My Blog

SUN 11 MAY

CPI for April was 8.5%, and minimum reserves up 0.5% By Michael Pettis

April’s CPI numbers were released earlier today and, as the pessimists among us expected, inflation came in at 8.5% year on year, quite a bit higher than most analysts’ predictions.  March’s year-on-year inflation was 8.3%.  Probably in response to the higher-than-expected numbers, late in the day the PBoC announced that minimum reserve requirements were going to be raised by 0.5%, to 16.5%.

 

Throughout the past two weeks we had been getting a lot of soothing noises about inflation and confident predictions from analysts and even from Governor Zhou of the PBoC that it would come in at 8% or just above – Bloomberg’s poll of 22 analysts predicted on average that year on year CPI inflation for April would be 8.2%.  Even Credit Suisse’s Dong Tao, who has normally been very pessimistic – and very right – about inflation, predicted that April’s CPI number would come in at 8% year on year.  It took a bitter, twisted guy like Stone & McCarthy’s Logan Wright, who refused to bask in the good feelings and insisted on counting the numbers up for himself, to throw in an 8.5% prediction.  He was right, thereby reinforcing my claim a few days ago that for the past six months you would have always done best by betting on the most pessimistic prediction.

 

Month-on-month inflation rose by 0.1%.  This means that inflation for the first four months of the year is running at an annualized 9.9%.  At this rate we would need inflation for the next eight months of the year to be 2.4% on an annualized basis to bring us to the government’s 4.8% target for 2008.  Clearly this is very unlikely, and even government officials have acknowledged that the official target is intended more for signaling purposes than as a real statement of government intentions.

 

I assume that most of the investment bank researchers, who are still predicting annual inflation for all of 2008 as coming in between 6% and 7%, will want to reconsider their predictions.  With CPI inflation running at an annualized 9.9% for the first four months of 2008, we would need price increases to run at less than an annualized 5.6% for the next eight months if we hope to bring CPI inflation under 7% for 2008.  This is not impossible, of course, but it is very unlikely to occur without a significant economic slowdown, so if investment banks are still predicting CPI inflation for 2008 below 7% they should probably revise their GDP growth expectations sharply downwards.  For the record, I think year-on-year inflation will exceed 8% in 2008 and could easily approach double digits.

 

Year on year non-food inflation at 1.8% was the same this month as last month.  Commodity, energy, labor, household items and residential property are the main culprits, which unfortunately suggests that inflation is, as expected, spreading away from food.  Remember that it is rising food prices that have absorbed inflationary pressures, according to my model of inflation in China, and because food prices have increased so quickly – 22.1% year on year – they have actually forced downward pricing pressure on non-food items.  The fact that non-food prices continue nonetheless to rise is, in my opinion, ominous.

 

Today’s numbers won’t do much to resolve the debate between the pork and money camps.  This of us in the money camp will point out that non-food inflation may still be relatively low, but instead of decelerating, it has been accelerating all year.  This is wholly inconsistent with the idea that Chinese inflation is just a food problem, since annual price increases of over 21% for food, with food officially 33% of the CPI basket, should have put tremendous downward pressure on non-food prices.  By the way I think the ADB claims (more realistically, in my opinion) that food is 40% of the consumption basket, not 33%, which if true would take CPI inflation up closer to 9.9%.

 

The money camp will also argue that recent foreign currency reserve growth has been way too high and is clearly causing excess monetary expansion, which must show up in overheating and inflation.  Finally, they will argue, even with the moderation in export growth, there has been no sign of a slowdown in the economy.

 

The pork camp will argue that non-food inflation is still low, and we are still seeing the delayed impact of the food supply constraints from last year and during this year’s storm.  As long as the government can resist pressures for inflationary expectations to spread, inflation for the rest of the year will continue to drop as the food supply problem eases.  They will also point to a slowdown in export growth and continued concerns about weakness in the US economy to insist that the financial authorities have very little room to get it wrong on the side of excess tightening.

 

We still need to wait and see a few more months of CPI inflation before this debate is fully resolved.  I am of two minds as to what the CPI numbers for May and June are likely to be.  On the one hand food prices have held up stubbornly but price increases are starting to moderate somewhat and in some cases may even be declining, so we may see some relief there.  Thanks to price controls and spending rigidities there may be a lag between a slowdown in food inflation and a pick-up in non-food inflation.  From that point of view we may see the CPI index rise only very slowly from its current level, and overall year-on-year CPI inflation hover around 8% to 8.5% for the next month or two, before picking up substantially in the third and fourth quarters as non-food inflation kicks in more aggressively.  

