My Blog

SAT 26 APR

Rice and margin By Michael Pettis

In yesterday’s China Daily there was an article titled “Pledge not to stop rice exports lauded.”  The article states that COFCO, China’s leading grain, food oil and food import and export group – which apparently exports rice equal to 1% of the volume of internationally trade rice – will not cut rice exports.  Given China’s own food supply problems, this is a commendable move if true because, as far as I understand, the supply of rice is close to crisis proportions in many Asian countries.  And of course it doesn’t make China’s own food supply problems any easier, although my back-of-the-envelope calculation is that this probably affects less than one-half of one percent of total Chinese rice production.  I suspect that a number of major governments along with the appropriate agencies – perhaps the World Bank and the Asian development Bank – are going to need to organize some coordinated response to the rice problems.  Perhaps China can take the lead here.

 

On a separate note, there are very persistent rumors, and some supposed quotes from unnamed sources at the CSRC, running around about the CSRC permitting margin purchases of shares.  In the past Chinese investors were required to put up the full amount of their share purchase and were not allowed to use leverage for stock investment purposes (although there have apparently been many ways to get around this regulation).  If true, and they do begin to allow buying on margin, I suppose we can add this measure to the number of administrative measures in the past few months aimed at supporting the market – increasing QFII quotas, permitting the launch of new funds (after they were stopped last year in the heat of the bull market), constraining the sale of strategic share holdings and new share sales, and most recently reducing the stamp tax.

 

If they do permit margin purchases this would certainly add buying power immediately, and so might result in a surge of buying if there is real desire on the part of investors to increase their exposure.  Nonetheless I hope they don’t do it.  I think in the past they have been wise to limit leverage and derivatives in the local markets because these can significantly increase the power of speculative traders, and that automatically adds volatility to the market – something of which we don’t really need more.  The argument that these types of instruments can also be used for hedging purposes or for more efficient capital allocation decisions does not hold in China, in my opinion, because the structure of the market precludes the existence of the types of investors who would use these instruments for non-speculative purpose.  I explain why I think this in my entry for January 2.

 

MON 28 APR

The market isn't too happy, and adjustment risks may be growing By Michael Pettis

Bad earnings were blamed for the poor start to the trading week, with the SSE Composite down 2.33% today.  Even Jim Rogers, who said over the weekend that he was scooping up Chinese stocks now that they were cheap again, was not able to psych the market up, and he is much quoted and admired among small investors here in China.  Rumors continue to swirl about additional measures to help prop up the market, but I suspect the failure of Wednesday’s cut in the stamp tax to sustain a rally will have seriously dampened the credibility of future administrative moves to strengthen the market.

 

There is not a whole lot of interesting news today, as far as I can see, and I have been too busy recently to write about an analysis my assistant Shang Ning did on debt levels among Chinese corporates, but I do plan to do so soon.  What small thing worth noting: China Daily has an article today (“Yuan appreciation dampens textile export”) that discusses how the rise of the RMB has hurt textile exporters, at least according to preliminary reports from textile firms wooing foreign buyers at the 2008 International Textile, Fabrics and Accessories Exhibition held recently in Zhejiang Province.  The article blames the rising RMB for the lack of orders, although given that they quote an Austrian businessman who complains about rising material and labor cost – and of course as a Eurozone country Austria has not seen any RMB appreciation at all – I would argue that the article confuses the impact of rising labor costs in China with the RMB’s appreciation against the dollar.  I suspect that this article is part of the internecine fighting among the growth and monetary guys vying over an explanation of what ails China.

 

Speaking about exports, I am increasingly concerned that the trade surplus in China is actually beginning to decline, and much faster than people think.  My reasoning is simple and completely intuitive – i.e. there is not a shred of hard evidence to back it up – but I nonetheless think it highly plausible.  I contributed the following (somewhat edited) comment to today’s discussion on Chinese reserves on Brad Setser’s blog (http://www.rgemonitor.com/blog/setser):

 

Given the rapid increase in various proxies for hot money inflow, it is probably pretty safe to assume that hot money disguised as FDI and/or trade is also growing quickly. Certainly the nearly 70% growth in FDI during the first quarter suggests that there has been an increase in speculative inflows disguised as FDI. After all there was no very good fundamental reason for this growth – in fact it is not hard to argue that FDI in China is less, not more attractive today than in the past few years.  If this is true and a big chunk of FDI is simply hot money, it is probably also plausible to argue that hot money disguised as trade has also increased significantly.

