Exports in March dropped a less-than-expected 17.1% from the same time last year – below expectations of 20% and the 21.1% drop for the first two months of 2009. Most of the articles I read in the Chinese and foreign press including, not surprisingly, comments from the customs bureau, hailed this as a sign that the export slump is bottoming out. According to an article in Saturday’s South China Morning Post, for example:

Many economists said the export slump of the past five months was finally showing signs of abating, with the Administration of Customs describing the latest export figures as a “marked improvement”. However, they cautioned that imports would remain weak in the near future, overshadowed by prevailing low commodity prices and the de-stocking of mainland factories and overseas importers.

“It is the beginning of stabilisation,” Citibank economist Ken Peng said yesterday. “We should have seen stronger import numbers last month. We had more money in place, but we’re not importing more and that’s surprising.”

A Bloomberg article had the following:

The “collapse of global trade and China’s exports in the last few months was not in small part due to a freeze in trade credit and aggressive de-stocking abroad as a result of extreme uncertainty,” said Wang Tao, an economist at UBS AG in Beijing. “As expectations start to stabilize, we expect to see export orders rebound in the coming months.”

I guess that different people have radically different ways of forecasting export growth. To me, it is completely meaningless to look at recent trends in China’s export performance in order to forecast the future. The only thing that matters is what will happen to net demand from the trade deficit countries – most of which is represented by US net demand – and so the recent improvement in China’s export performance (not really an improvement, of course, but an improvement in the rate at which it is deteriorating) really tells us very little.

The real question is will US gross and net demand continue to contract? Almost every serious economist I have spoken to believes that it will, with disagreements only on the speed, intensity and duration of the contraction. Someone whose blog I have been reading a lot lately (I like him because, aside from his Minsky-Fischer orientation, he has the audacity to claim that if you don’t know economic history then you don’t know economics and, what’s worse, he even insists that history extends to beyond the past twenty years), University of Western Sydney professor Steve Keen, suggests that from what he calls a non-orthodox, Hyman-Minsky point of view we should think of aggregate demand as “the sum of GDP plus the change in debt.”

That sounds right to me. Certainly debt accumulation seems to have represented the difference between the growth in US consumption and the growth in US GDP over the past decade, as I discussed in Wednesday’s post. If he is right, we should expect US consumption (and that of many other deficit countries, for that matter) to grow less than GDP by the amount of the deleveraging taking place. That is a lot of deleveraging.

In that case the export performance of countries like China can only get worse because the ability of deficit countries to consume China’s export of excess production will be contracting quickly, and in that light it doesn’t matter how successful you think the Chinese stimulus package may have been. Export growth depends on someone else’s import growth, which depends on their consumption growth, and in a world of contracting GDP, if consumption growth is even underperforming GDP growth, it is a little hard to be optimistic about export growth forecasts. The domestic stimulus is irrelevant.

Talking about the stimulus package, there has also been a lot of talk about its success as being evidenced by the way a number of indicators have bottomed out or even turned. Unfortunately it seems to me that most of those indicators fall into one of two groups. In some cases there were special circumstances that caused a surge, but whether the surge is sustainable, and in some cases whether it won’t be reversed in the future, is questionable. For example car sales have finally started to rise: China’s passenger car sales rose 10% in March from a year earlier. But this was after tax cuts and government subsidies boosted demand, and there are lots of rumors about government agencies and state-owned enterprises being persuaded to anticipate vehicle purchases. If that is the case, the surge in purchases may soon peter out, and in fact may slow sharply to the extent that planned purchases for later this year were accelerated.

The second group of positive indicators I would describe not as evidence that the fiscal stimulus is working but rather as evidence that some people are behaving as if they believe the fiscal stimulus will work. For example rising steel and concrete inventories and increased purchases of equipment suggest to me not that end demand has been created but rather that many producers are anticipating that end demand will be created. Perhaps they are right, in which case we should see more positive indicators in the future, but if they are wrong then we are likely to see nothing more than a temporary buildup that will have to be reversed.

But to get back to exports, China’s trade surplus for March was $18.6 billion. That sums to $62.6 billion for the first quarter, compared to $41.7 billion for the first quarter of 2008 and $114.3 billion for the last quarter of 2008. Although lower than the astonishing heights of January and late last year, the trade surplus is still much higher than this time last year. That means China’s export of overcapacity is still increasing, especially if you think, as I do, that February’s very low trade surplus ($5 billion), and possibly part of March’s, was caused by commodity accumulation to replenish strategic reserves.

More capacity?

In that light articles like this one from Friday’s Financial Times are not encouraging:

The aluminium industry has been hit hard by the global economic crisis with sharp falls in sales across the automotive, construction and aerospace industries. …However, a recovery has emerged in recent weeks and prices are 18 per cent off their lows. The concern in the industry now is that the nascent recovery could be nipped in the bud because Chinese smelters are busy ramping up production at a time when demand is continuing to fall.

As China accounted for about 35 per cent of global aluminium production and consumption last year, its supply and demand developments are of huge significance for the world market. Industry leaders warn that the outlook for demand remains weak

…However, Wen Jiabao, China’s premier, has made it clear that Beijing will do whatever is needed to maintain economic growth at “about 8 per cent”. This has led to huge pressure on local governments to ensure growth targets are met. One result is that aluminium smelters have been offered tax cuts and subsidised bank loans to encourage production to restart.

Last year’s price crash forced China to close about 3.1m tonnes (22 per cent) of its total aluminium production capacity as many of the country’s smelters fell into the red. But analysts at Macquarie estimate that 500,000-600,000 tonnes of capacity has recently been restarted in Henan province. “Local government officials, especially in Henan, have been urging the aluminium industry [the key income tax payer of the province] to restart spare production capacity immediately,” says Bonnie Liu of Macquarie.

China’s government has also been providing significant levels of support to the domestic market. The State Reserves Bureau, which has already bought 590,000 tonnes, is expected to expand purchasing up to 1m tonnes. The State Grid Corporation has bought about 400,000 tonnes and provincial governments have indicated they will buy up to 900,000 tonnes.