 

Alternatively, with the beginning of the great Olympic party, we may start to see pressure for price increases much earlier.  There are already reports of a significant increase in domestic airline tickets, and of course in and around Beijing we are all braced for a big increase in prices – if we haven’t seen them already.  There is also pressure for a relaxation of price controls on certain goods because of hoarding, smuggling, and their distorting impacts on consumption.  All of this might result in sharper increases in CPI inflation fairly quickly.  My worry is that even if we do see a pick-up in inflation in the next two or three months, those who continue to want to postpone the monetary adjustment will argue that the most recent bout of inflation will have been caused by yet another one-off event: the Olympics, which once it is behind us everything will be fine.

 

The stock markets have behaved a little erratically today.  According to my student Shang Ning, who follows the markets closely, the SSE Composite opened around 1.8% below Friday’s close of 3613, and traded further down to 3522 (down 2.5%) a few minutes before the release of the CPI numbers, on expectations that CPI inflation was going to be higher than expected and might result in further tightening action by the PBoC.  After the CPI release, however, the market rebounded for the rest of the morning and continued up in the afternoon to close the day up 0.37%, driven by airline manufacturers and steel companies.  It seems that bad CPI numbers haven’t really fazed anyone.

 

 

TUE 13 MAY

Demographic projections and trade implications By Michael Pettis

With yesterday’s bad April CPI number, the subsequent increase in minimum reserve requirements to 16.5%, and the slowing will-they-won’t-they appreciation of the RMB, it is tempting to stick to monetary topics in this and the next few blog entries, but regular readers know what I am going to say anyway.  First, inflation may get a little better in the next month or two (although I wouldn’t bet on it), but by now it is pretty clear, at least to me, that this is a monetary phenomenon and, given the continued recent expansion in the domestic money supply as reserves pile on, we are going to see non-food inflation surge in the coming months. 

 

Second, as far as the slowing of RMB appreciation is concerned, I bet this is going to be a very temporary phenomenon, and is probably largely a response to the dollar’s appreciation against the euro.  But this new strategy (or revival of a failed old one) is not going to improve the worsening monetary dynamics.  Reserves are going to continue to surge, driven increasingly by hot money rather than the trade surplus, and with inflation rising and still no sign of an economic slowdown it is just a question of time before the monetary authorities throw in the towel and go for the one-off appreciation.  Nothing else will work.  By the way last night I had dinner with a group of Chinese academics, including a very famous and influential finance scholar (who for obvious reasons shall remain nameless), and he said there was little doubt in his mind that a one-off revaluation was the only solution left to the country’s monetary problems.  Our only disagreement was that he said it should be a 10% jump, whereas I think that is too little and is only likely to encourage speculative inflows.

 

Interesting as all this is, however, in this blog entry I want to change the subject to something very different and with much longer-term implications.  I spent the last week going thorough historical and projected population data for China by age group, and the most interesting summary of the data I have put in the table below.  It shows the growth rate of Chinese population by decade (of course these are average annual growth rates for each decade), as well as the growth rate of subcomponents of China’s population.  Given the way the data is presented I am defining “Young dependents” as anyone 19 or younger, and “Old dependents” as anyone above the age of 65.  “Working population”, of course, is everyone else.

 

	1990-00	2000-10	2010-20	2020-30	2030-40	2040-50
Total population	1.00%	0.60%	0.60%	0.21%	-0.05%	-0.21%
Working population	1.72%	1.42%	0.40%	-0.26%	-0.60%	-0.49%
Young dependents	-0.51%	-1.50%	-0.30%	-0.44%	-1.36%	-0.41%
Old dependents	3.34%	2.43%	4.30%	3.51%	3.20%	0.62%

 

To summarize the raw numbers, China’s population is expected to grow from 1.32 billion today to 1.46 billion in 2030, after which it will decline slowly, to around 1.42 billion in 2050.  Its working population is currently around 840 million.  This component of the population will rise in the next ten years to around 910 million and then will decline quite rapidly to around 790 million by 2050.

 

The graph below shows the composition of China’s population by age group.  Needless to say the most dramatic change is the explosive growth of the over-65 population, followed by the decline in the share of the young.  Another way of understanding this is to note that China’s median age basically climbs over this period from 24 to 45 (which, by the way, may have favorable consequence for long-term political stability).

 

 

The graph shows the consequence of these differential growth rates on the age composition of China’s population.  Notice that the Y-axis begins at 50%, so the working population is much bigger than its share of the graph might indicate.  As is nonetheless evident, the real interesting story here is in the age composition, especially in the growth of the over-65 population.  In 1990 China had about 63 million people over the age of 65.  Today that number has grown to around 109 million.  The rate of growth really starts to pick up in the middle of the next decade so that by the year 2050 China is expected to have about 350 million people over the age of 65 – this, for comparison sake, is more than 15% bigger than the total current population of the United States.  The ratio of the elderly rises from 5% of the population in 1990, to 8% today, to an expected 25% in 2050.