From that it follows that export growth and the trade surplus have probably declined much faster than the small decline in headline numbers suggest.  If true, this complicates matters.  Thanks to deteriorating global conditions China may actually already be running a narrow trade surplus or even a small trade deficit, which could make the authorities all the more afraid of a maxi-revaluation, and yet for the reasons we have been discussing over the past fifteen months the maxi-revaluation is probably inevitable because of the crazy monetary consequences of hot money inflow.  The cost of a maxi-revaluation may be rising even as the cost of steady appreciation is.  The longer they wait the worse the options become.

 

In other words, if we are starting to see Chinese monetary growth powered exclusively by hot money inflows, instead of by the trade surplus as it was in the past, we are entering into a far more volatile stage of the game, where the consequence of a policy misjudgment may be higher than it has been in the past because the outcome is likely to be much more heavily determined by very volatile and hard-to-control and hard-to-judge hot money flows.  The risk associated with an adjustment is rising, in other words, even as the cost of not adjusting is too.  I worry that another quarter or two of $200 billion plus increases in reserves is going to make the adjustment process for China much more difficult.  It is increasingly important that the recession in Europe and the US be as brief as possible if China is going to have room to adjust.  If we see additional weakness in the global environment, I think China’s room for maneuvering declines substantially.

 

Speaking of Brad Setser, his blog alerted me to an article published last week in Caijing, China’s most influential business and economics magazine, and written by Wang Tao, head of Bank of America’s Economics and Strategy for Greater China.  You can find Wang Tao's article here.  He argues that given the hot money inflows that we have been seeing Chinas’s best option is a maxi-revaluation.

 

More drastic measures may be necessary to reduce liquidity-generating FX inflows and loosen the close link with the accommodative U.S. monetary policy. The answer may be a combination of a one-off revaluation and tightened capital controls, accompanied by structural measures…[T]he current and steady appreciation of the yuan has entrenched expectations and helped fuel speculative inflows. A one-off revaluation could help break the expectation in the near term if it is combined with tightened capital controls.

 

Two issues would immediately arise from the above approach: the difficulties in determining the appropriate size of the revaluation, and the questionable effectiveness of capital controls. On the first, we doubt anyone would be able to make an accurate estimate of the yuan’s fair value or degree of undervaluation. However, that may not be necessary. A sizable revaluation that is significant enough to have an impact on the trade surplus yet deemed acceptable by the government over a one-year period (say 10 percent) could be picked. An unexpected revaluation, combined with the right statement and other policies, could send a clear signal to the market that this round of yuan appreciation has ended, thus staving off speculative inflows.

 

I agree with much of his analysis, although I think 10% might be too little.  Still, it seems that more and more commentators are coming around to the view that China is being forced inexorably into a one-off revaluation.  I predicted in early 2007 that by the summer of 2008 this once-crazy proposal would become conventional opinion.  I think the sheer size of the problem and the weight of the numbers will eventually drive away all the objections.  It will be a difficult choice to make, but I can’t see the alternatives.

 

TUE 29 APR

Is RMB appreciation slowing? By Michael Pettis

The global slowdown and the huge uncertainty it has added to the process of evaluating the policy options available to the Chinese authorities could not have come at a worse time.  Exporters are increasingly shrill about the deleterious impact of the rising RMB, although it seems to me that their real problem is partly slowing global growth and partly a domestic trend that is actually very good for China in the medium term – local wages are rising and the former exporting centers of China (i.e. Guangdong province) are shifting rapidly into higher value-added manufacturing and services aimed more at domestic consumption.  Still, a lot of exporters are hurting and the appreciating RMB is an easy target, no matter how often it is pointed out that the RMB has not appreciated at all in trade-weighted terms – it has only really appreciated against the US dollar.