Too many people who should know better assume that trade policies are limited to raising import tariffs or devaluing the currency, and since both of these were addressed in the recent G20 meeting, we can all more or less relax. This is wrong. Anything that alters the gap between total production and total consumption must have a trade impact, and if capacity is boosted in the face of falling demand, that is as likely to force up the trade surplus as import tariffs or currency devaluation.

I do not believe that will go on much longer. Over the next few months we should start seeing even more pressure on China’s exports as either trade friction or exhaustion (on the part of countries who have had to bear more than 100% of the brunt of the contraction in US demand) forces continued global demand contraction to switch to China.

How important will that be? Ever since The Economist came out with a consensus-busting piece last year that China is much less reliant on exports than many people think (whatever that means), well-informed people have been assuring each other that “China is much less reliant on exports than many people think.”

Maybe. But it is still very heavily reliant on exports. When your total production exceeds your total consumption by 7% of GDP (in the past 12 months China’s trade surplus was $320 billion, while its 2008 GDP was $4.3 trillion), you rely very heavily on foreign demand to absorb a big chunk of your output.

According to a recent Andrew Batson article in the Wall street Journal, a trio of researchers at the Hong Kong Monetary Authority revisits the whole question of China’s dependency on exports. I was not able to find the cited piece, so I can only limit myself to the comments in the article, but, and sorry for the long quote, here is what they find:

The paper builds on previous work by one of the authors, Li Cui, who in a 2007 working paper for the International Monetary Fund presented evidence that China was becoming more dependent on external demand over time. Indeed, net exports contributed about 20% of China’s economic growth from 2005 to 2007, compared to less than 10% in the previous five years. But the authors of the new paper try to go beyond that number to capture the total effect of the export manufacturing sector on the economy, including investment in new factories by exporters, and spending by people employed in those factories. That leads them to conclude that the spill-over effects from the export sector are in fact quite large.

The authors estimate that a decline of 10 percentage points in export growth would be associated with a decline of about 2.5 percentage points in GDP growth. “This is about at least twice as large as what could have been expected if only the direct impact of exports is considered,” they write. Part of the explanation, they say, is that exports are extremely important to a group of Chinese coastal provinces, which themselves account for the majority of the national economy. So changes in export demand can cause dramatic fluctuations in those regional economies, even while the inland provinces are less affected.

But of course, China’s exports have recently slowed by a lot more than 10 percentage points. In volume terms, export growth rates have swung from around positive 20% in 2007 to nearly negative 20% in the first part of this year. The biggest effect of a decline in exports, the authors find, is on corporate investment, as companies scale back expansion plans. And since the sharp drop in exports is just a few months old, the full magnitude of the subsequent drop in capital spending may not yet be evident.

Foreign currency reserves

Besides export numbers the other piece of important news for me was the release of first quarter reserve numbers. According to Xinhua’s account:

China’s foreign exchange reserves rose 16 percent year-on-year to 1.9537 trillion U.S. dollars by the end of March, said the People’s Bank of China on Saturday. It represents an increase of 7.7 billion dollars for the first quarter, but the increase was 146.2 billion dollars lower than the same period of last year.

In March alone, the foreign exchange reserves rose by 41.7 billion U.S. dollars. The increase was 6.7 billion U.S. dollars higher than the corresponding period of last year.

This is the smallest quarterly increase we’ve seen in a long time. The first quarter of 2008, for example, saw reserves grow by an astonishing $153.9 billion, and 2008’s fourth quarter, the weakest quarter of the year by far, nonetheless saw reserves up by $40.4 billion.

2009	January	February	March	Q1
Headline reserve growth	-32.6	-1.4	41.7	7.7
Trade surplus	39.1	4.9	18.6	62.6
Net FDI	7.4	5.8	8.4	21.6
Currency gains or losses	-31.0	-16.0	15.0	-32.0
Interest income	6.8	6.8	6.8	20.4
Unexplained amount	-54.9	-2.9	-7.1	-64.9

With Logan Wright’s help I put together the above table to try to understand what is going on with reserves. The key thing on which to focus is the “Unexplained amount,” which is a proxy for hot money inflows or outflows. Of course my estimates for currency gains or losses and for interest income are nothing more than estimates and may be, especially in the former case, substantially off.

Nonetheless the picture the table shows is pretty clear and pretty consistent with what we would expect. January, a time of deep gloom, saw a large unexplained outflow at least part of which may represent flight capital from nervous Chinese businessmen. Confidence seemed to rebound in February and March, with widespread (but to me doubtful) claims that the fiscal stimulus was “working” and with the stock market rocketing up. During that time unexplained outflows collapsed to nearly zero. The only conflicting evidence was reports in the Hong Kong press of a serious increase in the amount of currency transactions among border money changers, in which the number of Chinese buying US and Hong Kong dollars with RMB rose to suspiciously high levels.

The overall picture is consistent with two different and popular predictions. First, the stimulus package is working and that China will soon emerge from the worst of the crisis. Second, that the fiscal stimulus represents a risky bet on the duration of crisis abroad, and if sustainable and recovery in global demand does not occur in the next few quarters, it will set the stage for a deeper contraction late this year and next year.

Trade determines reserve currency status

Finally, for those who might be interested in today’s version of my biweekly South China Morning Post piece, here is the original, pre-edited version:

People’s Bank of China Governor Zhou Xiaochuan generated huge controversy when he argued two weeks ago in favor of an international reserve currency to cure distortions in the global balance of payments. Although his reasons for worrying about excessive reliance on the dollar were probably correct, his proposal for an alternative currency based on SDRs was more problematic.

The SDR is not a currency. It is an accounting unit based on an artificial currency “basket”. As of January 1, 2006, the SDR valuation basket had the following weights based on their roles in international trade and finance: U.S. dollar 44%, euro 34%, Japanese yen 11%, and pound sterling 11%.

If countries accumulated reserves in the form of SDRs, they would effectively accumulate a basket of the above currencies. But of course no one needs SDRs to accomplish the same thing directly. If the People’s Bank of China, for example, felt that the SDR represented a more balanced and appropriate portfolio composition for its reserve holdings, nothing could have prevented it from apportioning reserves according to the SDR basket.

And yet informed observers believe that the US dollar accounts for anywhere from 65% to 70% of the PBoC’s total direct reserve holdings – even more if we include foreign assets of state-owned enterprises and minimum reserves held by China’s commercial banks.

