My Blog

SUN 29 JUN

Some anecdotal evidence of risks in the banking system By Michael Pettis

Before I talk about the banking system I just want to mention a quick story.  After the 18% hike in fuel prices last week I wondered how taxi cabs in the major cities would fare – obviously fuel is a major component of their running costs.  My understanding was that they had not been permitted to raise their prices in consequence of the price hike, and in Beijing I notice that I have been paying exactly the same prices for cab rides as I had before the price hike.

 

Yesterday Shouwang, one of my favorite local musicians (read about him in tomorrow’s New Yorker), had to pick me up in a taxi.  As I got in he apologized for the fact that the air conditioning was not on.  He had asked the cabbie to turn it on but was told that because of the fuel price hike the cabbie could not afford to do so.  That suddenly reminded me that in the previous week none of my cabs were air-conditioned, where typically half of them had been in the past.  It seems that from now on (at least until they allow taxi fares to rise) cabbies and their passengers are going to have to deal with the hot Chinese summers without the help of air-conditioning – yet another way to disguise inflation, I guess.

 

But back to banks.  Yesterday I had an interesting lunch with a Chinese investor.  We were discussing the informal banking sector in China, and he agreed that it seems to have grown a great deal in the recent past.  Interestingly enough, according to him, loans to real estate developers had become a particularly important source of growth for these banks, which is perhaps not surprising given lending caps and attempts by the PBoC to discourage the commercial banks from taking on more real estate exposure.

 

He told me that he believed that the highest quality real estate developers were able to obtain one-year funding for around 15% which, given CPI inflation of around 8% (probably understated by 1-2%) and PPI inflation of around 9%, represents, I think, a reasonable borrowing cost for a prime creditor in a developing economy.  Lower-tiered real estate developers, however, were paying 80% for one-year money, which is consistent with some of the other numbers I have heard.  Very few of the real estate developers would be considered prime enough to get the lower cost funding.

 

Needless to say 80% is a pretty high cost of funding, and almost certainly requires rising real estate prices in order to be economically viable.  In case of an economic contraction or declining real estate prices, I would assume that a lot of these real estate developers would face severe debt-servicing difficulties.  We discussed what would happen in the case of a default – besides the proverbial visit by the man with a baseball bat he suggested, with a completely straight face, it was also likely that one of your kids might be kidnapped.

 

This kind of collection process strikes me as a reasonably strong argument for lower default rates in the Chinese informal banking sector than in the formal sector, at least in the initial stages of a contraction, although it also suggests that the Chinese banking habit of deferring losses might not work here.  On the contrary, I expect that payment difficulties would lead to significant selling pressures as real estate developers try to raise cash as quickly as possible to meet their obligations (and get their kid back).  I guess that in areas characterized by large informal banking sectors, real estate price corrections are likely to occur much more rapidly than in places like Beijing, where I think the informal banking sector is relatively much weaker.

 

The other systemic implication I drew from this conversation was his claim that the informal banking sector gets at least part of its funding from the formal banking sector – in cities where the informal banking sector is large, the largest informal banks often have strong connections with senior bankers and senior local politicians.  This means that payment difficulties for informal bank customers, if they lead to payment difficulties for the informal banks, can spread directly into the banking system, as well as indirectly, if informal banks force liquidation of assets and so put downward pricing pressure on real estate in a time of generally declining real estate prices.  Unfortunately no one I speak to can estimate the size of these relationships.

 

On a separate but related matter, earlier this week I received an email from one of my former students, now working for a large international bank.  He told me that his credit people were getting worried about possible difficulties on some derivative-related transactions involving Chinese banks and their corporate customers.

 

According to him, a very popular recent lending structure involved lowering borrowing costs for corporate borrowers by having the borrower implicitly sell a complex derivative (this is a common, and often dangerous, way of lowering borrowing costs).  Let me explain this as schematically as I can.

 

A corporation borrows some notional amount from a bank, for five years, and agrees to pay 8% on the loan.  The corporation and the bank simultaneously enter into a swap, for the same notional amount, in which the bank agrees to pay the corporation 1% annually, as long as the euro interest rate curve is “normal”.  Should the curve invert, however, the corporation must pay the bank some amount, typically 4 bps per day according to my source.

 

The net result is that the corporation is able to borrow money at 7% instead of 8%, and in exchange it agrees to pay a significant penalty if the euro curve inverts – something that is extremely unlikely to occur, the CFO is probably told.  From the bank’s point of view, they are still getting 8% funding, because they simply strip the option and sell it on to the foreign banks, who have the capability and expertise to monetize the option.

 

It sounds great on the face of it.  As long as the euro curve does not invert, and I am sure the corporate borrower is given reams of data showing how rare that occurrence is, everybody is happy.  The corporation borrows at 7%.  The local bank lends at 8%, and makes additional fee income by implicitly buying the option from the corporation at a lower price than it sells to the foreign bank.  And the foreign bank gets to sell a fairly complex derivative whose pricing formula is opaque (in investment banking jargon, “opaque” means “I can get away with charging a lot”).

 

Unfortunately, from what I have been told, the euro curve has inverted, and has been inverted for over a month.  Furthermore, it is deeply enough inverted that there is little expectation that it will normalize soon.  Corporations have suddenly seen their borrowing cost mushroom.  The transaction that had previously reduced borrowing costs by 1% a year was now increasing borrowing costs by 10% a year on an annualized basis.

 

Many of these borrowers, apparently, are now refusing to honor the agreement.  Unfortunately for the local banks, however, because they entered into mirror agreements with their foreign bank counterparts, they must pay anyway, except that the expected income from the corporations, which would have hedged their position, is no longer available.  I guess that it is either embarrassing or politically difficult for the local banks to force their customers to honor the agreement.  

 

I have been told that all the major Chinese banks have received impatient margin calls from their foreign counterparts, and that there may even be court action. My source tells me there is about RMB 170 billion outstanding of these swaps.  That implies additional payments due of about $300 million per month.

 

The biggest problem with these transactions, of course, is not whether the banks are going to be paid for these specific losses, but rather that they occurred in the first place.  I cannot think of any way in which the euro yield inversion play might have been considered a hedge for Chinese corporations, and so I can only assume that the swap was a purely speculative bet on a completely unrelated market in which the bet was concealed via a lowered interest rate.  Anyone who remembers the derivatives-based debacles of the early 1990s, when interest rate markets suddenly did what everyone knew they could not possibly do, and so unleashed an explosion of losses on some truly insane derivative positions, can see where this kind of thing might lead.

 

I have no idea of how widespread these types of transactions are, but common sense and a little experience suggests that recent conditions have been ripe for an orgy of fairly dodgy derivative transactions sold to greedy customers, who salivate at anything that might lower their financing cost, but who lack the ability and stomach to address the risks.  Of course when everything falls apart, their first recourse will be to innocence – how could they possibly have know that all this free money came with strings attached? – and the banks, preferably the foreign banks, will take the blame.

 

But no matter who gets blamed, the losses will be real.  I cannot confirm that this story is true, but I did discuss this transaction with several knowledgeable friends and former students.  They all either had heard of these and similar transactions or told me that the story was completely plausible.  Unless the regulators are fully aware of the extent of these and similar exposures, there is a real risk that at exactly the wrong time for the banking system and the economy we will discover all sorts of additional and poorly-understood risks hidden away in banks’ balance sheets. 

 

WED 2 JUL

Hot money and informal banking By Michael Pettis

Sorry.  My blog site was down so this Wednesday entry was posted Thursday, one day late.

 

I was too busy to post anything Tuesday, but there wasn’t a whole lot new to say except to bemoan the stock market’s performance, again.  The SSE Composite dropped 3.1%.  Today after a rocky start it seemed to find its legs, trading up 1.8% by lunch, before giving it all up to end the day almost perfectly flat at 2701.  It is now trading almost exactly 10% below 3000, which as recently as three weeks ago was the market’s imagined government-intervention level.

 

The property market doesn’t seem to be doing a whole lot better, at least in Shanghai.  Two articles in today’s South China Morning Post warn that Shanghai’s property sales are down.  According to one, “The sale of new flats in Shanghai measured by floor area, plunged almost 50 per cent in the first half, and sources said the market was unlikely to turn around until September, traditionally the peak season for property sales.”  Shanghai residential prices have been under pressure for a while as a consequence.  The second article suggests that commercial property is also seeing selling pressure, although increased selling interest is not necessarily causing prices to drop:

 

The queue of investors seeking to sell their Shanghai properties is getting longer, leaving analysts divided over the impact of a fresh wave of disposals on the market…

 

"All these asset disposal plans will add uncertainty to the outlook for the investment market," said Clement Leung Wai-ming, an executive director for China valuation at property consultant Knight Frank.  But with Shanghai residential prices holding firm despite a sharp fall in deal volumes last month and evidence that new investors are ready to step into the market, others have a more optimistic view.

 

I think the fact that there is so much hot money flooding into the country has made the clearing mechanism complex.  Fleeing sellers are matched with buyers flush with cash, and the market, while trending down, hasn’t really gone down as much as it might.  Needless to say, this is very worrisome (but you knew I’d say that, didn’t you?).  Property exposure is extremely high within the Chinese banking sector, and if what is propping up real estate prices, however tenuously, is hot money inflows, then we have yet another nasty little volatility machines embedded in the banks’ balance sheets. 

 

Why?  Because hot money, as is sometimes forgotten, is almost by definition highly pro-cyclical, and is likely to flee exactly when conditions are bad and it is needed most – just as the banks are struggling to deal with the consequences of a future financial or economic contraction, in other words, the legs are likely to be kicked out from under the real estate market.  China has too many of these busy little pro-cyclicality machines embedded in its balance sheet, which means that good conditions as well as bad conditions are likely to be exacerbated by the dynamics of the balance sheet.  Perhaps that is one of the major reasons why China has seemed like the rest of the world hopped up on super steroids.

 

By the way it is becoming increasingly clear that a lot of real estate developers – frozen out of the banking system – are turning to the informal banks for short-term and expensive funding.  For a long time I have been discussing and wondering about the role of the informal banks in all of this, and I said several times that I was willing to bet that the informal banking sector in China was growing rapidly, if only there where a way to measure it.  I am glad to say that over the past few weeks this has suddenly become a very hot topic, so it is getting a little easier to get a sense of its impact.  I was particularly interested by an article in today’s China Daily (“Irregular financing channels rampant”).  According to the article:

 

Many small and medium-sized enterprises now mainly rely on “underground” funding to finance their businesses as credit tightening measures have dried up bank loans.  Policymakers have been tightening the purse strings to fight inflation since last year. The benchmark interest rate has been raised six times, to 7.47 percent, and the reserve requirement ratio for banks raised 15 times since last year.  These measures have made it all the more difficult for SMEs to get bank loans, a vacuum promptly filled up by underground financing channels, said industry observers.

 

The article goes on to quote one of these informal bankers:

 

“A lot of small firms come to us. Only the bigger enterprises go to the banks,” said an underground lender, who declined to be named. He has lent out 10 million yuan - he declined to say how he made that kind of money - at 30 percent annual interest rate.  “Interest is not an issue. They will go bankrupt if they don't get our short-term loans,” he said. “Our money is available at short notice. We can deliver the cash within 24 hours, while a bank loan might take at least six months. But I am only small fry, there are bigger fishes out there with more than 100 million yuan parked in underground financing.”

