Subscribe Feed (RSS)Monetary conditions might exacerbate the Chinese adjustment
January 15th, 2009 by Michael Pettis | Filed under Currency regime, Hot money, Informal banks, PBoC.I think if I were an economic policymaker in China I would be spending most of my time thinking about the money supply and how it works. There is a small but growing possibility that Chinese monetary conditions are going to go wrong at exactly the wrong time, and policymakers will need to have a well-thought out and vigorous plan to address it if it happens.
It has become pretty clear that the huge amount of hot money that poured into China last year and earlier this year is beginning to reverse itself pretty sharply. According to a PBoC release yesterday, China’s foreign exchange reserves increased to $1.946 trillion at the end of 2008, up from $1.906 trillion at the end of September. Here is what Logan Wright, of Stone & McCarthy, said in a release earlier today:
The Q4 2008 foreign exchange reserve data, released yesterday, indicate that China’s six-year liquidity cycle may be coming to an end, triggered by limited expectations of further yuan appreciation alongside a rapid downturn in both the domestic property market and global consumption of Chinese exports. Despite a record-high quarterly trade surplus of $114.3 billion and additional sources of capital inflow, China’s foreign exchange reserves rose by only $40.4 billion in the fourth quarter. This suggests that China saw significant levels of capital outflows during the fourth quarter, which we estimate totaled around $120-140 billion. Valuation adjustments may explain the decline in headline reserve levels in October (by $25.9 billion), but they cannot explain the entirety of the slowdown in reserve growth during the fourth quarter.
It has become harder than ever to figure out exactly what is going on with central bank reserves – and of course just when we need clarity most – so there is a lot of variation in all of our estimates about the different components of the adjustments in reserves, but Logan is one of the most careful of the PBoC watchers and his estimates on hot money outflow fall into line with my own and most of the other credible estimates I have seen. For example Mark Williams of Capital Economics said in a release yesterday that “hot outflows may have amounted to well over $100bn last quarter, equivalent to around 8% of Q4 GDP,” and Stephen Green at Standard Chartered said in another release yesterday that he calculated the “unexplained” amount of reserve changes to be about $110 billion, although at least part of that may be accounted for by a lag in trade payments.
Remember that there are two reasons for hot money to leave China – one on which most of us have focused, and another, which may be more important but which hasn’t received the attention it deserves. The first is the expected excess return for bringing money into China or taking it out – basically the RMB deposit rate plus the expected appreciation of the RMB less the equivalent US dollar deposit rate. When there were tremendous expectations for RMB appreciation, money poured into China, and now that those expectations are evaporating, or even going negative (i.e. there is some concern that the RMB may depreciate), it is likely to leave.
The second reason for hot money flows, not as widely discussed but at least as important, is the perception of risk, especially of the financial system. Remember that whether any given level of expected appreciation results in outflows or inflows depends also on the expected risk. As risk rises, it will take a lager expected return to encourage inflows. As China’s economy contracts, and as local businesses become increasingly worried about the potential for the current crisis to lead to deeper problems, including problems with the banking system, there is an increasing incentive for wealthy Chinese businessmen to take money put of the country.
For much of 2007 and early 2008 I argued that Chinese monetary policy had locked the country into a dangerously pro-cyclical trap, and unless the PBoC engineered a one-off revaluation that would stop hot money inflows, there was a real risk of incurring destabilizing capital inflows and outflows. When things were going well and the country’s economy was booming, hot money would pour into the country, unleashing a credit bubble and exacerbating the problem of overheating and overcapacity.
Once conditions turned around, however, I worried that hot money outflows would have exactly the opposite impact, causing a contraction in the money supply that would lead to credit contraction and an even sharper economic slowdown. This is always the great danger of hot money – when things are going well it pushes the economy into overheating, while squeezing the economy just as things start to get bad.
Needless to say, the PBoC did not revalue the RMB or otherwise move quickly enough to control the torrent of hot money inflow, and now they may be forced to deal with the accompanying but opposite problem. As conditions deteriorate, hot money outflows will become a real monetary drag.
This is not to say that these outflows are creating a problem for China right now. On the contrary, with outflows more or less matching current account and FDI inflows, the net impact is that for the first time in several years the PBoC finally has some apparent control over domestic monetary policy.
What worries me and some of my other PBoC-watching friends is the implication of this reversal on future monetary conditions in China. The outflows are almost certainly likely to cause contraction in credit – especially in the informal banking sector, where much of the hot money inflow may have hidden – and one can make a very plausible argument that outflows, and the attendant credit contraction, may exacerbate the slowdown in the economy.
If it does, and in so doing increases the perception of riskiness in China, it may create further strong incentives for local business owners to take money out of the country. China, in other words, has locked itself into a highly pro-cyclical monetary policy, and one of the key points to remember about highly pro-cyclical systems is that it is very hard to predict exactly where they are going, but it is a pretty safe to predict that whatever they do they will go to extremes (as if to confirm my worry about exacerbating tendencies, I see that China’s National Bureau of Statistics has just revised upward China’s sizzling 2007 growth rate of 11.9% to 13.0%).
To extend this a little further, it is worth remembering that there were at least three important factors that caused the severity of the Great Depression in the US. First, the US had to deal with a substantial industrial overcapacity problem just as the European countries that absorbed US overcapacity by running trade deficits with the US saw the financing of these deficits interrupted. I have written about this several times in the past few weeks so I won’t discuss it further.
