China’s stock markets keep bouncing around, sometimes in synch with the rest of the world and sometimes out of synch. Yesterday it was out of synch as it lost 2.9%, largely because a number of corporations announced lower-than-expected earnings growth. A useful chart I filched from yesterday’s Wall Street Journal Asia shows the slow-down:

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Today Chinese stock markets seemed to rejoin the global pack with the SSE Composite rising 2.6% to close at 1765. Last night’s interest rate cuts by both the Fed and the PBoC spurred some limited optimism and especially drove up financial stocks. The 3-year deposit rate was cut by 36 bps (greater than the traditional 27 bps), the 5-year deposit rate was cut by 45 bps (ditto) and the 1-year to 5-year lending rates were cut by 27 bps.

I say optimism is limited because trading today was sluggish and volume very low. We have now closed four days in a row below the supposedly solid support level of 1800, below which (once again) the market could not go. In belated recognition that 1800 was not as rock-solid as they had once thought, the government seems to be backing away from the introduction of short selling and margin trading – a policy it announced a few weeks ago to my great surprise. According to an article in yesterday’s South China Morning Post:

The central government is set to delay the launch of margin lending and short selling amid mounting worries the potentially risky trading methods will exacerbate market turbulence. Sources said the State Council had put on hold plans for the much-anticipated launch next month because of fears the introduction of the practices could send the market into another tailspin.

It is another remarkable about-face for mainland financial regulators, who delayed the introduction of index futures last year after getting cold feet about the impact on the market.

It may be embarrassing for them to have retreated so dramatically, but it is better to be embarrassed than wrong. Hopefully their retreat won’t have added to market fears.

What is more likely to inspire fear is information recorded in an interesting article by Geoff Dyer in today’s Financial Times. One of the things that had surprised me recently was the continued strong domestic demand in September. I had expected that as the buying spree associated with the Olympics wore off, we would see a sharp drop in the growth rate of domestic consumption. So far that hasn’t seemed to happen except in certain big-ticket items, like cars and apartments.

In fact in September retail sales – the best available but not always satisfactory proxy for household consumption – grew at a record pace in nominal terms, around 23% year on year, and with the decline in CPI inflation this translates into even higher relative real terms. But the things that we can measure didn’t hold up as well as that might imply.

Car sales, for example, in September were down around 4% (I am quoting from memory, so the number may be wrong), which is the first time this has happened in many years, and I am hearing that October isn’t going to be much better. Fewer people flew on domestic airlines last month than they did in September of last year. And not only are real estate prices dropping quite quickly, but volume seems to have collapsed.

Yet the September numbers show healthy retail sales growth. Perhaps weakening demand will show up in October numbers. According to Dyer’s article:

Signs are growing that China’s economy could be cooling quicker than expected, with a string of big industrial companies announcing production cuts over the past week. The cuts have come as anecdotal evidence from other companies suggests a surprising weakening of demand in October amid the global financial crisis and a local housing market slowdown.

…”Orders for cars and home appliances have already begun to shrink,” Xu Lejiang, chairman of Baosteel, China’s biggest steelmaker, said last week. Zhou Xizeng, analyst with Citic Securities, said steelmakers were trying to adjust rapidly to uncertainty about demand and an inventory build-up. “The recent drop in production is a sort of psychological panic,” he said.

Executives in a number of other industries also said demand had been unusually weak in recent weeks. But some executives said the slowdown could also reflect shorter-term factors such as customers reducing their inventories because of global uncertainties. “We had been expecting this to pick up a bit after the end of Olympics restrictions on factories, but things have been very quiet,” said the chief executive of the China operations of a large paints company. “We are trying to work out how much is due to weak demand and how much to destocking.”

As I have said many times on this blog, rising inventory is going to be a key indicator of trouble ahead. So far we can find trouble in specific areas, but inventory levels on the whole seem fairly stable. Obviously this will change if we see a real slowdown in demand, but so far the numbers are not disquieting.

On that note a group of about a dozen crack Peking University finance students, mostly graduate students, have recently formed the Guanghua Students Monetary Committee to act as a sort of shadow PBoC, and Logan Wright and I are their advisors. They will meet every Saturday to analyze economic and financial market conditions and the PBoC balance sheet, and to discuss PBoC policy, and one of the things they plan to compile and report on is inventory levels among Chinese corporations. They’ll have their own website up and running soon enough, and I’ll publish the address when that happens, but I expect to be able to use some of their findings in this site.

Finally, before closing I want to flag, for those who are interested, another excellent report from Standard Chartered’s Stephen Green. This one, called “China – How much bang for the fiscal buck” was published on October 27 and starts out:

How much growth can we expect the Ministry of Finance (MoF) to provide over the next few years? With China’s economy slowing, many folk are already breathlessly awaiting a fiscal rescue. In recent notes we have looked at how other governments stimulate their economies, how China organised its stimulus package 10 years ago, and how this coming package might be funded. Today, we think through what such stimulus might mean for GDP growth and the overall economy.

Green attempts to estimate the parameters of fiscal expansion and the amount by which it might boost next year’s GDP growth, and his calculations will surprise many. He figures that an expanded fiscal package might only add 0.5-1.0% more growth in 2009 than it did in 2008. Fiscal expenditures, in other words, are unlikely to make up for any significant slowdown in the economy due to slowing exports, weakening domestic demand, or declining investment unless the expansion is much greater than most think it is likely to be.

I have no ability to forecast or estimate growth based on anything more sophisticated than my previous experiences working in countries that have gone through economic slowdowns with weak balance sheets, and the two tend to be self-reinforcing, so the smartest projections tend systematically to under-estimate growth in rising markets and over-estimate growth in declining. As I have said often enough, I expect to see analysts continuously revise their estimates downwards for the next few quarters, as they have already been doing. Already I am hearing a number of pessimists posit 7% as an upper limit. Yikes!

Tags: Fiscal package, Green, GSMC

The third down week in a row had the SSE Composite finishing with a 1.1% loss Thursday and a 1.9% loss Friday, to close at 1840.  Checking the historical data provided by Bloomberg indicates that we have to go back nearly two years, to November 2006, right around the beginning of the ferocious Chinese bull market, to find the SSE Composite closing lower.  The wild bull market started at roughly 1500 in July 2006 and reached a high of around 6100, if I remember correctly, just over a year ago.  Given the growth of China’s GDP during this time, and assuming that earnings growth is more or less in line with GDP growth, I would say that we are already more or less back to where we were at the beginning of the bull market.

 

Recent declines were led by financials.  Part of the reason for the weakness in financials is all the further noise coming out about more derivatives losses among Chinese companies, which seems to have awakened widespread worries about risk mismanagement.  Shanghai Securities News reported Friday that unspecified sources claimed that there were apparently more “huge” losses and that policy-makers suspect losses were being hidden by companies, although without specifying which companies.  Right on cue South China Morning Post reported that Nanjing-based China High Speed saw its share price plunge 30% Friday on news of a very large hedge it had taken on. 

 

As I understand it, the hedge works so that CHS makes money if its share price goes up and loses if it declines – but this sounds like nothing more than a complicated name for a long forward position to me.  The company explained that this derivative position was to hedge a convertible they had earlier issued. 

 

Now let’s see if I can figure this out, and sorry to my uninterested readers for my indulging in the financial geek side of me.  Selling a convertible is like selling a call option on your stock.  This is already a hedge, as I see it, because you benefit upfront (lower borrowing cost) and only “lose” (sell your stock below its current market value) if your underlying conditions improve – i.e. your cost of capital declines.  That is how I define a hedge – the hedge wins when your underlying position deteriorates, and loses when it improves, thus bringing stability to your position.

 

But CHS decided to “hedge” this hedge.  In principle it seems to me that if you want to hedge this position you would buy a call option that matches the terms of the call implied in the convertible you sold, or something whose delta is reasonably close to such a position.  But CHS decided to go one better.  They seem to have entered into what looks suspiciously like a pretty plain-vanilla forward – which of course implies a much higher delta – perhaps disguised with some fancy bells and whistles.  The problem is, as most finance geeks know, you don’t hedge a short call option with a nominally-equivalent long forward.  If you do, you end up with nothing but a short put position.  CHS, in other words, by selling a convertible and buying a forward have effectively sold both debt and a put option on their own shares.

 

This is most certainly not a hedge.  On the contrary, it is a doubling up of your own bet – you make money if things go well, but if things go badly you double your losses.  I am only guessing about all this because the information in the various newspaper accounts is not terribly complete, but if my sketch is anywhere close to the truth, it is not a surprise to me that the market sold CHS down 30%. 

 

The aim here is not to make a big deal of CHS’s exposure, but rather to point out that nearly every derivatives “hedge” I have seen recently has turned out to be little more than a speculative bet that had nothing to do with the company’s underlying business.  Six months ago I was talking about the losses associated with the euro-inversion option many Chinese companies purchased, and now a company has been implicitly selling put options on its own stock – these range from useless to actually negative as far as hedging strategies go. 

 

I am sure there is a lot more of this stuff hidden under various rugs.  In my experience, whenever we suddenly start seeing a spate of unexpected financial losses like this, it suggests that a lot of companies in one way or another were making the same liquidity bet – go long stuff that tends to outperform in a rising market flush with liquidity – and unfortunately these bets all tend to go wrong at the worst possible time.  They also indicate more serious underlying problems in the various corporate and banking portfolios. 

 

After all, if lots of managers thought this was a good bet to make with derivatives, why should we doubt that a lot of loan officers also liked similar implicit bets?  Remember that in 1989-91 when the Japanese banking system was crashing with bad loans, Japanese corporates were getting smacked by all the bad zaitechu losses.  This was not an isolated incidence of bad luck.  These almost always go together.

 

Of course the stock market drop was not just all about hidden liquidity bets.  Part of the weakness in financial stocks also comes from more expected cuts in mainland interest rates, especially on mortgages.  The government is in a frenzy to stop the decline in real estate prices.  They have encouraged officials at the provincial level to engage in a whole lot of measures to prop up property prices, and at a more macro level they are planning to cut mortgage rates and lower the minimum deposit required to buy first homes. 

 

Lowering the minimum deposit for house purchases, my astute readers will realize, is similar to the stock-market measures announced three weeks ago allowing companies to issue bonds to purchase shares, and allowing margin purchases of stock.  All of these involve trying to support prices by allowing riskier buying strategies – i.e. more leverage.  The rest of the world seems to think that the best solution to their problems is to deleverage, but here we are leveraging up buying power.  If the problem here turns out to be small and manageable, this strategy will look very smart.  If it is worse than we expected, thise strategy will force greater adjustment and more deleveraging.

 

Xinxin Li at the New-York-based Observatory Group released an interesting report yesterday on Beijing’s moves to boost the property market.  He lists and extends the following three:

 

¨          Housing transaction taxes and fees were cut at the margin.  The real estate contract tax was reduced by 0.5 percentage point to 1%. The stamp duty tax was cut from 0.05% to zero. 

 

¨          Starting October 27, the interest rate floor on mortgage loans will be reset to 70% of the benchmark lending rate from a level of 85%.  Given that the current benchmark lending rate is 7.47% for a 5?year term or beyond, mortgage interest rate will be cut by about 112bp. 

 

¨          In addition, the minimum down payment will be reset to 20% from 30% for the first residence.  The down payment ratio for a second residence was kept unchanged at 40%. 

 

He is not terribly optimistic that these moves will have much impact, writing that “despite these seemingly bold measures, however, we believe that they may have limited effects in stimulating demand and holding back the ongoing price corrections.”  The best the government can do, he thinks, is to slow down the housing price correction, not reverse it, and in my opinion this may actually cause more medium-term pain than a fast correction, although I suspect that we are going to see a two-tiered correction.  The formal banking system will correct Japanese style, without sudden liquidations and over a longer period, and with more wasted capacity, whereas the informal banking sector will correct much more quickly and involve liquidations.  I don’t really have any idea of how this resolves itself because I don’t have much historical knowledge of corrections in a system with such a heterodox banking system as China’s.

 

Let me allow Xinxin his own words as to why he isn’t terribly optimistic:

 

¨          Due to extremely loose monetary conditions in the past few years, excess liquidity and housing speculation have already created a significant real estate bubble.  Official figures show that prices have at least doubled since 2004, making property unaffordable for a large share of households in many big and secondary cities.  The housing price-to-income ratio in these cities remains above 10, while even at the peak level of the latest US housing bubble, the same ratio in many US cities was around 6-8.  Given the deteriorating external and domestic environment, this housing bubble may come to an end. 

 

¨          Now the market consensus is that average housing prices will drop by at least 20% before real demand picks up.  This 20% sounds dramatic, but a 20% drop would return prices to the level prevailing in late 2006 and early 2007.  In comparison to still-high housing prices, the marginal drop in transaction and mortgage payment costs still are quite limited steps.

 

¨          From the policymaker’s perspective, the most difficult challenge is how to deal with market expectations.  If potential buyers are expecting that both housing prices and interest rates will drop further, why don’t they hold back and delay home purchase plans for a few more quarters?

 

¨          Moreover, there is an oversupply problem in many regional housing markets.  It is reported that in the aggressive housing expansion, real estate developers have accumulated as-yet-incomplete housing projects of 1.1bn sq meters, equivalent to China’s housing supply in the past two years.  This means it may take a couple of years for the housing market to absorb the excess stock of land and housing projects. 

 

I won’t quote the rest of his research report but recommend that anyone interested talk directly to him about it.  Getting the property market right is going to be key to understanding what happens next in China’s economy and financial systems.

 

I want to mention three other things before closing.  First, the further restructuring of the Agricultural Bank of China prior to its IPO was announced last week.  Central Huijin (a sub of the CIC) will inject $19 billion in capital in the form of equity into the bank.  I believe these will be in the form of US dollars, and ABC will not be able to convert them into RMB. 

 

In addition the government is creating a fund that will be managed by ABC and the MoF which will pay about $120 billion to purchase all of ABC’s NPLs.  These represent about one-quarter of the bank’s total loans but, lest anyone think the bank will emerge from this clean as a whistle, there is a lot of disagreement about whether Chinese bank NPL classifications are strict enough.  Most analysts worry that there is a lot more garbage in there, under gentler classifications, and this will become especially evident in a downturn.

 

If the NPL purchase (at face) is funded in the same way as the other AMC purchases, it will be funded by the purchasing fund via a bond issue guaranteed by the MoF.  I am not sure what the recovery value of these loans is likely to be, but as I understand they consist mostly of a lot of very small loans to bankrupt farmers.  One friend who understands these things better than I do says he thinks they will be lucky to get 10 cents on the dollar, and may easily get less than 5 cents.  I think NPLs at the other AMCs, which are generally considered to be of much higher quality, collected an average of 22 cents on the dollar on those portions that were sold or liquidated, but much of that consisted still of the best of the NPLs in the portfolio.

 

I mention this because of course the uncollectible portion should be added to the government’s debt when we calculate the total obligations of the government.  On a related note, recent government data releases show that fiscal revenue growth slowed sharply in September as corporate taxes declined and tax benefit measures increased, so that in the past two months the fiscal balance has swung into deficit (RMB 19 billion in August and RMB73 billion in September).

