My Blog

SAT 21 JUN

Fuel prices rise By Michael Pettis

I was going to write today about speculative inflows and their impact on Chinese monetary policy, but a lot has been happening – and just in the middle of my week-long trip out of China – so I will postpone that discussion for Monday.  On Thursday, as almost everyone knows by now, just after the market closed Chinese authorities announced that were allowing fuel and energy prices to rise – fuel by nearly 18%.

 

This came as something of a shock to everyone because it was widely believed that although fuel-related pressures were becoming intense, nothing would be done before the Olympics because of the socially disruptive impact a price hike might have – not to mention the worries about allowing inflationary expectations to grow.  Aside from showing how little faith we should place on expert consensus, and that the embedded wisdom that nothing bad can possibly be allowed to happen before the Olympics is an exaggeration, there are at least two interpretations we might place on the timing:

 

1.        The authorities were so comfortable with the May inflation report that they were not as frightened as many had assumed of the inflationary impact on CPI of a price rise, and decided that they can now begin allowing price freezes to unwind.

2.        The fuel-related losses and shortages had become so severe that it was becoming too dangerous to wait.

 

My suspicion is that the latter was more important a reason.  I have been hearing reports from friends and readers around China that shortages were becoming a far more serious problem than most of us realize.  I will discuss some of these reports and comments in a later entry, but it may be that it was getting harder and harder for the authorities to postpone some sort of price rise.  The relatively benign May CPI numbers may have created enough comfort for the authorities, especially if they were eagerly hoping for good news and willing to interpret any good news in the most positive light, that they were able to arrive at the necessary consensus.  If I am wrong, and it was the resurgence in confidence that inflation is being beaten that propelled the hike in fuel and energy prices, we should probably begin to see price freezes on food relaxed quickly.

 

At any rate the impact on the stock market of the hike in fuel and energy prices was quite predictable.  Rising oil prices have been especially bad for the Shanghai market because, aside from all the other negative economic consequences they have for most companies, they were especially bad for oil companies who had to sell rising amounts of imported oil at huge losses.  When China made the announcement that it would let fuel prices rise, and oil immediately fell on international markets, it was almost a certainty that the market would rise.

 

And they did.  Not without a struggle at first, however.  The market dropped 104 points in the first 30 minutes of trading, before staging a rally that took it up to 2902 by the end of the morning, after which it lost steam in the afternoon to close at 2832, up 3.01% for the day.  I don’t expect this rally to continue, although a number of large banks and funds have moved China to overweight on the argument that the Shanghai market is oversold.  Higher oil prices in China may be good for the oil companies, but I expect it is bad for everyone else, and after investors have had the weekend to think things over, I expect pessimism will return, unless international oil prices continue falling.

 

As a complete aside there is a pretty amusing article from last week’s New York Times (“Booming, China Faults U.S. Policy on the Economy”).  The article starts out:

 

Not long ago, Chinese officials sat across conference tables from American officials and got an earful.  The Americans scolded the Chinese on mismanaging their economy, from state subsidies to foreign investment regulations to the valuation of their currency. Your economic system, the Americans strongly implied, should look a lot more like ours.

 

But in recent weeks, the fingers have been wagging in the other direction. Senior Chinese officials are publicly and loudly rebuking the Americans on their handling of the economy and defending their own more assertive style of regulation.  Chinese officials seem to be galled by the apparent hypocrisy of Americans telling them what to do while the American economy is at best stagnant. China, on the other hand, has maintained its feverish growth.

 

For several years as the US benefited from the early pleasures of excessive monetary growth, the Bush administration (and, to be fair, the Clinton administration too, although perhaps not to the same ugly extent), seemed to find it hard not to assume a marked superiority over everyone else when it came to managing domestic economic policy.  We lectured our foreign friends fairly aggressively and a tad more arrogantly than was justified by the actual numbers.

 

But of course all good things must end, and an economic boom generated by monetary excess and greater risk-taking among financial institutions, as pleasant as it can be in its early stages, must end too, and usually in an ugly way.  As the US is working itself out of the now-obvious monetary excesses of the last ten or so years, this is a great time for once-lectured-at countries to sneer.