Second, the US did not expand fiscally nearly enough to counteract the decline in domestic and foreign demand for US production. I know that this is a controversial point and I don’t want to get into a debate about the efficacy of fiscal expansion, but as I see it the US would have been better off if the government had followed Keynes’ advice and expanded more quickly. Third, the US experienced a severe monetary contraction as some banks either collapsed, others sharply contracted their lending, and depositors and businesses hoarded cash. The Fed should have accommodated this contraction by relaxing monetary conditions but failed to do so. According to Milton Friedman this may have been the single biggest cause of the severity of the contraction.
So where does that leave China? The overcapacity adjustment in China may be much larger than the one faced by the US – with 40% of global GDP the US had to absorb a trade surplus of roughly the same magnitude as China, which accounts for only 7% of global GDP. On the fiscal side I think China will definitely expand much more aggressively than the US did in the 1930s (how could it not?) but of course there are real questions about how much real expansion there is, how it is going to be financed, and how much of it will simply be wasted or turn into NPLs. Most importantly, can China expand enough to make up for the contraction in US and European demand (the two economies are more than six times the size of China)?
The US experience in the Great Depression suggests that among the things we should be most worried about in China is underlying monetary conditions. If hot money outflows accelerate and, as is likely to happen, the trade and FDI surpluses drop sharply, we could start to see some large monthly net outflows, and it shouldn’t come as a surprise if large outflows increase the perception of risk and so encourage further large outflows. Remember that outflows mean dollars sold by the PBoC in exchange for RMB, which represents a contraction in the base money supply. If China is forced to experience a sharp monetary contraction on top of its economic adjustment, things could easily get out of hand.
A sharp monetary contraction, as I see it, basically means a sharp contraction in credit. Could we see this, and can the PBoC take steps to counteract it? Here is what the South China Morning Post had to say in an article two days ago
Yuan-denominated loans granted by mainland banks grew a robust 19 per cent last month from a year earlier, suggesting lenders are heeding Beijing’s calls to stimulate the economy. Mainland banks extended 740 billion yuan (HK$839.31 billion) in loans in December, the biggest monthly rise since January last year, the Shanghai Securities News reported yesterday.
The new loans started to rise from about 300 billion yuan monthly in most of last year to 476.9 billion yuan in November when the central government unveiled a 4 trillion yuan fiscal stimulus package and encouraged banks to help funding the toll road, railway, port and other projects under the scheme. “Bank lending has been a key indicator. It’s crucial to China’s economy-boosting efforts. The December figure shows the needed credit expansion is on the way,” said Peng Wensheng, an economist with Barclays Capital Research.
I am not sure I agree with Peng Wensheng. We are not seeing credit expansion so much as a growth in RMB-denominated loans in the formal banking system. Perhaps this is a good proxy for credit in China, but I suspect it isn’t. First, much of the growth has come in the form of a sharp increase in bill discounting, and I am not sure whether this might not include a lot of double counting. I have also heard whispers that companies are turning to short-term credit not for investment purposes but rather because of serious cashflow problems. If so, this might be the worst sort of credit expansion.
And second, it is not clear what is happening to off-balance sheet transactions – which may be in the process of being shifted back on balance sheets to meet credit targets with no real expansion in credit – or, more importantly, to the informal banking sector. The anecdotal evidence is that the latter is contracting sharply, which is consistent with the idea of hot money outflows.
Whether credit is indeed expanding or in fact contracting is, to me, still an open question, and I would argue that circumstantial evidence – the collapse in inflation, the open disgruntlement among banks about pressure to meet credit expansion targets, hot money outflows – suggest that it is contracting.
Frankly I am not sure where all of these musings lead, and I need to do a lot more thinking about the subject, but I worry that for reasons beyond the PBoC’s control we may see a much sharper monetary contraction in China than expected, especially if hot money outflows increase, and this could seriously exacerbate the downturn just as it did in the US in the 1930s. Can the PBoC accommodate this by relaxing? I don’t think so. Remember that I have argued for years that the PBoC has little to no real control over domestic monetary conditions as long as it retains the straitjacket of the currency regime. It should have gotten out years ago, or at least reduced the strength of its pro-cyclical impact by revaluing sharply before hot money flooded into the economy, but I am not sure it can easily adjust in the midst of a crisis. Perhaps they should anyway consider what the impact would be of either loosening the band considerably, or even floating.
very well thought out arguement. I agree, China is set up nicely for a massive Great Depression.
Think about the geopolitical consequences of this.
Investors complain about the lack of transparency and inability to quantify the asset values in US bank balance sheets.
I’m clearly not an expert in this area. But I don’t know how anyone can have confidence in the Chinese banking sector, if its primary mode of issuing loans is to fund an export driven model in a centrally planned economy.
We are going to a new destination in terms of the global economy, not this pseudo-symbiotic where US consumers spend and the Chinese supply credit/production. Time to write-down the value of China’s export sector and have banks generate domestic loans… consumer purchase of homes, cars, goods, etc.
Michael,
I continue to really appreciate your independent thinking which comes through in all of your writing. I think you are definitely correct that one of the main tasks for the Chinese government right now is expanding their money supply. But I don’t think that the hot money outflows really make that problem much more difficult.