But if holding more than 44% of a country’s reserves in dollars distorts the global balance and creates excessive currency concentration, why do the People’s Bank of China and other central banks willingly do just that? Dark mutterings about US hegemonic power notwithstanding, there are no legal or physical restrictions on the ability of central banks to choose the assets they purchase. For the past decade they could easily have purchased fewer dollars assets and more euro, sterling and yen assets.

The answer has little to do with geopolitics. It is a necessary requirement in global trade that capital and trade flows balance. Countries running trade surpluses must recycle their surpluses to the countries running trade deficits. Normally this is done through private investment flows, but following the 1997 Asian crisis a number of central banks, especially in Asia, began accumulating such large amounts of international reserves that their purchases of foreign assets completely dwarfed private investment flows.

Assets which the central banks of trade surplus countries purchase will to a significant extent determine which countries run trade deficits. If central banks mostly buy US dollar assets, the US will run the corresponding trade deficit. Contrary to popular opinion, financing flows do not necessarily follow trade flows. It is often the other way around..

Let us assume that over the past decade Asian central banks had decided to acquire reserves in the amounts described by the composition of the SDR. This means, assuming trade surpluses were constant, that they would have purchased between one-half and two-thirds the amount of dollars they actually did. The balance would have gone into euro, yen and sterling.

One likely consequence is that with less demand the dollar would have been weaker relative to the other three currencies then it has been. This would have cause a relative expansion in the tradable goods sector of the US, and a relative contraction in the tradable goods sector of Europe and Japan. With the expansion in the US tradable goods sector, and its positive impact on employment, the Federal Reserve would have kept interest rates a little higher, and US consumption would have been a little lower relative to GDP. Of course the exact opposite would happen in Europe.

Lower consumption means lower imports, and vice versa, in which case the US trade deficit would have been lower and the European and Japanese trade deficits higher by roughly the difference in the amount of dollar reserves purchased. By choosing to buy euros instead of dollars, in other words, Asian central banks would have forced a large part of the US trade deficit to migrate to Europe.

But could Europe have sustained a large trade deficit for any long period of time? For both political and economic reasons too complex to discuss here, it is reasonable to assume that Europe would not have been able to bear the burden of a substantially larger trade deficit. Most Asian policymakers know this.

That is why the US dollar is the world’s reserve currency, and most especially the reserve currency of Asian countries using foreign demand to boost domestic growth. In the distorted trade environment of the post-1997 world, the US was the only economy large and flexible enough to absorb the trade deficits that Asian countries required for their growth. US hegemonic power or deliberations had very little to do with it. Asia had to accumulate dollars if it wanted foreign demand to power domestic growth, and SDRs would have prevented this from happening. That is probably a good thing for the world, but a bad thing for China and Asia.

Tags: Steve Keen

The market (or at least that part of the market that obsesses over balance of payment flows) has been swept with rumors today that foreign exchange reserves were down in January by $30 billion.  My experience with these sorts of rumors is that they tend to be fairly accurate, and I suspect they will soon be confirmed.

 

If true, what does this imply about hot money flows?  The PBoC’s accounts have been more opaque than ever and it is extremely difficult to figure out what is really happening, but let me give try at least to bracket the range of outcomes.

 

China’s trade surplus in January was $39.1 billion.  It probably earned another $6-7 billion in interest income plus the reported $7.5 billion in FDI.  This means that absent other effects reserves should have risen in January by $52 to $54 billion.

 

But there were other effects.  China holds part of its reserves in currencies other than the dollar, and these declined in dollar terms January (the dollar appreciated).  The total loss here may be around $30-40 billion.  That means that absent other effects reserves should have risen by at least $15-20 billion.  If reserves in fact declined by $30 billion, it would indicate at least $40-50 billion in unexplained outflows.  Is this all hot money?

 

Brad Setser recently wrote a widely-read entry in his blog in reference to an article by Jamil Anderlini of the Financial Times about SAFE investments in equity markets that may have lost them $80 billion or more.  If this is true, and it seems plausible, some of those losses may have occurred recently, although since the most vicious equity markets were last year, very little of that loss should have occurred in January – and it is anyway an open question whether the PBoC would value these investments at book or at market.  Perhaps a small part of the unexplained $40-50 billion represents equity losses, but this cannot explain much of it.

 

We also know that China has stepped up its purchase of foreign commodities, either directly (which would have shown up already in the trade numbers) or indirectly via investments in commodity producers.  The latter would have caused “unexplained” dollar outflows from the PBoC.  It is not clear that much, if any, of this happened in January, but perhaps some of the outflow represents new outward investment of this sort.  We don’t know.

 

Against that there is the question of whether December’s 150 basis point reduction in minimum reserves represents a reversal of dollar assets held at the central bank by commercial banks (remember that earlier increases in minimum reserves in 2007 and 2008 had been redenominated into dollars, and so their reduction should have reversed that process).  If it did, and this would consist of about $30-40 billion, it would actually increase the unexplained amount. For the sake of conservatism, let’s assume that this hasn’t happened.  We should know when the PBoC release its balance sheet numbers if the “Other dollar assets” account changed significantly.

 

Where does that leave us?  There are about $40-50 billion in unexplained outflows and however you look at it there it is hard to believe that we haven’t seen at least $20-30 billion of hot money outflows in January.  From my many years experience in developing markets I should say that the informational content of hot money flows is often wider than many people at first think.  Much of the discussion about whether Chinese businessmen are bringing in or taking out money hinges on their perception of whether or not the currency will appreciate or depreciate (and in spite of the popular view of evil foreign speculators masterminding the flows, the truth is that the vast majority of this money is likely to be controlled by local businessmen).

 

But I would argue that usually a much bigger driver of hot money flows is the local perception of risk in the country experiencing the flows.  If hot money is flowing out of China, it could be because local business owners believe the currency will depreciate, but I think it is more likely that the flows represent their concern that local investment opportunities – for example their businesses – have become increasingly risky and uncertain.  Hot money flows tell us at least as much about risk perceptions as they do about profit opportunities, especially when the world is in trouble.

 

By the way, this exercise should indicate yet again why all the discussions and debate in China and the US – about whether or not China should continue financing the US fiscal deficit – are wholly beside the point, as I have been arguing almost monomaniacally for years.  China cannot finance the US fiscal deficit, nor can any other country.  China can only finance the US trade deficit, and it must do so by recycling its current account surplus, either via Chinese investors, or via central bank purchases of US dollar assets. 

 

If there are hot money outflows from China large enough to cause the central bank to lose reserves, the central bank will not only stop buying US Treasury bonds and/or other dollar assets, it will have to sell something, which is most likely to be US dollar bonds.  It has no choice. 

 

Chinese investors who have taken money out of the country, on the other hand, will now effectively be responsible for recycling the Chinese current account surplus.  They might decide to buy US Treasury bonds (and I suspect indirectly and directly many will), but they could also buy gold, Venezuelan bolivares, Moroccan real estate, or in fact anything else they choose, and it is their buying that will determine how the Chinese trade surplus gets allocated among China’s trading partners.

 

The other point to consider in all this is the impact on Chinese monetary conditions.  A net outflow from the central bank has to be financed by retiring central bank bills or “destroying” RMB.  This implies monetary contraction, and it is still difficult for me to see how this would not have a contractionary effect on underlying money.

 

Note 1:  Wednesday’s edition of the New York Times has an interesting article on Pingyao, a stunningly beautiful town about an hour from Taiyuan, in Shanxi province which, if it weren’t for the coal-dust-infested air, would remind me of San Miguel de Allende or some of the other old and protected silver-mining towns north of Mexico City.  I visited three years ago and plan to go back because of my interest in Chinese financial history.  Pingyao was probably China’s first financial center (although temples already operated as early banks thousands of years ago) and headquartered the largest and most famous piaohao – 19th Century merchant trading companies whose businesses had expanded to taking silver deposits in one city and making them available in other cities (travelling was dangerous), collecting the emperor’s taxes and transferring revenues, and ultimately to making loans.  This is only marginally related to my blog, but for those readers interested in this kind of stuff, I encourage you to read about Pingyao and the piaohao.  It is a fascinating story. 

 

Note 2:  Once again my site is blocked in China.  I don’t know why– I hope it only has something to do with last week’s NPC meeting and will be fixed soon – but until it is resolved my formatting will be screwed up and I won’t be able to respond to comments.  For China-based readers, I think you can access this site easily on SeekingAlpha.com

I have been on the road for the past few (and next ten) days, in part because of Spring Festival, so I haven’t been able to post as much as I normally do, but I was asked to write an article for a Chinese magazine, which I recently finished, on comparisons between today and the beginning of the 1930s.   As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it.  I and a few others have discussed one of the similarities so many times and in so many different places that I think by now the whole issue of the trade impact of US overcapacity in the 1920s and 1930s and how it relates to China today is pretty widely recognized.

But there is more.  I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history).  One of the points he makes – in fact it is probably the main point of the book – is the way currency policies (i.e. adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis.  It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis.  Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold.  They were also the ones most harmed by the 1930s crisis.  I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions.  Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

1. The first I have discussed many times.  Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports.  However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries.  As international trade collapsed – especially after the US tried to force the adjustment abroad by the passage of import tariffs – domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically.  It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending.  This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment.  Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.
2. To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending.  The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract.  When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster.  According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all.  The first and most obvious is the scale of China’s overcapacity problem.  China’s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 – roughly 0.5% of global GDP – but its economy is less than one-fifth the relative size of the US in 1929.  Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts.  For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods.  In that direction lays trade friction, which would have a devastating impact on Chinese businesses.

Perhaps not nearly as strong as the US in 1930, China is nonetheless in a reasonably strong position fiscally – although municipal reliance on land sales for revenues, contingent liabilities in the banking system and in provincial and municipal borrowing, and overall lack of transparency, make it difficult to judge.  More importantly, however, there is widespread recognition among policymakers, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand.  Unfortunately it is not yet clear exactly how aggressively the Chinese government will expand fiscally and whether it will do so fast enough to replace declining US and European imports.

The second point may be the more important.  Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth.  When this happens the financial system often responds by taking on excessive credit risk and over-investing.  Given the complexity of the China’s formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry.  Warren Buffett once quipped that you can never know who is swimming naked until the tide goes down.  The tide is receding and we are about to see how many naked bankers there are.

How the PBoC will respond to any signs of sharp money contraction is probably the most important question to answer and also the most difficult.  On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk.  The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy.  In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management.  This is one of Eichengreen’s key points.  Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain.  Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently?  Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency.  This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.

The PBoC has other tools: most importantly its influence on credit creation (I am skeptical about the usefulness of open market operations) which it can expand partly by reducing the minimum reserve requirement for banks and partly by moral suasion within the banking system, but I am not sure how effective this is likely to be.  Remember that much of the credit expansion from previous years seems to have migrated off the balance sheets of commercial banks (including into the informal sector) when the PBoC tried to constrain credit growth.  In my opinion when underlying monetary conditions are consistent with rapid credit expansion there, is little the regulators can do to prevent this from happening.  At best they can decide whether it happens in the regulated parts of the system or whether it simply migrates to other areas.

The reverse is also likely to be true.   Attempts by the PBoC and other policy-makers to force banks to expand credit may result in higher loan growth reported on bank balance sheets, but overall credit growth within the economy is likely to be much less.  If the underlying money supply is consistent with contracting credit, the system will most likely see contracting credit (and I am saying nothing about the possibility that much of the formal credit expansion reported by the banks will consist of empty lending into future NPLs).

With international trade falling, it is probably only a question of time before China’s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave.  This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces.  We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency  terms, the PBoC has limited ability to manage the domestic money supply.  If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending.  This would undoubtedly worsen China’s difficult economic adjustment to the problem of overcapacity.  It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans.  China can learn a lot from the mistakes of US policy in the 1930s.

By the way whenever I say that money outflows could become a problem for China, inevitably someone rushes in to pour scorn on the idea that China is vulnerable to a 1997-style Asian crisis.   I agree it isn’t, and I will repeat (again) that this is not and never has been the point of my concern about hot money outflows.   China does not have a currency mismatch risk worth bothering about.  The reason to worry about hot money outflow is that it has a domestic monetary impact.

Tags: Eichengreen

I think if I were an economic policymaker in China I would be spending most of my time thinking about the money supply and how it works. There is a small but growing possibility that Chinese monetary conditions are going to go wrong at exactly the wrong time, and policymakers will need to have a well-thought out and vigorous plan to address it if it happens.

It has become pretty clear that the huge amount of hot money that poured into China last year and earlier this year is beginning to reverse itself pretty sharply. According to a PBoC release yesterday, China’s foreign exchange reserves increased to $1.946 trillion at the end of 2008, up from $1.906 trillion at the end of September. Here is what Logan Wright, of Stone & McCarthy, said in a release earlier today:

The Q4 2008 foreign exchange reserve data, released yesterday, indicate that China’s six-year liquidity cycle may be coming to an end, triggered by limited expectations of further yuan appreciation alongside a rapid downturn in both the domestic property market and global consumption of Chinese exports. Despite a record-high quarterly trade surplus of $114.3 billion and additional sources of capital inflow, China’s foreign exchange reserves rose by only $40.4 billion in the fourth quarter. This suggests that China saw significant levels of capital outflows during the fourth quarter, which we estimate totaled around $120-140 billion. Valuation adjustments may explain the decline in headline reserve levels in October (by $25.9 billion), but they cannot explain the entirety of the slowdown in reserve growth during the fourth quarter.

It has become harder than ever to figure out exactly what is going on with central bank reserves – and of course just when we need clarity most – so there is a lot of variation in all of our estimates about the different components of the adjustments in reserves, but Logan is one of the most careful of the PBoC watchers and his estimates on hot money outflow fall into line with my own and most of the other credible estimates I have seen. For example Mark Williams of Capital Economics said in a release yesterday that “hot outflows may have amounted to well over $100bn last quarter, equivalent to around 8% of Q4 GDP,” and Stephen Green at Standard Chartered said in another release yesterday that he calculated the “unexplained” amount of reserve changes to be about $110 billion, although at least part of that may be accounted for by a lag in trade payments.

Remember that there are two reasons for hot money to leave China – one on which most of us have focused, and another, which may be more important but which hasn’t received the attention it deserves. The first is the expected excess return for bringing money into China or taking it out – basically the RMB deposit rate plus the expected appreciation of the RMB less the equivalent US dollar deposit rate. When there were tremendous expectations for RMB appreciation, money poured into China, and now that those expectations are evaporating, or even going negative (i.e. there is some concern that the RMB may depreciate), it is likely to leave.

The second reason for hot money flows, not as widely discussed but at least as important, is the perception of risk, especially of the financial system. Remember that whether any given level of expected appreciation results in outflows or inflows depends also on the expected risk. As risk rises, it will take a lager expected return to encourage inflows. As China’s economy contracts, and as local businesses become increasingly worried about the potential for the current crisis to lead to deeper problems, including problems with the banking system, there is an increasing incentive for wealthy Chinese businessmen to take money put of the country.

For much of 2007 and early 2008 I argued that Chinese monetary policy had locked the country into a dangerously pro-cyclical trap, and unless the PBoC engineered a one-off revaluation that would stop hot money inflows, there was a real risk of incurring destabilizing capital inflows and outflows. When things were going well and the country’s economy was booming, hot money would pour into the country, unleashing a credit bubble and exacerbating the problem of overheating and overcapacity.

Once conditions turned around, however, I worried that hot money outflows would have exactly the opposite impact, causing a contraction in the money supply that would lead to credit contraction and an even sharper economic slowdown. This is always the great danger of hot money – when things are going well it pushes the economy into overheating, while squeezing the economy just as things start to get bad.

Needless to say, the PBoC did not revalue the RMB or otherwise move quickly enough to control the torrent of hot money inflow, and now they may be forced to deal with the accompanying but opposite problem. As conditions deteriorate, hot money outflows will become a real monetary drag.

This is not to say that these outflows are creating a problem for China right now. On the contrary, with outflows more or less matching current account and FDI inflows, the net impact is that for the first time in several years the PBoC finally has some apparent control over domestic monetary policy.

What worries me and some of my other PBoC-watching friends is the implication of this reversal on future monetary conditions in China. The outflows are almost certainly likely to cause contraction in credit – especially in the informal banking sector, where much of the hot money inflow may have hidden – and one can make a very plausible argument that outflows, and the attendant credit contraction, may exacerbate the slowdown in the economy.

If it does, and in so doing increases the perception of riskiness in China, it may create further strong incentives for local business owners to take money out of the country. China, in other words, has locked itself into a highly pro-cyclical monetary policy, and one of the key points to remember about highly pro-cyclical systems is that it is very hard to predict exactly where they are going, but it is a pretty safe to predict that whatever they do they will go to extremes (as if to confirm my worry about exacerbating tendencies, I see that China’s National Bureau of Statistics has just revised upward China’s sizzling 2007 growth rate of 11.9% to 13.0%).

To extend this a little further, it is worth remembering that there were at least three important factors that caused the severity of the Great Depression in the US. First, the US had to deal with a substantial industrial overcapacity problem just as the European countries that absorbed US overcapacity by running trade deficits with the US saw the financing of these deficits interrupted. I have written about this several times in the past few weeks so I won’t discuss it further.

Second, the US did not expand fiscally nearly enough to counteract the decline in domestic and foreign demand for US production. I know that this is a controversial point and I don’t want to get into a debate about the efficacy of fiscal expansion, but as I see it the US would have been better off if the government had followed Keynes’ advice and expanded more quickly. Third, the US experienced a severe monetary contraction as some banks either collapsed, others sharply contracted their lending, and depositors and businesses hoarded cash. The Fed should have accommodated this contraction by relaxing monetary conditions but failed to do so. According to Milton Friedman this may have been the single biggest cause of the severity of the contraction.

So where does that leave China? The overcapacity adjustment in China may be much larger than the one faced by the US – with 40% of global GDP the US had to absorb a trade surplus of roughly the same magnitude as China, which accounts for only 7% of global GDP. On the fiscal side I think China will definitely expand much more aggressively than the US did in the 1930s (how could it not?) but of course there are real questions about how much real expansion there is, how it is going to be financed, and how much of it will simply be wasted or turn into NPLs. Most importantly, can China expand enough to make up for the contraction in US and European demand (the two economies are more than six times the size of China)?