 

The graph also indicates that, thanks to the baby boom in the 1950s and the implementation of the one-child policy beginning in the mid-1970s, China has enjoyed a huge demographic dividend beginning around 1970 or so, when people of working age comprised around 51% of the working population (one worker for every non-worker), to 2015, when they will comprise around 65% of the total population (one and one-half workers for every non-worker).  Their share is then expected to decline to around 56% of the population by the middle of the century.  During and after the 1970s, the working population exploded as the baby boomers joined the work force, but with very few children being born, even the very rapid growth among the elderly (thanks, I assume, to significant improvements in health care) meant that China’s working population grew much faster than its total population.  Even if worker productivity were constant (and it wasn’t – it rose dramatically), the consequence would be a sharp improvement in per capita income and living standards.

 

I don’t have the figures yet from before 1990, but looking at other sources I would guess that China’s working population grew by about 2% or more annually during the 1970s and 1980s.  In the 1990s, as the table indicates, the growth rate of the working population slowed to 1.72%, declining further in the current decade to around 1.42% on average.  The number of working Chinese keeps growing until around the middle of the next decade, and then begins to decline by about half a percent a year.

 

Actually these numbers might understate the change, since as China transitions from a largely rural society to a largely urban one I suspect that the definition of the working population becomes more rigid.  In a peasant and rural societies, in other words, the definition of working population is probably a lot more flexible, and many too-young people and too-old people do the same work that the working population does.  As the society becomes increasingly urban, however, young people are expected to go to school and old people to retire, so their contribution to the work force probably declines.  This suggests that the real working population may have grown a little more slowly in the past decade or so and may decline a little more rapidly in the coming decades than the age numbers indicate.

 

All this has important implications both for nominal growth rates and per capita growth rates in the next few decades.  For one thing, a country’s GDP growth rate can be expressed as a factor of the growth rate of its working population and the growth rate of average productivity per worker.  As the growth rate of the working population swings from positive to negative – by a little more than 2%, depending on what periods you compare – this will have a commensurate impact on Chinese GDP growth rates, i.e. all other things being equal (which of course they are not).  China’s equilibrium growth rate should be about 2% lower than the equilibrium growth rate of the past two or three decades.

 

The other thing worth noting is that beginning some time in the next decade, China’s working population will begin to grow more slowly (or shrink more quickly) than its total population, suggesting that the demographic dividend it has enjoyed during the past three decades will become a demographic tax.  Per capita income, in other words, will grow more slowly than the growth in worker productivity. 

 

Since total consumption is a function of the size of the total population and its income per capita, and total production is a function of the size of the working population and its productivity, the demographic relationship between total production and total consumption also will change.  Remember that a country has a trade surplus if it produces more than it consumes, and a trade deficit if it consumes more than it produces.  This implies that over the last three decades China has had a demographic bias towards trade surpluses (working population, a proxy for production, grew faster than total population, a proxy for consumption), but over the next three decades it is likely to have a demographic bias towards trade deficits.  

 

This doesn’t mean, of course, that China necessarily ran trade surpluses during the last three decades (in some years it ran deficits) and will necessarily run trade deficits over the next three decades.  Other factors, including most obviously changes in worker productivity and savings rates, matter too.  But it does mean that since demographic conditions contribute towards the relationship between consumption and production, in China we are going to see a switch in those conditions from a bias towards trade surpluses to a bias towards trade deficits.

 

Three years ago I argued in a Wall Street Journal OpEd piece that because of the aging and declining populations of Europe and Japan (and to a lesser extent China and Russia), compared to the growing population and relatively stable age distribution in the US, it was not unreasonable for the former countries to run large current account surpluses with the US since they would need the accumulated claims against the US to pay for the current account deficits they would need to run to manage their demographic adjustments.  This is why I have never been terribly worried about the sustainability of the US trade deficit.  In the next decade it is likely that demographic changes will create pressures to reverse those US trade deficits.

 

It also suggests at least one extenuating circumstance explaining the very mercantilist trade policies followed by the Chinese government.  As they are probably very aware of the dramatic demographic adjustments China will need to make in the coming decades, it is reasonable for them to want to accumulate claims against the US to pay for these adjustments.  Of course now, I think, their policies have caught them in a monetary trap from which it is very difficult to escape and which is causing balance sheet havoc.  Still, after their upcoming monetary adjustment, however painful, I expect them to continue favoring export oriented policies.  The only certainty about their demographic future is that there will be a difficult adjustment from a rapidly growing working population to a rapidly shrinking working population.

 

 

WED 14 MAY

The devastating earthquake is also bad for monetary policy By Michael Pettis

This has been a sad week for China, and it has certainly not been easy to watch on television the heartbreaking scenes of the effect of Monday’s earthquake.  Sichuan is a heavily populated province, and many of my students have friends and family in the affected areas, so the disaster has hit us very hard.  The fact that so many of the victims were schoolchildren makes it all the more horrifying.  Bless China, as my student Gao Ming wrote me earlier today, a phrase many worried and dismayed students around campus have been repeating.  Next week my friends and I will organize a concert to raise money for the earthquake victims.  It’s not much, but everyone feels helpless and wants to do something to help, however small.