 

The article also refers to a survey conducted by Beijing's Central University of Finance & Economics, which found that underground lending totaled 1.98 trillion yuan in 2007, equal to 28% of the amount banks lent.  This is a pretty large amount, and there is a lot of circumstantial evidence that the informal banking sector has gotten significantly larger, especially as hot money inflows seem to have grown very rapidly in the past few months at the same time that lending caps and hikes in the minimum reserve requirements have sharply curtailed loan growth in the formal banking sector.

 

The size and growth of the informal banking sector is not just of academic interest.  It has at least three implications for those of us worried about monetary conditions in China.  First, it makes the management of domestic monetary policy, to the extent that such a thing exists, much more difficult because the PBoC has no direct control over the informal banks.  If, for example, a lending cap on the commercial banks simply pushes loan origination off the commercial bank balance sheets and onto the informal banking sector, the lending cap can’t and won’t have much of an effect on domestic money or credit growth.  In addition, because the rate informal banks charge on loans is also beyond the reach of the regulator, the PBoC’s management of interest rates is also partially constrained (although on balance, given negative real rates and the consequent misallocation of capital, this is probably a good thing).

 

Second, it raises important questions about the structure of Chinese corporate balance sheets.  We don’t know for sure, but there are very good reasons to believe that loans extended by the informal banking sector are of much shorter maturity and of much higher rates than is typical for the commercial banks.  If this is true, and it almost certainly is, corporate balance sheets are much more vulnerable to an economic downturn or a sudden liquidity contraction than we might otherwise think (yet another dynamic little volatility machine embedded in China’s balance sheets).

 

Third, the rise of informal banks partially answers the question about where, if China is indeed being flooded by hot money, as I have been arguing since early last year, is all this money going?  Part of it is going into the informal banks.  Add the role of informal banks to the mix of rising bank deposits, the hoarding of commodities, real estate investment in secondary cities, and so on, and it is not so difficult to see where the money goes.

 

At the end of the China Daily article, the piece confirmed in a rather macabre way what my lunch companion last Saturday told me.  As I wrote on my Sunday blog entry:

 

We discussed what would happen in the case of a default – besides the proverbial visit by the man with a baseball bat he suggested, with a completely straight face, it was also likely that one of your kids might be kidnapped.

 

According to the China Daily article:

 

“Many a time, the borrowers cannot pay back,” the private lender said. “What can you do in such cases? You just have to resign yourself to your fate.”  But not all lenders give up that easily. Some can go to the extent of hiring gangs to kidnap the borrowers or their family members to recover the loan, he added.

 

We definitely need to think more about the informal banking sector in trying to get our arms around China’s financial risk profile. 

 

Besides informal banking, the other “hot” topic about which a few of us have been pounding the table for months is, of course, hot money inflows.  I think increasingly people in China – and not just at the PBoC – are waking up to the sheer magnitude of the problem.  Today’s Xinhua has an article titled “Unprecedented capital inflows test Chinese regulators.”  According to the article:

 

China has taken a series of increasingly aggressive measures in the past several months to blunt the impact of so-called "hot money," amid the explosive growth of its foreign exchange reserves, which have soared beyond what can be explained by trade and investment flows.  The inflows have been so massive as to raise alarms over the country's financial security.

 

The article is worth reading because it gives a sense that either there is rising concern in official circles about the impact of hot money in China or, alternatively, someone, probably in the PBoC, wants to raise such concern.  I am working on a piece, which I hope to complete soon, discussing the implications of the increasing role of hot money in China’s burgeoning reserve accumulation.  One interesting data point:  In the first quarters of 2005 and 2006, the combination of FDI and the trade surplus accounted for 60-70% of reserve accumulation.  By 2007, it accounted for only 46% of reserve accumulation.  This year, it accounted for 45% of headline reserve accumulation, but if you adjust for the “outsourced” portion of reserve accumulation (transfers to the CIC and minimum reserve redenomination), it amounted to barely 20%. 