The US experience in the Great Depression suggests that among the things we should be most worried about in China is underlying monetary conditions. If hot money outflows accelerate and, as is likely to happen, the trade and FDI surpluses drop sharply, we could start to see some large monthly net outflows, and it shouldn’t come as a surprise if large outflows increase the perception of risk and so encourage further large outflows. Remember that outflows mean dollars sold by the PBoC in exchange for RMB, which represents a contraction in the base money supply. If China is forced to experience a sharp monetary contraction on top of its economic adjustment, things could easily get out of hand.

A sharp monetary contraction, as I see it, basically means a sharp contraction in credit. Could we see this, and can the PBoC take steps to counteract it? Here is what the South China Morning Post had to say in an article two days ago

Yuan-denominated loans granted by mainland banks grew a robust 19 per cent last month from a year earlier, suggesting lenders are heeding Beijing’s calls to stimulate the economy. Mainland banks extended 740 billion yuan (HK$839.31 billion) in loans in December, the biggest monthly rise since January last year, the Shanghai Securities News reported yesterday.

The new loans started to rise from about 300 billion yuan monthly in most of last year to 476.9 billion yuan in November when the central government unveiled a 4 trillion yuan fiscal stimulus package and encouraged banks to help funding the toll road, railway, port and other projects under the scheme. “Bank lending has been a key indicator. It’s crucial to China’s economy-boosting efforts. The December figure shows the needed credit expansion is on the way,” said Peng Wensheng, an economist with Barclays Capital Research.

I am not sure I agree with Peng Wensheng. We are not seeing credit expansion so much as a growth in RMB-denominated loans in the formal banking system. Perhaps this is a good proxy for credit in China, but I suspect it isn’t. First, much of the growth has come in the form of a sharp increase in bill discounting, and I am not sure whether this might not include a lot of double counting. I have also heard whispers that companies are turning to short-term credit not for investment purposes but rather because of serious cashflow problems. If so, this might be the worst sort of credit expansion.

And second, it is not clear what is happening to off-balance sheet transactions – which may be in the process of being shifted back on balance sheets to meet credit targets with no real expansion in credit – or, more importantly, to the informal banking sector. The anecdotal evidence is that the latter is contracting sharply, which is consistent with the idea of hot money outflows.

Whether credit is indeed expanding or in fact contracting is, to me, still an open question, and I would argue that circumstantial evidence – the collapse in inflation, the open disgruntlement among banks about pressure to meet credit expansion targets, hot money outflows – suggest that it is contracting.

Frankly I am not sure where all of these musings lead, and I need to do a lot more thinking about the subject, but I worry that for reasons beyond the PBoC’s control we may see a much sharper monetary contraction in China than expected, especially if hot money outflows increase, and this could seriously exacerbate the downturn just as it did in the US in the 1930s. Can the PBoC accommodate this by relaxing? I don’t think so. Remember that I have argued for years that the PBoC has little to no real control over domestic monetary conditions as long as it retains the straitjacket of the currency regime. It should have gotten out years ago, or at least reduced the strength of its pro-cyclical impact by revaluing sharply before hot money flooded into the economy, but I am not sure it can easily adjust in the midst of a crisis. Perhaps they should anyway consider what the impact would be of either loosening the band considerably, or even floating.

The US loses the most jobs since 1945, the Financial Times headline blared out yesterday. According to the article:

The US economy lost more than half a million jobs in December for the second month running, figures showed on Friday, making 2008 the worst year for job losses since 1945 and intensifying pressure on Congress to pass a fiscal stimulus. The number of jobs lost during the year reached 2.6m, while the unemployment rate – 4.4 per cent before the credit crisis – jumped to 7.2 per cent in December, its highest level in 16 years.

Yesterday’s Telegraph was not a whole lot warmer on the subject of Europe. It had an article entitled “Europe’s economy contracts at rates not seen since 1930s,” which started off with:

German exports and industrial orders have both plunged at the steepest rate since modern records began and Spain’s unemployment has surged above three million, capping one of the most disastrous days for Europe’s economy since the Second World War.

It is pretty obvious that consumption in trade deficits countries is adjusting at a breakneck pace – “adjusting” being a word often used by economist’s to mean “the party’s over”. The rising savings rate required by households to repair tattered balance sheets has not just meant an equivalent decline in consumption, since this rise is occurring so quickly that income is declining. The total drop in consumption is, and will continue to be, severe.

With consumption declining so quickly, and fiscal spending so far unable to keep pace, what does this do for countries exporting excess production? In some trade surplus countries – i.e. Germany – the predictions some of us had been making about the “second stage” in the crisis, in which trade surplus countries get hit with deeper and longer-lasting adjustments, seem already to be coming true. Exports are collapsing, and with no increase in domestic demand to compensate, it is pretty hard to imagine how businesses are going to cope.

For all the attempts by the government to keep confidence up, Chinese businesses, not surprisingly, are worried. Yesterday’s South China Morning Post had the following article:

Business confidence in the mainland plunged in the final three months of this year to an eight-year low as the mounting effects of the financial crisis weighed on exports and industrial output, an official survey showed on Friday. The business confidence index fell 29.2 points in the fourth quarter to 94.6, the National Bureau of Statistics said. That is the lowest reading since the start of 2001, the earliest date for which official figures are available.

Hardest hit were manufacturers, hurt by shrivelling demand in the United States and Europe and a weakening domestic property sector. Their sub-index plummeted 32.1 points from the third quarter to 87.2. That reading is in line with two purchasing managers’ surveys published earlier this month, which showed a continued contraction in the sector, as well as economists’ expectations that exports shrank more quickly in December.

The debate locally about what caused the trouble and what to do about it (and not incidentally, who to blame) continues strong, and recently two things seem to have been added to the stew. One, the China-trade-imbalance argument has gotten enough traction within China that suddenly the debate seems to have erupted into the spotlight. A number of local analysts, especially critics of both the left and the right, have been arguing that Chinese monetary and fiscal policies may have been part of the root cause of the imbalances that led to the crisis.

Regular blog readers know that I won’t find this argument at all surprising, but local policymakers are inordinately sensitive to being blamed for anything, and the official position is that China is simply an innocent bystander in a problem wholly concocted and hatched elsewhere. However an increasing number of Chinese economists and academics seem to be challenging that position, so much so that the People’s Daily posted a rather angry editorial three days ago titled “U.S. blame game cannot change facts of financial crisis.” The article blasts Paulson and Bernanke for saying that “a failure to address the rise of emerging markets and resulting imbalances was partly to blame for the global financial crisis,” and concludes:

Imbalances in global trade and investment did have a role in the crisis but were not at the root of the problem. Loose supervision that helped pump excessive dollars into circulation was the root cause. When a morally upright person is mired in difficulties, he or she will engage in introspection rather than shift responsibility. China has moved to cope with the problem with a stream of measures and so have other large world economies.

It is not time to play a blame game. Regulators in the United States might not want to miss the chance that they failed to seize before the crisis, when property companies, investment banks and insurance companies juggled various financial products and Wall Street “elites” snatched tens of millions out of the bubble.

It is hard to argue with these conclusions, but a cynic might wonder if any of the participants in the crisis would be considered, by this argument, “morally upright.”

The second thing we seem to be hearing a lot of is concerning capital flows and whether or not China is experiencing hot money outflows. We are all still trying to figure out what is happening to capital flows and to the composition of reserve accumulation (or is it reserve dissipation?). In a recent note, Logan Wright of Stone & McCarthy tries to back out the things we know to get some sense of what is happening to capital flows.

He concluded in an email to me that was attached to his research report that “outflows of around $100-150 billion for the quarter seem within the realm of possibility, but we won’t know anything until we see the data,” but was at pains to establish that he is only guessing. His guesses would be easier to dismiss if a SAFE official hadn’t made a rather surprising announcement four days ago. According to Bloomberg:

China faces a threat of “abnormal” cross-border capital flow because of global financial tumult, the country’s foreign exchange regulator said Tuesday.

I accidentally erased the article and can’t get it back, so I can’t quote much more from it, but I do remember finding the whole thing a little odd. There was no clear explanation of what was “abnormal”, but all the evidence suggests that money flows are not behaving as well as we would want them to. Other interesting official commentary last week included the following, from an article in Tuesday’s South China Morning Post:

The mainland’s financial position will be difficult in the year ahead as revenues fall and spending surges, Minister of Finance Xie Xuren warned yesterday. Painting the most sombre picture of the government’s finances in years, Mr Xie said that shrinking corporate profits caused by rapidly slowing economic growth, as well as tax cuts, would lead to a drop in revenue, while government measures to boost growth would add to spending.

“[It] will be a very difficult year,” Mr Xie told an annual national meeting on fiscal affairs in Beijing. “The problem of unbalanced income and expenditure will be prominent in 2009.” His warning came as an official revealed that the mainland’s giant state-owned enterprises had reported a rare decline in profits last year. “Profits of state-owned enterprises directly under the central government fell about 30 per cent year on year in 2008 to 700 billion yuan [HK$800 billion],” said Huang Shuhe , vice-chairman of the State-owned Assets Supervision and Administration Commission

Some of my older readers will remember last year when I argued that something a lot of analysts saw as a real strength – the huge surge in China’s fiscal revenues, which left the fiscal account more or less in balance – was, in my debt-trader-influenced pessimist’s eyes actually a real problem. If the fiscal account stayed in rough balance with fiscal revenues soaring by 30% a year, it seemed to me that any discrepancy between the rate of revenue growth and expense growth could lead to a sudden unexpected rise in the fiscal deficit, especially since in a downturn the pressure for revenues to decline and for expenses to rise would be unbearable.

The probability geek in me instinctively worries about very rapidly changing numbers, even when they are good, because there is a lot more room for things to go very bad. From what Mr. Xie is saying, the worry was on the mark. The growth rate of fiscal revenues and fiscal expenses have already sharply diverged, and this is even before the big spending plans have been put into place. The article goes on to say:

Ha Jiming , chief economist at China International Capital Corp, said the weakening financial position would cast doubt on the government’s much-vaunted economic stimulus package. The measures, including the 4 trillion yuan stimulus package and tax cuts, are to stem a rapid slowdown in economic growth, by boosting public spending and private consumption.

It claims that economists “expect the mainland will have a budget shortfall this year, with the deficit between 500 billion and 800 billion yuan.” I am nowhere near smart enough to predict what the deficit will be, but I am happy to bet anyone it will be a lot more than the current predictions.

Finally one last comment about recent interesting, and even surprising, government statements, is about a report last week in Laiowang, a Xinhua publication. According to an article on the topic in South China’s Morning Post:

The mainland faces surging protests and riots this year as rising unemployment stokes discontent among migrant workers and university graduates, a state-run magazine said in a blunt warning about unrest in this sensitive year. The unusually stark report was in this week’s Liaowang [Outlook] magazine, issued by Xinhua news agency, which laid out the hazards facing the mainland and ruling Communist Party as growth falters during the global economic crisis.

“Without doubt, now we’re entering a peak period for mass incidents,” a senior Xinhua reporter, Huang Huo, told the magazine, using the official euphemism for riots and protests. “In this year, Chinese society may face even more conflicts and clashes that will test even more the governing abilities of all levels of the party and government.”

This report has been so widely discussed that I don’t have a whole lot to add to it.

My last comments are about two recently published pieces. On yesterday’s Economists Forum on the Financial Times website Martin Wolf published my short version of a longer article also published today in Far Eastern Economic Review on the global balance of payments and the US-Chinese adjustments.

Tags: Logan Wright, US jobs

Between the holiday slowdown and the number of writing commitments I have it has been a little too easy to neglect my blog. What free time I have has been spent reading, and I am reading for the third time what I think is one of the best books ever written on financial history – Barry Eichengreen’s Golden Fetters: The Gold standard and the Great Depression.