 

Unfortunately the earthquake and its corresponding devastation are almost certainly going to complicate matters horribly for the PBoC in its attempt to manage monetary policy and fight inflation.  Already before and immediately after the earthquake the new numbers coming out were worrying.  For example yesterday the authorities announced that new RMB lending for April amounted to RMB 464 billion, up substantially from March’s RMB 283 billion (Merrill says this is equal to 43.0% of their second quarter quota, while CSFB says it is 51.5%).  The total new lending year to date is RMB 1.79 trillion, which is not much less than half of the RMB 3.6 trillion increase in loans for all of 2007.  This year we were supposed to see a cap on loan growth equal to last year’s total increase in lending, so we are already at nearly half the full year’s new loan quota.

 

Banks have typically front-loaded their quarterly lending quota into the first month of each quarter, and this quarter seemed at first to be no different in that respect from other quarters.  Had it not been for the earthquake I would have predicted that banks would certainly exceed their loan quota for the first half of the year, but not by nearly as much as the year-to-date figures imply.  With the devastation wreaked by the earthquake, however, and the mounting anger and need for reconstruction accompanying the devastation, I am not so confident of that prediction.  I suspect that the financial authorities are more likely to lean towards leniency on loan growth than to insist on strict maintenance of the caps.

 

They will also most likely be pretty lenient about money growth, even though the most recent numbers suggest they have already been too lenient.  Besides the jump in lending we’ve seen a rebound in M2, which grew 16.9% year or year in April – according to Bloomberg the market was expecting an already high 16.2% increase.  M1 is also up, by 19.1%.  Both of these measures increased relative to March year-on-year figures.  The China Daily quotes Fan Fangzhi, an economist with the Chinese Academy of Social Sciences, as saying "The statistics indicated that the Chinese economy is still challenged by excess liquidity and a rebound in credit growth."  I would find that hard to dispute.

 

Interestingly there has been a veritable battle in the press about which way to go.  One article in China Daily yesterday proclaimed “Chinese economy still under liquidity pressure” and argued for more tightening,  while an article by Xin Zhiming today is headlined: “Fears grow yuan lending may stoke inflation.”  Both of these articles warned about excessively loose monetary policies and the inflation threat.

 

On the other hand yesterday’s China Daily also published an article titled “Price battle half-won,” which claims, rather optimistically I think, that the government’s “tightening” policy is working and must be maintained, although the author does acknowledge that it is “far too early to claim victory in our battle against rising inflation.”  Yes, I think I agree.  It is far, far, far too early to declare that particular victory.  Meanwhile an article today by Ma Hongman proclaims “Maintaining growth the only option,” and he argues that while the causes of inflation in China are not under the control of policy-makers, “the three engines for economic growth - investment, consumption and trade - have all slowed down their forward pace”.

 

In short, the Chinese economy is seeing an overheating and a slowdown in different parts simultaneously, making it much more difficult to choose specific policy tools.  Thus, it is advisable that the policymakers prepare themselves for the worst scenario in future when they fix economic policies.

 

The "worst scenario" mentioned above is stagflation, when inflation is combined with stagnation.  The high inflation level is primarily caused by the elevated prices on the international market sneaking into China through its huge import volume. Since the domestic economic slowdown is also possible, it is hence not impossible for the country to witness a stagflation.

 

Although I too worry about the possibility of stagflation (and this is the first time I think I have seen the word used in the Chinese press about China) I think Ma is mistaken in seeing inflation as caused primarily by rising prices in the international market and so out of the control of local policy-makers.  It seems to me that domestic monetary policy is clearly at the root of Chinese inflation, but his argument is an interesting new spin in the growth-versus-inflation debate – yes there is inflation, he acknowledges, but there is nothing we can do about it so let’s focus on growth.

 

The government is, however, very worried about the inflationary impact of the earthquake, and is taking steps to control the impact, but perhaps the wrong steps.  According to Bloomberg:

 

China ordered authorities in earthquake-hit areas to step up price monitoring, to prevent “large-scale” increases and hoarding.  Prices of food, fuel, medicine and drinking water will be closely monitored and local governments can take “intervention” measures, the National Development and Reform Commission said in a statement on its Web site late yesterday.

 

Clearly the earthquake in Sichuan will not only impact agricultural production and the ability to deliver products to the market, but its reconstruction will fuel a boom in demand for energy, materials, and a wide variety of related goods and services.  Recognition of the impact of the earthquake both on loosening monetary policy and on increasing the demand for a variety of goods seems to have powered the stock market today.  It closed up 2.73% today, driven by smelters and banks. 

 

The government’s automatic response to this potential surge in demand is to clamp down even tighter on price increases, but this cannot possibly have any but the most adverse effect.  After all it is one thing to freeze prices in order to drive out inflationary expectations, but the earthquake has caused a real increase in demand and a real decrease in supply – and the stock market immediately recognized that fact.  How can price freezes possibly eliminate the disequilibrium?