 

This is a dramatic shift.  I know I have been pounding this drum over and over again quite a bit recently, but I am absolutely convinced that it is just a question of time that this, too, becomes a hot topic.  My prediction: worries about the shifting composition of China’s reserve accumulation will soon be one of the big stories in the financial pages.

 

As an total aside, after complaining last week that since the fuel price hike it has been almost impossible for me to find a taxi with air-conditioning here in hot, sticky Beijing, three of the four taxis I rode today were air-conditioned.  This is not a very scientific indicator, but given that taxi fares haven’t risen to match the increase in fuel costs, and their incomes must be wilting, I wonder if taxi drivers have at least come to some sort of agreement with the government.  Yesterday I had lunch with my friend Pierre Mongrué, with the Economic Department of the French Embassy, and he thinks that there may be an agreement to subsidize or otherwise accommodate taxi drivers.  If there is, the process of managing the very complex relationships of subsidies related to fuel price caps must be a nightmare, not to mention highly distortionary.

 

THU 3 JUL

The PBoC battles hot money By Michael Pettis

Sorry for posting two longish entries on the same day, but I wasn't able to post yesterday's entry until this morning, and both days have had some important events worth writing about.

 

Last night SAFE came out with an announcement that I think many of us were openly expecting and secretly dreading.  According to today’s Xinhua (“China toughens forex receipts and export settlements”),

 

Stepping up the battle against "hot money" flowing into and out of China, three Chinese central governmental departments are to link their internal electronic systems from July 14 in a trial check of foreign exchange receipts and exports settlements, the State Administration of Foreign Exchange (SAFE) said Thursday.  These measures were interpreted by analysts as one of the latest efforts by the Chinese government to monitor capital flows and prevent more so-called "hot money" from flooding in and out of the country.

 

Exporters will now be required to place revenues in special accounts while the authorities verify that the funds were the result of genuine trade transactions.  We now begin an extended curriculum on the difficulty of eliminating hot money inflows through administrative measures.  I am reasonably confident that this new move will slow hot money inflow through the trade account in the short term while in the medium term it will have little impact (although it is worth noting parenthetically that most of our estimates for hot money don’t take these into account anyway, and if the measure only succeeds in driving hot money inflows out of the trade channel and into other channels, its main impact will have been a welcome but unintended increase transparency).  It will also create significant frictional costs for the trading sector and so dampen real trade transactions.  Finally, the new administrative measures may ultimately be used as a tool to manage trade, i.e. minimize imports, and so add to international trade tensions.

 

I won’t say too much about this directly because I think the press is covering it quite well (see for example Geoff Dyer’s “China in clampdown on ‘hot’ money” in today’s Financial Times), but I will say that it does suggest that there isn’t an awful lot the authorities can really do about inflows.  It is also not going to make a big difference.  Bloomberg today gives one expert’s reasoning, citing Li Youhuan, a researcher at the Chinese Academy of Social Sciences:

 

“Speculative money can always find loopholes,'' said Li, who undertook an investigation last year into how hot money was entering China. “Inflows through service deals are even faster and simpler than via the exchange of goods. How can the regulators judge whether the prices paid for corporate identity designs, for example, are fair or not?”

 

As Stone & McCarthy Logan Wright pointed out in a note today:

 

Overall, this is likely to be the first of several attempts by financial regulators to monitor speculative capital inflows; more supervision of foreign companies' bank accounts and registered capital may appear in the coming weeks or months. However, independently, the new SAFE restrictions on exporters are unlikely to have a significant effect on hot money flowing in through the trade account, and are likely to create cashflow difficulties for exporters already suffering from declining sales volumes and higher input costs. The measures suggest that the central government is much more likely to turn to administrative measures to target capital inflows rather than accelerating the pace of yuan appreciation (or pursuing a one-off revaluation), because controlling capital flows reflects the path of least political resistance. However, as long as market expectations for further yuan appreciation exist, speculative capital flows are likely to continue, despite the Chinese government's attempts to tighten controls.

