  Last night’s move has already been far more effective, but the reported doubling of stock trading volume today doesn’t indicate to me that people were excited about holding onto these newly-valuable stocks.  I would almost read it as professionals taking advantage of higher prices to shift shares into the hands of retail speculators.  Let’s see how firm the rally is over this week and next.  If it too fizzles out, government intervention is going to lose even more credibility – something that will surely happen soon enough anyway.

 

At any rate given how far it has come off since October is the market finally fairly valued?  According to Bloomberg the market is priced at roughly 21 times earnings.  This is not cheap, but with real interest rates negative (and declining in real terms), and with GDP growth still very high, this might suggest that certainly for ordinary Chinese stocks are a pretty good alternative to bank deposits, and for the rest of us they are a reasonable play on Chinese long-term growth.   

 

Still, we might need a period of stability and rising prices before Chinese or foreign investors jump back in.  It is worth noting, by the way, that B-shares, which have all the rights and dividends of A-shares but trade in foreign currency and can be purchased by foreigners, are trading at discounts to A-shares of 35-45%.  One can make a very plausible argument that they are a great medium-term buy, especially if, as is widely expected, the distinction between the two is eventually eliminated and B-shares are converted into A-shares.

 

Of course before jumping in it is worth noting that the government is still signaling that it is concerned about the need to tighten the economy further.  According to today’s South China Morning Post:

 

People’s Bank of China governor Zhou Xiaochuan has called for further monetary tightening and said the central bank would step up measures to cope with economic uncertainties at home and abroad.  In a speech to an internal meeting of central bankers, Mr. Zhou said further tightening was needed despite the current austerity policy already having an impact.

 

The PBoC’s website, which published the speech, had Zhou saying that the PBoC should make greater efforts to slow overly fast growth in the money supply, although he also called for increased lending to support the agriculture, services and consumers sectors.

 

Most people believe that attempts at monetary tightening and lending controls will continue, although in my lunch with a senior Chinese banker yesterday I was told that it is mostly the small- and medium-sized companies that are taking the full brunt of loan growth constraints.  According to him, many of these companies seem to be turning to the informal banking sector for working capital loans.  Loan growth, in other words, may be higher than the PBoC thinks because of non-regulated loan growth in the informal banking sector.

 

How much more tightening do the authorities want?  Although I am skeptical that they have the tools to mange monetary policy, I had suggested in earlier entries that the minimum growth they would accept would probably be determined by the amount of growth needed to keep unemployment for accelerating.  I speculated that this might be around 10%.  Today’s Bloomberg has an interesting variant on this.

 

China should stick with its tight monetary policy unless the economy's expansion slows to below 9 percent, a National Bureau of Statistics official said. “Below 9 percent, it means the tightening is overdone and needs to be loosened,” Zheng Jinping, the bureau's chief engineer, said at a seminar in Beijing today.  

 

…China can't afford a sharp slowdown because it needs to create jobs, reduce poverty and continue with urbanization, he added.

 

Zheng then said “A reasonable combination for this year is 4.8 percent inflation and 9.7 percent GDP growth,” adding that inflation might come in between 4.5% and 5.5%.  At the same seminar Fan Jianpang, the State Information Center's economic forecast chief, said “As long as inflation can be kept below 6 percent, there's no need for further tightening measures and economic growth should be able to stay strong.”

 

I don’t know if they are saying this because they believe it or because they are simply observing the official line, but inflation is not going to come in below 6% in 2008.  I am pretty sure of that.  So apparently are others.  According to the same Bloomberg article, and in reference to a 5.5% inflation forecast for 2008 by the Chinese Academy of Social Sciences, “The central bank’s forecast is ‘more pessimistic’ Wang Yi, an official with the central bank's research and statistics department, said today, without giving a number.”  I’ll bet it is.

 

FRI 25 APR

Stock market is down today By Michael Pettis

This is exactly what I was worried about.  After a strong start this morning on the back or yesterday’s furious rally the Shanghai and Shenzhen stock markets suddenly turned negative and ended the day lower, with the SCI dropping by 0.71%.  It is widely known among financial market experts that governments can have powerful impacts on the market by signaling their intentions, but the more often they do it by pure signaling (i.e. with measures that have no fundamental impact) the less credible their signaling becomes over time.  In other words the more you intervene to control the market the more empty your intervention becomes – this is a weapon whose greatest power lies in the rarity with which it is used. 

 

I suspect we may be about to prove this yet again.  For the past year we have seen a whole series of interventions designed explicitly to manage market prices – and although they have worked well, they have done so with decreasing success.  The market surged 9.3% yesterday when the tax authorities announced that they were cutting the stamp tax, but everybody bought just because they expected everyone else to buy.  There was no real conviction.  

 

And since the announcement provided no real change in the earning prospects for Chinese companies, savvy investors seem to have taken advantage of the event to shift their shares into the hands of the more gullible.  China Daily today quotes a man who trades stock at a Shanghai broker saying, in the midst of yesterday’s rally “I bet the market would undergo a strong rebound before the Olympics, and I will exit the stock market forever if I can make any gains then.  It is just too risky for ordinary people like me.”  He is probably unhappier than ever today.  If this kind of opinion is widespread, and I think it is, it bodes badly for the longer-term development of the stock markets.

 

How aware are the authorities of the risks of this kind of intervention?  The always astute Li Xinxin at Observatory Group wrote yesterday about the reasons for the stamp tax cut – a decision that he worries about no less than I do.

 

The new cabinet, especially Vice‐Premier Wang, once intended to reinstitute the non-intervention principle for China’s capital market, but their effort failed.  In recent weeks, there was an intense debate among both policymakers and scholars about whether the government should rescue the stock market.  Wang preferred not to use the trading tax rate to micromanage equity prices, but his opponents used the social stability argument as a major reason for such a decision.  This is a critically strong argument in an Olympic year, and particularly when top leaders already are stretched by challenging issues such as Tibet and inflation.  

 

The government has performed particularly poorly in public communications. Vice Premier Wang and his team had a good chance to establish new criteria for government intervention by expressing their views and guiding market expectations. But no government officials dared say anything on this issue, reflecting a very rigid political system.  That silence gave the impression that the government made a major concession to market pressures in return for nothing. 

 

With this tax rate cut, the government reversed an 11-month-old tax increase and reinforced the policy-driven feature of China’s stock markets.  Certainly, the constant change of market rules does not help build a well-functioning market which could efficiently distribute financial resources in the long run.  In this sense, the new cabinet is not different from its predecessor.  

 

It will be interesting to see what happens to prices next week.  My assistant Shang Ning tells me that there are rumors that the big buyers who pushed prices up prior to the announcement of the cut in stamp tax were the local pension funds.  I have no idea if this is true, but they do tend to have better access to information than the rest of us do, and clearly someone either very lucky or with very good information sources was buying the market if it traded up 4.2% after so many weeks of decline.  

 

If many small investors really do expect a pre-Olympic rally that lets them out of their losing positions, I am afraid this is going to result in another disappointment.  Still, maybe the government has a few more tricks up its sleeves.  I think 3000 is widely considered to be the minimum level below which the government acts.  Call it the “3000 put”?

 

In June 1999 I remember that Paul Krugman wrote a note on the implicit euro “put” that existed because for purely symbolic reasons European authorities were loathe to let the euro trade below $1 (how long ago that seems!).  His conclusion, reached by an elegant application of option theory (you can find the note at http://web.mit.edu/krugman/www/hershey.html), was that when the euro finally broke $1, it would break big.  It did.  Perhaps this has nothing to do with the Shanghai markets, but if the “3000 put” really does exist, it might have.