 

In fact yesterday’s China Daily had a very long article on the difficulty of maintaining existing price freezes.  The article is called “To raise oil prices or not, that is the question” and starts out very bluntly with: “Diesel sold out. This notice can be seen at many gas stations in the country.”  It explores both the difficulty of keeping prices at current levels – shortages and an increasing fiscal subsidy – and the difficulty of letting prices rise – the inflationary impact.  People like me of course will point out that price freezes simply convert inflation from one kind, the kind that’s measured in CPI, to another, the kind that shows up as shortages and higher taxes, but the idea that China does not have monetary inflation, simply a temporary food-supply problem, has become so ingrained in policy, even though fewer and fewer people believe it, that its impact will stay with us for a while.

 

THU 15 MAY

PBoC is biased towards more tightening By Michael Pettis

My third-year finance undergrad, Liu Bing, who is following in the footsteps of Logan Wright and becoming a central-bank sleuth and obsessive (almost literally following in his footsteps, I guess, since he is interning at Stone & McCarthy), sent me the following email today.  I have edited it slightly:

 

The PBOC released the Q1 monetary policy report yesterday.  I translated a special column on "hot money" as follows:

Summary: Special Column on FX Reserve Analysis

In the first quarter 2008 money kept flowing into China, mainly as the result of a good fundamentals for the Chinese economy and a large trade surplus and FDI.  Moreover, the sub-prime crisis and turbulent international financial markets have led to international speculative money pouring into China, which is thought a "Safe Market".  Overall, the speculative capital is flowing into China through legal ways, and is the reasonable behavior of companies and individuals given the RMB appreciation expectation.  These legal channels mainly include:
1. Commodity trading: mainly as a result of the mismatch between the delivery of goods and the disbursement of payments.

2. FDI and foreign-invested companies borrowing in foreign currency and using the proceeds to inflate their registered capital figures.

3. Settlements of exchange under household account.
4. Companies undertaking IPOs abroad and exchanging the money raised for RMB (in 2007 this number reached $23.63 billion, mainly concentrated in non-financial institutions, especially domestic registered real estate companies).
5. Services account.
6. QFII
7. Trading gold and copper forward with the purpose of arbitrage.

In the near future, uncertainty about the world's economic development, and the interest rate spread between China and the US may lead to more speculative money flowing into China, so increasing the difficulties of monetary policy.  We must resolve domestic economic imbalances first in order to reduce “hot money” inflows.

 

This strikes me as being a fairly accurate and realistic assessment of hot money inflows into China, although I would have substituted “good fundamentals for the Chinese currency” in place of “good fundamentals for the Chinese economy”, and it would have been better if they attempted some estimates of the amounts entering in via the various legal channels they identify.

 

There are two things that I find particularly interesting here.  First, according to the PBoC, one of the main channels for hot money is the trading of gold and copper futures for the purpose of arbitrage.  I am not sure what they mean – are they buying gold abroad for delivery in China?  At any rate I have often thought that now that it is much easier to trade spot and forward gold in China, with and without delivery, gold might be one of the preferred alternative investments for Chinese households if they ever decide to take their money out of the banks – either because of negative real interest rates or because of credit concerns.  

 

I don’t know enough about the gold market in China, and don’t know how easy it is to arbitrage spot and future markets in and out of China, but it is something worth looking into.  My hypothesis is that if there are significant frictional costs in the arbitrage, including capital controls, the spread between gold abroad and gold in China might tell us something about domestic monetary confidence.  Perhaps one of my smarter students or former students can start figuring out the mechanics of the market and how the arbitrage works.

 

The second thing of interest is the very last line, which suggests that, aside from the obligatory reference to foreign sources of hot money inflows, the PBoC recognizes that the main cause of hot money inflows is domestic imbalances.  It would have been nice if they had been a little more explicit about those imbalances, but I assume they mean the upward appreciation pressure on the RMB caused by the currency regime.  

 

Does this give some inkling about what kind of policies will be needed to resolve hot money?  It seems to me that they clearly understand that the problem can only be addressed via the currency regime.  But, so far, neither the policy of slow appreciation nor the policy of fast appreciation has helped much.  There is still, of course, the possibility of a one-off maxi-revaluation. 

 

This particular option has been so widely discussed, now, that it is no longer considered out-and-out lunacy, even though the government and most analysts, even those who believe that it is the best policy option (and who, I am glad to say, are not longer in a tiny minority), nonetheless insist that it is a wholly impractical policy option and is not likely ever to happen.  My view is that a sudden one-off revaluation is indeed impractical, but the alternatives are even more impractical, and I would argue that it is just a question of time before the perceived impracticality of current appreciation policies exceeds the perceived impracticality of the maxi-revaluation. 