For about a decade, in order to keep the RMB week, the People’s Bank of China has been reducing credit available to the Chinese people by issuing Chinese government bonds, payable in RMB, converting the RMB to dollars, and then lending those dollars to the United States (such as by buying US Treasury bonds).
To reverse this process, they just need to sell US Treasury bonds, convert the dollars to RMB, and use the RMB to buy back the bonds that they have been issuing. The result would be to increase money and credit available to the Chinese people. Also the RMB would strengthen, which, incidentally, would reduce the hot money outflows.
Howard Richman
http://www.tradeandtaxes.blogspot.com
[...] Monetary conditions might exacerbate the Chinese adjustment [...]
Quote: It should have gotten out years ago, or at least reduced the strength of its pro-cyclical impact by revaluing sharply before hot money flooded into the economy,
The large amount of money flows into and out of China were and are generated by external conditions, namely the rise of the global credit bubble and then it’s collapse. If the PRC had sharply appreciated its currency and then cooled it’s economy last year, then it would be looking at a much larger devaluation and capital outflow and a much more drastic economic contraction.
Instead of looking at GDP going from 13% to 8%, it would be looking at going from 8% to 3% which would be a disaster. The fall in GDP is going to be in loss of net export demand which is going to be constant no matter what Chinese policies was previously. Similarly the amount of money going out right now would have remained the same regardless of what policies China has followed, and so having more money enter the country in the boom is a good thing (as long as you put it in a vault and don’t borrow against it) since it keeps you economy from busting when times go bad.
The Chinese government got one very important thing right. Until mid-2008, no Western economist that I can think of imagined a situation in which the RMB would depreciate and China would be facing massive capital outflows and fears that this would happen were largely dismissed as paranoia. Simply the fact that China has large reserves means that there is no chance of a currency crisis, and crisis avoidance is extremely important since it gives you time to think about what to do next.
Pettis: This is always the great danger of hot money – when things are going well it pushes the economy into overheating, while squeezing the economy just as things start to get bad.
But if you have a pool of domestic savings that buffers against this effect. When money is flowing in, you sterilize, when money is leaving you desterilize. The sterilization isn’t perfect and neither is the desterilization.
Pettis: Perhaps they should anyway consider what the impact would be of either loosening the band considerably, or even floating.
If the PRC floats as long you have capital flows outward this means that the currency is going to be devalued, with all of the interesting implications for trade. If you devalue trade deficits are going to increase.
As far as banks go.
Also quite honestly, unless Chinese businessmen are buying treasuries, and don’t see how one could plausible argue that the Chinese banking system is riskier than the US one, right now. Two of the four major banks in the US have bad balance sheets and are going to get government bailouts on top of the bailouts that they already have, and you are likely to see hundreds of bank failures in the US next year.
I have no doubt that lots of bad stuff as about to come out in Chinese banking. Booms lead to excesses which get revealed with the tide goes out. However, Chinese banks may have sufficient reserves to deal with all the bad stuff whereas US banks clearly do not.
The other thing that may be a huge factor is that Western companies are pulling out money because they are desperate for cash. Bank of America, UBS, and RBS have sold massive stakes in Chinese banks in order to get every penny they can.
Prophets,
You might be interested in this from today’s Bloomberg:
Rising bad debts for companies and individuals because of the global recession may lead to a second wave of financial turmoil, said Zhu Min, vice president of Bank of China. Property markets will continue to see corrections, share prices of financial firms will continue to fluctuate and market liquidity will remain tight, Zhu wrote in a commentary in the China Securities Journal yesterday. Bank of China has lost more on mortgage investments than all Chinese banks combined after a global crisis that has triggered more than $1 trillion in losses. The bank, the nation’s largest foreign-exchange lender, said in October that profit rose at the slowest pace in two years as credit market losses increased and loan demand declined in China.
Twofish this isn’t a factor because bank stocks are being sold to the CIC and others in the foreign markets. It has no impact on capital inflows or outflows.
Howard (and Twofish), I don’t think that is correct. The PBoC has a currency regime, not a domestic monetary policy, and for this reason PBoC actions to control credit growth cannot and have not been successful. CB bills are a close substitute for money and are held as cash, so exchanging RMB for bills in principle has little impact on underlying money conditions. More importantly, until last summer there clearly was significant credit expansion, far beyond what the PBoC was comfortable with, but it was almost impossible for them to control it because, as I have discussed many times here, direct attempts to control credit expansion by limiting the growth of RMB loans on bank balance sheets simply pushed credit creation off balance sheet or onto unregulated parts of the system, most importantly the informal banks. The same thing is happening now. They are allowing bills to run off so as to create underlying money, and they are forcing banks to lend, but the circumstantial evidence is that money and credit is nonetheless contracting. This is exactly what we would expect given their currency regime (the so called “impossible trinity”).
Twofish, I think a lot of people used to believe with you that “If the PRC had sharply appreciated its currency and then cooled it’s economy last year, then it would be looking at a much larger devaluation and capital outflow and a much more drastic economic contraction,” but fortunately (in my opinion) that belief is rapidly fading. It is a strange argument to say that the best way to deal with an imbalance is to exacerbate it because then the subsequent adjustment will be less dramatic. Policies aimed at reinforcing imbalances during the boom period simply cannot reduce the subsequent cost of adjustment. They increase it. A weak currency constrains consumption and enhances production, and helped put China into a greater position of overcapacity, large trade surpluses, and out-of-control money expansion. Now China needs to do the exact opposite. The fact that they allowed this imbalance to go on so much longer they might have, had they appreciated, means that the needed adjustment today would have been a lot less severe.
