My Blog

SUN 18 MAY

Green on the PBoC Q1 report By Michael Pettis

On Friday Stephen Green of Standard Chartered delighted his fans in the market by putting out a piece called “We strike gold in the Q1 PBoC report” in which he highlights 14 “gold nuggets” he found hidden away in the PBoC report.  There was a lot of interesting stuff in his report and I recommend that people who are interested ask Standard Chartered to send them a copy.

 

I want to highlight three of these “nuggets”.  First, Green notes that the official GDP deflator rose substantially – from 5% year on year in the last two quarters of 2007 to 8.2% in the first quarter of 2008.  There are a lot of problems with the GDP deflator figure, but Green argues that the fact that it jumped so sharply is more evidence that inflation has become a real problem and is spreading through the economy.  Given how sharply it jumped he even wonders why there weren‘t big headlines about this.

 

Second, and this is most interesting to me, lending constraints on commercial banks have been applauded for having slowed the growth in lending by 14% in the first quarter of 2008, compared to the first quarter of 2007.  But these lending constraints do not seem to apply to the policy banks, and their total lending surged by 86% compared to the first quarter of 2007.  Since they comprise 12% of all new lending in Q1 2008, their impact on loan growth is far from negligible – including their loans, total new lending only declined by just under 8%.  I can’t prove this, of course, but I suspect that if we were to include loans from the informal banking sector, loan growth might not have slowed at all in the first quarter. 

 

Remember that one of the strongest tools available to the PBoC to fight domestic overheating and excess demand has been restrictions on loan growth.  I was never very confident that these kinds of measures would work because I assumed that, given the country’s explosive monetary growth, lending constraints would simply push new investment off the banks’ balance sheets.  Green’s “nugget” seems to suggest one way in which this is happening.

 

Third, and perhaps another way in which this is happening, Green notes that foreign currency lending by Chinese banks soared in the first quarter, from $2 billion in Q1 2007 to $48 billion in Q1 2008.  The PBoC claims that 73% of this lending went to support foreign acquisitions by Chinese companies, but Green finds it hard to understand how this can be the case.  He believes a lot of this lending may actually have been used for domestic lending, perhaps to get around RMB lending quotas, and if these were added to the total new RMB loans issued in the first quarter of 2008, including the surge in loans by policy banks, new lending would actually have grown, not declined – if you include loans by policy banks and foreign currency loans, total new lending was 15% higher in the first quarter of 2008 than over the same period last year (and this still ignores the possibility of expansion in the informal banking sector).

 

By the way another “nugget” Green discovers is that average lending rates at the Chinese commercial banks have gone up by only 20 bps from January to March, much less than inflation.  I would argue that this is additional circumstantial evidence that the lending constraints are not biting, or else I would have expected corporations to bid up borrowing rates.  I may be wrong here, because existing banking relationships might make it hard for banks to raise their lending rates too quickly, but it seems to me that if corporations were starving for access to loans one way of rationing this access might have been to raise lending rates.

 

Green also observes a big jump in FX swaps during the first quarter, and suggests this supports his view that a significant portion of foreign currency loans are being spent in China, not for foreign acquisitions.  By the way this may explain some of the remarkable jump in foreign currency reserves at the PBoC during the first quarter.

 

Turning away from Stephen Green’s detective work, the PBoC Q1 report also noted that NPL’s declined from 6.2% at the end of 2007 to 5.8% at the end of the first quarter.  Remember that the NPL ration can improve by a decrease in NPLs or by an increase in total loans.  I don’t remember how much total loans increased during the first quarter (and I am going to the dentist in a few minutes because of a massive toothache that has made my weekend miserable, so I don’t have time to dig up the numbers), but I note that a 6.5% increase in loans would be enough fully to account for the decline in the NPL ratio.

 

TUE 20 MAY

The effect of the earthquake is increasing uncertainty By Michael Pettis

The stock market seems to be getting increasingly worried about the economic impact of the earthquake, even though Sichuan province comprises just 4% of China’s GDP production and most of Sichuan’s most developed areas, including its capital Chengdu, were left relatively unscathed.  Still, it seems that uncertainty has increased in a variety of areas and investors don’t know how to respond.

 

Part of the reason may be because of the quake’s potential impact on fuel and food stocks.  Sichuan is a big agricultural producer (I think I read somewhere that it is the most important province in China for producing pork), but it seems likely that it is going to be a net drain on food supplies for at least the next few months, rather than a net provider.  This of course will prolong the period of food scarcity and make it harder for food prices to come down. 

 

The quake may also make fuel shortages worse, thus increasing pressure on the authorities to let fuel prices move a little closer to world prices.  According to today’s Bloomberg, Sinopec “has diverted gasoline and diesel supplies from southern and coastal regions to quake-hit Sichuan province and lifted rationing on fuel sales as the recovery effort boosts demand.”  According to the company newsletter, the nation's biggest oil refiner has cut back on supplies to Hunan, Hubei and Guangdong.

 

The stock market trade up 0.4% last Monday, the day of the earthquake.  It dropped 1.8% the next day as we began to get the first indications of its severity, only to shoot up 2.7% by Wednesday, as investors began expecting a big fiscal and monetary push in response to the earthquake. 

 

The stock market started Thursday also very strong, but the release late that morning of the PBoC’s Q1 report, ended the party.  The PBoC’s report suggested that excessively high levels of investment and monetary loosening were still a problem, and although they tried to sound positive on inflation, it was clear that they were worried about hot money inflows and rising prices.  This report seriously damaged expectations that the PBoC would be forced to loosen considerably in response to the earthquake, and the market closed down 0.5% for the day.  It lost another 0.4% Friday, and then continued dragging down by another 0.6% Monday.

 

Today, however, the market took a real beating.  It started the day relatively strong, trading up 0.8% in little more than an hour, but after that it was all downhill.  During the last hour of trading the market moved into panic mode, trading volume surged, and prices dropped steeply, handing investors a 4.5% loss for the day.  My student Shang Ning tells me that with a very few exceptions (some highway and cement companies based in Sichuan or nearby Chongqing) all sectors of the market were badly hurt. He ends his market roundup with: “I feel the market is now without ideas and very afraid of the effect of the earthquake.  Not many investors want to play in the markets now – everyone seems just to want to watch and see what happens.”

 

The market is now at 3443, about 15% above 3000, which many investors believe is the minimum level below which the government does not want to see the market go. Remember that on April 22 it broke 3000 for a few minutes, and within two days the government announced the reduction of the stamp duty, setting off a rally which drove the market up by over 25% over the next few days to close, on May 5, at 3761.

 

Given the huge attention being placed on the rescue effort and the fact that most media are discouraged from reporting anything but positive images of the rescue efforts, it is hard to know what exactly is going on in the market and in the minds of the authorities.  Obviously their number one concern must be the rescue effort, although by now there is little hope that we will find additional survivors.  Still, the PBoC and the financial authorities must be monitoring the stock market closely and they must be working overtime to figure out just how much slack they have for fiscal and, more importantly, monetary loosening. 

 

They must also be worried that today’s market collapse could so harm investor sentiment that within a few days we return to striking distance of 3000.  I discussed in my May 6 entry (“Perceptions of market support can add shocks”) that one unfortunate consequence of an investor perception that a major player will intervene to support prices at a certain level is that the market can drop very sharply if the support level is ever breached.  We now have the risk that if we continue to see several more very negative days so that the 3000 level is tested, it may be difficult for the government to know how to respond while we are still in the midst of the earthquake crisis.

 

WED 21 MAY

Lots of speculation on oil price hikes By Michael Pettis

I don’t normally write so much about the stock market but today, like yesterday, the stock market seems to be at the center of events.  Not unexpectedly the SSE Composite started the day badly after yesterday’s awful 4.5% drop to 3443.  By midmorning it was down a whopping 2.6%, to 3355.  Later in the morning, however, it partly recovered and then quickly gave it back again, until early afternoon, when it suddenly shot up in less than two hours to 3544, which is 5.6% off its lows for the day and 2.9% above yesterday’s close.

 

What caused this surge?  The first thing to note is that although over 80% of the stocks traded up, the best performers by far were the large oil companies.  Sinopec went up 10%, the maximum permitted by the Shanghai Stock Exchange in any one day.  PetroChina jumped 6.6%.  Those with suspicious minds have already noted that smaller oil refiners, like Shandong-based Taishan Oil, actually began the rally much earlier, trading up yesterday in spite of overall terrible markets.  My finance-obsessed student Shang Ning tells me that electricity generators and coal companies also did very well, which is surprising because in China the electricity generators are forced to sell power at government-set prices but must buy coal at market prices, so that rumors of intervention or non-intervention in the coal markets tend to help one at the expense of the other.

 

What seems to have caused the sudden rally was a spate of rumors that the government was planning to lift price caps on refined oil products.  Chinese oil companies are forced to sell refined oil products domestically at a fraction of the world oil price and, not surprisingly, this has really crimped profits.  It has also led to hoarding, shortages, and smuggling.