 

The key is hot money. There are very few people left who still think China doesn’t have a serious hot money problem, and all the various attempts to measure the dimensions of hot money inflow during the first quarter came to the same conclusion – the amount of money flowing into China is unsustainable.  Unless second and third quarter numbers show a very dramatic reduction in foreign currency reserve growth, the pressures for a maxi-revaluation can only increase.

 

There were other things in the PBoC first quarter report.  Growth has been better than expected, they say, and inflation has remained high.  “We will strengthen the flexibility of the yuan's exchange rate and utilize its role in optimizing resources to hold back rising prices,” they say.

 

Confirming the first of the two statements, fixed asset investment climbed 25.7% in the first four months of the year.  This is slightly above the same period last year and slightly below economists’ expectations, but it is still extremely high, and the PBoC says there is a risk it will accelerate.  In light of the need to rebuild Sichuan, this is almost certainly going to happen.

 

The stock market started the day well, continuing its bull run yesterday on the assumption that the earthquake will cause an increase in demand and a ;loosening of monetary policies,  It trade as high as 3707, up 1.3% for the day, but in the afternoon the strong fixed asset investment numbers suddenly changed sentiment.  The numbers, plus the PBoC’as report, suggested that there is still a risk of tightening, and most if yesterday’s winner became losers.  The SSE Composite closed at 3637, down 0.55% for the day.

 

By the way I see that Morgan Stanley in their May 12 China Data Release (“Surprise Rebound in April CPI Inflation”) is predicting inflation for 2008 of 6.5%.  My quick-and-dirty calculation tells me that they are effectively predicting that inflation drops from an annualized 9.9% during the first four months of 2008 to an annualized 4.9% for the last eight months of 2008.  I am still predicting that it will exceed 8% for 2008 and probably will get close or cross into 2 digits.  Let’s see what happens in May.

 

FRI 16 MAY

No but this time really is different

Today is relatively quiet on the China-financial-news front (the SSE Composite was down 36 bps, but not much else happened), so rather than discuss the most recent numbers and events and their possible implications for financial policy, I want to write about something a tad more theoretical.  For the past two months there has been a big buzz about a paper by Carmen Reinhart and Kenneth Rogoff (which I will refer to as R/R) called “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.”  As the title implies, the authors examine the historical evidence of financial crises over a long time frame in an effort to develop an understanding of the causes and consequences of financial crises.

 

As someone who has been interested for a long time by the history of international capital flows and financial crises (a big part of my book The Volatility Machine was an examination of developing country crises over the past 200 years), it was a dead certainty that I would read the R/R piece, and sure enough I have just finished it.  It was a great pleasure to see so many references to some of the classic and obscure books on financial history that I have read so often that I feel almost as if they were old friends.

 

There is a lot in this paper and of course it would be hard to discuss all of it, but I thought it might be interesting and useful to take four of the points that the authors make about financial crises and put them in the context of China.  None of these points are particularly new, and in fact are generally widely known among people who have studied the history of financial crises, but often they seem counterintuitive or surprising to the general observer. 

 

First, most countries in history, especially rapidly growing developing countries, have experienced periodic financial crises and sovereign defaults.  Furthermore R/R argue something that is well-known to financial historians: there are regular patterns of periods of global debt crises, with a significant share of the world’s countries in crisis or default, followed by periods where the occasional sovereign default is the rare exception.  They point out that “the current period can be seen as the typical lull that follows large global financial crises” (pp. 3) and then follow up two pages later with the rather chilling comment: “each lull has invariably been followed by a new wave of defaults.” 

 

China, of course, is no exception to this history.  Not only has China experienced financial crises throughout its history, sometimes alone but more often as part of an international wave of financial crises, but Chinese governments have defaulted several times on the country’s sovereign debt, including on its external debt, during these periods of global crisis.  There were a number of external defaults, for example, in the 19th century, beginning I believe in the late 1860s shortly after the issuance of the Qing’s first public bond.  R/R point out that in the 20th century China has not defaulted since 1949 – as Max Winkler might have knowingly pointed out (see below), this is largely because China had almost no external debt during much of this time and its domestic debt market was barely functioning – but prior to 1949, in 1921 and 1939, it did default.  I myself collect old defaulted bonds as a hobby and I have a number of defaulted Chinese government bonds from the 19th and 20th centuries.

 

For China, like for any developing country that has access to financing, one of the obvious conclusions from the R/R piece is that there will be more financial crises in the future and possibly even sovereign defaults.  The interesting question, as far as I can see, is not whether China is likely to experience financial crises, but rather what form they will take and from the point of view of policy what can and should be done now to minimize the economic impact of these future crises.  In fact I would argue that the main role of liability management at the sovereign level is not to prevent the kinds of financial adjustments that often come in the form of financial crisis – that is probably impossible, and for the reasons that Hyman Minsky noted in his work on financial crises – but rather to construct the kinds of balance sheets that minimize the cost of these adjustments by minimizing their impact on the real economy.