 

Still, the combination of angry exporters and the fact that, contrary to the expectations of many, a more rapidly rising RMB has not had much impact on reducing inflation, the argument against a too-rapid appreciation of the RMB seems to be gaining ground.

 

“There've been many calls from the big ministries, especially the Ministry of Commerce, State Administration of Foreign Exchange (SAFE) and National Development and Reform Commission (NDRC),” said a Communist Party official familiar with the decision-making process. “They all believe that the yuan's current rise is too fast.”

This comes from an article in yesterday’s Market News International discussing the fact that in April RMB appreciation has slowed significantly, rising by a modest 0.42% over the month, including today’s 0.24% jump (it closed at 6.9898), compared to its 4.0% appreciation during the first three months of the year.  The article goes on to say: “The government is preparing to step up its intervention in the foreign exchange market to maintain a sharply slower yuan rise against the U.S. dollar, abandoning the policy of recent months to use a stronger currency to fight inflation, government officials and economists told Market News International.”  So what’s going on?

The same old thing.  China’s monetary trap has all but eliminated its policy options.  Slow appreciation didn’t seem to work, and the recent fast appreciation doesn’t seem to work either, so maybe its time to try slow appreciation again.  Unfortunately both policies have resulted in the gradual or more rapid building-up of imbalances to the point where the adjustment is increasingly urgent and increasingly difficult to implement. 

 

When the authorities began speeding up the rate of appreciation in August and September of last year, the hope was that this would result in lower inflation and a sharp reduction in overinvestment (remember that the pick-up in inflation started at the end of 2006 and the beginning of 2007, long before the pick-up in the rate of RMB appreciation), but I think this hope was based on a misunderstanding of the underlying dynamics.  China’s problem is a monetary problem caused by its currency regime, and the only way to address the problem is either to alter the currency regime so that the PBoC is no longer forced to monetize massive amounts of capital inflows, or to alter the RMB trading level so that the incentive for massive capital inflows is eliminated.  Neither faster appreciation nor slower appreciation will do the trick, since neither resolves the problem that needs resolving.

 

As early as February of 2007 (and in my June 2007 Far Eastern Economic Review articles), I pointed out that the then-glacial pace of RMB appreciation meant that China would be force to countenance the growing imbalances for much longer than was sustainable.  I also pointed out that any attempt to quicken the pace of appreciation would collapse over the problem of accelerating hot money inflows.  This seems to have happened, and after only six months. 

 

That is why I argued that they had run out of options.  It was clear that gradual appreciation was storing up massive imbalances that would lead to overheating and inflation, while faster appreciation could not possibly help the fight against inflation because it would actually result in even faster monetary expansion in the short term, which would increase, not decrease, monetary pressures.  The Market News International article goes on to say:

 

Sources said that the pick-up in the pace of appreciation, which began in early December in the face of rising domestic inflation, has brought with it evidence of rising levels of speculative “hot money,” pouring into China to bet on a further rise in the currency.  It has also led to increased complaints from the export sector -- which has powerful backing from the Ministry of Commerce -- that its margins are being hammered as its competitiveness is eroded by the rising currency. The opposition to the pace of the currency's rise has spilled into the public forum, where a number of influential officials and economists have called on Beijing to take action to counter market expectations about the yuan.

Xia Bin, an prominent government economist with the Development Research Center, an influential think tank under the State Council, became the latest of these when he was quoted on Monday by the official China Securities Journal as saying that the exchange rate can have only a limited impact on the fight against inflation and that expectations need to be stabilized.  “There are so many people saying this -- it's clearly a government signal and there will probably be measures introduced very soon,” said Zhao Xijun, an economist at Beijing's Renmin University.

 

Unfortunately I am still willing to bet that a slowing pace of appreciation will not stop hot money inflows anywhere close to the extent necessary.  At best, I suspect, slower appreciation will slow capital inflows marginally while lengthening the period during which the imbalance can grow, although even then inflows may actually pick up speed initially if the PBoC steps up intervention to limit the RMB’s rise.  At worst it will signal to the market that with the PBoC so clearly running out of options, the probability of a maxi-revaluation will have increased so significantly that it makes more sense than ever to bet on the RMB.  In fact I suspect it will be the latter.  Let’s watch the hot money proxies closely over the next few months.