 

The New York Times article goes on to suggest that the problems besetting the US economy, set against the rude good health of the Chinese economy, has created a “brash new sense of self-confidence on the part of the Chinese.”  For the first time in several years the Chinese are behaving in a less humble – some might even suggest arrogant – manner and are pushing back.  They are arguing that perhaps their model of development is not so obviously inferior to the more markets-oriented models proposed ham-fistedly by the US and the other “Anglo-Saxon” countries.

 

It must be an especially great pleasure to point out publicly, and in international forums, the problems with US currency management, after hearing for so long that their own currency was mismanaged.  Unfortunately just because your critic turned out to be full of hot air doesn’t mean his criticisms were all wrong.  China’s currency has been mismanaged, and China is going to be forced into some kind of adjustment – and I am willing to bet it will be more difficult than what the US is likely going to suffer. 

 

I guess it is hard to begrudge Chinese officials their forgivable glee in seeing US self-righteousness brought down, but I wouldn’t take too much comfort if I were them.  The fact the US financial model had serious flaws shouldn’t make us too confident of alternative financial systems.  They all have the same basic flaws – the real question is how quickly they can adjust.

 

My worry has intensified because there are rumors that at a recent high-level meeting in Beijing involving the most senior economic policy-makers, the consensus was that an economic slowdown is a much more urgent problem than that of monetary excess.  Maybe, but monetary excess is a very big problem – a much bigger problem for the long-term – and it won’t pay to downgrade its policy-making implications.  The longer this goes on the more vulnerable China’s financial system becomes, and the harder it will be to adjust.

SUN 22 JUN

Of course Chinese dollar holdings rose, but something changed drastically By Michael Pettis

There is an interesting, if perhaps predictable, June 17 Bloomberg article by Patricia Lui that discusses China’s holding of US dollar reserves. According to the article:

 

China is adding to its holdings of U.S. assets, data from the U.S. government showed yesterday, easing concern the Asian nation will sell dollar investments.  Total holdings of U.S. equities, notes and bonds among foreign investors rose by a net $115.1 billion in April from $79.6 billion the previous month, the Treasury Department said yesterday in Washington. China’s holdings of Treasuries gained $11.4 billion to $502 billion, holdings of U.S. agency debt rose $11.9 billion and U.S. corporate bond investments increased $6.9 billion, data showed.

 

The discussion about whether or not China will continue funding the US deficit by buying dollar assets has been going on for a long time, and has caused an unnecessary amount of alarm among analysts worried about the consequences of a possible Chinese decision to stop buying dollar assets – without Chinese purchases of US securities, they worry, how can the US possibly finance its ballooning trade deficit?  Yet time after time the data show that China continues to add to its dollar hoard – sometimes in amounts close to or even greater that the US deficit, as Brad Setser recently implied – and so for a little longer those concerns “ease”.

 

If you believe that the explosive growth in the US trade deficit since the late 1990s was caused primarily by a sudden massive increase in the desire of US consumers to consume, then it may make sense to worry about how the deficit must be financed.  After all according to this view, the cost of out-of-control consumption by Americans exceeds American income, and so this requires some foreign saver to finance the consumption.  At the individual level it was the wealth effect of rising stock markets and real estate prices that allowed Americans to increase their consumption, but in the aggregate a country running a current account deficit by definition needs external financing.  Should this financing stop, US consumption would have to drop drastically in order to eliminate the current account deficit, and with it the US (and world) economy would slow sharply.

 

But if you believe, as I do, that the global balance of payments disequilibrium is driven primarily by the increase in external savings of a number of developing countries – mostly East Asian and OPEC, with China being by far the largest player – then worrying about how the deficit will be financed shouldn’t take up a lot of anyone’s time.  The deficit exists primarily because of the need for China and other countries to invest the current account surpluses their monetary and fiscal policies were designed to create (or the windfall current account surpluses from high commodity prices, if they are commodity exporters).