 

The second thing I wanted to say before closing is that I haven’t mentioned in a long time that one of the few blogs that I read religiously is Brad Setser’s blog.  The October 21 entry (The End of Bretton Woods II) is a particularly good entry and of obvious interest to anyone interested in China’s position in the macro-economy.  I am thoroughly convinced that it is a waste of time trying to figure out what is going to happen to China without placing it in the context of the unraveling of the old global balance-of-payments relationships and the evolution towards a new one.  China was a fundamental part of global imbalance (indeed the US-China relationship was at the heart of it), and any meaningful change will require both countries to adjust their relative positions sharply.  Brad’s blog is required reading if you want to try to figure this out.

 

Finally, and more as a way of introducing a little humor, let me mention a statement by Thailand’s Deputy Prime Minister, Olarn Chaipravat, about the recently completed Asia-Europe Meeting (ASEM).  “The message of this initiative” he said earlier this week, “is for China to consider whether or not China would open up its banking system and allow the strongest currency in the world, which is the Chinese yuan, relative to anybody, to be the rightful and anointed convertible currency of the world.” 

 

It is perhaps a little too easy to take potshots at world leaders who discuss economic and monetary issues, but I found these comments to be particularly funny.  It was always unlikely that China would open up its banking system and allow the currency to become fully convertible in such treacherous times, when it has steadfastly refused to do so when both its own economy and financial system were in better shape and the global environment was a lot more benign.  Doing so now would almost certainly cause a domestic financial collapse.  More importantly, the RMB is only “the strongest currency in the world” if you consider it to be the most undervalued.  The RMB’s rise is a function largely of its having been undervalued for so long that it caused serious monetary headaches domestically. 

 

Not surprisingly, the final statement issued by the 7^th ASEM contained no such revolutionary new proposals.  I think the most striking thing about it – but hardly unexpected – is that China and Asia are apparently falling behind European proposals for greater regulation of the global financial system. 

 

This was an inevitable consequence of the crisis – every financial crisis in modern history (and pre-modern, I suppose) leads to the same calls for stricter policing of the banks and brokers, and a ferocious attack on the structures and securities that were at the heart of the crisis, but no real discussion of what links the most recent financial crisis to the hundreds of almost identical crises that have come before it.  Nothing changes.  It is as if this is the first time we have ever seen a financial crisis, and since this is also the first time we have seen the explosion in sup-prime loans, the surge of complex derivatives, and off-the-charts compensation for young traders, then it is pretty obvious that one caused the other.

 

Of course the most fun part of the aftermath of the crisis is the accompanying demand that the guilty, meaning anyone involved in the financial system, be punished.  On my flight back from Shanghai Wednesday I reread Charles MacKay’s “Extraordinary Popular Delusions…” and came upon this passage about events nearly 300 years ago:

 

The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England. He arrived on the 11th of November, and Parliament was summoned to meet on the 8th of December. In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South Sea Company. Nobody blamed the credulity and avarice of the people – the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.

 

Punishment was as important as repair, and new measures to ensure that such a calamity would never again happen were, everyone agreed, vital.  After the appropriate rogues were identified and punished, Parliament subsequently passed a whole series of laws to make sure no such thing ever happened again, including making it more difficult than ever for corporations like the South Sea Company to come into existence (retarding, in the opinion of most historians, the development of the Industrial Revolution), and I am pleased to say that the new rules were brilliantly conceived and England never again to this day has suffered from a financial crisis.

 

Just kidding.  England continued to suffer from financial crises as regularly as ever, even though each crisis brought out a new group of suspect causes that were subsequently eliminated.  This time around after we’ve assigned blame we’ll have the same flurry of regulatory activity to protect ourselves from financial instability in the future.  And, weirdly enough, we will continue to have financial crises.  I know this sounds a little pessimistic, but history makes pessimists of us all.

 

Fortunately the next round of regulations probably won’t do as much harm as they have in the past, especially if it results in greater transparency and more flexibility in allowing innovation to occur within the regulated system, instead of forcing it to occur outside (although I guess I am doubtful the latter will happen).  If the new global regulations do achieve these two ends, the world’s financial systems will better function during the good times.  However even with these excellent measures they are no less likely to be susceptible in the future to renewed financial crisis. 

 

This is because the next crisis will inevitably be caused by another period of rapid liquidity expansion, during which time financial institutions will accommodate themselves to the excess liquidity by taking on increasingly risky structures, and in order to do so they will either innovate around the regulatory constraints, grow outside the regulated system, or lie.  This always happens, and will happen again.  But I guess that at least we can all rest happier knowing that the next crisis won’t involve sub-prime mortgages.

 

Speaking of Maginot lines, according to Reuters today during the ASEM meeting “Sarkozy has told Chinese President Hu Jintao that he fears the United States, which is wary of excessive regulation, would be content if the summit produced ‘principles and generalities,’ according to a French presidential official.”  I read the final ASEM release and I assume that the US is content.  My cynical Chinese friends in government tell me that because ordinary Chinese are still so angry at France over the treatment of the Olympic torch, Sarkozy is eager to build trench camaraderie with China.  Bring on the new global financial order – it will make everyone feel good and it might even help a little.

 

After several rallies in the past month I said it was just a question of time before the Chinese stock markets tested their recent lows, and today the SSE Composite closed at 1896.  It’s become so easy to be skeptical after every surge that I don’t want to fall into the trap of just assuming that each is bound to fail.  Still, I have had trouble finding a good reason for any of the recent rallies – all driven primarily, it seems to me, by government attempts to bully the market up – and, sure enough, they have always reversed themselves fairly quickly.  

 

This week in spite of a good Monday (up 2.2%), the market lost ground on Tuesday (down 0.8%) and Wednesday (down 3.2%) with the SSE Composite finishing below its October 16 close of 1910.  This is flat from its September 18 close.  Remember that Thursday September 18 was the day the government announced a bunch of market-supporting measures, including that Central Huijin was going to buy bank shares.  Coming on the back of a global market surge the SSE Composite rallied 9.5% that Friday and ran up another 7.8% the following Monday, adding a further 2.7% over the next three days.  Less than four weeks later it has given everything back.

 

Aside from the continued insanity in the markets, a lot of things have happened during the three days I was at a conference in Shanghai, which means I have not been able to cover events on this blog in the timely way I would have liked.  As everyone knows by now CPI and PPI numbers for September were announced on Monday and came in lower than last month’s numbers.  I don’t have a lot to say about this beyond what I said in my last entry.  On Monday 4th quarter GDP growth was also announced, and at 9% it came in well below everyone’s expectations.  We seem to be fully caught up in the game of constant downward revisions in everyone’s estimates for this year’s and next year’s GDP growth numbers.

 

During the conference (a very interesting one organized by Chatham House) I was asked by one participant about what I thought next year’s GDP growth numbers would be.  I had to beg off by saying I am not an economist and the only thing I would want to predict about next year’s numbers is that they are going to be lower than expected. 

 

I say this because it seems to me that we have yet seen the full impact of the global crisis.  As I see it, much of the dynamics of the past few years can largely be described as the relationship between Chinese excess savings and American excess consumption, and I think these are going to alter considerably, and not in a benign way.  It is the latter that absolutely must change in response to the global crisis.  The US is unlikely to continue to have such a low rate of savings as crashing house prices and stock markets reduce so much of the stock of accumulated savings – American savings, in other words, will almost certainly rise as a share of GDP (as probably will, by the way, Europe’s).

 

This has an inescapable corollary.  The rest of the world must inevitably see a rise in consumption that is as great as the US (and European) decline in consumption (the flip side of the rise in savings, made worse if US income stalls or declines), if global demand is to remain unchanged.  When you add to this the fact that in large parts of the world we are unlikely to see much of a rise in consumption, and may even see a fall (in Latin America, for example, and among commodity exporters), this in principle means that Chinese (and other Asian) consumption is going to have to grow sharply to absorb most of the US and European decline.  If it doesn’t, world growth will slow sharply.