 

At any rate in neither case will inflation slow down.  I expect inflation will continue to rise because of the already-huge growth in money.  As it does, the lack of policy options will become clearer than ever, and those people at the PBoC and related agencies who understand how serious the monetary imbalances are will see their arguments in favor of a sharp adjustment much strengthened.    I hope this happens quickly.

 

Unfortunately the authorities still have one or two more tricks they might try.  For example, according to Market News International, “The official said that capital controls will also be introduced to stem the inflows of hot money.”  Capital controls?  Hmmm.

 

I am pretty pessimistic about the usefulness of capital controls in such a large country with such active and porous borders.  Increased capital controls are likely mainly to distort economic activity (how do you distinguish between legitimate trade and FDI transactions and hot-money-related transactions without significantly increasing the cost of monitoring?) while increasing the opportunities for corruption, without seriously reducing hot money inflows for more than a few months – which is all it will take for people to figure out how to get around the new rules.  After all China has had capital controls basically since 1949, and the empirical evidence suggests that capital controls become eroded over time as alternative channels develop.  Can anyone doubt whether Chinese businesses, with extended family networks abroad, have figured out how to evade capital controls?

 

By the way and on a very related topic, some of my blog readers might remember in March when I quoted one of my former Tsinghua students, now a VP at a large investment bank, who told me about a sign he had seen at his golf club in Shenzhen saying that, according to SAFE, as of April 1 Shenzhen golf clubs would no longer be able to accept Hong Kong dollars as payment for their services. A few days ago he sent me another message:  “Remember I told you about the banning of the use of HKDs in Shenzhen golf clubs?  Ha ha I again used HKD today to pay. No problem.”

Meanwhile, and making it all the less likely that more moderate appreciation will eliminate hot money incentives, the drumbeat for a maxi-revaluation is steadily rising.  According to yesterday’s Bloomberg:

 

China may revalue the yuan by 10 to 15 percent in the coming months as policy makers seek to temper inflation close to an 11-year high, according to Frank Gong, head of China research at JPMorgan Chase & Co.  The currency's 16 percent gain since the last revaluation of 2.1 percent on July 21, 2005 has failed to curb import prices, and attracted funds seeking to take advantage of continued yuan gains which have flooded the economy with excess cash… The chances of a one-off adjustment are higher than the 10 to 20 percent odds previously forecast, wrote Gong in the note published yesterday. He was unavailable for comment today.

 

The authorities are really in a tough position, and I am certainly glad I am not the one forced to make the decision about what to do.  The wrong decision, or even the right decision at the wrong time, could be a real career buster.  I think for political reason the authorities need to try every alternative policy option before they can develop a very wide consensus that none of them work.  Unfortunately the longer they wait the more difficult the adjustment will be. 

 

I am curious to see the trade data for the next few months.  If export growth slows, as I expect, and if inflation picks up, as I also expect, what is there left for them to try?  By the way I heard one recent projection of 8.4% CPI inflation for April.  If true, it implies an annualized rate of inflation for the first four months of 2008 of 9.5%.  I suspect that April CPI inflation may actually be higher, but if it is 8.4% this will certainly provide some relief, since it implies no real month-on-month inflation for April.

 

WED 30 APR

Exporters are complaining loudly By Michael Pettis

The Shanghai stock market had a good day today – its last trading day before the May holiday and the very long four-day weekend.  The SSE Composite is up 4.84% and trading volume was up substantially too.  What seemed to propel the market today was a bunch of companies reporting good earnings, especially the banks – three of the Big Four reported very healthy first quarter earnings growth, perhaps a consequence of January’s huge jump in loans.  There are also more rumors about things the government might do to keep the market from falling.

 

Meanwhile it seems the fight over the currency is intensifying. Chinese Academy of Social Sciences economist Li Yang, formerly a member of the PBoC monetary policy committee and currently an advisor to the powerful NDRC, was reported by Market News International to have said in a lecture today that the government should stop allowing the RMB to appreciate because of the pain it is bringing to export companies.  He said that the RMB is currently at a “balanced level,” and elaborated: “One important factor to decide whether we're at a balanced level is that our companies are making losses on this appreciation. So we shouldn't move it any more.” 