 

I have explained why I think the latter is a better description of the global balance of payments disequilibrium several times in my blog, the last time in a June 4 entry (“Chinese savings and US deficits”) and in two longer entries on September 15 (“China and the savings glut” Parts One and Two).  As I pointed out in those entries, I think a very plausible argument can be made that the 1997 Asian financial crisis created such a strong impression on Asian policy makers that their decision to protect themselves from a reoccurrence prompted them to put into place very strong mercantilist policies guaranteed to save them from a future external debt crisis.  This implied substantial trade surpluses and rising reserves.  It also required that some other country or countries be willing and able to run corresponding current account deficits.

 

The data show that after 1997-1998 Asian current account surpluses grew so quickly, and central bank reserve accumulation along with it, that for the first time developing countries as a group became net exporters of capital when reserve accumulation exceeded net private capital inflows (you can find the actual numbers in Jorg Bibow’s “The International Monetary (Non-)Order and the Global Capital Flows Paradox”).  China was by far the biggest factor in this process, and of course as long as China was running such a policy, it needed to invest those surpluses.  They were invested in the US.

 

The point is that China had no choice but to finance the US current account deficit.  As long as it ran mercantilist policies aimed at generating trade surpluses only four things could happen:

 

1.        China finances the US current account surplus directly by buying US dollars assets.

2.        China finances the US current account surplus indirectly by buying euros and yen, and Japanese and European investors (most probably their central banks), buy US dollar assets.

3.        China buys euros and yen and Europeans don’t compensate by buying dollars, in which case China’s current account surpluses shift to Europe and Japan, who end up running current account deficits to replace the rapidly declining US current account deficit.

4.        China stops buying foreign assets, in which case its current account surplus disappears.

 

Since the whole point of the exercise was to generate current account surpluses and foreign currency reserves, China could not choose Option 4.  In addition, as its currency regime locked it into a self-reinforcing system in which rising trade surpluses forced more surpluses (I explain why in “The value of the RMB does matter to the trade balance” Parts One and Two) there was no way for China to choose Option 4 without a serious adjustment to the currency regime and the possibility of a sharp and difficult collapse in exports.

 

Either China had to finance the US trade deficit, or it had to find someone else willing to accommodate its trade surpluses.  The only important question, then, was whether Europe could absorb the necessary current account deficits or not.  If so, China could begin to shift its reserve holdings into euros and so cause enough strength in the euro relative to the dollar that the US trade deficit would shift to Europe.  To a certain extent this has been happening, but I am not sure it can continue for too much longer.

 

So as I see it, the question of whether the US trade deficit can be financed or whether China can suddenly “change its mind” about financing the deficit is not a very worrying one because the US trade deficit and, increasingly, the European trade deficit are consequences of foreign financing, not their cause.  However something very important has changed recently, and I am not completely sure about its implications.

 

Specifically, for many years China’s burgeoning reserves were powered primarily by its burgeoning trade surplus (with net FDI playing a secondary role).  In that case it was pretty easy to trace out the balance of payments flows and their consequences.  I agree with most pessimists that the balance of payments numbers were becoming unsustainable, but not mainly because the US current account deficit was unsustainable.  In fact I don’t think it is, for reasons I explain partly in “Demographic projections and trade implications”.  For me the biggest problem with the existing balance of payments relationships was that China’s reserve accumulation was becoming unsustainable because of its domestic monetary impact.

 

Recently this has become an even bigger problem.  In the past few quarters China’s reserve accumulation has mushroomed to levels that make the 2006 and 2007 numbers, as incredible as they seemed back then, almost laughably small today.  And yet China’s trade surplus and net FDI have not grown to nearly the same extent – in fact the trade surplus, while still incredibly high, has actually shrunk, and FDI, which is much smaller but has grown sharply, probably includes a healthy dose of speculative inflows disguised as FDI (as does, many of us suspect, the trade surplus).