As for your claim that “Until mid-2008, no Western economist that I can think of imagined a situation in which the RMB would depreciate and China would be facing massive capital outflows,” I am not sure if you consider me, Logan Wright, Brad Setser and several others Western economists, but we had been obsessing about hot money outflows since late 2007 (and me since early 2007) precisely because, we argued, the problem of hot money inflows was the threat of their reversal. You are right that our views were sometimes dismissed as paranoia (including by you) but we nonetheless argued it would happen. In the beginning of 2008 I predicted several times that this was going to be a real problem in 2009 (ok, so I was three months late). I also tried to correct many times (unsuccessfully, I guess) the misconception of people who, like you, argue that high PBoC reserves meant that hot money outflow wasn’t a problem. It wasn’t a problem only if you believed that financial crises are synonymous with currency crises. But I argued that the risk wasn’t a currency crisis (China has almost no risk of this problem) but of a monetary contraction.
Your continued faith in the Chinese banking system is admirable but I think it is going to be increasingly hard to maintain it. I see TR has inserted a Bloomberg article that I was going to myself. Fitch has also come out with a bad report and privately most Chinese bankers I talk to believe we are going to see a huge increase in NPLs unless they can resist PBoC attempts to force them to lend. For them the choice is stark – credit contraction or exploding NPLs.
Prof Michael,
It’s wrong to say china have no control on monetary policy.It’s somewhat wishful thinking that china’s closed capital account policy doesn’t work.Why?
Not so long ago,we have a few mild cycles going on in our economy.eg,late 1980s and early 1990s,when inflation rate shot up to 12% which barely overthrow deng xiaoping;during asian financial crisis when export nearly collapsed and RMB still dont budge becoz of zhu’s famous promise; when US IT bubble blows up,china remained intact.
How China really managed to get out of these cycles without much damage I still wonder.You may wonder even more beacause according to your hot money doctrine and monetary framework,china wouldn’t escape these crises.So the only explanation don’t lie in capital movement.
Besides,China don’t need froeign money.in other words,foreign money don’t CAUSE growth herein.NO FUCKING CORRELATION!
Hmm It seems the nationalistic youth found its way here too. No matter there are still people around who can tell critical perspectives from propaganda.
I wonder “if large outflows increase the perception of risk and so encourage further large outflows” The perception of risk being that ones RMB might be worth more in USD or that the Chinese economy is not a safe short term bet anymore?
This could be said for almost any economy in the world right now, so to really alter the perception of risk I still think there has to be more, especially a scenario with strong nationalistic uprising (with our friend above as example) or more mayor riots in Inland and East coast provinses. The Nov/Dec outflows are money going back to those who gain on a bet that the yuan would appreciate it did and now they pull home some of the hot money there is still no argument that they should pull home even more just because the export sector or the real estate slows down, there is still the same risk level as in the rest of the world
Mr. Anders all Chinese are not nationalist youth and many of us respect greatly Mr. Pettis views. Every important blog in the world must attract many ignorant people and it is not correct to blame a whole country for this. I think Monyillusionist is confused between the lack of Chinese crisis and the lack of Chinese media to discuss the truth. He says “we have a few mild cycles going on in our economy.eg,late 1980s and early 1990s.” Of course he is wrong and has no economic understanding of what happened in China. Those were very difficult times and certainly should be considered crises, but following our Chinese policy if the official media says they were mild cycles than we must agree that they are mild cycles. If foreign money causes no growth in China, why has the government made so many efforts to attract foreign money?
Oh,com’n.Let’s not be political.I’m not an nationalist or an economonics student ,okay?I’m just introducing some simple perspective here.
About the late 1980s to early 1990s period,No one can say 12%inflation rate is not mild,but household income was also grew substantially during that period.(from my average family experience)
Asian crises is a more colorful example of good gov. intervention.
Chinese gov. may do a terrible job to curb over-heating,but indeed do a good job to steer the economy out of bad times.
What I mean by “China don’t need foreign currency”is that with high savings rate,there is too much liquidity here.so attracting foreign money is indeed attracting foreign technology or management.
Since we are all crystal balling it here with regards to hot money flow, why is trade protectionism being ignored as an influence. Current conditions are effecting current flows. For near certain Europe will move to limit Chinese imports. The US is bound to follow. I don’t think that there are going to be any large inflows until China adopts a non export based economic model.
Quote: “What I mean by “China don’t need foreign currency”is that with high savings rate,there is too much liquidity here.so attracting foreign money is indeed attracting foreign technology or management”
Three years ago Chinese economy insiders warned us of a complete waist of Chinese people`s aggregate savings by the large state owned companies. Companies received these savings by domestic lending, but it was said that an enormous stake of in fact are lost, allthough still valued as assets on bank`s balance sheets. We believe that there are some hints that the amount of NPLs is much higher than officially stated. For this, within the last years China could have desperately tried to attract foreign money just to fill already existing holes. If foreigners distract their money now at a great extent, these black holes might become clear to everyone and “the Chinese emperor might be realised as having no clothes on”.
This means, the Chinese bubble could be a much greater one than the US housing bubble, adding a second crisis to the existing global problems.
XuX: Twofish this isn’t a factor because bank stocks are being sold to the CIC and others in the foreign markets. It has no impact on capital inflows or outflows.
Even if the shares were sold in foreign markets if the ultimate funding is in RMB, then there has to be a currency conversion somewhere.
I understand that all Chinese are not….. I just commented on this one post, and when saying that “there are still people around who can tell critical perspectives from propaganda” this of course includes all, especially the many thoughtful and gifted Chinese I know and learned from.
No matter. Just did not like the last part of the post “Besides,China don’t need froeign money.in other words,foreign money don’t CAUSE growth herein”
The political and economic situation around the 90ies is different as to what we have today with a stronger national interdependency in the world economy. China should be proud that her economic well-being has become essential to the rest of the world.
Michael: It is a strange argument to say that the best way to deal with an imbalance is to exacerbate it because then the subsequent adjustment will be less dramatic.
That’s because I don’t think the concept of “balance” and “adjustment” leads to correct policy. It suggests that you should go up when you should go down, and left when you should go right.
During a boom, the policies should
* encourage investment in production and discourage consumption
* encourage savings and then place those savings in reserve
* increase reserves and do not borrow from overseas
That way when the bust happens, you end up with idle factories, out of work workers, and lots of cash. You then use the cash to wipe out the capital debt of those factories and then combine them with idle workers to do useful things, and there are lots of useful things that could be done. The idle capacity of all those steel and concrete plants can be used to fix up the railway system and create housing for migrants. If the money had gone into consumption, those factories would not be available.
Michael: Policies aimed at reinforcing imbalances during the boom period simply cannot reduce the subsequent cost of adjustment.
I think they can, but you have to look carefully at what those policies are. If during a boom, you borrow massive amounts of overseas money for construction, you are doomed when there is a bust. The thing to do is that during a boom, you ask yourself what happens when the boom stops and the economy busts. It’s not a hard analysis, but the danger here is assuming that the boom is permanent and that is when the really bad things happen when it isn’t.
I don’t think that trying to control the boom/bust cycle is very effective since what causes the boom and the bust is usually outside the control of an emerging market. I also don’t think that for an emerging market trying to moderate the size of the boom will contain the bust.
Michael: But I argued that the risk wasn’t a currency crisis (China has almost no risk of this problem) but of a monetary contraction.
I respectfully disagree. Monetary contractions take place over weeks or months and so you have time to control them and the consequences of making a mistake are much less severe. If you handle a monetary contraction carefully, you will have a recession lasting for a year.
Currency crisis take place over hours, there are no good ways of dealing with them, and they can kill economic growth for a generation.
So given a choice between bad options, I’m much rather go for the option that increases the chance of a monetary contraction and decreases the chance of a currency crisis. You will note that this current situation is likely to have much less bad impact on emerging markets than the crisis of 1997.
Michael: Your continued faith in the Chinese banking system is admirable but I think it is going to be increasingly hard to maintain it.
By the end of the year, we’ll see who is right. I’m optimistic about the Chinese banking system because they tried to implement the advice on risk management of Western bankers, unlike the Western banks. The most important thing about risk management is do not pretend you do not have a problem. Assume you will have a problem and see that you can deal with it. The problem with US banks is that because they believed they had excellent risk management when it was really crap, they are having increasingly large problems now. Since we knew Chinese banks had crappy risk management, the problems that come out now are likely to be less bad, because they were expected.
There are going to be massive amounts of NPL’s coming out of the Chinese banking system this year. The question is whether they will overwhelm reserves, and the reserves are large enough so that I think this is unlikely. The term I like to use is “preemptive bailout.”
Michael: I see TR has inserted a Bloomberg article that I was going to myself. Fitch has also come out with a bad report and privately most Chinese bankers I talk to believe we are going to see a huge increase in NPLs unless they can resist PBoC attempts to force them to lend.
The solution to this is simple. If the PBC wants to force banks to lend for macroeconomic reasons then the PBC should guarantee the loans.
Michael: For them the choice is stark – credit contraction or exploding NPLs.
It’s the same problem that US banks have, and it’s even worse since US banks already have broken balance sheets and can’t do any real new lending.
It’s something that you can’t resolve at the bank level.
I’m starting to get the suspicion that a lot of the credit in the informal banks didn’t come as a result of leakage from domestic banks but rather as a result of trade credit issued by overseas banks.
If this is the case then you have a really big problem. If you increase the exchange rate to cool down the economy, then you end up with high interest rates which then gives you inflow anyway. Instead of relying on currency appreciation for returns you rely on interest rates.
I’m rather pessimistic that a developing country can follow a strategy of “preventing a bust by limiting the boom.” The trouble is that the timing and magnitude of the boom/bust is rather outside the control of developing country. You might be able to argue that had China not more agencies there wouldn’t have been a housing bubble in the US, but suppose China bought less but the Arab nations bought more. Suppose the US never invaded Iraq in 2003 or was wildly successful or was forced to pull out in 2005. All of these things would have changed the global macroeconomic conditions far more than anything any one emerging market such as China could have done.
The other issue is that people are reluctant to take away the punch bowl while the party is going on, and once you figure out that you aren’t being listened to, you can either wait and say “I told you so” or you can think of ways that can mitigate the damage, once the bust comes.
I have no doubt that China is going to get hit by a massive financial storm that will cause large amounts of turmoil. That is not the question. The question is are the mechanism and systems in place to manage and mitigate the storm so that it becomes a historical footnote rather than a total catastrophe.