 

The NDRC has been eager to deregulate oil prices, or at least to reduce the gap between world prices and domestic prices, but has been reluctant to do so up till now (the last price hike was, if I remember correctly, a 10% hike in October) because of the potential impact on inflation and inflationary expectations.  Those who argue that Chinese inflation is largely a consequence of temporary food-supply shortages (the too-little-pork camp) are determined that until food supply comes back on line the greatest risk is that rising inflationary expectations lock China into a self-fulfilling cycle of rising inflation.  China has aggressively implemented price freezes and tried to control rising prices so as to address the psychological impact of rising prices and prevent them from creeping into wages.

 

Those of us (the too-little-money camp) who believe that Chinese inflation is a monetary problem, caused by an inflating money supply – a consequence of the forced purchase of capital and current account inflows by the PBoC – have never believed that price freezes will work.  In our view they will simply cause inflation to shift to other goods and, in so doing, will distort demand in the market and encourage hoarding and shortages.

 

Either way, price freezes are expensive, and with food comprising so important a part of the consumer basket (officially 33% but probably much more), it seems that inflationary expectations may be forming anyway.  Whether you believe inflation is caused by too little pork or too much money, at this point you have to be pretty pessimistic about the inflation trajectory for the rest of the year.  Shang Ning told me yesterday that many of the local commentators who were effectively arguing two months ago that they expected average prices to peak in May and begin declining in June are now saying that they expect average prices to peak in September and begin declining in October.  This is already at least the second or third time they’ve pushed back their expectations for the end of inflation – any bets on whether or not they will soon push the timing back again?

 

What is the likelihood of the rumors of a hike in oil prices being true?  It is hard to say, but these rumors have been around for a while, and in China policy tends to emerge first as rumor and only later as policy.  The fact that smaller oil companies shot up yesterday, and larger oil companies today, suggests that there are at least some who believe very strongly in the rumors.

 

What about the timing of a relaxation of the price freeze – given the recent devastating earthquake and the country in mourning, is it likely that the authorities would engineer a price hike now?  Part of me thinks that there might be enough anger and economic disruption over the earthquake for this not to be a good time to raise oil prices, but on the other hand I think there are at least two good reasons for the government to go ahead and raise prices now, 

 

First, the impact of the earthquake on food production (Sichuan is not important in industry but is fairly important in agriculture, and is in fact the country’s largest pig producer) may have ended the authorities’ hopes that food prices will come down soon enough to prevent a sharp increase in inflationary expectations.  In that case it is probably better to adjust oil and other prices now, rather than have them continue to distort energy use and be forced up anyway at some point in the future – this is maybe a variation on the idea that you should release all the bad news immediately and then release the good news in batches, so as to create the illusion of continuous improvement. 

 

Second, the earthquake has caused a huge outpouring of nationalist fervor and support for the government, along with fierce criticism of anyone deemed not supportive enough (one of my nicest students told me today that he has been criticized for wearing a brightly-colored shirt, which is considered inappropriate under the circumstances), so the government may believe that it is easier to raise prices and make other tough moves now.

 

If the rumors are really right, and oil prices are about to be hiked, it may be good for oil companies but I don’t expect the rest of the market should surge in sympathy.  On the contrary other stocks should get hit.  Any meaningful increase in oil prices is certainly going to push CPI up, and as it does it will put even more pressure on the PBoC and the financial authorities to tighten monetary policies.  Remember that after the run-up in stock prices after the earthquake, it was the Thursday PBoC Q1 report, with its warnings of excess growth and the need to tighten, that caused the market to turn around and begin its more than 6% decline from its peak.

 

THU 22 MAY

The informal banking sector is growing By Michael Pettis

After yesterday’s stock market excitement, the government “quashed” rumors today that they were going to relax prices on refined oil products.  According to China Daily, “the National Development and Reform Commission (NDRC), China's economic planning agency, said rumors that the authorities plan to relax domestic oil and gas price controls are baseless.” The Shanghai Securities News, the official paper of the stock exchange, quoted an unidentified government official as saying that relaxing the pricing regime would hinder earthquake relief and reconstruction.

 

What may have started the rumors yesterday were indications that the government may instead help oil companies by reviewing the windfall profit tax imposed on all upstream oil producers.  Apparently PetroChina lat week appealed to the government for just such a review.  It is worth noting that the government is likely to be – and for good reason – very secretive about any plans to change oil prices since this is only likely to encourage hoarding in the short term.  Shortages continue to be a problem and low domestic oil prices – at roughly one-third the world price – have done nothing to stimulate energy conservation.  I think the problems of hoarding, shortages and smuggling are only going to get worse over the next few months, especially as the serious reconstruction in Sichuan kicks in, and we will see a resurgence of these rumors about relaxing price freezes from time to time.  It cannot be easy for the government to cope with the consequences of maintaining low domestic oil prices, and it certainly isn’t cheap.