 

It now seems that China’s rate of reserve accumulation, seemingly unsustainable even two years ago, has reached even higher levels, but what is powering it now is not the (relatively) stable trade surplus and FDI accounts but rather highly unstable speculative inflows (for an explanation of how reserve accumulation has been generated see “What? $74.5 billion? Is this a mistake?”).  If I am right, it seems to me that there has not just been a quantitative change in China’s and the world’s balance of payments accounts in recent months (i.e. even more rapid growth in an already unsustainable rate of Chinese foreign currency reserve growth), but also a qualitative change – the cause of China’s reserve growth has shifted significantly.  The old mechanism, large trade deficits in some countries balanced by rapid reserve accumulation in others, has been converted into something much more complex and maybe even pro-cyclical (hence volatility enhancing): large trade deficits in some countries plus massive speculative inflows in others are being balanced by even more massive reserve accumulation in the latter countries.

 

I still need to work out in my mind what some possible implications are, but I would be lying if I said I didn’t find this change worrisome.  My instinct is that because of the intensely pro-cyclical nature of speculative inflows, this new system is a lot less stable than the old one.

 

WED 25 JUN

China’s reserves grew $40.3 billion in May By Michael Pettis

I just got back from my one-week trip having taken a very early morning flight, so I am a little too tired to write much for today’s entry, but I couldn’t let pass a media report earlier this afternoon that claims that China’s foreign currency reserves at the end of May reached $1.797 trillion..  Although these media reports are unofficial, they have in every case that I can think of been subsequently confirmed by the PBoC, and these are very likely to be accurate numbers.

 

If so, this means that China’s foreign currency reserves grew by $40.3 billion in the month of May.  After the blowout $74.5 billion for the month of April there is the obvious temptation to think this is a relatively healthy number for China’s reserve growth, but it isn’t.  This is a huge number, materially above the $38.2 billion monthly average for 2007, a number that at the time was almost impossible to believe.  May’s $40.3 billion only seems small because monthly reserve growth year to date has averaged $53.7 billion, and it is worth reminding readers that, like the headline reserve growth numbers for the rest of this year, May’s number almost certainly significantly understates the true growth in reserves.

 

To recreate the chart I have been running every month, a reasonable and very plausible description of the composition of inflows to China’s PBoC this year looks like this:

 

	January	February	March	April	May	Total
Headline reserve growth	62	57	35	75	40	269
Trade surplus	20	9	14	17	20	79
FDI	11	7	9	8	8	43
Currency gains	10	10	18	(12)	1	27
Interest	5	5	5	6	6	28
Unexplained amount	16	27	(11)	57	5	92
Reserve hike	22	-	24	22	22	90
Adjusted reserve growth	83	57	59	97	62	359
Unexplained amount	38	27	12	79	27	182
Transfer to CIC	-	-	75	-	-	75
Adjusted reserve growth	83	57	134	97	66	434
Unexplained amount	38	27	87	79	27	257

 

To explain the chart, the trade surplus and FDI numbers for May were reported as $20.2 billion and $7.8 billion respectively.  Interest income is broadly the same as last month and I think currency gains in May were quite low (I will check with my friend Logan Wright, who tracks this better than I do).  There was another 50 bps hike in minimum reserve requirements for banks, and probably about $22 billion of that was redenominated into dollars, thereby pulling headline reserve growth down, although the monetary impact is nil.

 

Add and subtract the relevant numbers and we are left with about $27 billion of unexplained inflows into China for the month of May.  This is not necessarily all hot money, but it is a good proxy for hot money, and anyway it is a pretty safe bet that a significant part of FDI and the trade surplus really consists of disguised hot money. 

 

Over the year, the unexplained part of total adjusted inflows, including the redenomination of reserves and the transfer to the CIC, may amount to as much as a whopping $257 billion, which is only slightly less than the headline growth in reserves.

 

Surprisingly enough, or perhaps not so surprising given the amount of pain many banks are reported to be feeling, according to today’s Bloomberg a recent survey of Chinese banks by the PBoC suggests that Chinese banks believe monetary policy is too tight: