I usually don’t post a new entry so soon after the last post, but there was an interesting article in today’s Wall Street Journal by Andrew Batson. 

China is center stage when it comes to fears that buyers will one day spurn U.S. Treasurys. The bond market has been the source of much political theater between the U.S. and China in recent months, with Chinese officials passing up few chances to lecture the U.S. on its profligacy. 

But that has obscured an important change: The market for Treasury bonds is now more reliant on U.S. buyers — including the Federal Reserve after its recent buying spree — than the Chinese. 

China held $801.5 billion in Treasury debt at the end of May. The Fed at that time held about $598 billion, although that has now risen to $704 billion. The latest figures for U.S. households, from the first quarter, showed holdings of $643.9 billion — more than double the $266.6 billion in the fourth quarter of 2008.  

The rising budget deficit, which has led to record issuance in recent months, doesn’t necessarily mean the government is becoming more indebted to foreigners. While the U.S. government is borrowing furiously, the current account deficit has actually halved from an annualized $829 billion in mid-2005 to an annualized $409.5 billion in the first quarter of 2009. That shows the U.S. is now less dependent on external financing, because it is saving more domestically. The U.S. government may be in hock, but it is increasingly to its own citizens. 

This shouldn’t be a surprise.  The reason for the growing US fiscal deficit is to slow the economic impact of a rise in US household and corporate savings.  This means that the period in which very high Asian savings were matched by very low US household savings is changing to one in which the pressures to save in Asia remain while US households are increasing their savings (or reducing their borrowing, which amounts to almost the same thing).  The pool from which the US Treasury can borrow is increasing, not decreasing.  

In addition, as the US current account deficit drops, foreign net purchases of dollar assets must also drop.  The rising US fiscal deficit will increasingly be financed by Americans and less and less by foreigners, and the much-decried impact on US interest rates of the massive US borrowing turns out to be very small. 

Brad DeLong, who also expected this to happen, has a very similar take from a different angle, which he discusses in a recent blog entry: 

And the interesting thing is that I knew that this [that the market would easily absorb a huge increase in government debt] was going to be what would happen–or, rather, I strongly believed that this was going to be what would happen–and all because I had read John Hicks (1937). 

Let me give you the Hicksian argument about what happens in a financial crisis–a sudden flight to safety that greatly raises interest rate spreads, and as a result diminishes firms’ desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods as they, too, try to hunker down. 

In Hicks’s model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms adn so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely–in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative. 

Batson goes on to say in his article: 

History suggests there is plenty of room for households to increase their holdings. 

The Chinese government may be politically uncomfortable with lending money to the U.S., but it remains locked into purchasing Treasury bonds because of its currency’s tight peg to the dollar. The challenge for the U.S. government isn’t just reassuring China. 

It also is to maintain the confidence of the domestic investors who are an increasingly important source of financing for the wave of government debt supply hitting the market. 

The only point with which I disagree is on the need to “reassure” China.  As I have pointed out many times, although there are plenty of good reasons for China to worry about the value of its dollar holdings, and I hope many people, not just the Chinese, are looking warily at growing US fiscal deficits and making disapproving noises, the fact is that there is little China can do about its dollar holdings without either causing a damaging rise in trade tensions with Europe (or any other country whose currency is an alternative to the dollar) or causing a collapse in its export industry.  As long as China’s trade surplus directly or indirectly is connected to the US trade deficit, China will have to recycle the surplus into the dollar pool that ultimately funds the US fiscal deficit, and it is in the best interest of the US that the US trade deficit decline smoothly, which means that it is also in the best interest of the US that foreigners, including the Chinese, buy fewer US dollar assets. 

What is confusing is the conflict between China’s natural position and its stated position.  Rather than demand reassurance that the US will control its fiscal spending, China should be secretly hoping that the US fiscal deficit will mushroom.  It is after all largely the size of the US fiscal deficit that will determine the speed with which US imports and the US trade deficit contract, and it is in China’s best interest that these contract very slowly. 

On a similar subject, I was recently interviewed for a TV show about – yet again – the awful continuing prospects for the dollar as a the dominant reserve currency.  Besides expressing my deepest skepticism that the most recent hullabaloo about the dollar was likely to be more reasonable than during all the previous the-sky-is-falling-on-the-dollar periods, I also said that it seems to me that the argument had somehow gotten backwards as far as its proponents and opponents were lining up. 

In my view it is the US who should be agitating for an end to the US dollar as the default reserve currency, because this means that any time a country needs to grow reserves or turbo-charge domestic growth with mercantilist industrial policies, thanks to the flexibility of the US financial system and the foreign desire to accumulate dollars, it is almost always the US tradable goods sector that is forced to adjust.  In a similar vein it should be foreigners, especially Asians, and most especially China, that should want to maintain the existing currency system.   

I also suggested to the interviewer that in two or three years no one would be talking about this topic anymore.  She was surprised and asked me why.  The reason has to do, I think, with the expected evolution of the US current account deficit.  For several years the US has been running, as we all know, very large current account deficits.   

This means that the net accumulation of dollars by foreigners (foreign purchases of dollar assets minus American purchases of foreign assets) has been extremely high – just as in the 1960s when the combination of a trade deficit, foreign military spending, and large foreign aid programs created a dollar glut, along with heated arguments about the international role of the dollar.  If the US current account deficit remains high, foreigners will continue to be large net acquirers of dollars. 

But if the current account deficit declines quickly, as it has and as I expect it to continue doing for a while longer, the problem of too many dollars being held abroad will disappear – or, more technically, it will simply be the obverse of the change in investment flows into the US.  Once the world stops accumulating hundreds of billions of dollars every year through the US current account deficit, the argument over the dollar will fade away and, not coincidentally, a larger portion of foreign reserves, and probably international trade, will naturally be denominated in non-dollar currencies.

In my last entry I tried to set out the necessary shifts over the next few years as the world, and especially China and the US, works out its imbalances.  These shifts will take place, I am pretty sure, but they can do so under a “good” scenario and a “bad” scenario.

So what does all this have to do with the SED?  It means that the best hope for the two countries, I think, is a well coordinated set of policies acknowledging that the US savings rate must rise, and with it the Chinese must decline, but also recognizing that if this happens too quickly, or is accompanied by a collapse in trade, it will be bad for the US and terrible for China.  These coordinated policies must also acknowledge – and this becomes much more difficult – that the current Chinese stimulus may be making the adjustment more difficult, and much of it will have to reversed at the same time as the “appropriate” measures aimed at spurring consumption may cause a short-term rise in unemployment.

Finally, the while the US commits to keep fiscal spending high, to turn a blind eye to trade disputes, and to run large trade deficits for several years more, China must commit to the financial sector and currency liberalization that will effectively reduce subsidies to producers and constraints on consumption.  The SED might also discuss the ability of workers to demand and enforce wage increases, since there is a wide consensus in China and abroad that among the main reasons for low household consumption in China is that wages are rising too slowly relative to GDP, and household savings are “taxed’ too heavily via interest rate policies.  Of course discussing workers right in a bilateral context is politically difficult, even without the irony of this particular discussion, so it will probably not happen.

When I discuss these issues, I am often confronted by the “aha!” crowd who point out that my analysis must be wrong because if China does what I think they should do that would cause a rise in unemployment.  How can a policy be the right one if its implementation leads to a bad outcome?

That’s easy.  It can be the right policy if the alternative leads to a worse outcome.  That’s the problem.  There is no silver bullet here that can kill all the demons and leave us living happily ever after.  As I see it, the imbalances of the past decade were real and must be addressed, and we have broadly speaking three possible ranges of outcomes:

1. The US returns to its consumption orgy, the US trade deficit surges, and we’re back to the wonderful days of 2005. China can continue pumping out production and funding US consumption.  The problem of course is that this cannot be a permanent solution.  It just postpones the resolution of the global imbalances while fueling another asset bubble and saddling the US with even more debt and China with even more excess capacity.

2. China begins a long – five or six years at least – process of forcing the necessary structural changes that will permit a shift from a production-led economy to a consumption-led economy.  The changes necessary involve liberalizing interest rates and the banking system, allowing workers higher wages, and a number of other measures to boost SMEs, the service sector, and household consumption.  In the short term, however, nearly all of these measures will involve closing down unprofitable production facilities.  This must be done in conjunction with the US, so that the US adjustment is slowed down to a pace which China can absorb.  The US would do this by keeping fiscal expansion high enough to counteract the contraction in US household consumption.

3. Everyone does what they want to do anyway with no attempt at serious coordination.  US savings rise.  Chinese production rises too.  These two forces are globally incompatible and eventually lead to a sharp contraction in global GDP growth.  The effects on China might include, but are not limited to, an explosion in Chinese inventory, a sharp and nasty contraction in international trade, or a brutal rise in Chinese NPLs and an unsustainable government debt burden.

High savings in China is not an accident.  Chinese trade and industrial policies that were aimed at generating employment growth by directly or indirectly subsidizing the cost of production, including currency and interest rate policies, nearly all effectively created forms of income and consumption taxes that constrain consumption even as they boost production (and a rising savings rates just means that production is growing faster than consumption), and to remove the latter you need to remove the former too.

It’s not so easy to increase consumption

So they have a dilemma: Remove the producer subsidies so as to allow consumption to grow, but cause subsidized producers to go out of business.  Or keep them in place, and perpetuate the production/consumption imbalance.

One way or the other Chinese policymakers are destined to be “successful” in raising the consumption share of GDP, because as the US reverses its earlier relationship between consumption growth and production growth, the rest of the world, which ran the opposite position, must also ultimately reverse.

Now for the next few years China’s savings rate will almost certainly decline and its consumption rate rise – it has no other choice except to inflate a major, debt-fueled overinvestment boom – but will that happen because of high growth in consumption or low production growth?  That is where policy matters very much, and the longer they wait to address the imbalance, the worse the outcome gets, I think.

Clearly Beijing wants to raise consumption quickly.  Not too long ago a group government economists were reported to have reported on their website (sorry, but I lost the link):  “The new policy measures and initiatives will be the latest effort to shift growth from focusing on capital investment to a more sustainable model that gives domestic consumption a more important role in boosting economic growth.”

But they’ve been wanting to do this for a several years – as they explicitly acknowledge by calling this the “latest” effort – but the fact that it is harder to this now then it might have been three or four years ago doesn’t inspire me with much confidence.  It seems to me that most policies that will boost consumption in a stable and efficient way fall into one of two camps.  Measures like building the medical and social safety net, gradually getting banks to direct lending to service industries,  loosening the one child policy, and so on can be very successful, but will take years before they have much impact on real consumption.

In that camp I might add measures to force banks to increase consumer lending, because I think the last time they tried that (with car loans), nearly half the loans went NPL, suggesting that at first consumer lending will simply consist of free consumption financed indirectly by the government, when it bails out the NPLs.  This is a form of “consumption” I guess, but it is not really what the doctor had ordered.

Bad or worse

On the other hand reversing the policies that might have repressed consumption in the past will probably work more effectively within a shorter time horizon.  These would include liberalizing interest rates and allowing them to rise (which reverses the implicit transfer from households to producers), allowing workers to organize to demand higher wages, raising the value of the RMB, and so on.  Unfortunately nearly all of these measures would hurt manufacturers, especially in the export sector, and would cause an initial rise in unemployment.  I am not sure it is possible to manage the transition without a sharp, short-term rise in unemployment caused by the downsizing of the export sector as its implicit subsidies are removed, and it isn’t clear to me that any country that has managed a similar transition has been able to avoid this. My guess is China will have to do this, but will wait until they have no choice – building up in the mean time even more excess capacity and bad debt. And bad debt, as I have argued before, must be resolved at some point in the future, and unfortunately usually in a way that constrains consumption growth.

One of the things that worries me is that the trajectory of rising US savings and increased investment in Chinese production is likely to squeeze the tradable goods sector in most countries around the world as China increase its market share.  This will lead to accusations that China is behaving in a predatory way, and will almost certainly lead to increased trade tensions as policymakers around the world try to protect their tradable goods sectors form “unfair” Chinese competition.

But I don’t believe that China should be considered predatory. China desperately wants to raise its consumption rate, because it is highly likely that for the next few years Chinese GDP growth will be limited to something below Chinese consumption growth.  Beijing would love to find the magic policy that transforms Chinese consumption overnight and turns China into a continental economy driven by internal demand.  It would love to see the trade surplus reduced not by a collapse in exports but rather by a shifting of exports to domestic consumption and a rise in imports (this last maybe).

The problem is that there is no such magic policy.  I cannot find any historical precedent of a country that was able to make the transition quickly and painlessly, and because of its own domestic problems – especially the employment effect of the contraction in the export sector – China is facing a difficult set of policy choices.  The fact that the fiscal stimulus may be exacerbating China’s reliance on the export sector was not the plan.  The fiscal stimulus is aimed at arresting a sharp and probably politically unacceptable rise in unemployment, and the fact that so much spending has gone into investment, rather than consumption, reflects rigidities in the economic and financial structure.  China would love to see explosive growth in domestic consumption, but there is no way they can easily engineer such growth.

So we are stuck with policymakers, in China and elsewhere, making the best of a bad situation.  They can be criticized for not beginning the adjustment process when conditions were much easier, but that is a criticism that can be spread around pretty thickly to policymakers in quite a few countries.  Anyway it is too late.

In these circumstances policy coordination matters a lot, and I see too little of it to have much optimism.  Beijing, Washington and Brussels must recognize that China and the world is still in a more vulnerable position than anyone seems to realize, and that rising US savings and rising Chinese investment create conditions for two seemingly irresistible forces to go head to head, and without coordination the consequences could be much worse than we expect.

Beijing music and art

 

Things have been so busy that I haven’t been posting as much as I would like.  Besides my increased writing commitments and the constant barrage of news, I would like to mention that over the past weekend we completed the second annual festival of experimental and avant garde music, featuring the best Chinese composers and performers from all over the country, and several of my regular blog readers attended – thanks for that, even though this blog is no longer available inside the Chinese firewall.  

 

Twenty hours of music over two days is not always easy, especially when some of the music is “challenging,” to say the least, but I am pleased to say that this festival has become the premier event in China for new and experimental music and the turnout was larger than expected and very enthusiastic.  So far we don’t seem to have been affected by the economic crisis.  In particular performances by Mamur, Li Jiahong and Li Tieqiao, Shouwang’s White Ensemble and a number of others were exceptionally good.  We’re all still exhausted, but already I have been getting urgent enquires about our plans for next year.

 

While on the subject of art I should note that the People’s Daily had an article today on difficulties facing the Chinese art market.

 

The global economic meltdown has hit the city’s art exhibition industry, with several big international events attracting less funds than before or even being postponed, exhibition organizers said.

 

The article goes on to discuss difficulties facing the 798 Art District in Beijing “a center featuring primarily non-government-funded art events, where many shows were cancelled.”

 

I am not totally sympathetic because it seems to me that the commercial art scene here was simply part of the late stage credit bubble, and the young artists I like best were never really able to participate.  But it is a nonetheless interesting story because historically art bubbles have always been part of the bubble cycle.

 

On that topic, I thought I would make a quick, and perhaps a little snide, reference to an article in last month’s New York Times about the Chinese art market.  About a year ago I had dinner with a group of people which included a couple of gallery owners specializing in contemporary Chinese art.  Not surprisingly, they were ebullient about the seemingly inexorable rise of Chinese contemporary art prices, and perhaps also not surprisingly, I was enough of a wet blanket to argue that we were soon going to see a total collapse in art prices. 

 

Why?  Because every serious financial bubble in history was, towards its later stages, accompanied with an even more ferocious bubble in art prices, and when the bubble burst, art prices were among those worst hit (I refrained from adding that although there are a number of young Chinese underground artists whose works I really love – stand up, Cult Youth Collective – for the most part I was very unimpressed with the commercial stuff getting most of the attention).

 

Needless to say most of the dinner guests were politely skeptical, and my pointing out the examples of the Japanese art market in the 1980s and the Arab art market in the 1970s – two markets that people don’t talk about much anymore, it seems – didn’t make much difference.  One month later I read in one of the British newspapers that some well-known London-based art dealer had announced that prices in the art market had reached a level that represented long-term artistic value, and would not be affected by the crisis (art prices have reached a stable plateau? I hope he was otherwise as good an art dealer as Irving Fisher was an economist). 

 

So what does the New York Times article say?

 

A global financial crisis has wiped out vast amounts of personal wealth, prompting a plunge in art prices. Suddenly bereft of visitors, galleries are laying off staff members, and the collectors who patronized them now worry that their art investments may prove a colossal folly.  “It’s been a long, cold winter,” said Zoe Butt, director of international programs at Long March Space, which is closing two of its three Beijing galleries. “The era of Chinese contemporary art commanding such high prices is over.” 

 

…Globally, the recent rise in Chinese artists’ fortunes was unparalleled. Only one Chinese artist — Zao Wouki, a traditional painter who lives in France — ranked among the Top 10 best-selling living artists in 2004, according to Artprice.com, which tracks auction sales. (He ranked ninth.) But by 2007, 5 of the 10 best-selling living artists at auction were Chinese-born, led by Zhang Xiaogang, who trailed only Gerhard Richter and Damien Hirst. That year, Mr. Zhang’s auction sales totaled $56 million, according to Artprice.com. Many collectors were seduced by the numbers. “For people who got into the market three years ago, I feel sorry for them,” said Fabien Fryns, who runs F2 Gallery in Beijing.

 

When people say that it isn’t easy to know if we were in the midst of a bubble, I can only respond that when, in just three years, the number of Chinese artists in the top ten living best-sellers zooms from one to five, it must be obvious that we are in a particularly frothy bubble.  No matter how rapidly talent and access to collectors improve, the quality of an art scene simply cannot adjust at anywhere near that speed.  I am sure even Renaissance Florence under Cosimo de Medici’s very wise patronage took much longer than three years to move so far up the artist-income scale.

 

A new reserve currency

 

But back to less exalted things.  The number one topic of conversation right not seems to be an essay posted in both English and Chinese on the PBoC’s website by PBoC Governor Zhou Xiaochuan.  In it Governor Zhou argues that the world needs a new and better reserve currency, one not dominated by a single country, and that it is in the best interest of the world that this reserve currency be created by a body like the IMF.  Funnily enough for all the attention the essay received I saw no mention of it on either Xinhua or the People’s Daily. 

 

We have heard these kinds of arguments many times before over the course of the 20th century, and usually in response to a global balance of payments crisis.  Is there anything new about this proposal?  Some commentators saw this essay as a purely political move.  Jamil Anderlini of the Financial Times, for example, had this to report:

 

China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.  In an essay posted on the People’s Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, said the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”.

 

Analysts said the proposal was an indication of Beijing’s fears that actions being taken to save the domestic US economy would have a negative impact on China.  “This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC.

 

Although Mr Zhou did not mention the US dollar, the essay gave a pointed critique of the current dollar-dominated monetary system.

 

Others were more intrigued by the theoretical implications of the essay.  A number of people including Columbia University’s Joseph Stiglitz, are supportive of the idea, arguing that the status of the US dollar as the world’s reserve currency creates unnecessary problems for both the US and the rest of the world. 

 

Most importantly for the US it means that it is very difficult for the Fed to manage domestic monetary policy because the US financial system must accommodate not only conditions in the US but also distortions introduced by the use of the US dollar as a reserve currency, and these distortions can be massive.  The most obvious example is the way over the past decade systematic industrial policies mainly in China and East Asia aimed at running trade surpluses and the accumulation of reserves meant that the US economy and its financial and monetary systems were forced to adjust in ways that created large and serious imbalances, which only now are we resolving.  

 

But although I think the world would be better off if there were an active alternative to the US dollar, I can’t help but think all this flurry of talk is a waste of time and driven mainly by political considerations almost wholly divorced from any understanding of exactly what a reserve currency is and how its status is achieved.  Every decade or so there are calls for the replacement of the US dollar with a more international reserve “currency” but they always lead exactly nowhere, and I can’t think of any reason why this time will be different.  On the contrary, one of my working assumptions is that with the end of the global liquidity cycle the value of liquidity will be higher than ever.  New currencies and currency unions thrive during the liquidity cycle.  They almost never survive the end of the cycle. 

 

Perhaps Governor Zhou has much more faith than I do in the role policymakers have in creating reserve status – as if you could fill a few boxes, make a political decision, and then simply create a new, widely used reserve currency.  But the fact is that excessive reliance on the US dollar was not a policy decision.  If the world truly wants a more “balanced” reserve currency system there are, after all, many currencies that could have functioned alongside the US dollar, but investors, central banks, and international traders seem to have had little interest in acquiring a “balanced” portfolio of reserve currencies. 

 

For one thing liquidity is key, and I think not even the euro – and certainly not SDRs or alternatives to the SDR – can ever hope to achieve anything like the level of liquidity implicit in the US dollar market.  For another thing, for a currency to achieve reserve status there must be some systematic way of delivering the currency to central banks and other players who want to acquire it, and the US does so by its ability and willingness to run persistent trade deficits.  How will the IMF or whoever controls the SDR create and assign reserves?

 

More specifically, if the SDR is indeed a true reserve currency, and not simply an accounting entry that allows central banks to pretend that they are not holding dollars but whose value ultimately rests on its convertibility to the US dollar, who will determine the global money supply and how do we prevent this from becoming a horribly politicized process?  After all the Fed has an interest in seeing stability in the value and use of the dollar, and so it can be counted on more or less to act in the best interest of the reserve currency, but why should anyone care about the value of the SDR over the long term and, more importantly, how can prudent behavior be enforced?  More worryingly, if Europe has had so much trouble managing monetary policy among a group of neighboring countries with fairly similar social and economic conditions, how do we manage monetary policy on a global scale?

 

Perhaps the SDR is a covert way of getting back to something resembling the gold standard by creating a fiat currency with very strict rules about its expansion.  If that is the case, the SDR almost certainly won’t last long.  Since we’ve gone off the gold standard we have forgotten how brutal and unforgiving gold-standard discipline can be, and I think it was Barry Eichengreem who argued in Golden Fetters that the gold standard could only work in a society in which the poor and the weak have little political power, the voting franchise is limited, and the impact of monetary policies on underlying economic conditions was not widely understood.

 

Unemployment

 

All this talk of new currencies and new financial architecture is obviously aimed at the upcoming G20 meetings.  I very much doubt anything useful will come of the meeting except for diplomatically restrained name-calling, and I am currently writing a piece to be published by the Carnegie Endowment (who I recently joined), which I hope to have by the end of this week, discussing some of the issues the participants are going to face.

 

Bu away from the world of high finance I thought I would mention two things.  The first is an article in last week’s Xinhua on hiring prospects.

 

The latest report by major job service provider Manpower indicates that hiring prospects in China may continue to drop by a “considerable 10 percent” in the second quarter as the global financial crisis began to affect the real economy.  The report, based on a survey which covered 4,149 employers across the country, showed that the eastern job markets were experiencing the weakest hiring climate in four years.

 

The next article, on the same topic, is from today’s People’s Daily. It focuses specifically on the job outlook for college graduates.  Last week I read an article – also in People’s Daily, I think, but I can no longer find it – in which it was claimed that the share of Guangdong students graduating in 2009 who already have job offers was less than half of the share last year at this time.  Today’s article seems to confirm this:

 

In an unfortunate reversal of fortune, more than 70 percent of upcoming graduates have yet to secure a job.  “Normally about 70 percent of graduates have job offers in March, but now the situation is completely upside down,” Wu Xiaohui, senior campus recruitment consultant with Shanghai Foreign Service Co Ltd (SFSC), told China Daily yesterday.

 

The article goes on to say:

 

According to another survey by SFSC, about 55 percent of the city’s 104 multinational corporations didn’t intend to recruit new staff this year amid the deepening recession.  Among those who plan to hire, half will recruit fewer than 10 people, compared with an average of 50 to 100 people in previous years.

 

Along with this gloomy outlook the World Bank last week cut its growth forecast for China.  When they cut their forecast last year, I said they would revise it downward at least one more time.  Perhaps this time will be the last downwards revision for 2009, but if it is, expect a series of downward revisions for 2010.  This is from last week’s Xinhua:

 

The World Bank (WB) has cut its forecast for China’s 2009 economic growth yet again — this time to 6.5 percent from 7.5 percent, it said here Wednesday.   This is the second cut the bank has made for China’s 2009 gross domestic product (GDP) growth forecast. Last November its prediction stood at 9.2 percent.

 

This came after the bank lowered its forecast for the 2009 world economy, which was expected to decline 1.5 percent from 2008. In November, the WB forecast the world economy would grow 1 percent this year.

Tags: Art bubble

The piece I wrote for YaleGlobalOnline, which I mentioned in my last entry, was published today, and is called “US and China Must Tame Imbalances Together.” In the article I try to argue that the roots of the current financial imbalance – or, more accurately, of the latest and strongest stage of the current financial imbalance – are buried in the trade and capital relationship between, primarily, China and the US. It is very important, I argue here and elsewhere, that the US and Europe do everything possible to help what could otherwise be a very difficult adjustment for China. The editor’s summary of the piece is:

With surging liquidity and massive trade imbalances, no one should have been surprised by the global economic crisis, because as finance professor of Peking University Michael Pettis explains, this has been the historical pattern. Pettis details the history of the crisis, starting in 1980s, when US policy encouraged securitization of mortgages, converting illiquid assets into highly liquid investments; US households shifted money into homes rather than savings accounts, and housing prices climbed; China, enjoying a trade surplus, collected US dollars and invested in US assets. A self-reinforcing cycle led US consumers to buy more, Chinese factories to produce more, banks in both countries to lend more, and the bubbles burst in late 2008. US adjustment is more rapid than China’s, which could lead to a new set of problems. Pettis warns that replacing US household consumption with US government consumption will only perpetuate the imbalances, and he urges the two nations to act responsibly, coordinating fiscal and monetary policies to ease US overconsumption and Chinese overproduction.

The argument I am making here is also part of a spirited discussion among a group of China scholars who communicate regularly on China-related themes. At the heart of the discussion is an argument over the monetary and policy mistakes made by the major players in permitting or even encouraging the credit bubble of the past decade. Although at its worst these kinds of discussions can quickly degenerate into a fruitless who-to-blame invective (”It is all the fault of Chinese polices” versus “It is all the fault of the US failures”), at its best – and the discussion has generally been quite good – it is a real attempt to understand the roots of the current crisis and the still-unclear ways in which it may continue to unfold.

I am not allowed to publish or publicize any of the comments among this group since the moderator wants to encourage completely open discussion, but I can say that one of the participants wondered about the sequence of events and questioned my claim that crises are always caused as a result of periods of excess liquidity, and that it is difficult for regulators to prevent excessive risk-taking when the financial system is forced to accommodate excess liquidity. I think that this is an interesting enough discussion, and very relevant to China, to repeat the argument and my response.

My friend argues that although he agrees excess liquidity is a necessary condition for credit bubbles, it is not at all clear to him that it is a sufficient condition. Besides excess liquidity, he argues, we need misguided regulatory policies to create a bubble and a subsequent financial collapse. In his view, the Fed was primarily responsible for the crisis because of its failure to regulate the financial system with sufficient rigor, and given the expansion of liquidity, it was only a question of time before that failure would lead to crisis.

In my response I argued that it is hard to say if excess liquidity growth is both necessary and sufficient condition for crisis since we would need an objective way to measure excess liquidity growth, and that is extremely difficult, at best. The late Frank Fernandez, while chief economist of the Securities Industry Association, spent years trying to do so, but always complained that the financial system was too good at developing new and unexpected ways to expand money.

I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and I doubt the ability of regulators to prevent bubbles. Part of my skepticism about whether or not a robust regulatory framework can truly prevent credit bubbles is theoretical, and part of it is empirical, with the latter resting on two personal experiences. First, in my reading on financial history and current events there has clearly been tremendous improvement over the past 300 years and more in our understanding of financial risks, the functioning of the financial system, the sophistication of our regulatory institutions, and monetary policy, but absolutely no concomitant reduction in the incidence of credit bubbles.