 

On a related note, two days ago Morgan Stanley published a widely-read piece by Qing Wang on hot money flows (“China: Counting Hot Money”) in which the author cautions about attributing too much of the reserve accumulation net of the trade surplus and FDI to hot money, which he refers to as the “residual” method.  In particular he points out that there are several other types of transactions that can affect the net number which have not been taken into account by most analysts estimating hot money inflows. 

 

First, this indicator treats some items under the current account such as remittances and income, for which high-frequency data are not available, as part of hot money flows. This tends to overstate the amount of hot money flows.  Second, this indicator is a net flow concept and fails to take into account capital outflows/inflows originating from China-based financial institutions, which are at times heavily influenced by domestic policy changes.  Third, changes in US dollar-denominated FX reserves could simply reflect changes in the cross rates between the US dollar and other major reserve currencies (e.g., euro, yen); however, this indicator attributes these valuation effects to changes in ‘hot money’ flows.

 

Some of his comments are fairly obvious – and most credible estimates of hot money do take them into account, but he does point out two things that are worth repeating.  First, the net numbers do not take into account capital outflow transactions, most of which officially directed:

 

Capital outflows originating in China are mostly carried out by domestic financial institutions and closely reflect government policy, in our view.  For instance, we think that the large amount of purchases of MLT debt securities that originated in China in 2006 reflected the special FX swap arrangements between the PBoC and several large domestic banks in 2006, under which the banks were asked to park their funds (some of which were raised from the mega bank IPOs in Hong Kong) offshore.

 

Wang concludes that the “residual” method of calculating hot money underestimated hot money inflows in earlier years and over estimates them currently, which, if true, suggests not that hot money inflows are not substantial but rather than they have been less volatile than previously estimated.  This is a point well worth making.

 

In fact much of what Wang says is reasonable, but I have some disagreements with his conclusions.  He says:

 

A key reason for ‘hot money’ becoming a popular issue among market participants is the concern about the potential negative impact on the economy if ‘hot money’ inflows were to turn suddenly into outflows.  The common fear is that in the event of ‘hot money’ outflows, the renminbi exchange rate would come under considerable depreciation pressure and there could be serious domestic liquidity shortages that may potentially destabilize the domestic banking system.

 

While these concerns are not entirely unwarranted, they are overdone, in our view.  First, despite the considerable uncertainty in the current market environment, the underlying fundamentals of the Chinese economy remain very robust, and we do not envisage circumstances that could bring about a major downgrade of investors’ medium-term outlook for the economy and thus reverse the direction of capital flows.

 

Second, we estimate that the potential amount of the ‘hot money’ stock is likely to be US$200-300 billion.  Even if all these funds were to leave China, this would be unlikely to generate much depreciation pressure on the renminbi exchange rate.  With US$1.8 trillion in FX reserves outstanding and rising, China should be able easily to defend the renminbi exchange rate in the event of potential outflows of a magnitude of about 15% of the total FX reserve stock.

 

Third, the potential negative impact of ‘hot money’ outflows on domestic liquidity can be easily mitigated as well, in our view.  With China’s current ratio for required reserves (RRR) at 17.5%, one of the highest levels in the world, the potential liquidity impact as a result of US$200-300 billion ‘hot money’ outflows could be effectively offset by the PBoC lowering the RRR.  We estimate that the liquidity impact of US$200-300 billion in outflows could be offset by a reduction in the RRR of about 500bp from 17.5% currently to 12.5%.  Even at 12.5%, the RRR level is still very high by international standards.

 

His first point is correct as it stands, but Latin American and other developing country experience suggests it is irrelevant.  Of course the underlying fundamentals in China seem robust.  This is almost a precondition for hot money inflows.  But in previous cases, whether we are discussing hot money inflows into Argentina in the late 1990s, or into Thailand, Malaysia, Indonesia and Korea in the three or four years before the 1997 crisis, or in Mexico in 1992-93, it was robust-seeming conditions in every case that precipitated the inflows.