 

Second, “countries experiencing sudden large capital inflows are at a high risk of having a debt crisis.” (pp. 8)  They elaborate: “Crisis-prone countries, particularly serial defaulters, tend to overborrow in good times, leaving them vulnerable during the inevitable downturns.  The pervasive view that this time is different is precisely why it usually isn’t different, and catastrophe usually strikes again.” (pp. 33).

 

The implication, as I see it, is that during periods of large capital inflows countries experience all the heady pleasure of growing economies, rising asset prices, loose money and overly easy access to financing.  These periods can lead both to overconfidence – the idea that conditions can suddenly reverse themselves seems improbable at best, i.e. this time really is different – and to inefficient and risky forms of borrowing.  After all during the heady boom times the biggest winners are systematically those that take more risk, so, as Hyman Minsky might theorize, during boom times the whole system tends towards greater and greater risk-taking.

 

Or as the old banking saw would have it, bad loans are made during good times.  Of course during the good times it is generally hard to believe that favorable conditions can so abruptly reverse themselves, so the best strategy seems to be one that effectively doubles the bet, but as I argue in The Volatility Machine, it is precisely those financing structures that magnify the impact of the boom times that make the busts so terrible. 

 

A lot of my blog readers may bridle at my discussing China in the context of “crisis-prone countries”, but before I get swamped with outrage, let me suggest that there is at least the possibility of regarding China as a crisis-prone country from a financial point of view.  And as long as that possibility exists it would be prudent for businesses and government officials to consider the risks very seriously. 

 

There are at least two reasons I would argue that China can be considered crisis-prone.  First, almost every country in history during its stage of rapid development has been crisis-prone, and it is useless simply to assume that China will be an exception – and I note, by the way, that nearly every other country has, at one time or another, considered itself an exception to this rule, to its great subsequent dismay.  Rapidly-growing and rapidly-transforming countries have always been, and are likely still to be, prone to crisis.  China’s economy is volatile, its financial system is rigid and very poor at allocating capital efficiently, and like any country undergoing rapid social and economic transformation, its social, political and institutional structures are unable to change as rapidly as the underlying economic and social circumstances.  All these create the conditions for serious imbalances, whose subsequent adjustments often come in the form of financial crises.

 

Second, and perhaps contrary to consensus opinion, so far China certainly hasn’t been an exception.  Over the past 200 years before 1949, the period I know best, China has had regular financial crises, as many as other developing countries have had, and the only reason these have not been as famous as some of those of other countries, e.g. Latin American countries, is because they occurred at lower levels of debt or with much smaller financial systems.  China’s pre-1949 history certainly doesn’t suggest anything exceptional.

 

From 1949 until the mid-1970s China has not really had a financial system as we would understand it, and so it is hard to argue that it has suffered from the same kinds of financial crises as market economies have, although it did suffer numerous economic crises, including, most spectacularly, the 1958-61 Great Leap Forward.  Over the past 30 years, however, with the re-establishing of a functioning financial system China has had at least three pretty serious monetary and financial crises.  The first, during the period 1985-1987, was a period of high inflation and instability.  Because of the very limited information available it is hard for me to get a very precise sense of the causes and consequences of the crisis, but many of my Chinese friends who lived though the period seem adamant that it was a period of very difficult economic adjustment.

 

Far better known was the second crisis, the 1993-94 inflation and banking crisis, which led, among other things, to the rise of Zhou Rongji and the series of radical and often unpopular reforms he implemented to repair the country’s tattered financial and monetary system.  Finally, in 1997-98 during the Asian crisis, China also experienced a series of sharp financial adjustments, after which time the country’s banking system was massively bankrupt.  I don’t have the numbers in front of me but I believe the World Bank estimated the cost of the banking cleanup at 55% of China’s GDP – making it one of the costliest banking crises of modern times.

 

To return to R/R’s point about sudden large capital inflows, remember that large capital inflows will never occur in countries about which there is a consensus that they are at significant risk of crisis, so please dismiss altogether the argument that China is different and money is entering the country because investors have correctly assessed the risk to be low.  Every country experiencing large capital inflows was firmly believed to be “different” – this is almost a necessary pre-condition for large capital inflows into risky, developing countries.  The point is that today China is experiencing large capital inflows, and historically, according to R/R, large capital inflows have often preceded financial crises.  That proves nothing about China’s future, of course, but it should at least create worry among policy-makers.

 

Third, the widely-held belief that sovereign debt crises are largely external debt crises is incorrect – historically they have been just as likely, or even more likely, to be domestic debt crises.  In fact I have been working on a piece that will argue that the next set of sovereign crises is likely to be driven largely by domestic debt, not external debt.

 

This is a particular important problem in the current environment, and not just for China.  One of the consequences of the Asian crisis of 1997 was the determination on the part of many governments, including that of China, that it was necessary to build balance sheets that would protect them from the re-occurrence of similar currency crises – by limiting external debt and accumulating reserves.  Unfortunately this meant explicitly or implicitly setting up currency regimes that resulted in the monetization of large capital inflows (as central banks created local currency or local-currency equivalents, like central bank bills, with which to purchase these inflows).

 

The net effect has been that the fight to protect national balance sheets from currency and external debt mismatches has led to excessively loose monetary policies which converted these external mismatches into over-extended domestic financial systems, with a wholly different but perhaps equally destabilizing set of mismatches.  In the case of China, and several other countries, the currency regime has led to explosive lending growth, speculative real estate and stock markets, a large “informal” banking system, and inverted domestic debt structures.  It also seems to be leading to a rapid rise in inflation, although there is still a sharp debate about how serious this inflation is likely to be.  These can easily create the conditions for the kinds of financial crisis which occurred, for example, in the US during much of its developing stage.  The US suffered from financial crises nearly every 10-15 years, in some cases extremely damaging crises (the 1790s, the 1830s, the 1870s and the 1930s, for example), but they were never external debt crises, mainly because the US had little external debt.

 

Fourth, successful countries, i.e. countries that have managed to make the transition from developing to developed economy, have generally had limited experience with sovereign defaults.  That might seem obvious at first, but it is not so obvious where the causality runs.  As the authors write: “Do high growth rates help avert default, or does averting default beget high growth rates?” (pp.16)  At least part of this answer must have to do with the special damage caused by sovereign default.  It is worth noting that the United States, one of the most economically successful countries in history, has a very low incidence of sovereign default, but, as I mention above, it does not have a low incidence of system-wide financial crises.  On the contrary, the US, especially in the 18th and 19th centuries seemed to have had financial crises fairly regularly (and by some accounts still does), but they rarely if ever involved the federal government debt.

 

Why?  Is it because the US government was particularly prudent and/or careful?  I doubt it.  I suspect it has a lot more to do partly with the peculiarities of US political life such that for much of its history the central government struggled with the states over centralized power, including over its fiscal role, and partly with the deep distrust Americans had until the middle of the 20th century for banks and for government debt – after all Andrew Jackson won his 1836 campaign largely on opposition to the Bank of the United States, a quasi-central bank that was closed down when its charter was not renewed in 1838.  Until recently the US government simply did not have enough debt on which to default – most debt was at the state, municipal, and corporate level, but at the state and corporate level there were more than enough defaults to satisfy any historian.

 

My own theory is that sovereign debt crises are an especially brutal kind of crisis because when the central government is in default, or perceived to be near default, the country suffers from a whole set of financial distress costs that make it very difficult for the financial system to clear.  In those cases every domestic borrower, even healthy ones, suffers from capital flight and disinvestment, and the economy cannot begin again to grow until the sovereign credit has been substantially repaired, unlike the kinds of financial crisis that affected, say, the US, in which there was no or little perceived threat of a sovereign default.  In that case after the crisis bottomed out investors were not afraid to snap up cheap assets and restructure troubled companies and, in so doing, they restored economic growth.  This does not happen when the central government is in default.

 

I won’t go into it in too much detail (again I discuss this extensively in my book) but one conclusion is that the sovereign credit must be protected at all costs.  For that reason governments should push as much borrowing as possible off the central balance sheet, including, most importantly provincial, municipal and project-related borrowing.  In the case of China, it should probably cut its links to provincial and municipal borrowing as soon as it can and it should try to push the financing decision as far down as it can.  It should also refrain from protecting large borrowers from the consequences of their borrowings, although this may be culturally very difficult for an actively interventionist government to accept.

 

As good as the R/R paper is there are, inevitably, some things I would have liked to see discussed more.  For example there has not been much discussion in the R/R paper about the role of contingent liabilities in sovereign crises.  As a very interesting book published last March by the IADB (Living with Debt) notes repeatedly, very often the debt that “caused” the financial crisis was not the long-term accumulation of fiscal deficits but rather the very sudden emergence or conversion of contingent liabilities.  These contingent liabilities suddenly exploded – for a variety of reasons – and were generally structured in ways that exacerbated both the previous good conditions and the current bad conditions.  

 

The two most common forms of this have been the explosion in the relative value of debt denominated in foreign currency, following a currency crisis, and the explosion in contingent liabilities through a collapsing banking system.  In my opinion these have been two of the most common causes of “unexpected” financial crisis, and it is worth considering any country’s, including China’s, risk of either event occurrence.

 

China, of course, is in little risk of seeing the former happen.  With less than $400 billion of external debt and close to $2 trillion of foreign currency reserves, China is at no risk of a recurrence of the 1997 Asian crisis.  The real threat for China is in the second set of contingent risks, that of an explosion of liabilities arising though the banking system.  I am obviously not the first person to point this out – China’s massive loan growth and its stubbornly high NPL ratio in spite of what can only be described as a dream time for bankers suggests at the least that in a sharp downturn there is a very real risk of a surge in NPLs.