Quite the contrary, and if good regulation prevented crises, why wouldn’t we have seen evidence of gradual improvement in the number and viciousness of crises? Second, as a former smart-ass banker/trader I am too respectful of the enormous ability of the market to game any system that can be put into place. Regulators simply cannot outplay the market, and when too much liquidity leads to an increase in risk appetite, the financial system will find a way to take on more risk that might be healthy. As I argue in my piece, “When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.”

That leaves me a hard-core Minskyite on financial instability, and it is Minsky who creates the theoretical basis for my skepticism. According to Minsky it is not possible even in theory to eliminate financial instability because the very mechanisms used to control one form of instability will cause changes in the financial system (all those smart-ass bankers/traders) that will create new forms of instability. The whole purpose of a financial system is to intermediate risk, and when risk appetites change, the financial system will find a way to accommodate that change, whether or not regulators are comfortable with the change.

That doesn’t mean regulations are a waste of time. On the contrary, they are extremely important in the proper functioning of the financial system, but we need to be clear where they matter and where they don’t. As I see it, the purpose of the regulatory framework is:

1) To create a financial system that in “normal” times optimizes the ability of the system to allocate capital cheaply and efficiently. This is where issues of transparency, corporate governance, agency problems and information asymmetry matter.

2) To eliminate balance sheet feedback mechanisms that are automatically pro-cyclical and, to the extent possible, create fiscal and balance sheet stabilizers. These don’t eliminate bubbles and crises, but they do reduce the impact and weaken the transmission mechanism into the real economy.

To bring this back to China, it is for these reasons that I am more skeptical than most about the recent financial reforms in China. As I see it, the financial system here is replete with balance sheet pro-cyclicality, which the government has not directly addressed (in fact many of their interventions increase the risk) and so China runs the risk of a big, “unexpected” jump in volatility when things turn bad.

The strongest element of counter-cyclicality in China is probably government ownership and control of the banks, but even this is counter-cyclical only up to a point, beyond which it becomes massively pro-cyclical –for example if problems in the banking system ever threaten government credit, which is why I have always advised anyone who will listen that the government should be very sparing in its willingness implicitly or explicitly to guarantee credit risk. Government control of the banks can prevent banks from behaving in ways that exacerbate a downturn, and usually this is a good thing, but in a very severe downturn – like that which Japan experienced after 1990 – the attempt to control banking activity can actually backfire if it leads to a surge in government debt that threatens government credibility. This loss of government credibility hasn’t happened in Japan (yet) but it has happened in a number of other cases.

This is basically why I think the liquidity creation generated by the Chinese recycling of the US trade deficit would have led to crisis anyway, even if there had been stronger regulation within the US financial markets. And, by the way, although I share in the general horror about the huge breaches in our regulatory framework, I also remember that during the enormous petrodollar recycling in the 1970s, the US regulatory framework was much more robust, regulated, rigid and constrained then it is now, but that didn’t prevent excess risk-taking. The only impact of regulatory constraints was that extremely foolish behavior – massive loans to countries that had no chance in hell ever to repay – still occurred among American banks (to such an extent that by the time I joined the market in 1987 only one – JP Morgan – of the top ten US banks was not insolvent) but they occurred outside the regulatory constraint. For all the regulatory prudence the risky behavior simply migrated to London, where international banks were not as strictly regulated by their home countries.

The real fault of the Fed in the current crisis, in my opinion, was not to foresee that this unsustainable system would eventually come to a breathtaking close, and to prepare the stabilizers that would have prevented the decimation of the US financial system and its brutal transmission into the real economy. In fact every time they intervened to prevent the system from clearing, they increased the accumulation of balance sheet mismatches. The regulators did have a role, but it was not to prevent the crisis but rather to mitigate its impact. In my opinion the Fed could not have prevented the crisis except by engineering a recession in the US to counteract strong mercantilist policies in Asia, and that is perhaps a lot to ask.

One last thing about the joy of assigning blame, I have read and re-read several times Charles McKay’s Extraordinary Popular delusions and the Madness of Crowds and thought I should post the following selection from his chapter on the South Sea Bubble – after the bubble collapsed bringing ruin in its wake:

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.

This was the almost unanimous feeling of the country. The two Houses of Parliament were not more reasonable. Before the guilt of the South-Sea directors was known, punishment was the only cry. The king, in his speech from the throne, expressed his hope that they would remember that all their prudence, temper, and resolution were necessary to find out and apply the proper remedy for their misfortunes. In the debate on the answer to the address, several speakers indulged in the most violent invectives against the directors of the South-Sea project. The Lord Molesworth was particularly vehement. “It had been said by some, that there was no law to punish the directors of the South-Sea company, who were justly looked upon as the authors of the present misfortunes of the state. In his opinion they ought upon this occasion to follow the example of the ancient Romans, who, having no law against parricide, because their legislators supposed no son could be so unnaturally wicked as to embrue his hands in his father’s blood, made a law to punish this heinous crime as soon as it was committed. They adjudged the guilty wretch to be sown in a sack, and thrown alive into the Tiber. He looked upon the contrivers and executors of the villanous South-Sea scheme as the parricides of their country, and should be satisfied to see them tied in like manner in sacks, and thrown into the Thames.” Other members spoke with as much want of temper and discretion.

Mr. Walpole was more moderate. He recommended that their first care should be to restore public credit. “If the city of London were on fire, all wise men would aid in extinguishing the flames, and preventing the spread of the conflagration before they inquired after the incendiaries. Public credit had received a dangerous wound, and lay bleeding, and they ought to apply a speedy remedy to it. It was time enough to punish the assassin afterwards.” On the 9th of December an address, in answer to his majesty’s speech, was agreed upon, after an amendment, which was carried without a division, that words should be added expressive of the determination of the house not only to seek a remedy for the national distresses, but to punish the authors of them.

Robert Walpole, for those who don’t remember, was the brilliant (if not always scrupulous) statesman – effectively Britain’s first Prime Minister, although the title hadn’t yet been invented – who had been more or less pushed out of favor for speaking strongly and often against the South Sea scheme and warning of its consequences. After the collapse, he was called back to London to clean up the mess – predictable, right? Perhaps because he had been so widely reviled for speaking against the South Sea scheme, he was not fully sympathetic to the claims that the whole thing had been a scam foisted on innocent people by evildoers. He was perfectly happy to avoid the whole orgy of blame and deal with the actual consequences, but needless to say blaming the schemers was always likely to be a lot more satisfying than acknowledging that an awful lot of people participated a little too willingly in the whole thing. Walpole was famously a realist – when there were sufficient incentives for foolishness and fraud, he didn’t doubt that even the nicest people would act stupidly or dishonestly.

Tags: Walpole

After dropping as low as 1679 on Tuesday the Chinese stock markets managed nonetheless managed to put in a decent week, with the SSE Composite closing the week at 1748, up 1.1% for the week, helped by Tuesday’s Obama-inspired global rally. A lot of people have asked me what I think the bottom of the market is likely to be, and though I have a very low level of confidence in my ability to predict these things, I think that even with a sharp expected drop in corporate profitability we are already at reasonable valuations.

I would guess that we are probably within 20% of the bottom, which would suggest, if I am right, that the SSE Composite is unlikely to go much below 1500. This would take the index close to its 2006 lows although, for what it’s worth, we did test 1000 in 2005. In relative terms it should be remembered that China has seen official annual GDP growth rates of over 10% during this period.

We will probably see the markets surge Monday because of recently released news (which I will discuss further below) about the State Council’s approval tonight of a RMB 4 trillion package of fiscal expenditures through the end of 2010. This is great news, but I don’t think the surge will last very long because there are many questions about the fiscal package and I don’t think there is a lot of fundamental good news out there. The biggest problem I think is the size of the global adjustment within which China must participate. This leads to two points I want to make in this entry.

1. The size of the US adjustment in Chinese terms.

The first is just to an attempt to get our arms around the magnitude of the global adjustment within which China must participate. Last week I met with a Japanese economist working for a major US fund manager who showed me a very interesting presentation he had prepared. He asked that his name not be mentioned, so over the next few weeks I will be plagiarizing his material without crediting him.

One of his graphs shows the US household savings rate from the 1950s to the present. From his graph it seems that until the early 1990s the US household savings rate tended to hover somewhere between 6% and 10% of GD, except for a brief period in the mid-1970s when it exceeded that level. Since then, as is well known, the US savings rate has declined, to around 2-3% of GDP.

As I see it the most recent globalization cycle began in the late 1980s and early 1990s. My model posits globalization cycles as being caused by rapid liquidity expansion, for which there have historically been many different reasons (including gold discoveries, the invention and expansion of joint stock banks, the recycling of trade deficits or surpluses, even in one case war reparations payments, etc.). The latest liquidity cycle was probably caused by the recycling of the large and growing US trade deficit, which can be seen as a machine that has converted US consumption into Asian savings – at first primarily Japanese and later primarily Chinese. The decline in US savings beginning in the early 1990s is simply the flip side of the accumulation of Asian savings, and the numbers fit my model well.

Whatever the reason for the decline in US savings, I think most of us agree that it was related to the long rally in stock and real estate markets in the US, which were seen to obviate the need for households to save out of income (I would argue that the liquidity creation fueled the accompanying stock and real estate market rallies – long bull markets have always been a feature of globalization cycles). The banking system played a key role in the process by intermediating the capital inflows into the US (the obverse of the trade deficit) and converting them into consumption via an expansion in mortgage, credit card and consumer loans.

This process has probably stopped. Banks are no longer willing to make consumer loans, and with stock and real estate markets down so dramatically, the US household savings rate will almost certainly rise.

By how much? With households seeing their home and equity savings decline so dramatically I think one can easily argue that we will probably go above or at least to the higher end of the “normal” range of 6-10% of GDP, but even if we assume that households will only go back to the middle of the range, that still implies an annual adjustment of at least 5% of US GDP (around.$700 billion)

If global demand isn’t to collapse, someone else has to increase consumption by that amount. But who? The US government will probably increase its net spending, although it has already significantly increased its gross debt by recapitalizing the banks, and it will almost certainly see tax revenues fall. Corporations are more likely to be cutting spending than increasing it, so the combination of the two is not likely to be significant.

Can the rest of the world step up and replace US consumption? I am not an expert on global economies, but I think it is pretty safe to say that European, Japanese, and Latin American households and businesses are unlikely to be in a hurry to increase spending. In fact they are all likely to reduce consumption, although perhaps not as dramatically as the US. Given high debt levels in all those areas, there are also some constraints on fiscal expansion.

That leaves the net exporters, of which China is the most important. It is the largest saving nation, and the “other” nation along with the US at the center of the global balance-of-payments imbalance, and so much of that adjustment is likely to be forced onto China. As the country that has benefited most from US over-consumption, in other words, it is likely to be the one that will most have to adjust to a drastic cut in consumption.

What are the comparable numbers for China? US GDP ($13.5 trillion) is about 3.4 times the size of China’s ($4.0 trillion). In that case a 5% adjustment in the US is equal to roughly a 17% adjustment in China. That means, all other things being equal, Chinese consumption must go up by 17% of GDP just to compensate globally for the decline in the US, and bear in mind that consumption in China is only around 30-35% of GDP. What is worse, there is reason to believe that Chinese private consumption is likely to slow down in response to rising uncertainties and a slowing economy. Domestic consumption tends to be positively correlated with exports – a very pro-cyclical type of relationship typical for developing countries with large export components.

There are great hopes pinned on fiscal expansion in China, but I have already expressed my doubt about the government’s ability to expand as rapidly as many of us hope (and Stephen Green and Nouriel Roubini have anyway argued that there is less here than meets the eye). Even if they are able to expand dramatically without crowding out domestic investment, the sheer magnitude of the numbers make it almost impossible that China can successfully bear the burden of the global adjustment.

Of course it is not China’s job to replace US demand. Chinese policy-makers are only interested, in principle, in protecting growth in the Chinese economy. So why worry about whether China can or cannot replace US demand? Because with the rest of the world unable to step up, and in many cases even reinforcing the decline, if China cannot do so the whole world must see declining growth and a rise in savings, and since China was the main counterbalance to excess US consumption, it will probably bear much of the brunt.

An excessively high savings country, in other words, cannot benefit from a massive rise in global savings, and just as the astonishing flexibility of the US financial system meant that until recently US consumption had to adjust to absorb excess Asian savings (warning: I am a believer in the Bernanke savings glut hypothesis), the seizing up of its financial system means it no longer can absorb those savings, and so something must break. Instead of the US adjusting to excess savings, excess savers must adjust to declining US consumption. The world must balance.

I know this quick analysis is going to be accused of excess oversimplification, and I accept the accusation, but the point of this exercise is not to work out the process in full complexity, and certainly not to make policy prescriptions, but rather simply to get an idea of the adjustment that must be made, and if it isn’t China, as one of the two main players in the global imbalance, that will make the adjustment, then we need to figure out who else will. The biggest potential mistake in my argument, I think, might be my assumption about how much US savings will need to adjust. Perhaps the adjustment will be much lower.

2. What difficulties might China face in trying to reduce the cost of the adjustment?

The second point is to discuss some of the policy options that I think China will consider. The first and most obvious is fiscal expansion, something which I and other China experts have discussed and about which there is very real and very honest disagreement, with very plausible arguments on both sides. I have already discussed many times why I am skeptical about the ability of fiscal expansion to make up the slack.

As I write this Xinhua reports that the State council has approved fiscal spending over the next two years equal to nearly 15% of current annual GDP. The very short article says in its entirety:

China has decided to adopt active fiscal policy and moderately easy monetary policies to boost fast but steady economic growth by expanding domestic demand, according to an executive meeting of the State Council on Sunday. It is estimated that investment into infrastructure, social welfare and other key sectors will amount to four trillion yuan by the end of 2010.

A Bloomberg article gives a little more color:

The spending announced today, of which 100 billion yuan is earmarked for this quarter, will cover low-rent housing, infrastructure in the rural areas, as well as roads, railways and airports, the State Council said. The government will also allow tax deductions for purchases of fixed assets such as machinery to stimulate investment, a move that will reduce companies’ costs by an estimated 120 billion yuan

This seems like a very large spending plan (nearly $600 billion, or about 14-15% of one year’s GDP spread out over two years), and I think it may be enough to keep Chinese growth close to current levels, but only under the following conditions:

¨ It represents net new spending above current levels of expenditure. I think government expenditures represented around 14% of GDP last year, so if that suggests government spending will increase by around 50%.

¨ These are actual expenditures – for example tax deductions aimed at stimulating investments must actually stimulate investment by as much as the numbers project. Without looking carefully at the numbers (and possessing an understanding of budget issues much greater than mine), it is hard to say how much of this is real spending and how much wishful “projections”.

¨ The increased spending is not paid for out of an increase in taxes but rather by borrowing. I think this is likely.

¨ There is no large reduction in private consumption, the government borrowing and investment does not crowd out private investment to any material extent, and there is no significant reduction in municipal government spending financed by real estate sales. Here I am much more skeptical, especially about the last two points.

¨ Disbursements begin rapidly and are not wasted.

¨ At least half of the global adjustment tales place outside China.

The success of this plan depends crucially on continued government credibility in the face of rapidly rising deficits (I predicted earlier this year that guessing the real size of the government liabilities would be a popular sport next year) as well as on the health and stability of the banking system.

If the banking system can withstand a downturn without any significant rise in NPLs and without forced credit contraction, this may be the shot in the arm China and the world needs, but there are very big question marks. Still, I think it is an indication of how worried the government is and how determined they are to address the issue that this plan was approved. (As a complete aside, I also think it is an implicit acceptance of Bernanke’s savings glut hypothesis.)

The discussion of the health and stability of the banking system leads easily into the second much-discussed option – really sort of a variation on the first. The government can force credit expansion by requiring the banks to lend more. Although there has been a process over the last decade of freeing the banks and allowing them more discretion in lending as a way of improving China’s dismal capital allocation process, there is no reason why policy-makers cannot reverse course and force banks to lend more.

Certainly they are trying. Last week, after weeks of rumors that loan caps were being relaxed, the PBoC announced that they were junking the credit restrictions they had previously imposed on banks (interestingly enough they have always denied that they had imposed constraints). But instead of gleefully exploiting their newfound liberty banks have refused to party, and loan growth has been very low.

This is hardly surprising. In such dire economic circumstances with global credit markets and liquidity seizing up, with domestic bankruptcies rising, with inventories and receivables also rising, it takes both brave banks and brave borrowers to accommodate credit expansion. Most good companies seem reluctant to borrow and anyway banks are reluctant to lend.

So what if policy-makers simply announce minimum loan growth targets for every bank? That should certainly cause an expansion in banks’ balance sheets.

I think, however, that there are two problems with such a policy (although administrative measures of this sort hold a dangerous allure to policy makers). First, I don’t think it will be effective in net credit creation for the country. This argument is simply the flip side of my previous arguments as to why I did not believe the loan caps that were in place until this summer actually restricted credit creation.

In those days I argued that if monetary conditions are consistent with rapid credit creation, we will see credit creation. Any attempts to restrict credit creation will simply meet with some or all of the following responses:

1. Banks will innovate around the restrictions.

2. Credit creation will occur outside the restricted areas.

3. Banks will lie.

In China’s case we have definitely seen innovation (securitizations and transactions that took loans off the balance sheets of banks) and outside growth (rapid increases in dollar loans and policy bank loans and, most importantly, growth in the informal banking sector). If there is a sharp contraction we will know if there have also been many cases of lying.

The same thing can happen in reverse. If banks don’t want to lend but are forced to, we will see off-balance sheet transactions placed back on balance sheet and a much more rapid decline in loans from informal banks. That means that real credit expansion can still be negative even with minimum loan growth target enforced onto the banking system.

The second problem is likely to be the quality of the loans. It is always possible to find borrowers, even in a sharp economic contraction and an overinvestment crisis. The problem is that many of these borrowers are not the ones that any prudent bank should be dealing with, and to the extent that the forced loan expansion is successful, it will probably do little more than ease the credit crisis in the immediate near term and make it much worse in the medium term.

A variation of this might have happened in Japan in the 1980s. As Japanese GDP growth slowed from its very high levels in the 1970s (from an average of roughly 10% to an average of roughly 6%), Japanese banks flush with liquidity were eager to extend loans. Loan growth actually accelerated steadily from around 7% in 1980 to around 14% in 1987, even as GDP growth declined from around 8% in 1980 to around 5% in 1987. Credit creation vastly exceeded real credit needs during this whole period, with the balance going largely into real estte lending and, later, stock market speculation.

We may have already seen this process in China in the last four years and of course I don’t want to suggest that the processes in China and Japan are identical, but I do want to point out that forcing credit expansion beyond the real needs of the economy can create tremendous future problems, and China may have already gone through this very process with a monetary policy that accommodated too-rapid credit growth (much of which may have occurred, of course, outside the banking system).