Seen from this angle, it may be better to know that you are going to have a bust cycle coming up than to believe that you won’t. It’s still very early, but the point that I need to make is that so far, nothing has happened to the Chinese banking or financial system that hasn’t been discussed for the last decade, and this means that people have given some thought to how to handle the problems at hand.
By contrast, we are in new and completely uncharted waters with the US banking system, and if was able to travel back in time to late 2007 or early 2008 and describe exactly what 2008 was like, I think a lot of people would have thought that I was a lunatic.
I agree with Mr. Pettis here. The failure to intermediate is going to catch up sooner or later. When you have a successful industrial policy tilting towards export and construction, then you can overlook this failure of intermediation. But when that industrial policy collapses, it’s the banking sector that is going to take the hit. The sad part is, the banks still don’t have the technical competence and the country still lacks the legal and political framework to properly allocate capital. Looking into the future, forget about past NPLs, that’s the part that has to worry you.
TR & Michael,
In the article that Zhu Min wrote about second wave of financial turmoil quoted in the Bloomerg report, Zhu was refering to international financial situation, NOT Chinese banks or financial industry.
To Tenman Prognosys RIKES:
Thanks for your reminding.Wildcat banking squandering savings have been secular since there have been banking.According Joseph Stigliz,US financial system’s ONLY good job is assigning capital to tech start-ups like Google.So I hate ppl saying that US system is resilient,flexible,etc.
US economy grow stronger and stronger not in spite of this wildcat financial system,but exactly becoz of such system(ironical?maybe not)so maybe we shouldn’t worry too much about boom-bust cycle.Chinese economy problem really don’t lie in monetary side.
Twofish.
I have to disagree with you about the “idle factory and cash” thing
If your customer orders went down, you usualy run out from the cash paralell it,and if you don’t have enought experience (as usualy in the case of the chinese plant managers) it will increase the problem.
and e I didn’t started to talk about the loans for new machines and so on.
There is many plant,which laying now idle.Example car compressor plant, whit a lot of money in the building and machine,and in the core engineergin/production group.
How can you utilise it for anythin?within one year,if you want to avoid the redundancy of the workers?
bomlar: If your customer orders went down, you usually run out from the cash parallel.
At which point, what should happen if you have a functioning bankruptcy system is that you get relief from debt service which should give you enough cash to keep the plant open and pay creditors. In the United States, if you have capital assets, the second you file for bankruptcy, you are going to get massive loans from the banks to keep the plants operating until they can be restructured. Bankruptcy is something that the US does, really, really well.
bomlar: There is many plant,which laying now idle.Example car compressor plant, whit a lot of money in the building and machine,and in the core engineering/production group.
bomlar: How can you utilise it for anything?
You liquidate and sell it off to the highest bidder who can then use the plant for something. The thing that you really need to watch out for is that the plant managers don’t close the plant, fire the workers, keep the money from the assets, and then leave the banks with debts. Which is what basically happened with Russia.
When a factory goes bust, it doesn’t mean that things are worthless. There is usually a huge amount of worth in factory plant. You just need to make sure that these valuable assets are disposed of properly. In many cases, the plants become immensely profitable after the banks wipe out the debt, which is why the Russian Oligarchs are as rich as they are.
bomlar: within one year,if you want to avoid the redundancy of the workers?
In the US, what happens is that the plant into Chapter 11, and workers salaries are pretty high on the list of things that bankruptcy will pay for since they are necessary for the plant to keep running. You had something functionally similar with SOE’s in the late-1990’s. We have a new bankruptcy, and that is going to be tested this time.
You still have a factory with industrial plant that is good for something, and therefore you are better off than if you just spent the money on consumption. At some point, the economy will start functioning again, and you can use the plant for something.
A lot depends on the details, and when you are in a boom, you have some time to think about what you can spend you money on and how the system will and should rationally react when the economy goes bust. If you run into a situation when you have a factory that goes bust, that’s not the end of the story, only the beginning.
Perhaps building a air compressor or steel factory wasn’t the best thing to do, and you should have built something else. The trouble is that if you build something else that generated even more wealth for less input, you have an even bigger “overcapacity” problem, which is why I don’t think that “balance” and “overcapacity” are useful ways of thinking about the economy.
If you frame the problem as “overcapacity” and “imbalance” it suggests that the thing to do is to spend less money on things that will increase productivity and production and more things on things that won’t (i.e. consumption). I find the conclusion somewhat absurd. Maybe it may work for Japan or even Russia, in which you can argue that there is nothing useful that you can spend capital on, but it certainly isn’t the case in China in which there are things that you can usefully spend money on.
Also, the problem is not NPL’s, There are lots of things that you can usefully spend money on that would create a return. The problem is who gets stuck with the NPL’s.
If the government needs banks to loan money on things that won’t produce a return (like loans to build schools and museums or just pay people so that they don’t riot) that’s fine as long as it is clear to everyone that the government will pay for the loan when it comes due, and as long as people keep track of the amounts.
Governments don’t have balance sheets (nations do, but governments don’t).
As for the question whether or not China was in need of foreign capital to accelerate its economic growth, Huang Yasheng, Associate Professor at the MIT Sloan School of Management, argues that the main driver of China’s economic miracle up to the end of the 1980s were domestic private village and township enterprises.