 

I am not sure I understand his reasoning.  I have seen very little in the academic literature that suggests that a currency has reached an equilibrium level when some of its exporters are losing money.  I would have thought that any definition of equilibrium would have focused instead of the level of the trade surplus, the amount of central bank intervention, the growth rate of exports, or on any of a number of other factors that suggest that RMB is still not near an equilibrium level, but I suspect that Li’s argument actually has more to do with the terms of the debate within China than with economic reasoning.

 

There is a very deep, and reasonable I think, concern that a significant slowdown in the exporting sector might not be matched by a sufficiently large increase in domestic consumption in the short term, and so the result may be that China will not grow fast enough to absorb new entrants into the labor market.  If we see slower growth in fixed asset investment on top of that, the reduction in Chinese growth may be significant and may have adverse unemployment consequences – something the government does not want to have to deal with, especially right now.  I think there is a lot of pressure from exporters, provincial leaders and Ministry of Commerce officials to reduce the appreciation rate as a way of making life easier for Chinese exporters.  They are worried about its impact on growth, even though this probably reflects an excessive focus on the dollar – as has been pointed out many times, the RMB is not appreciating in general; it is only appreciating against the dollar.

 

By the way, and to support the argument that it is not the rising RMB that is hurting Chinese exporters, Gene Ma of ISI-CEBM sent me an interesting piece today.  In it his team argues that “he main driver behind China’s narrowing trade deficit is not slowing exports, but the changing terms of trade. In particular, prices of imports are rising much faster than exports.”  They also note that China’s export engine is moving northward.  “The share of the Pearl River Delta in total exports fell from 47% in 1995 to 30% today.  The share of the Yangtze River delta rose from 20% to 40%.”

 

What this suggests to me, as I have discussed often on this blog, is not so much that China’s exports are getting clobbered.  It suggests that China is evolving – very naturally I might add – so that its export performance is shifting as a consequence of development differentials across the country.  China itself is not losing out to other countries as much as exporters in the Pearl River Delta think.  China’s export competitiveness, instead, is shifting north.  If you keep your eyes to firmly focused on the performance of the southern exporters, it would be easy – but of course very mistaken – to conclude that something awful is happening to China’s export capability.  It isn’t.  Not yet, anyway.

 

I do think however that we may be seeing a gradual, and very positive, shift in the importance of exports to China.  I am currently reading a very interesting April 29, 2008, report by Credit Suisse called “China: the Beginning of the End of an Era.”  In the report the authors say:

 

We think the end of an era in terms of China’s mighty export industry has just begun. Current conditions will likely go beyond the cyclical slowdown caused by the US recession, in our view. After years of currency appreciation, wage increases, and material cost surges, we think the Chinese export sector has started to crack. The introduction of the Labor Contract Law this year is probably the straw that broke the camel’s back.

 

As part of their argument they note:

 

China’s private consumption is seemingly on the rise, led by service consumption and rural consumption. The “one-child generation” is emerging as an influential new force that may redefine Chinese consumer behavior. Our projections show China leapfrogging the US as the world’s largest consumer market before 2020.

 

If they are right, and their argument is certainly plausible, we may be at the beginning of a process of rebalancing the Chinese economy away from the export sector and towards the domestic market.  This is obviously a very healthy and necessary part of China’s long-term development, but it is worth noting that there is no reason to expect the process itself to be an easy one.  I have mentioned several times before on my blog how it took the very deep and painful crisis of 1798 to turn the US economy away from its dependence on exports towards a healthier domestic focus.  China’s refocus may also come with a difficult adjustment period.  Part of the reason for the fight over the appreciation of the RMB is, I suspect, the reluctance to pay the cost of this adjustment.

 

There is one fascinating piece of information that comes from the report that gives a sense of the scale of the demographic adjustment that China is undergoing: “Thirty-five years ago, for every one hundred people, representing new labor worldwide, thirty came from Chinese. Today, the number declines to thirteen and    is projected to be only three in thirty-five years.”  Wow!  This is a huge slowdown in the rate of growth of the working population – one of the inevitable consequences of the one-child policy.