Tags: credit expansion, Fiscal plan

The Chinese stock market had a fairly volatile day, with the SSE Composite bouncing up and down by 1% or more several times during the day before it closed at 2306, down 0.8% for the day.  I think we have to go back to end of 2006 before we can find a lower close.  We have pretty much wiped out all the spectacular stock market gains of 2007.

 

The decline was led by financials, largely, I think, on speculation that there will not be the credit easing that many had hoped for.  This is still a market looking almost exclusively to government policy and intentions for direction.  I have no strong reason for saying this but I wonder if we aren’t at or near a bottom.  Multiples are pretty reasonable (especially if you consider B-shares, which foreigners are allowed to buy directly) and most of the comments I hear in the market suggest that many fund managers have given up on optimism.

 

Still, three days ago the South China Morning Post ran an article that had a different take:

 

Nonetheless, some managers remain unfazed, saying they are optimistic amid Beijing’s loosening of monetary policies and a slide in global crude oil prices.  Eight fund managers surveyed by Reuters recently suggested that their allocations for equities will increase.

 

The same article pointed out that a Galaxy Securities report showed that about one-third of mainland asset managers running the funds have less than a year’s experience, so maybe we shouldn’t take their opinions too seriously, although funnily enough the article was titled “Mutual funds double fees despite 1.1tr yuan losses.”  It discussed how in spite of losing $170-80 billion this year (of their $440-50 under management at the start of the year), they earned total fees of nearly $2.8 billion, 120% more than they did over the same period last year.  Of course this is an unfair comparison because they had a lot more under management this year than last.  Still, it’s nice work if you can get it.

 

One of the big questions for stock market investors is China’s currency policies, about which here has been a lot of attention again recently and a lot of back-and-forth.  In the past month there has been little appreciation in the RMB against the dollar – and even some depreciation, depending on what period you measure.  The impression most of us have is that by allowing the RMB to weaken the government hopes to introduce enough uncertainty to make the one-way bet on the RMB a lot more risky. 

 

Maybe.  This currency strategy is part of a basket of policies aimed at reducing speculative inflows.  In an article two days ago the People’s Daily reports

 

China will start regular annual checks of banks’ foreign exchange operations to make sure they observe relevant rules, the foreign exchange regulator said on Friday.  The move is a concrete step towards implementing the country’s newly approved foreign exchange rules that were set earlier this month and curbs cross-border speculative capital flows, analysts said.

 

These new annual checks are part of the heated debate over how the PBoC can regain badly-needed control over its explosively expansive monetary policy.  Fortunately in spite of increased attempts to control the border, much of the debate is still primarily about what to do with the exchange rate.  On Monday, joining the growing European chorus against China’s exchange rate policy, German Finance Minister Peer Steinbrueck, in a four-day meeting with his Chinese counterpart in Beijing, called for China to let its currency appreciate more quickly against the euro.

 

In contrast, or perhaps not, Cheng Siwei, vice-chairman of the standing committee of National People’s Congress, and an influential voice in Chinese economic policy making, told the Financial Times on Sunday that China does not need to accelerate the appreciation of the renminbi – against the US dollar, at any rate.  According to the article:

 

“My point is that we don’t need to accelerate the appreciation of the renminbi. The dollar will not weaken very much and may get stronger, as happened [in August],” Mr Cheng told the Financial Times in an interview.  “This makes appreciation of the Chinese currency against the dollar less necessary,” he said, because the renminbi was still likely to appreciate against other currencies.

 

He is certainly seems to be reflecting the public consensus among many policy-makers, but whether they really believe this or are merely trying to convince the world not to bet on an appreciating RMB I am not really sure.  At any rate I think that a lot of this talk misses the point.  It continues to posit RMB policy largely in terms of its trade impact, instead of its domestic monetary impact. 

 

As a domestic monetary problem, I think, the argument for appreciation is much stronger.  In that context there is an excellent new piece out by Ronald McKinnon and Gunther Schnabl (MS), with the title “China’s Financial Conundrum and Global Imbalances”.  Although I think I disagree with its main recommendation, it is a typical McKinnon piece – elegant and informative – whose abstract includes the following:

 

China’s financial conundrum arises from two sources: its large saving (trade) surplus results in a currency mismatch because it is an immature creditor that cannot lend in its own currency. Instead foreign currency claims (largely dollars) build up within domestic financial institutions. And economists—both American and Chinese— mistakenly attribute the surpluses to an undervalued renminbi.  To placate the United States, the result is a gradual appreciation of the renminbi against the dollar of 6 percent or more per year.

 

This predictable appreciation since 2004, and the fall in U.S. interest rates since mid 2007, not only attracts hot money inflows but inhibits private capital outflows from financing China’s huge trade surplus. This one-way bet in the foreign exchange markets can no longer be offset by relatively low interest rates in China compared to the United States, as had been the case in 2005-06. Thus, the People’s Bank of China (PBC) now must intervene heavily to prevent the renminbi from ratcheting upwards—and so becomes the country’s sole international financial intermediary.

 

Despite massive efforts by the PBC to sterilize the monetary consequences of the reserve buildup, inflation in China is increasing, with excess liquidity that spills over into the world economy. China has been transformed from a deflationary force on American and European price levels into an inflationary one. Because of the currency mismatch, floating the RMB is neither feasible nor desirable—and a higher RMB would not reduce China’s trade surplus. Instead, monetary control and normal private-sector finance for the trade surplus require a return to a credibly fixed nominal yuan/dollar rate similar to that which existed between 1995 and 2004.

 

MS argue that “Currency stabilization would allow the PBC to regain monetary control and quash inflation,” and point out that China’s immature financial system and rapidly transforming economy make monetary aggregates pretty useless in discussing domestic monetary conditions – something I have argued many times.  They conclude: “For a developing country like China on the periphery of the dollar standard, the exchange rate is best considered just an extension of domestic monetary policy – and not an instrument of trade policy.”

 

I agree wholeheartedly.  The issue for the PBoC is not what they should do to the RMB directly to rebalance international trade.  As I have argued many times, China’s trade surplus is more a function of the way the currency regime converts capital inflows via the banking system into increasing industrial production.  Of course part of the reason China runs a trade surplus is that the RMB is undervalued – and I am sympathetic to Nicholas Lardy’s and Morris Goldstein’s argument that thanks to China’s rapid productivity growth relative to that of its trade partners the RMB may be even more undervalued today than it was earlier in the decade.

 

But it has always seemed to me that the soaring trade surplus was largely a monetary phenomenon – locked into place by the self-reinforcing cycle of rising trade surplus leading to expanding money leading to surging fixed asset investment leading to a rising trade surplus.  That is why in 2003 and 2004, when most analysts were arguing that China’s then-seemingly-large trade surplus was a temporary phenomenon that would soon subside, I instead argued that it would continue to rise inexorably.

 

What is worse, as MS recognize, is that more recently China’s trade surplus has been augmented by rising speculative inflows based on the expectation that the RMB must rise in order to rebalance the trade surplus.  Rather than make things better (rebalance trade, reduce inflation), however, a rising RMB has actually made things worse.  It has caused an already excessively loose monetary policy to careen out of control. 

 

MS blame this mostly on “China bashing” – the criticism of China’s currency regime as the root cause of the trade imbalances has created appreciation pressure – because it has created widespread expectations of currency appreciation.  If the market hadn’t been convinced of the need for the RMB to appreciate in order to rebalance trade, it wouldn’t have bet so heavily on appreciation and in so doing worsened China’s domestic monetary problem.

 

So what should China do?  MS argue that in order to regain control of the money supply China needs to eliminate expectations of a rising RMB.  One possibility is to let the RMB float, but MS quickly reject this option. 

 

I agree with their rejection of the option to float, although for different reasons (I think).  MS say that China’s financial immaturity forces a significant currency mismatch onto domestic balance sheets, which makes currency volatility very risky and perhaps self-reinforcing.  This volatility would have an adverse impact on domestic production and consumptions.  

 

I would argue that if the RMB were to float, rather than quickly reach some sort of stable equilibrium it would suffer from massive and persistent volatility as small changes in the perception of relative Chinese risk or growth prospects caused large, self-reinforcing flows into or out of the country.  Perhaps we are arguing the same thing, but I am not sure.

 

The other option is for China to peg the RMB credibly against the US dollar until its financial system was sufficiently robust and flexible to permit it a floating exchange rate.  Of course I agree with this option, and have been arguing this for a long time. 

 

Where MS and I disagree is on the definition of “credible”.  I think MS argue that except for the effect of the “blame China” crowd, as they put it, a reasonable level at which to peg would be the current RMB exchange rate.  Because it would require a reduction in trade-related criticism to eliminate the expectations of appreciation (and thus to achieve credibility), this would have to be done as part of an internationally coordinated effort.  I think many analysts have interpreted MS as saying that the RMB is not undervalued, and perhaps this is indeed what they are implying.

 

In my opinion, however, that the RMB is definitely undervalued, and if it is, a peg at current levels runs the risk of locking current imbalances into place for much longer.  I am not so worried about the adverse impact of China’s trade surplus on the rest of the world, although I do agree that long-running imbalances can create balance sheet vulnerabilities that can later prove destabilizing.  Still, this is probably the biggest disagreement I have with my friend Brad Setser, who is much more worried about the economic consequences of China’s trade surpluses on the US, Europe and the rest of the world.

 

For me the issue is, as MS point out, largely a domestic monetary issue.  If this can be fixed (i.e. if net inflows can be sharply reduced) and China can regain control of its domestic monetary policy, then the trade surplus will quickly adjust, via a better balance between the growth in consumption and growth in industrial production.