 

These inflows themselves created the conditions for the subsequent outflows – most importantly over-extended balance sheets and unstable financial systems.  In the case of China the danger is not that hot money is pouring into a country that is clearly on the edge of disaster – it never does.  The real danger is that if conditions turn, whether because of domestic or international shocks, the inflows can reverse and exacerbate the impact of the shock.

 

My problem with the second point is that I think he dismisses, and very effectively, the wrong concern.  I don’t think the worry people like Logan Wright, Brad Setser and me have is simply that capital outflows could force a depreciation of the RMB one day (in my case I don’t even think it is likely).  The worry is that capital outflows could drive domestic liquidity from the financial system and expose very vulnerable balance sheets.  The idea that a financial crisis is by definition a currency crisis may be deeply established, but it is wrong.  Most financial crises historically have been domestic financial crises, and as I have said perhaps too many times, the next set of crises will more likely be domestic banking crises than external debt crises (with Argentina being, as it always has been, the honorable exception).

 

This also suggests what it wrong with his third point.  It is true that rising minimum reserve requirements constrains lending growth, but it is not equally true that lowering them forces lending growth.  Minimum reserve requirements are a constraint on, not a determinant of, lending volume.  If we experience the conditions in which China would suddenly see massive capital outflows, it is a pretty safe bet that banks would be more concerned about preserving liquidity than about lending as fast as they were legally permitted.  This does not even consider the impact of illiquidity on the informal banking sector, which according to one estimate (see yesterday’s entry) may comprise not too much less than one-third of total banking assets.

 

One final point, the biggest concern about hot money is not whether or not it is hot money by definition.  The biggest concern, for me at any rate, is its sheer size and its pro-cyclicality.  It doesn’t matter too much whether a specific inflow is illegal or otherwise constitutes someone’s definition of hot money.  What matters is whether it forces the PBoC to expand the money supply, and whether it is likely to increase or decrease underlying economic and financial volatility.  I would argue that most of the recent increases in headline reserves do both.

 

Certainly last night’s announcement by SAFE indicates that the PBoC is also very worried.

 

FRI 4 JUL

Hot weather, cold market By Michael Pettis

For the past few weeks Beijing weather has been either hot and drizzly or, even worse, ferociously hot.  Today we got a little bit of variation by interspersing ferociously-hot with the occasional tropical downpour.  I really hope things get better before the Olympics or else soon enough we are going to have a lot of very bad-tempered out-of-towners running around the city monopolizing all the taxis.

 

At least the gloomy weather more or less matches the mood of the stock market.  The market was up 2.0% yesterday and down 1.2% today to finish the week just over 2.3% down, at 2670.  Banks are surprising on the upside with better-than-expected profits, but higher oil prices drove most of the rest of the market down.

 

Meanwhile the RMB dropped 0.116% today to 6.859.  The PBoC, as even little children are now widely aware, is trying to curb speculative inflows by adding dollops of “uncertainty” to the RMB’s upward trajectory.  Unfortunately, the fact that everyone knows what the PBoC is doing and why they are doing it isn’t likely to make this measure particularly effective.

 

We will probably see the currency fairly flat over the next couple of weeks before it shoots up again.  Even the daily newspapers are saying this.  I have had this discussion many times on this blog, so I don’t want to reignite it, but I am afraid that the net effect of all this “uncertainty” is likely to be nothing more than that people who were very eager to bring money into China as quickly as possible may be, if they really believe that the trajectory is slowing down for a week or two, in a little less of a hurry.  Some of the June inflows, in other words, will show up only as July inflows.  This isn’t going to make much of a difference.  I think the last time they did this was in April, during which month reserve accumulation, at $75 billion, hit at an all-time world record.