 

The stock market reacted very strangely today to all of this.  The SSE Composite opened down and lost 2.1% from yesterday’s close within the first thirty minutes of trading, before bouncing around for much of the morning within a 1-1/2% trading band.  It suddenly shot up in the early afternoon to a few points above yesterday’s close, before collapsing in the last 90 minutes to 3586, down 1.65% for the day.  Neither I nor my student Shang Ning was able to get much of an explanation for the sharp ups and downs today.  This has the feel of a very uncertain market chasing its own tail.

 

Meanwhile there was an interesting article in today’s South China Morning Post about the increased cost of converting HK dollars into RMB.  Bank of China, the city's RMB clearing bank, widened the spread between the buy and sell rates for the RMB early this month from 10 basis points to 75 basis points.  This was reportedly done because the PBoC was worried that increasing demand for RMB in Hong Kong could affect its exchange management and its domestic monetary policy.

 

Sure enough, the exchange volume dropped significantly since the move, but the newspaper report quotes Joseph Yam Chi-Wong, the chief executive of the Hong Kong Monetary Authority, as saying that “some transactions may shift to money exchangers or even through underground channels if people are very sensitive to the buy-sell spread.”  They may shift?  I think it is a dead certainty that money is shifting to informal channels.  After all there is plenty of evidence that hot money inflows are high and increasing, and if there is a slowdown in the formal channels for RMB purchases, what else can one assume?

 

Along that line I missed a very interesting article in the April 23 edition of a local magazine, The Economic Observer.  The article, titled “Chinese Firms Tapping Informal Loan Networks,” discusses one of the things I have been wondering about a lot on this blog.  I have always assumed that one of the consequences of the stricter lending caps imposed this year would simply be to move borrowing out of the formal banking system and into less formal borrowing channels, and I had heard anecdotal evidence that this was indeed happening.  Apparently some economists at the All-China Federation of Industry and Commerce have been doing their own work on the subject.

 

Research by the Federation estimated that Chinese companies raised some 800 billion yuan through informal channels last year, among which researcher Chen Yongjie said over 20 billion yuan likely came from Wenzhou.  Businesses that raised money in this fashion would likely be charged a 5% monthly interest rate, amounting to around 60% in one year.

According to Chen, over five million private businesses made up 70% of China's total, making up 65% of China's GDP.  But despite the importance of this segment to Chinese industry, Chen's data indicated that the proportion of loans from banks to them decreased over the past three years. The proportion of short-term loans to private business was about 11% in 2005, but only 9% in 2006.  China Society of Private Economic Research chairman Bao Yujun had spent two weeks investigating in Shaoxing, Wenzhou and nearby regions, and discovered that underground fundraising was indeed gaining momentum in Wenzhou. 

 

Despite the fact that underground fundraising goes against regulations made by financial supervisory bodies in the Chinese central government, the local governments were turning a blind eye.   Bao spoke with a prominent politician of one city in Zhejiang who stressed that there was no way they could clamp down because businesses had to survive and that locals had to remain employed.

 

Wenzhou, for those who don’t know, is a city in the south famous both for the ferocious entrepreneurialism of its citizens and for its extensive informal banking sector – with the second characteristic probably not unrelated to the first.  The point the researchers are making is that as small businesses in China grow, they are getting less and less help from the large commercial bank, who prefer to concentrate their now-limited lending power to loans to the large SOEs – yet another way in which China’s financial system fails miserably in delivering capital to its most efficient users. 

 

Not surprisingly, these private companies are turning to the informal banks for funding, in spite of borrowing costs as high, according to the article, as 5% a month, which they describe as 60% a year but which I would qualify as 80% a year if correctly compounded (which at least gives some idea of the profitability both of the private companies and of the informal banking sector).  

 

The worrier in me would make two points about this – besides the obvious one about how the banking system misallocates capital.  First, such high borrowing rates can spell catastrophe if the economy were to suffer a sharp slowdown since borrowing at this rate must require optimal economic and profit conditions to be justified.  Second, any attempt to measure real loan expansion in China is likely to be overly conservative if we ignore the impact of these informal lending institutions.  Credit growth is almost certainly higher in China than what the numbers from the commercial banks suggest.