 

Given that the economies whose savings rate must grow account for anywhere from one-half to two-thirds of world GDP, that puts a huge amount of pressure on a sickly Japan and South Korea and an increasingly unsteady China to generate rising domestic demand.  I think it is unlikely that such an increase in domestic demand will happen without a much more massive fiscal expansion in China than most of us are counting on, so my guess is that we are going to continue to revise our growth future estimates for China (and the world) downwards.  

 

One of the impressions I got at the Chatham Conference (ok, not a new impression, but a reinforcement of an old one) is that there is a very sharp split in the views on the Chinese financial system between analysts who have extensive experience in a wide variety of markets and analysts who focus almost exclusively on China.  The former seem generally to share my pessimism about the Chinese financial system, whereas the latter are amazingly (to me) sanguine. 

 

Because their main experience of crisis is the recent US crisis, I think these scholars are confusing risky balance sheets in general with the specific risks that brought down foreign banks reently.  There is real difficulty here in understanding that even though Chinese banks probably have little exposure to the sub-prime mess or to complex derivatives, it is not those instruments per se that created the crisis, but rather excess risk–taking encouraged by excessively loose money (although to be fair I think most foreign commentators don’t get it either).  These instruments were only the way in which banks took on excessive risk, they were not the cause of the excessive risk.  Japanese banks in 1990 weren’t brought down by US sub-prime mortgages or toxic derivatives, but rather by old-fashioned loans, and it is useless to think that these former are the only risk to a banking system.

 

In that light it is worth noting the recent CITIC scandal.  Over the weekend some of my students began telling me about rumors of a $2 billion loss at CITIC.  This was confirmed on Monday, when it was announced that a badly conceived and unauthorized hedging strategy had gone seriously wrong and, as a consequence, CITIC was facing a huge unexpected loss. 

 

It is still not clear exactly what happened, but from what I can tell this “hedge” was a pretty bizarre hedge – it seemed far more like a misconceived speculative bet to me.  According to an article in today’s South China Morning Post it was also not exactly a recent problem:

 

Questions have also been raised about the timing of Citic’s profit warning, given on Monday. It knew about its currency exposure six weeks ago. Stock exchange rules require listed companies to disclose price-sensitive information promptly.

 

The article goes on to say “More worryingly, other local companies are exposed to similar currency contracts.”  Almost right on cue another problem was announced:

 

Shenzhen Nanshan Power warned that company officials had signed oil derivatives contracts without the firm’s approval, intensifying fears about internal risk management at mainland companies.  Shenzhen-listed Nanshan Power said on Wednesday its officials had signed two option-related contracts with a subsidiary of Goldman Sachs to bet on crude oil prices, although analysts said the contracts were still in the money.  Trading in the stock was suspended last week.

 

What does all this mean?  It has been very difficult to get a firm grasp on exactly what is going on in Chinese companies and banks as far as risk management goes.  My working assumption is that they have very little risk management experience, very weak rules on disclosure, and a perverse set of incentives.  That suggests to me that when faced with the same set of pressures faced by the leading Western corporations and financial institutions – i.e. ferocious liquidity growth and a previous environment of high rewards for excess risk taking – they are even more likely to have made some very risky bets.

 

Their lack of transparency has kept us from knowing exactly what is happening, but lack of transparency protected US and European banks for only so long before that very lack of transparency became the problem itself.  The few glimpses we can get into risk management among Chinese institutions do not give me much comfort.  If there is an economic slowdown, prepare to be surprised by all the garbage that comes out.

 

After the globally coordinated rescue package was announced Monday the Chinese stock markets boomed in sympathy with the rest of the world, with the SSE Composite closing up 3.6% for the day.  Tuesday the SSE Composite shot up 3.5% within minutes of opening, but the party was already over in China.  Over the rest of the day the SSE Composite drifted down nearly 6% from its peak to close the day down 2.7%.  Wednesday was another bad day with the marking closing once again below 2000, at 1995, down 1.1% for the day.  Nothing, it seems, is able to keep this market up.

 

The announcement that the US government would use about $250 billion of the $700 billion rescue package to re-capitalize the largest US banks is in line with actions by other European governments, and will reduce some of the credit pressure on the banks.  That’s a good thing, even if it turns out not to be enough.  A lot of people are calling this move unprecedented, and representing a major change in the institution of financial capitalism in the US, but to me it only confirms that in time of crisis the government has been willing to change its ownership position.  I don’t have the numbers in front of me, but I believe that the current move to purchase equity stakes in the large US banks is not much bigger in real terms, and probably smaller in relative terms, than the purchase of bank stocks by the Reconstruction Finance Corporation in the 1930s.

 

As an aside, rumors are once again swirling around about leadership changes in the large Chinese banks and among regulators, but these rumors have been around for several months, and with everyone expecting announcements around the time of the October holidays, this seems to be happening more slowly than expected – a possible indication that leadership discussions are paralyzed by the uncertainty surrounding the crisis.  I have also heard several of my friends in the written and broadcasting media say that there are increasing constraints on what may and may not be said in the press and on TV about the international financial crisis and its possible impacts on China.

 

All this suggests that authorities are very nervous.  While the PBoC periodically announces that conditions are solid, the banking sector sound, and the economy slowing but still strong, the South China Morning Post reported yesterday the creation of a new very high level crisis committee:

 

Vice-Premier Wang Qishan will head a committee being set up to deal with fiscal uncertainties caused by the deteriorating global financial crisis, according to an official source. The decision to set up the committee is the latest step by mainland authorities to try to prevent the domestic economy following western countries into recession.

 

At the end of the Communist Party Central Committee plenary session on Sunday, the leadership said that despite the international turmoil, the mainland’s basic economic situation had not changed. However, precautions to guard against the side effects of the international slowdown were needed. The source said the central government believed “losses from the international financial crisis are limited and the country’s risk and exposure to the crisis is still controllable”.

The new committee will be at the core of efforts to deal with the international problems. It will monitor financial changes overseas and respond by adjusting mainland economic policies when necessary.

 

It is definitely a good idea to create a high level crisis committee to monitor risks and to formulate policies for a rapid response, but if the thinking really is that the main risk to China is of contagion from international exposure, I am a little puzzled. 

 

To me the real risk has always been that the same excess monetary expansion that led to overextended and vulnerable financial systems abroad will have done the same thing in China.  In other words the risk was not so much (in my opinion) that there was a huge amount of hidden exposure to sub-prime mortgages or some other foreign toxic waste that will bring the Chinese banking system down, but rather that we have our very own time bombs hidden in the various formal and informal parts of the domestic banking system and that any sufficiently large adverse shock – financial or economic or even political – can cause a sharp contraction in the banking system. 

 

The fact that the authorities seem much more obsessed with the direct contagion impact – and that the media may have been instructed not to discuss these issues too openly – makes me wonder if there is not a lot more here than I at first imagined.  I am surprised that there has been so little debate within China about whether or not the crisis presents a huge buying opportunity for China (the foreign media has been much more excited about discussing this).  Could it be that SAFE and the CIC already have such a mess on their hands that no one has any intention of buying more assets abroad for a long time?

This is all just speculation, of course.  The real news yesterday was the release of PBoC reserve numbers, but as an indication of how furiously busy things have been, it was only by late today that I have been able to look at the numbers.  After going through the numbers and talking to my friend Logan Wright, who keeps sharp tabs on the PBoC, I have to say that there are two easy conclusions from the latest release.  First, hot money inflows have almost certainly slowed and maybe even reversed.  Second, the data is getting fiendishly hard to interpret, just as we are most eager to get a little clarity.