 

But what is a “credible” rate at which to peg?  Since the beginning of 2007 I have been arguing that China needed to engineer a one-off 15-20% revaluation and peg.  There was nothing “fundamental” about that 15-20% number.  It was merely the smallest amount by which I thought a revaluation would be credible.  For my way of thinking, any other option would either lock in the monetary imbalances for too long (e.g. a peg at current levels, or a slow appreciation) or cause an explosion in speculative inflows that would undermine the very goal an appreciation was trying to achieve (e.g. a rapid appreciation).  A “non-credible” revaluation and peg would, of course, fall into the latter camp.

 

I continue to believe that China needs to engineer maxi-revaluation before it pegs, but now I think the needed revaluation is less than what I used to argue for.  At this point I think an 8-10% revaluation followed by a peg would do the trick, especially if the PBoC announced explicit market-oriented measures to make the peg credible – for example by providing tools for speculators that allowed them to bet on continued appreciation without increasing speculative inflows (I have written about these elsewhere). 

 

I am convinced that financial risks have risen enough in China that a smaller revaluation should be enough to stop or even reverse speculative inflows, which should bring monetary growth much more into line with PBoC wishes.  The fact that a smaller revaluation is enough to halt or reverse inflows is not a good thing, by the way.  The last two years of monetary growth have almost certainly resulted in a much more vulnerable banking system, and I think investors are nervous enough that their exit level is lower than it had been before.  The longer the PBoC wait to regain control of monetary policy, by the way, the less it will take to cause speculative investors to flee the country.

 

The biggest risk continues to be the effect of a revaluation on bank balance sheets, which are, I think, vulnerable and getting more so all the time. On that note Caijing has an article  claiming that government auditors have accused nine banks and four fund managers of lending billions of RMB for illegal stock market and real estate speculation.  I am sure the real number is much higher than whatever the auditors found.  Bank instability is a real risk for an abrupt change in the exchange rate policy, but it is pretty clear to me that the longer breakneck monetary expansion continues, the more vulnerable the banking system will be to a shock.  

 

I was just sent a very interesting paper by German economist Jorg Bibow of the Levy Economics Institute of Bard College (The International Monetary (Non-)Order and the “Global Capital Flows Paradox”).  In it the author considers the “paradox” of high and rising capital flows from developing to developed countries during the past decade.  This is a paradox because most economic theory (and history) suggests that developing countries are net recipients of investment, not net providers.

 

This paper came at a good time for me.  About two weeks I had dinner with three senior Peking University finance professors and a well-known and very smart American economist from one of the world’s leading investment banks.  Not surprisingly, much of our conversation during dinner was about China and current monetary conditions. 

 

The American economist and I agreed on most things concerning the financial system in China (and the rest of the world, for that matter) but we did have one disagreement, and that was on the global savings glut hypothesis.  As I understand it this hypothesis argues that policies or conditions that have a caused a systematic increase in savings in several countries, primarily in Asia, have resulted in the necessary corollary of compensating reductions in savings – or increase in consumption – elsewhere.  As the only country deep enough and with a sufficiently flexible labor market and financial system, the US is the natural equilibrator, and so US savings must decline and the US run a current account deficit.

 

For the American economist the hypothesis of the global savings glut made no sense, but as far as I could see his main criticism of it was that it represented a political view which tried to put the “blame” for the current global imbalances on China, Asia, OPEC and anyone else except the US, where, he believed, it belonged.  This is the same position as that of one of the best-known criticisms of the global savings glut hypothesis, which came in the form of a research note published by Stephen Roach of Morgan Stanley in July 5, 2005, in which he said “There may be a deeper and potentially more sinister meaning behind the saga of the global saving glut.  In my view, it is being used as a foil to deflect attention from one of the world’s most serious imbalances — the excess consumption of America’s asset-dependent economy.”

 

The American economist also argued at dinner that there has been no real increase in global savings, so therefore the idea of a global savings glut made no sense.  Again, Stephen Roach’s piece made the same argument:

 

IMF statistics provide our best gauge of global saving.  In 2004, the IMF’s global flow-of-funds framework put the world saving rate at 24.9% of global GDP.  While that marks the second consecutive yearly increase in this measure, it is only 1.9 percentage points above the 23% norm that prevailed from 1983 to 2000.  Yes, the global saving rate has edged up from its longer-term average, but this hardly qualifies as a glut. 

 

I have addressed both of those very common criticisms before in my blog, but let me summarize very quickly why I think neither of them is valid.  To address the first, the idea that competing theories are proposed largely to assign blame is something that I find of little value in this or most other economic debates.  Furthermore, unlike many other analysts I do not think that such a large US current account deficit is unsustainable over the medium term.  I also think the US-China “imbalance” has actually been better for the US than for China, and so I do not think it is necessary to find someone to blame for US conditions. 

 

At any rate it is obvious, I think, that any imbalance requires at least two players, both of whom are necessarily to “blame” for the resulting imbalance.  The point is to try to understand why and how the imbalance occurs.  There is no question in my mind that loose monetary policy in the US and the fiscal cost of the Iraq war made it easier for the savings glut in one part of the world to balance a consumption “glut” in another, but without the excess savings driving the process the financing of the Iraq war would have created a very different set of outcomes.

 

The second point is, I think, easier to dismiss.  The idea of a savings glut necessarily requires not an increase in global savings but rather a shift in the composition of global savings, in which the share of savings in the “glut” countries increases while the share of savings in the equilibrating countries decreases.  It does not require, and in fact cannot require, an increase in total savings.  In a closed system, like that of the global economy, capital and trade flows must balance.  The only precondition, and hard evidence, we would need for a global savings glut is a major shift in the share of savings within the global economy and, ironically, Stephen Roach provides this very evidence in the same piece quoted above.

 

Alas, the devil is in the detail — or, in this case, in the shifting composition of global saving and investment.  Two main forces have been at work in reshaping this mix — namely, a record plunge in the US saving rate matched by an equally large increase in the saving rate of the developing world, especially Asia.  On the IMF’s basis, the US gross saving rate fell to 13.6% of GDP in 2004…That represents a 3.3 percentage point plunge from the 16.9% average that prevailed over the 1983 to 2000 period.  By contrast, the IMF puts the saving rate in the developing world at 31.5% of its GDP in 2004 — up a whopping 6.5 percentage points from its 1983 to 2000 norm of 25%.  Reflecting the sharp increase in Chinese saving, developing Asia has led the way on the saving front; its overall saving rate is estimated to have surged to 38.2% in 2004 — up dramatically from the 28.8% norm of the 1983 to 2000 interval.

 

That is exactly the point.  A surge in Asian savings, reflecting especially a surge in Chinese savings, must lead either to a reduction in savings elsewhere or a significant slowdown in global growth.  That is the source of the global imbalance and the justification of the global savings glut hypothesis.

 

What does all of this have to do with the Jorg Bibow paper that I mention in the very first line of this entry?  Bibow also rejects the global savings glut hypothesis, but my understanding of his paper is that he agrees with much of what I understand the theory to be but rejects it on much narrower technical grounds – he claims that the saving glut hypothesis is based on the “fatally flawed” (his words) loanable funds theory.  However his narrative of events seems very close to the one I and people like Brad Setser (also a proponent, I believe, of the global savings glut hypothesis) have developed.

 

But what interests me most is the data he provides in his paper (and you can see the accompanying graphs by following the link to his paper).  First off, Bibow discusses the evolution of the US current account deficit over the past fifty years.  Why is the US current account important?  Because according to the global savings glut hypothesis, the US current account deficit is the almost automatic counterpart to the rise in Asian savings. 

 

Basically, according to the data quoted in Bibow’s paper, the US current account has been within a range of a surplus of 1% of GDP and a deficit of 1% of GDP for most of last fifty years with two exceptions.  The first exception occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990.  The second exception began technically in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, before it began to decline again, but it really took off in 1997-98, when it raced forward in almost a straight line to peak, in 2006, at 6.2% of GDP.

 

If the US trade deficit was driven simply by an out-of-control US consumption binge, it is a little hard to see why it would have followed a pattern of general stability marked by two surges – a small one from 1984-188 and a very large one after 1997.  If it was driven by Asian savings, this pattern becomes a little easier to understand – or at least, what amounts to the same thing, we can posit a more plausible story to explain it.  

 

I will ignore the 1980s surge because this post is already too long, but again one can tell a very plausible story based on Japanese trade policies and domestic savings.  The post-1997 surge is much larger and more interesting.  1997 was, of course, the year in which several Asian countries, after years of tremendous growth and what seemed like invulnerable balance sheets, experienced terrifying financial crises and viciously sharp economic slowdowns, which profoundly impressed Asian policy-makers and has affected policy decisions to this day. 

 

Since the main cause of the crisis seemed to be the sudden reversal of current account surpluses into substantial deficits, along with highly mismatched balance sheets in which large external obligations were mismatched with domestic assets and “hedged” with extremely low levels of foreign reserves, one of the main (if mistaken) lessons policy-makers learned was the need to run current account surpluses and to amass large foreign currency reserves to protect countries from a repeat of the disastrous crisis of 1997.

 

These countries, consequently, but into place decidedly mercantilist policies in order to achieve both goals – persistent trade surpluses and large amounts of foreign currency reserves.  Unfortunately, these policies simply transformed the balance sheet risk and in many cases – that of China being the most notable – locked the countries into positive feedback loops in which trade surpluses and accumulating reserves (or, rather, the domestic monetary consequence of accumulating reserves) fed into and reinforced each other.