Then at the beginning of the 1990s, the central government decided to shift the economic development scheme towards urbanization driven and controlled by the public and governmental sector. The central government began to offer preferential treatment to foreign investors and foreign capital, thus effectively suppressing domestic private enterprises. Note that township and village enterprises are private enterprises, NOT (as widely misbelieved) public enterprises owned by local governments.
Now the point is: Huang argues in his studies that economic activity driven by the private sector in townships and villages in the 1980s have led to greater benefits for the Chinese people then the subsequent government- and public sector-led urbanization. What do you think of his view?
Here’s the article: http://www.mckinseyquarterly.com/Private_ownership_The_real_source_of_Chinas_economic_miracle_2279 (registration might be required)
[...] as Michael Pettis observes, China potentially faces the opposite problem. Money is flowing out, reserves are no longer [...]
Twofish
This is the story about the compressor plant:
http://www.lvrj.com/business/36871499.html
The Delphi had to move the plant to chine from the US , in good case they could move it to a warehouse,and use the capacity of an other plant to make compressors(in Mexico or in Brazil).
But the point is not this:the current development of china was not connected to the consumption,but to the central planed investment (example export industry).
You could do an investment into assets for service or consumption.
If your salary,and purchasing power growing,you still can save money,but your investment will go to amusement park instead of a brand new export factory.
This is a miss allocation of the resources: the party want a simple economy,not a long term sustainable.(they know that in the future they will lose the power,so let say 5-10 year is the maximum event horizon for them)
The bankruptcy and the chapter 11 could work in the US,but it can not work in a Communist country.
In the Us,it could put back the economy onto the track,but in china the party will command the re-allocation of the resources.
And they will try to conserve the existing environment.(it is so hard to avoid,even in the US they try this)
DB: As for the question whether or not China was in need of foreign capital to accelerate its economic growth, Huang Yasheng, Associate Professor at the MIT Sloan School of Management, argues that the main driver of China’s economic miracle up to the end of the 1980s were domestic private village and township enterprises.
Somewhat correct but completely irrelevant…..
What he doesn’t mention is that in order to drive this economic growth, these TVE’s had to borrow extremely heavily to the point where you had rural credit instititutions that were (and still are) insolvent. The TVE’s growth phase ended around 1990 when the countryside basically ran out of cash.
DB: Then at the beginning of the 1990s, the central government decided to shift the economic development scheme towards urbanization driven and controlled by the public and governmental sector
Because they had no choice in the matter. The boom in the countryside was not because private enterprise was particularly good but because Maoist communal agriculture was a total disaster. By 1990, the rural countryside had recovered from the Maoist disaster. At that point, there were no productivity gains to be made anymore, and the rural credit institutions that were designed to take advantage of these gains started going bust.
Also “privatization” is not a good way of describing rural land ownership. The “contract responsibility” system is something that is not quite private and not quite socialist. You can see it when people like Huang are saying good things about it that it becomes private, but when they say bad things about it, it becomes non-private.
DB: Now the point is: Huang argues in his studies that economic activity driven by the private sector in townships and villages in the 1980s have led to greater benefits for the Chinese people then the subsequent government- and public sector-led urbanization. What do you think of his view?
Maybe it is true, but it is completely irrelevant. The basic problem is that what worked in the 1980’s wouldn’t necessarily work in the 1990’s and the 2000’s and the 2010’s. The reforms of the 1980’s were designed to fix the problem of the 1970’s, and once those problems are fixed, you have to do something different. Times change, and policies that create a miracle in one place and time can be totally disastrous in another. Much of the “China miracle” wasn’t that privatization was very good, but because Maoist communal agricultural was particularly bad, and switch to another system (any other system) would have improved things.
This is the problem that I have with ideological people whether they are socialist or capitalist. They fail to adapt when the situation changes. People loved the Soviet model in the 1960’s not because they were total idiots but because the Soviet Union generated extremely large amounts of economic growth in the 1950’s. When talking about the failures of state planning in the 1990’s, we also have to consider the successes in the 1950’s. We can certainly learn things from the 1980’s, but we can’t repeat them because the world is different.
This applies to current issues. I personally think that Chinese industrial and banking reform in the 2000’s was a huge success. Does that mean that I think that we can relax and just follow exactly the same policies? Hardly. *Because* it has been a success, a lot of the problems that the policies had to fix have been fixed, which means that there is nothing more to do. China’s economic model in the 2000’s is highly capital intensive and highly export intensive. It worked well in the 2000’s because China is where the Soviet Union was in the 1950’s or where East Asia was in the 1980’s.
It’s going to stop working in the 2010’s Much of the export intensive part will never come back. Building one expressway is going to be very useful, but building two isn’t. Right now building stuff works because there are a lot of things that need to be built. As time passes there are going to be fewer and fewer things that can be usefully built.
So right now the big thing in China is trying to move the economy from an capital driven, export driven economy to an technology based, innovation based economy. This means basically tearing lots of things up and starting over again, and looking at how other countries (particularly the United States) promote innovation. It’s going to be wrenching and painful, change always is, and people will do a lot of stupid things and make lots of mistakes, just like they did in the 1990’s and in the 2000’s. Expect to make mistakes and set things up so they aren’t fatal ones.