 

Headline reserve growth was $96.8 billion in the third quarter.  This is an extraordinarily high number by any standards, but it is a measure of how out-of-control reserve growth has been in China that it is being seen by researchers and the press as a serious moderation in reserve growth.  Once again (as in the good old days before hot money hijacked the process), most of the reserve growth is fully explained by the trade surplus (which soared in the third quarter of 2008) and FDI, which was higher than average for the last few years but lower than the first two quarters (much of it puffed up by anticipated investment – a nicer name for a form of speculative inflows).

 

However there is a lot of confusion in the numbers.  Currency valuation changes during the quarter, especially in August, added a lot of volatility to our analysis.  We can only guess at the currency composition of PBoC portfolio, so unfortunately even small errors in our estimate are going to have a magnified impact on our final numbers.

 

There were also some strange goings-on in the dollar account at the PBoC account which, following my previous usage (although the name is no longer fully appropriate) I have put in the “Reserve hike” account.  I won’t go into too much detail here because the numbers aren’t big enough to change the conclusions.

 

?	Q1	Q2	July	August	September	Q3
Headline reserve growth	153.9	126.7	36.3	39.0	21.4	96.8
Trade surplus	41.7	58.2	25.3	28.7	29.3	83.3
FDI	27.4	25.0	8.3	7.0	6.6	22.0
Currency gains	38.0	-7.1	-6.5	-24.0	-12.0	-42.5
Interest	16.5	18.0	6.0	6.5	7.0	19.5
Unexplained amount	30.3	32.6	3.2	20.8	-9.5	14.5
?	?	?	?	?	?	?
Reserve hike	30.0	72.4	-1.5	-5.6	-11.0	-18.1
Adjusted reserve growth	183.9	199.1	34.8	33.4	10.4	78.7
Unexplained amount	60.3	105.0	1.7	15.2	-20.5	-3.6
?	?	?	?	?	?	?
Transfer to CIC	75.0	0.0	0.0	0.0	0.0	0.0
Adjusted reserve growth	258.9	199.1	34.8	33.4	10.4	78.7
Unexplained amount	135.3	105.0	1.7	15.2	-20.5	-3.6

 

The results of my calculations, with input from Logan Wright, I have listed in the table above.  Don’t focus on the absolute numbers because there is a lot of possible error in the numbers.  What seems pretty certain is that the huge unexplained inflows of previous months (a proxy for hot money and its various close relatives) have all but vanished by July and August and in fact have probably turned into outflows by September.

 

Should we worry?  Yes and no.  Obviously since China was, and still is, suffering from explosive monetary growth, and it is precisely this monetary growth that is creating so much risk in the domestic financial system, the fact that hot money inflows have slowed and may have even reversed is unquestionably a good thing, especially as the trade surplus has surged.  Make no mistake, however – having reserves rise by roughly $100 billion in a single quarter would in any other time or country be seen as outlandish.  If we eliminate non-monetized components of this increase in reserves (interest income and currency valuations), there were net inflows into the country of $120 billion that had to be purchased by the PBoC with a combination of currency and PBoC bills. 

 

This is more than twice the $60 billion quarterly average of 2006 – a number which once seemed astonishing.  This is a lot of domestic money growth.  Fortunately for the monetarists out there (but not for those who fear that the economy is slowing too quickly) it seems that the banks are not eager to expand loan volume too quickly.

 

But there is something about the latest PBoC numbers which should indeed cause worry.  For me one of the bad-case scenarios that we have most to worry about is a sudden reversal of hot money inflows, large enough that it puts liquidity pressure on the formal and informal banking systems.  This is clearly not a problem yet, but the shift in a matter of months from massive inflows to moderate outflows is not confidence building.

 

As a related aside, and I am now straying into areas about which I need a lot more information, by coincidence I had two meetings yesterday – one with a world famous Harvard economist and a group of PKU professors, and the other with a group of traders and bankers – in both of which South Korea suddenly became the topic of conversation.  I am no expert on Korea but the kinds of things I was hearing raised all my Latin-American-bond-trading hackles.  One of the academics said he thought that Korea would come under tremendous liquidity pressure in the next three months.  If there are problems once again in Korea I would lay pretty serious odds that capital flight will become a serious problem all through East Asia.

 

After the globally coordinated rescue package was announced Monday the Chinese stock markets boomed in sympathy with the rest of the world, with the SSE Composite closing up 3.6% for the day.  Tuesday the SSE Composite shot up 3.5% within minutes of opening, but the party was already over in China.  Over the rest of the day the SSE Composite drifted down nearly 6% from its peak to close the day down 2.7%.  Wednesday was another bad day with the marking closing once again below 2000, at 1995, down 1.1% for the day.  Nothing, it seems, is able to keep this market up.

 

The announcement that the US government would use about $250 billion of the $700 billion rescue package to re-capitalize the largest US banks is in line with actions by other European governments, and will reduce some of the credit pressure on the banks.  That’s a good thing, even if it turns out not to be enough.  A lot of people are calling this move unprecedented, and representing a major change in the institution of financial capitalism in the US, but to me it only confirms that in time of crisis the government has been willing to change its ownership position.  I don’t have the numbers in front of me, but I believe that the current move to purchase equity stakes in the large US banks is not much bigger in real terms, and probably smaller in relative terms, than the purchase of bank stocks by the Reconstruction Finance Corporation in the 1930s.

 

As an aside, rumors are once again swirling around about leadership changes in the large Chinese banks and among regulators, but these rumors have been around for several months, and with everyone expecting announcements around the time of the October holidays, this seems to be happening more slowly than expected – a possible indication that leadership discussions are paralyzed by the uncertainty surrounding the crisis.  I have also heard several of my friends in the written and broadcasting media say that there are increasing constraints on what may and may not be said in the press and on TV about the international financial crisis and its possible impacts on China.

 

All this suggests that authorities are very nervous.  While the PBoC periodically announces that conditions are solid, the banking sector sound, and the economy slowing but still strong, the South China Morning Post reported yesterday the creation of a new very high level crisis committee:

 

Vice-Premier Wang Qishan will head a committee being set up to deal with fiscal uncertainties caused by the deteriorating global financial crisis, according to an official source. The decision to set up the committee is the latest step by mainland authorities to try to prevent the domestic economy following western countries into recession.

 

At the end of the Communist Party Central Committee plenary session on Sunday, the leadership said that despite the international turmoil, the mainland’s basic economic situation had not changed. However, precautions to guard against the side effects of the international slowdown were needed. The source said the central government believed “losses from the international financial crisis are limited and the country’s risk and exposure to the crisis is still controllable”.

The new committee will be at the core of efforts to deal with the international problems. It will monitor financial changes overseas and respond by adjusting mainland economic policies when necessary.

 

It is definitely a good idea to create a high level crisis committee to monitor risks and to formulate policies for a rapid response, but if the thinking really is that the main risk to China is of contagion from international exposure, I am a little puzzled. 

 

To me the real risk has always been that the same excess monetary expansion that led to overextended and vulnerable financial systems abroad will have done the same thing in China.  In other words the risk was not so much (in my opinion) that there was a huge amount of hidden exposure to sub-prime mortgages or some other foreign toxic waste that will bring the Chinese banking system down, but rather that we have our very own time bombs hidden in the various formal and informal parts of the domestic banking system and that any sufficiently large adverse shock – financial or economic or even political – can cause a sharp contraction in the banking system. 

 

The fact that the authorities seem much more obsessed with the direct contagion impact – and that the media may have been instructed not to discuss these issues too openly – makes me wonder if there is not a lot more here than I at first imagined.  I am surprised that there has been so little debate within China about whether or not the crisis presents a huge buying opportunity for China (the foreign media has been much more excited about discussing this).  Could it be that SAFE and the CIC already have such a mess on their hands that no one has any intention of buying more assets abroad for a long time?