 

One final thing, I was discussing with my students over coffee the effect of the new export-management controls on inflows announced Wednesday night (and discussed in Thursday’s entry).  We agreed that if these measures are at all effective in seeking out hidden hot money inflows, the monitoring period would probably add a few weeks to the time between when foreigners pay for an exported good and when the cash is actually disbursed to the Chinese exporter.  One of my students, whose uncle is a Southern-province-based exporter, told me that he believed (he wasn’t sure) that typically exporters would need to find financing for this period, and since most of them are excluded from commercial bank financing, they would need to take short-term loans from the informal banking sector.  This sounds pretty plausible.

 

I have heard that short-term loans are going for 5% a month, and my friend Victor Shih tells me that he has seen even higher rates for “prime” borrowers.  That means that if we assume that disbursals are two weeks later than payments for export shipments, the cost of production, including financing, for many Chinese exporters will go up by a minimum of 2-3%.  Given razor-thin margins in many of the export sectors, I wonder how exporters are going to deal with this.

 

My guess is that after a few weeks of this we are going to see a lot of pressure by exporters to roll back the measures announced Wednesday, or else many of the provinces, especially Guangdong and nearby provinces, will quietly let the monitoring process slip.

 

FRI 4 JUL

Internal debate intensifies By Michael Pettis

Just a very quick post today, largely consisting of two news articles.  The first comes from Xinhua. 

 

Yesterday, according to the article, Li Yining, a leading economist and member of the all-important Standing Committee, told the Second Meeting of the Standing Committee of the 11th NCCPPC, the country's political advisory body, that:

 

China is facing a pressing challenge of preventing inflation turning into stagflation.  He said stagflation, the co-existence of high unemployment and high inflation, might occur if improper measures were taken to fight inflation so as to disrupt market expectations, or the economy failed to survive the global slowdown…

 

The economist said China should continue to take a firm grip on the country's foreign exchange flows, and be alert to problems that might occur in the context of a global slowdown given the huge forex reserves.

 

He said the government should not over-reach itself in fighting inflation or be misled by the concept that only a low inflation rate would be a complete success in the anti-inflation campaign.  "The inflation rate, if controlled at about 60 percent of the growth rate, would be appropriate, such as keeping the rate at around six percent for a 10-percent growth in economy," he said.

 

I don’t have an awful lot to say about his comments except that his warning of stagflation risks is even more interesting to me because of the play it got in the Chinese press (The very large headline is “Economist warns of stagflation risks to China”).

 

The second article, first pointed out to me by blog reader Jonathan Lerner, appear in various forms in a wide number of papers.  The best account I think was Denise Tang’s “State academics push temporary yuan free float” in the South China Morning Post.  She says:

 

China should temporarily let its currency float freely to control runaway inflation and speculative capital inflows, said two government-backed academics, rekindling the debate on the politically sensitive issue.  He Fan and Zhang Yue of the Chinese Academy of Social Sciences see the temporary free exchange of the yuan as a quick and cost-effective way to thwart speculation, especially as inflation rises and the room to tighten monetary policy shrinks, according to their commentary in China Securities Journal yesterday.

 

The government think-tank academics painted a gloomy picture for inflation in consumer and producer prices, and they warned of a cash crunch at companies as well as a possible jump in banks' non-performing loans as side-effects of existing currency measures.

 

As Jonathan points out in his email to me, major policy changes, especially on economic and financial issues, are almost always preceded by non-official or quasi-official commentary and debate in the official press.  That doesn’t mean, of course, that they are about to float the RMB, but it does mean that there is some discussion and debate going on in policy circles about what is, after all, a pretty sensitive topic.  I would assume that academic researchers with CASS are unlikely to propose something that seems so radical without some sense that there are people in the government willing to listen.

 

I don’t want to read too much into this, but if we see more articles along this line it would be significant.  By the way, one way of interpreting the debate about a free float is in the context of the debate over a one-off currency revaluation.  The more extreme idea of a free float may make it easier to reach a compromise position on the amount of revaluation necessary.