 

This (I think plausible) story is reinforced by another graph Bibow reproduces.  The global capital flow “paradox” to which he refers in his title is the fact that developing countries are exporting capital to rich countries.  According to his data, developing countries have always been net recipients of private capital flows – which is what one would have expected from most economic theory and history. 

 

They have generally been net providers of official capital as far as foreign currency reserve accumulation goes, but for most of the last fifty years reserve accumulation on average was significantly less than net private inflows, so developing countries were net recipients of capital.  (For much of the 1980s the balance on both was zero or close to zero, and I suspect that this reflects negative private flows to Latin American and others among the 32 defaulted or restructuring LDCs, as they were then called, netted against positive private flows to Asia.)

 

It is only in 1998 that reserve accumulation among developing countries begins to take off and by 1999 it exceeds net private capital flows to developing countries.  This is when the “paradox” of net capital flows from developing to developed countries begins.  Except for a small decline in 2001 net flows from developing countries surge almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows).

 

I am sure there can be other competing explanations for the timing of these flows, but I am very impressed by the fact that Asian savings, as expressed in reserve accumulation, surge after 1997, as does the US trade deficit.  Given the virulence of the 1997 crisis and the tremendous shock it provided to Asian policy-makers (and policy-makers in developing countries elsewhere), it seems to me that a very plausible argument can be made that it was the effect of 1997 that caused the shift in developing-country policies that led to the surge in savings and the corresponding increase both in trade surpluses and reserve accumulation.  The surge in the US trade deficit after 1997 is also more easily explained by a shift in Asian trade policies and currency regimes than by a shift in US consumer preferences.

 

I am less familiar with the consequences of these policies elsewhere, but it seems to me that for now China has found itself locked into these mercantilist policies, except that in the past year we have seen a major shift take place that must force a sharp adjustment.  The policies aimed at eliminating the risk of a 1997-style financial crisis have worked, but they have not eliminated the risk of crisis.  Instead they have only transformed the risk of an external crisis into the risk of a domestic banking crisis.

 

What is worse, China’s reserve accumulation is no longer being driven by its trade surplus and is increasingly being driven by very unstable private (speculative) capital flows.  I don’t have the data at ahnd, but I suspect (and this was also argued in the Reinhart/Rogoff paper, on which I commented three weeks ago), that when a developing country receives so much speculative capital, balance sheet vulnerability rises inexorably and the likelihood of a shock large enough to force an adjustment also rises.  What happens to global savings and the US current account deficit after that, I am not really sure, but it is something I am trying to figure out.

Most PBoC watchers have always believed that the PBoC has been among the most vocal supporters of a stronger currency, and has argued in the past that an appreciating RMB is the best way to fight inflation. Yesterday, however, Zhou Xiaochuan, governor of the PBoC, surprised a number of people at his NPC-related press conference. He said, among other things, that “faster currency appreciation helps to rein in inflation, but not a lot. To curb inflation, we will rely more on domestic policies. ?There is no need to use exchange-rate reforms as a way to fight inflation.”

A lot of commentators are reading this as meaning that currency appreciation is losing its appeal as a way of attacking inflation (The Wall Street Journal Asia headline was “China’s Zhou Says Strong Currency May Not Be Best Way to Fight Inflation”), while raising minimum reserve requirements and hiking interest rate will be used more aggressively. I am not sure I agree, since Zhou also commented on the difficulty or using interest rates as a tool, and admitted that the recent aggressive rate cuts in the United States are restricting his agency’s ability in raising the cost of capital. He also said “We have to consider and measure the impact of interest rate changes on domestic demand,” which doesn’t sound like he is expecting to raise the deposit rates by a whole lot.

Zhou may have meant what he said about the currency, but it is also possible that he was just trying to talk down hot money inflows by downplaying the prospects of large appreciation gains. Actually I think Zhou is partly right about the limited efficacy of RMB appreciation in the fight against inflation, but not perhaps for the reasons he means. Looking at the rate of appreciation of the RMB and the CPI inflation numbers, it is hard to draw the conclusion that an increasing appreciation rate has reduced inflation.

In part this shouldn’t be a surprise since there are inevitably going to be lags between the currency and its impact on domestic inflation, especially if you believe, as I do, that the inflationary pressures have been accumulating for many years and have only just emerged. On the other hand it isn’t much easier to see the inflation-reducing impact of raising interest rates or minimum reserve requirements. None of the policy measures have worked – that is the big problem facing the authorities.

If Chinese inflation is a monetary problem, which I think it is, I it seems clear to me that the only way to reduce inflationary pressures is to reduce monetary growth, and that means of course reducing the net capital and current account inflows into China. A more rapid rise of the RMB is not only unlikely to reduce those inflows (at least until the RMB is much more expensive than it is now), but on the contrary it will actually increase net inflows by encouraging hot money faster than it reduces the trade surplus (and anyway so far the trade surplus hasn’t declined). This is what seems to be happening, and a recent report by Bloomberg, that “China will increase (QFII) quotas for overseas investments in yuan-denominated stocks and bonds this year,” seems unnecessarily to complicate things, unless they are hoping that it will boost the stock market.

The contradictory relationship between the currency regime and currency inflows forces the authorities back into the policy gridlock I have discussed so many times before. China must adjust the RMB to regain control of its careening monetary policy, but the very process of adjustment is likely to make things much worse before they can get better, and it is not clear to me that China has room for things to get much worse. That is why I think ultimately they must be forced into a much more abrupt currency adjustment.

And they are certainly going to have to do something about inflation. During Premier Wen’s speech he announced that the inflation target for 2008 will be 4.8%, equal to 2007’s CPI inflation (the 2007 target of course was under 3%). I haven’t found a single person, Chinese or foreign, who doesn’t believe that this target is more about reining in expectations and letting the Chinese people know that the government is fighting inflation than it is a serious forecast. Everyone I have spoken to thinks inflation will come in much higher for 2008, and there are some pessimists (including me) who expect it to average above 7%, perhaps well above 7%.

So far, of course, the pessimists are right. I have mentioned in previous posts that CPI inflation for February is widely expected to come in at no less than 7.8% and perhaps even exceed 8% (we will know Tuesday – January CPI inflation was 7.1%). A very interesting report by my friend Paul Cavey at Australian investment bank Macquarie is a whole lot grimmer. He writes:

Inflation definitely is a big worry. According to the Ministry of Agriculture’s wholesale price index, food prices were about 30% higher than in the same month a year earlier. This index tends to be quite a good predictor of food CPI, suggesting overall inflation in China could make double-digits in February. Statistical quirks could bring the published number lower, but it is still likely to be high enough to be scary.

Paul also argues, based on China’s two previous bouts with inflation in the late 1980s and the early mid 1990s, that the policy responses are going to less vigorous than we might have expected because “Contrary to the popular perception of a Communist Party seeing inflation as a life or death issue for the regime, Beijing’s response to inflation has usually been late and indecisive. The reason of course is that as much as the government is worried about the social consequences of rising prices, it is also concerned about the dissatisfaction that an inflation-tackling slowdown would cause.”

Unemployment, in other words, will trump inflation as a cause of concern. Of course we might get both. Premier Wen predicted that GDP growth for 2008 will be 8%. That might seem shockingly low after the last year’s GDP growth of 11.4%, but remember that most years (including last year) the government projects next year’s GDP growth at 8%. This is not really a target but a base case. In fact I would define 8% growth as stagnation, since for me stagnation in the Chinese context means GDP growth that isn’t great enough to prevent a rise in urban unemployment. On this topic Xinxin Li at Observatory Group has some useful reminders:

The 8% GDP growth rate is only a bottom line growth rate, and the real target of Beijing’s policymakers is around 10%.  Note that Wen also announced an annual target of new urban job creation at 10mn.  That won’t happen without stronger economic growth.  (Forget the unemployment rate target of 4.5%, as the real number could be much higher, too.)  In the past three years, China created 9.7 million, 11.8 million and 12.0 million new urban jobs respectively, but its annual GDP growth was steadily high at 9.9%, 11.1% and 11.4%.  In other words, 10% is viewed as a minimum growth rate for Beijing to reach its employment target.

If China can’t keep its GDP growth rate above 10%, it will have great difficulty in maintaining the necessary employment growth, and with unemployment rising among the young (and among university graduates) there is a lot of pressure to keep growth effervescent. China’s conundrum is that it has too many economic policy objectives not only which are contradictory but also for which they seem to have no very efficient tools. Last year around this time Premier Wen shocked everyone by saying that the Chinese was on a clearly unsustainable path. One year later the country is still racing, faster than ever, down the same path.

Leaving China briefly and turning to the rest of the world I saw the following in today’s Financial Times:

Capital flows to emerging markets reached record levels last year as investors fled the US and other developed economies in search of higher yields and faster rates of economic growth, the Institute of International Finance said on Thursday. The IIF said total flows to emerging markets reached an estimated $782.4bn in 2007, a sharp rise from $568.2bn in 2006 and $521bn in 2005.

I am not surprised that during this time of developed-world crisis so much money is flowing to emerging markets. There is plenty of risk-loving liquidity looking for a home (see Brad Setser’s latest blog entry), and I do not believe we are at the end of the latest globalization cycle, in which rising international trade and investment flows and the always coincident “next stage” in the industrial revolution are always underpinned by a sharp rise in global liquidity.

Still, the developing-country financial historian in me finds this worrisome. In the past, massive capital flows into developing countries with their weak financial systems and inverted balance sheets often created serious imbalances in sovereign and banking capital structures. These were only resolved by financial crises that were often deep and long lasting. The “lost decade” of the 1980s was merely the most recent such period.