This is all just speculation, of course.  The real news yesterday was the release of PBoC reserve numbers, but as an indication of how furiously busy things have been, it was only by late today that I have been able to look at the numbers.  After going through the numbers and talking to my friend Logan Wright, who keeps sharp tabs on the PBoC, I have to say that there are two easy conclusions from the latest release.  First, hot money inflows have almost certainly slowed and maybe even reversed.  Second, the data is getting fiendishly hard to interpret, just as we are most eager to get a little clarity.

 

Headline reserve growth was $96.8 billion in the third quarter.  This is an extraordinarily high number by any standards, but it is a measure of how out-of-control reserve growth has been in China that it is being seen by researchers and the press as a serious moderation in reserve growth.  Once again (as in the good old days before hot money hijacked the process), most of the reserve growth is fully explained by the trade surplus (which soared in the third quarter of 2008) and FDI, which was higher than average for the last few years but lower than the first two quarters (much of it puffed up by anticipated investment – a nicer name for a form of speculative inflows).

 

However there is a lot of confusion in the numbers.  Currency valuation changes during the quarter, especially in August, added a lot of volatility to our analysis.  We can only guess at the currency composition of PBoC portfolio, so unfortunately even small errors in our estimate are going to have a magnified impact on our final numbers.

 

There were also some strange goings-on in the dollar account at the PBoC account which, following my previous usage (although the name is no longer fully appropriate) I have put in the “Reserve hike” account.  I won’t go into too much detail here because the numbers aren’t big enough to change the conclusions.

 

?	Q1	Q2	July	August	September	Q3
Headline reserve growth	153.9	126.7	36.3	39.0	21.4	96.8
Trade surplus	41.7	58.2	25.3	28.7	29.3	83.3
FDI	27.4	25.0	8.3	7.0	6.6	22.0
Currency gains	38.0	-7.1	-6.5	-24.0	-12.0	-42.5
Interest	16.5	18.0	6.0	6.5	7.0	19.5
Unexplained amount	30.3	32.6	3.2	20.8	-9.5	14.5
?	?	?	?	?	?	?
Reserve hike	30.0	72.4	-1.5	-5.6	-11.0	-18.1
Adjusted reserve growth	183.9	199.1	34.8	33.4	10.4	78.7
Unexplained amount	60.3	105.0	1.7	15.2	-20.5	-3.6
?	?	?	?	?	?	?
Transfer to CIC	75.0	0.0	0.0	0.0	0.0	0.0
Adjusted reserve growth	258.9	199.1	34.8	33.4	10.4	78.7
Unexplained amount	135.3	105.0	1.7	15.2	-20.5	-3.6

 

The results of my calculations, with input from Logan Wright, I have listed in the table above.  Don’t focus on the absolute numbers because there is a lot of possible error in the numbers.  What seems pretty certain is that the huge unexplained inflows of previous months (a proxy for hot money and its various close relatives) have all but vanished by July and August and in fact have probably turned into outflows by September.

 

Should we worry?  Yes and no.  Obviously since China was, and still is, suffering from explosive monetary growth, and it is precisely this monetary growth that is creating so much risk in the domestic financial system, the fact that hot money inflows have slowed and may have even reversed is unquestionably a good thing, especially as the trade surplus has surged.  Make no mistake, however – having reserves rise by roughly $100 billion in a single quarter would in any other time or country be seen as outlandish.  If we eliminate non-monetized components of this increase in reserves (interest income and currency valuations), there were net inflows into the country of $120 billion that had to be purchased by the PBoC with a combination of currency and PBoC bills. 

 

This is more than twice the $60 billion quarterly average of 2006 – a number which once seemed astonishing.  This is a lot of domestic money growth.  Fortunately for the monetarists out there (but not for those who fear that the economy is slowing too quickly) it seems that the banks are not eager to expand loan volume too quickly.

 

But there is something about the latest PBoC numbers which should indeed cause worry.  For me one of the bad-case scenarios that we have most to worry about is a sudden reversal of hot money inflows, large enough that it puts liquidity pressure on the formal and informal banking systems.  This is clearly not a problem yet, but the shift in a matter of months from massive inflows to moderate outflows is not confidence building.

 

As a related aside, and I am now straying into areas about which I need a lot more information, by coincidence I had two meetings yesterday – one with a world famous Harvard economist and a group of PKU professors, and the other with a group of traders and bankers – in both of which South Korea suddenly became the topic of conversation.  I am no expert on Korea but the kinds of things I was hearing raised all my Latin-American-bond-trading hackles.  One of the academics said he thought that Korea would come under tremendous liquidity pressure in the next three months.  If there are problems once again in Korea I would lay pretty serious odds that capital flight will become a serious problem all through East Asia.

 

Yesterday’s 27 bp rate cut and 50 bp reduction in minimum reserve requirements by the PBoC had the expected impact on the stock market: None.  The SSE Composite declined 0.8% today to close at 2075.  Another day like yesterday and we’ll be testing 2000 once again.

 

Of course it is unrealistic to expect that the PBoC’s actions should have had an immediate impact on either the economy or the stock market.  The consequences of monetary policies are only supposed to reveal themselves over a several month period, during which time the hope here was that companies will have been given greater access to loans and consequently will more aggressively borrow and invest.  The one-day market reaction was inevitably going to be colored by a lot more than just the immediate consequences on economic fundamentals of the PBoC actions, and I don’t doubt that bad markets overseas didn’t help.

 

But even over the medium term will the consequences be positive?  I already said yesterday that I was skeptical:

 

It seems to me that at least part of the reason for slowing loan growth has been corporate reluctance to borrow.  If that is the case, I doubt whether lower rates (let alone lower minimum reserves) will have much impact.  After all it hasn’t been high interest rates that have constrained borrowing in the past.  We will need to watch loan growth figures closely in the next few months.

 

Let me explain a little further why I worry that easier lending terms won’t cause a surge in borrowing and investing (as they didn’t either in Japan during the 1990s, by the way).  For lending and investment to surge, it isn’t enough that banks make it easier to borrow.  Corporations must also want to borrow.  And when I say “corporations”, I should make it clear that I mean corporations who plan to borrow to invest in new facilities, plant, equipment, distribution systems, etc.  I don’t mean corporations who are holding illiquid assets and who are desperate for liquidity – of which I understand that there are quite a few, especially in the property sector.

 

But why should these “good” corporations want to borrow and invest?  Obviously enough because they believe that there are profit opportunities that justify their taking the risk of increasing debt servicing costs.  The problem is that if foreign demand for Chinese goods declines with the decline in the world economy, who is going to buy the newly-produced Chinese goods?  With the huge amount of fixed asset investment we have seen in recent years, industrial production in China is very high and growing.  As long as the world was also growing rapidly, China could export its excess production.  If the world economy slows down, however, China might not be able to rely on foreign consumers to take up its excess.

 

So what about Chinese consumers?  After all nearly everyone agrees that it is in China’s best interest to rebalance the economy, by engineering a transition from an export-led to a domestic economy.  As Chinese households get richer, they are likely to ramp up their spending.  Can they take up the buying slack?

 

Maybe, but I am doubtful that we are going to see the necessary surge in domestic private consumption, and although we won’t get September and October numbers for a while (July and August were probably tainted by Olympics-related buying), I think the poor auto sales in September may be a harbinger.  Certainly it cannot be easy for Chinese households, confronted every day by terrifying stories of declining local stock and real estate markets and of foreign financial crises, to decide that now is the best time to draw down the savings account and splurge on new consumer goods.