I’m optimistic because managing an economy requires constant change and constant renewal, and my feeling is that the people in the Chinese government aren’t trapped replaying the glories of the past like the Soviet leaders of the 1970’s or frankly like Ya-Sheng Huang is.
Hi Twofish
Always very active. I appreciate that your view have evolved with time. Certainly getting very pragmatic. I should say that I tend to agree with most of your current set of views as well most of Michael’s ones by the way. Even if they tend to contradict sometimes
However you said:
“When a factory goes bust, it doesn’t mean that things are worthless. There is usually a huge amount of worth in factory plant. You just need to make sure that these valuable assets are disposed of properly”
Concerning factories going bust and its subsiding value, we have some background and experience.
What you say is alas wrong.
A fully functional industrial plant is certainly a miracle of human Genius. As long as it can sell its output in acceptable conditions.
However the financial value of a factory in overcapacity times is extremely low. A decent resale of equipment is “wishful thinking”.
Equipment is incredibly costly and, most important, its value is only related to very smart completely “ad hoc” engineering that is completed destroyed during a very rough bust.
Whatever valuation techniques you may employ and resale you may use. It is very often getting in the negative side.
Quite a number of family relatives – I should now say ancestors since this is both a story starting around 1850 closing during the end of the XXth century – has been in industry for long enough to have been personally instrumental in both opening and closing factories of various natures and size over a very long period of time. Including relatively recently steps that implies resale of equipment to, say, oversea countries…
I certainly hope that you do not have to deal personally with the financial and social consequences of such an event.
I just hope that Chinese authorities will do what is needed. That is support their own people in relatively difficult times. And not try to reverse the flow of history. That would have terribly damaging consequences.
bomlat: But the point is not this:the current development of china was not connected to the consumption,but to the central planed investment (example export industry).
The Chinese export industry didn’t arise as a result of centrally planned investment. If you look at the companies that are in the export industry, they are mostly private or local government owned companies that get their funding from informal sources or from overseas.
It’s a mistake to think that China is like the Soviet economy or the American economy or to try to put it into simple categories like “socialist” and “capitalist.” The Chinese government copies whatever works, which means that you have a strange mismash of different systems. One problem is that there is no good introduction to the structure of the Chinese economy because as soon as someone writes a book, it changes.
bomlat: This is a miss allocation of the resources: the party want a simple economy,not a long term sustainable.
It’s a mistake to say that the “Party wants.” There are lots of different people in the Communist Party with different goals and ideas for what China should do. Within the Communist Party, you see all sorts of economic beliefs from supporters of Soviet style Marxist central planning to people that want to push China in the direction of laissez-faire capitalism.
This diversity of beliefs within the Communist Party I think is a good thing. The reason that the Communist Party tolerates and to some extent encourages internal debate is that they want to stay in power, and one thing that the Party has learned is that if you don’t tolerate some internal debate, then you just stagnant.
bomlat: The bankruptcy and the chapter 11 could work in the US, but it can not work in a Communist country.
One good thing about China is that there is no ideological barrier to borrowing an idea from the United States if you can convince people that it will help the Party stay in power. There has been a lot of work done on a bankruptcy law, and it will be interesting to see how well it works in practice.
[...] just don’t think money supply is one, or at least not a major one. Yes, the hot money and significant FDI is leaving. But there [...]
Francois: A fully functional industrial plant is certainly a miracle of human Genius. As long as it can sell its output in acceptable conditions. However the financial value of a factory in overcapacity times is extremely low. A decent resale of equipment is “wishful thinking”.
Agree totally which is why it is usually the worst thing in the world economically speaking to dismantle a working factory, and why chapter 11 bankruptcy exists. Most of the value in a factory consists of know-how and human relationships, and when a factory can’t pay its debts, you do not want to immediately shut down the factory. Instead you want to arrange immediate funding that keeps the factory running while you can think of a way of maximizing value.
In almost all cases, this means wiping out capital debt, and keeping the factory intact.
Francois: Whatever valuation techniques you may employ and resale you may use. It is very often getting in the negative side.
The problem that you get into in situations without good bankruptcy production is massive asset stripping in which the manager of the factory gets control of the assets of the factory, sells them, puts the funds in his personal account, and then leaves the debt in the hands of the state or the factory.
A lot of free market theory is based on interactions between a buyer and a seller each which is trying to maximize profit, and the theory is that they will act in ways to maximize utility. However, in situations where you have complex relationships, it doesn’t always act in this way. In particular if you have a factory manager with control over assets but no liability for debts, then they may act in ways that don’t maximize social utility.
Towfish
I think you miss the point: the central goverment is just a part of the party.
The bigger part of it is the mid and low level officials.
the botleneck for the chapter 11,or for a sustainable ecceonomy comming from the low level mainly.
In this enviroment the private and the state ovned is not clearly separated,because the point is not the ovnership,but the supporter of the business.
(a party official…)
They are quick,you can make projects in china which are extremly quick,because the party member support you.
The target of an avarage party member is simple:
A.,power
B.,money
And they are the law.
Oh,and I don’t know the Chinese communist party.
But I know the polish/hungaryan/slovakian/DDR way.
[...] minds are reading Monetary conditions might exacerbate the Chinese adjustment by Prof. Michael [...]
[...] minds are reading Monetary conditions might exacerbate the Chinese adjustment by Prof. Michael [...]
[...] minds are reading Monetary conditions might exacerbate the Chinese adjustment by Prof. Michael [...]