 

One other thing worth noting that has nothing to do with trade: according to today’s China Daily a senior official from the NDRC, Xu Zhimin, director of the NDRC's economic operations department, said that the government will not increase the price of refined oil or electricity until inflation is brought under control.  The NDRC has reportedly wanted for a while to deregulate the price of energy and resources, but they are too worried about inflation to do so now.

 

Needless to say, if you believe the inflation problem is largely a problem of expectations, they may be right to postpone deregulation.  If you believe it is a monetary problem, however, freezing prices of electricity will only cause the momentary pressure to show up in other kinds of inflation.

 

P.S.  For those who read my blog directly, once again the firewall here in China seems to have gotten worse, making it very hard for me to participate in the “Comments” section.  Sorry for not responding to comments, although of course I do read them.

THU 1 MAY

Sleepy May Day holiday By Michael Pettis

Today’s China Daily has yet another article bemoaning China’s export performance.  The article is titled “Growth of Exports in Steady Decline” and it starts out:

 

The growth of exports from China's labor-intensive industries is slowing, and the trend is set to continue, the Ministry of Commerce said Wednesday.  In the first quarter of the year, the value of clothing exports rose 14.7 percent, less than the 17.6 percent growth reported for the same period of last year, the ministry said in a report. Similarly, the value of shoe exports rose 11.2 percent (compared with 16.7 percent last year) and toy exports grew 3.3 percent (down from 29.9 percent).

 

It is only at the bottom of the article that they point out that “the value of China's exports in the first three months grew 21.4 percent to $305.9 billion year on year. In contrast, the value of imports rose 28.6 percent to $264 billion in the first quarter.”  This doesn’t strike me as a collapse in exports, but it does strike me that some exporters and their government allies are waging a very spirited campaign against further appreciation of the RMB.

 

Even if there is a slowdown in exports, it seems, at least for the time being, that domestic consumption may be taking up the slack.  The Purchasing Manager’s Index in March rose to its highest level ever (although it was only started 28 months ago, so this might not be as big a deal as it seems).  Most of the increase came from domestic customers, with export orders actually declining slightly for the first time in three months.  This is exactly what we want to see – exports decline in importance and domestic demand increase in importance – but of course we shouldn’t get too excited about just one or two data points.  We need to see this continue over the rest of the year before we can talk with confidence about a real rebalancing of the economy.

 

Today is a major holiday in China, as is tomorrow, so there is not a whole lot happening.  My student Shang Ning tells me that there was an article in the current Caijing (probably China’s leading financial periodical) in which a senior SASAC (State-owned Assets Supervision and Administration Commission) official warned that because of the “uncertain macroeconomic environment”, large SOEs should “get ready for a two-year period of tightening.”  The article claimed that this year is the first year since the SARS year of 2003 that we are expecting a decrease in SOE profits, led by the energy companies.  His advice was that large Chinese companies should “control their debt levels and manage their budgets carefully.”  A major concern he discussed was the weakness in operating cash flows.

 

I think this is very sound advice and gives an indication of how worried officials are about the next couple of years.  I don’t have the numbers yet but my impression is that debt levels among large companies are very high and a large part of that debt is short term.  Cashflow for many companies is weak, and of course any forced build-up of inventories caused by declining demand will put even more serious cashflow strains on companies.  This, of course, is exactly the kind of balance sheet that seizes up during a contraction and forces companies into the type of self-preserving activities that are systemically bad.

 

That’s all for now.  For any of my readers in Beijing, the only thing to add to this sleepy, slow day (it is very hot outside) is that today is the anniversary of D22, the music club I started two years ago.  Since we have been credited with having been at the heart of the Beijing explosion in new and underground music, nearly everyone of the best bands in Beijing (and from elsewhere in China) have trooped to our doors, beginning two days ago and continuing on until Sunday, for celebratory performances.  If you’re in Beijing I strongly recommend that you come tonight and Friday night, when we have some really great artists performing, but come early because we will probably be forced to close the doors at 10.  These are going to be packed shows.