 

So if neither export growth nor growth in private consumption is going to absorb the higher industrial production, who is going to buy?  The stock answer to the question, and one much beloved of research analysts, has been: The government.  The Chinese government, according to this argument, is in a very strong fiscal position – it runs a more-or-less balanced account and has relatively little outstanding debt – and so has plenty of room to borrow and spend without running into credibility constraints. 

 

In fairness there are some analysts who disagree that fiscal spending can easily take up the slack.  I think Stephen Green of Standard Chartered pointed out several times that turning on fiscal spending is likely to be a lot harder and slower than simply announcing a fiscal expansion package.

 

I agree with Green, but in addition, as I have argued many times, I don’t think the government is in nearly as strong a fiscal position as most other analysts think.  Total direct and indirect debt (and I am not including long term obligations like unfunded pension liabilities) is probably much higher than the official numbers which, depending on how you count, range from 15% to 30% of GDP (by contrast I think US government debt is around 30-35% of GDP and European government debt averages around 60-65% of GDP, albeit with big variations around the average). 

 

However, for reasons I have discussed many times before on this blog, I think actual Chinese government debt exceeds the visible debt.  My guess is that without counting the possibility of rising NPLs in case of an economic slowdown (which ultimately can become contingent liabilities of the government), total government debt in China is probably 50% of GDP or higher.  That means that China has a lot less room for running large fiscal deficits than we might suppose, and during the time it most needs to run a deficit – when the economy is slowing sharply – we may anyway see a surge in contingent debt as bank NPLs surge.  

 

And it is not just that there may more debt out there than we expect.  There is also a problem with the current fiscal balance – it is not as stable as might at first appear.  On that topic last week’s Economic Observer has an article by Xi Si titled “Shrinking Coffers Challenge Chinese Finance Ministry.”  According to the article:

 

Slower tax revenue growth and higher pressure for more spending have posed a challenge to Chinese budget planners in the ongoing drafting of the 2009 budget.  Tax revenue growth stumbled in July and August and was likely to continue falling, but there was a growing need for more spending to stabilize prices in China and rebuild disaster-hit areas.

 

Official data showed that in July, China’s state revenue grew by 16.5% compared with the same period last year, 14 percentage points lower than in June. The growth rate continued to fall in August, when state income dropped below 400 billion yuan. “There will be no problem meeting the budget, but there may not be as much excess income as last year,” an official from the Ministry of Finance (MOF) told the EO.

 

Compared to the same time last year, budgeted revenue for the beginning of 2008 was up by 14%. By the end of August, the actual revenue saw a year-on-year growth of 28.4%. Judging from this, the above-mentioned official believed there would still be excessive revenue even if the growth rate continued to stumble in the next four months.

 

The current economic situation at home and abroad, as well as companies’ profit-earning ability, explained why state income had fallen for two consecutive months. Many officials and scholars thus worried that the high revenue era of China might come to an end.

 

My basic problem with the fiscal numbers has always been that, with both revenues and expenses surging by 30% a year or more, it wouldn’t take much of a shift in the relationship between the two to swing the budget into a large surplus or deficit.  With global and domestic conditions in a seeming downturn, it is easy to posit a plausible scenario in which expenses begin radically to outpace revenues.  I don’t know if this is happening or not, but even though the conservative in me is happy to see fiscal balance, the bond guy in me gets very nervous when the balance is achieved on the back of such rapidly surging revenues.  Very rapidly changing numbers create very volatile potential outcomes.

 

The market continued its losing streak with the SSE Composite dropping 64 points to close at 2093, down 3.0% for the day, with financial institutions and property developers once again leading the way.  During the trading day my student Shang Ning sent me the following (slightly edited) email:

 

The PBoC issued 1-year bills, at 3.91%, 9bps lower than last week, and 15bps lower than the annual average 4.06%.  This pushed up the market like crazy; with yields dropping some 10-20 bps for medium-term treasuries.  Obviously the auction indicated that banks were eager to buy bonds. 

 

What else it can indicate?  Can it suggest a declining willingness to lend money out to corporations, since bond market and loan market are substitute goods?  Or a great expectation of basis rate cut soon?

 

Shang Ning seems to have got it right.  Seemingly as part of a concerted global effort to support markets, the PBoC announced later that it was cutting interest rates (for the second time in less than a month, after six years of raising rates), with the benchmark 1-year rate dropping from 27 bps to 6.93%.  The PBoC also reduced minimum reserve requirements by 50 bps to 17%.

 

How effective will these measures be in spurring the economy?  According to the most recent data loan growth has been slowing.  I don’t have the numbers in front of me but an article last week in Caijing had this to say:

 

In the second half of 2008, the People’s Bank of China loosened its credit control by five percent. But July and August statistics did not show a rebound for loan growth. Even if the quota were further relaxed, loan growth this year would hardly match 2007’s.

 

It seems to me that at least part of the reason for slowing loan growth has been corporate reluctance to borrow.  If that is the case, I doubt whether lower rates (let alone lower minimum reserves) will have much impact.  After all it hasn’t been high interest rates that have constrained borrowing in the past.  We will need to watch loan growth figures closely in the next few months.

 

On a completely separate topic, a journalist friend of mine called me earlier today to ask me what I thought about the popular discussions about whether the current crisis marked a “paradigm shift” that would see a sharp decline in the relative power of Wall Street and London and a rise in the power of one of the Asian financial centers.  Aside from the fact that I am a little allergic to paradigm shifts, I thought this was an interesting question.  I usually get asked where the New York or Shanghai stock markets will close Friday (for the record: I don’t know). 

 

This is also one of those “big” questions about which I think most of the current debate is a little muddled.  To begin with, I don’t think the current crisis is a paradigm shift at all.  It is simply yet another in the sequence of crises that have marked the six (as I count them) globalization cycles of the past 200 years.  Of course there will be big changes in the worlds of commerce, finance, and politics, but these changes won’t represent a brave new world so much as a reversion to a more standard world.

 

After all, during the great liquidity cycles that underlie the globalization cycles, we always see in the late stages a massive growth in financial transactions and the power of financial institutions.  During these periods banks get larger and larger, often though acquisitions and expansion abroad, and financial activity expands dramatically until it seems to become the hub of all industrial, commercial and political activity.  

 

But it is these late periods which are the anomaly, not the norm.  Every end of a globalization period (which usually ends in crisis) we experience a sharp deleveraging and a massive reduction in speculative activity.  Along with that inevitably banks and financial markets become less central and less active.  The expected decline of Wall Street and London, in other words, is not a shocking new reality but simply a reversion to more normal times – when it is not the dream of 8 out of 10 graduates of elite colleges to become investment bankers.  To tell the truth when I was graduating I didn’t even now what investment bankers did.  In a few years an awful lot of young graduates will be just as ignorant as I was.  That is probably not a bad thing. 

 

I suspect that a lot of experienced bankers, academic, and students of financial history will agree with me so far, but here is where I am going to get controversial.  The debate about the “paradigm shift” seems mainly to be between those who say that the current crisis marks the relative decline of Wall Street as the center of world finance and those who argue that it will maintain its relative position.

 

But I think the effect of the crisis will actually increase the relative position of New York and London as world financial centers.  Why?  I say this largely because previous global financial crises were just as brutal as the current one, or even more so (1825, 1837, 1873, and 1929 were all more brutal), and yet during the subsequent years the then-global-financial-centers became more, not less, central.

 

Why this happened is not hard to figure out, I think.  During the liquidity booms, the great advantage of the primary financial centers – the fact that they are much more liquid than other markets – is usually sharply eroded by the huge increases in liquidity, trading volumes, and financial transactions across the world, and with them, the decline in the value of liquidity.  In fact it was always during the long boom periods that secondary financial centers were able to grow in importance – just as Sao Paolo, Frankfurt, Delhi, Shanghai, Singapore, Dubai and even Hong Kong have all grown dramatically in the past 10 years.

 

After the booms, however, the sudden reduction in underlying liquidity and the greater value investors and issuers placed on liquid markets typically causes most of the secondary financial centers to die out as trading and issuance migrate to the deeper markets of the primary financial centers.  This is simply a form of the old traders saw – “liquidity draws liquidity.”  If liquidity truly dries up around the world and trading and issuance volumes collapse, the value for investors and users of capital of accessing New York or London will be greater, not smaller.

 

What about the argument that an Asian financial center will rise in relative importance?  I think this may very well happen, but it will have little or nothing to do with the current crisis. 

 

An Asian financial center will or will not rise depending on several factors.  These include the liquidity and value of its currency for international transaction, the strength and impartiality of its legal framework, the scope for political and regulatory independence, a clear governance framework (which implies, among other things, that managers are minimally constrained by policy needs), the size of the home market, the openness to foreign markets, the importance of financial markets (as opposed to large banks) in financing, and several other obvious and not-so-obvious things.  The financial center also needs to be perceived as politically (and geopolitically) safe and stable, and especially a safe haven in times of tension, which is not always an easy thing in an Asia which consists of several very large, often heavily armed countries with a long history of mutual distrust and rivalry.

 

I may be wrong about whether or not New York (and London) maintain their pre-eminence, but I think I am certainly right in suggesting that any argument about what-will-happen-next that ignores the last 200 years of surging and waning global liquidity and the past several globalization cycles is likely to get very little right.  What we are experiencing is dramatic, but it isn’t new

The holiday week continues to limit information and policy-making, and of course the Chinese stock markets are closed, but there were nonetheless two interesting articles, one in the Chinese press and one from abroad, worth noting.  The first was a very long article in today’s Xinhua called “The rise of the yuan – where now for China’s currency?” in which the author, Zhu Yifan interviewed a number of economists on prospects for the RMB.

 

After going through the benefits a rising RMB has had for Chinese consumers and the costs to exporters, the article shifts gears and refers to the currency regime as a structural part of China’s problem:

 

The reverberations of the rapid appreciation of the yuan are deep and complicated. The change was not as simple as a boost in buying power or a squeezed trade surplus. Behind it lies a shift in the country’s overall economic strategy, driven by recognition that the current export structure won’t support economic development the way it used to.

 

“China’s currency had been kept in an undervalued state since the 1997 Asian Financial Crisis, and the government in effect used it to finance the imports and exports sector at the cost of its non-trading industries,” says Professor Pan Yingli, of the Shanghai Jiao Tong University management school.  A large profit margin was then created between low production costs paid in undervalued yuan, and the high revenues reaped by selling these products to international clients.

 

This brought prosperity for the country, but took a heavy toll with high pollution and energy consumption. Too much labor-intensive industry with low-efficiency and little added value stretched supply by demanding evermore manufacturing materials, which pushed up upstream prices. The heavy reliance on overseas markets was detrimental to the establishment of an overall balanced industrial structure in China.  It also created a persistent gap between the well-developed coastal east, which thrived by trading with the outside, and the poor central and western regions in China.

 

“The structural conflict has accumulated to a stage that demands a solution,” says Pan.  “Strengthening the yuan is the rational choice as it helps stabilize inflation and leads to the optimization of industrial structure.”

 

The article then goes on to point out that the strategy to accelerate the RMB’s appreciation foundered, as should only have been expected, on the issue of speculative hot money inflows, which have poured into the country in the last year.  It quotes Liu Yuhui, researcher with Chinese Academy of Social Sciences, as warning that losing control of capital inflows would ultimately cause policy-makers to lose control of the underlying macro-economy – something which, I believe, has already happened.

 

I am not sure where the article was ultimately headed – it concludes:

 

Given the complexity of the situation, opinion is divided over whether the appreciation will continue, or whether there will be a one-off appreciation to end the uncertainty. Guesses are made at the so-called ceiling of the yuan. Central bank governor Zhou Xiaochuan says China would gradually expand the elasticity of the exchange rate, sending out the signal that Beijing would let the yuan fluctuate rather than rise unilaterally.

 

The fast appreciation of the yuan in the first half might not continue, and the concern over possible fallback of foreign trade could weigh against continuous further appreciation, says Peng Xingyun, of the Chinese Academy of Social Sciences.  “There are many factors in the market that affect supply and demand, which, if changed, would sway the exchange rates,” says Peng.

 

Still, I think this article was the strongest example of a recent spate of articles I have noticed reopening the debate over the RMB.  In the past month or so we have seen a sharp decline in the rate of appreciation of the currency, and I think there is a big debate with policymakers on one hand arguing that with a slowing world economy and declining export growth this is the wrong time to be raising the value of the RMB, and on the other hand recognizing that China needs desperately to rebalance its economy away from export orientation and, just as desperately, needs to regain control of its own monetary policy.

 

The only thing I can add to the debate is the fear that policymakers waited way too long to resolve this debate, and I think in particular the last year of massive inflows has probably undermined the financial system to the point where it is very vulnerable to shocks.  In a sense, they’re damned if they do and damned if they don’t.  Maintaining the value of the currency continues the unbalance, speeding up the appreciation re-ignites speculative inflows, and even my once-favored response – a one-off revaluation – is now a very risky strategy that could provide the shock needed to cause the banking system to unravel.

 

Add to the mix the second article I found interesting today.  John Thornhill has a piece in today’s Financial Times about the developing political and economic strains between China and Europe.  I have argued for a long time that as long as China maintained its currency regime it forced a trade deficit onto the rest of the world, which for the most part meant the US.  However as the dollar weakened versus the euro in response to the strains associated with the US trade deficit, it shifted China’s trade surplus from the US to Europe, something which I never believed could last very long.  Europe simply doesn’t have the labor and financial flexibility and has too many “old” industries for it to be able to accept a sustained trade deficit with China.

 

China’s astonishing economic rise over the past three decades has unsettled many countries and regions, but perhaps nowhere more than Europe, which in some respects still regards itself as the centre of the world.  For a while, Europe’s politicians and business leaders marvelled at China’s economic dynamism and applauded its successes in reducing mass poverty. Alarmed at US unilateralism at the time of the Iraq war, leaders such as Jacques Chirac of France and Gerhard Schröder of Germany even held out the prospect of a fully-fledged strategic partnership with the growing power. The European Union has been steadily developing an extensive – and largely positive – dialogue with China over a vast range of subjects spanning economics and trade, the role of the United Nations, counter-terrorism, cultural exchanges, Iran, North Korea, Darfur and Burma.

 

However, as the world’s centre of economic gravity slips inexorably eastwards, the perception appears to be spreading among European voters that China’s rise is as much of a curse as a blessing. As China has regained its reputation as the workshop of the world, it has seemingly sucked manufacturing plants and jobs out of Europe and flooded the EU with cheap manufactured imports. The EU’s trade deficit with China has recently been rising by an estimated €15m an hour.

 

The article quotes Eberhard Sandschneider, director of the German Council on Foreign Relations, as saying “Europe has switched from China hype to China angst.”  He adds: “The popular view is that the Chinese are stealing our jobs.”

 

Anti-China feeling has been rising sharply in Europe and I think this seriously limits China’s room for maneuvering, especially on the RMB.  I just saw an interview with Steve Roach, the chairman of Morgan Stanley Asia, and he is convinced that the dollar is due for more weakness against the euro.  I am not sure I agree, but any dollar weakness is going to cause real problems between China and Europe since dollar weakness also means RMB weakness.

 

China is going to be forced somehow to adjust just its monetary policies just when everything on the external front has gone wrong.  This won’t be easy.  We should all hope the recession associated with the US financial crisis is very, very mild.