Eichengreen’s book has an awful lot to tell us about our own current crisis, as does any good book on financial history. In spite of all the unending nonsense written about what went caused the financial crisis this time around – derivatives, securitization, deregulation, greedy bankers, overpaid traders, fraudulent behavior – the fact is that financial crises going back over at least 2000 years are disconcertingly familiar, and have nearly identical consequences and processes, even when they include none of the conditions blamed for the current mess. To focus on those particular triggers as being the main causes of the crisis is what I would call the “trigger fallacy.” They are merely the symptoms of the underlying problem – excess liquidity, which the financial system is forced into accommodating by taking on increasingly levels of risk, either inside or outside the regulated areas.

Not surprisingly then it is impossible to read Eichengreen’s book in the current economic climate without several “aha!” moments, but this passage (pp. 11 of the 1992 edition) I found particularly interesting:

The arrival of the Fed on the international scene was a significant departure from the pre-war era. Disputes between New York and Washington rendered the new institution unpredictable. Until the Banking Act of 1935 consolidated power, considerable influence was wielded by reserve city bankers from the interior of the country with little exposure or sympathy for international considerations.

Eichengreen is discussing how the advent of the US as a major financial center changed the “rules of the game” involving cooperation between the major European central banks – mainly the UK, France and Germany – when the closest thing to a US counterpart was the very well-managed and internationalist House of Morgan. During the end of the 1920s and beginning of the 1930s the Fed’s role became increasingly prominent and increasingly erratic especially after the death of Benjamin Strong, who ran the New York Federal Reserve Bank and who had a very strong relationship with Montagu Norman, the Governor of the Bank of England.

The point is that before power was consolidated under the Chairman of the Federal Reserve System in Washington DC, the US central bank consisted of 12 regional banks with quite a lot of independent power, and the regional banks tended to be, not surprisingly, more parochial, more beholden to the dominant economic interests of their region, less understanding of the US role within the global system, and less sympathetic to the need for the US to behave in a manner befitting what was later dubbed a “global stakeholder.”

This had consequences. It was very hard for the US central bank to act in a consistent way to manage its proper role within the global context, and this failure not only created a very debilitating uncertainty, but also ensured that parochial interests trumped international interests even when the US was better off parochially from understanding its role within the international context. For example US trade policies aimed at helping regional economic interests at the expense of the outside world ultimately ensured both a collapse in international trade and, as result of the US position of overcapacity, a brutal collapse in US capacity.

What does this have to do with China? Perhaps nothing, but I am of course not the first to observe that the PBoC has very little independence and is largely beholden to the State Council and senior officials within the Standing Committee for its policy decisions. This is, in itself, not a problem and might even result in better coordination between the country’s treasury and central bank functions. However there are persistent rumors of serious disagreements among senior policymakers and especially a split between one camp, dominated by provincial leaders more concerned about social issues arising from unemployment and income inequality, and another camp, based in the major international center and more concerned about macroeconomic imbalances at both the national and global levels.

Is there a possibility that the PBoC will find itself, like the Federal Reserve in 1929-31, riven by very different understandings of the country’s role within the global crisis and with different priorities in resolving the crisis – ones that misconstrue how the global adjustment will affect China’s adjustment? I have no idea, and perhaps the game of finding parallels between 1929 and 2008 gets a little carried away at times, but it is worth considering that monetary policy-making in China has not always been consistent and, like most major policy-making, can be easily subject to competing views of Chinese political priorities and China’s role within the crisis.

This is not to say that the illusionary triumph of parochial over global interests is inevitable, as occurred in the US in the 1930s, but it certainly is a possibility. This is yet anther reason why I am convinced that US, European, Japanese, and especially Chinese leaders need to get a clear macro picture of what the global balance of payments adjustment will mean for each country, and give up the silly blame game to work out a reasonable long-term period (at least three or four years), during which time China can adjust to the global adjustment. Any quick adjustment will be bad for the world and devastating for China.

But the prospects for understanding don’t look good. Local newspapers are filled with worried articles about rising unemployment, and on Saturday Premier Wen made an unscheduled and very surprising visit to one of our academic neighbors. According to an article in today’s People’s Daily:

Chinese Premier Wen Jiabao has pledged to university student that the government would seek to provide more jobs for graduates and “put the issue of graduate employment first.” “Your difficulties are my difficulties, and if you are worried, I am more worried than you,” Wen told the students at the Beijing University of Aeronautics and Astronautics. Wen made the remarks in a surprise visit on Saturday afternoon.

…He said the country is in a difficult period as the global financial crisis has continued affecting the country’s real economy. The government has begun measures to sustain the economy, such as the four-trillion-yuan stimulus package and interests cuts. “We are considering taking more measures at proper time. But currently we are most concerned about two issues, migrant workers returning home and employment for graduates,” Wen said.

The financial crisis and China’s slowing economic growth has forced 4 million migrant workers to return to their rural homes, according to a report from the Chinese Academy of Social Sciences. The report also said as of the end of this year, 1.5 million graduates are likely to have failed to find jobs, and the country could see an ever tougher employment situation in 2009 as there will be about 6.1 million seeking jobs (from 5 million last year).

Other headlines fret about the mass migration – well before the traditional Spring Festival period – of unemployed workers returning to their rural homes. According to an article in Friday’s South China Morning Post:

Up to 9 million migrant workers have left coastal areas this year amid diminishing job prospects and falling wages, prompting fears that unemployment in inland provinces may increase sharply next year. Home-bound migrant workers have packed major railway stations in major cities, catching the central government by surprise because the traditional passenger peak arrives just before the Lunar New Year, which is late next month.

There is still more about the rise of criminal gangs, more protests, and all the other indications of social tension. In these circumstances it is not hard to see why policymakers may decide that short-term unemployment pressures trump the global balance of payments adjustment, and push to subsidize and encourage more production, rather than worry about rapidly expanding domestic consumption. This would, of course, only exacerbate the Chinese overcapacity problem and increase the likelihood of trade tensions which, if they lead to global protectionism, could scuttle any chances of China’s recovering from the crisis. I guess this is exactly what they mean by “between a rock and a hard place.”

One other thing to discuss before I finish this long posting – Bloomberg posted the following article today:

China’s foreign exchange reserves dropped for the first time in five years as a result of the global financial crisis, Market News International reported, citing Cai Qiusheng, head of the investment management bureau under the State Administration of Foreign Exchange. The current figure must be lower than the peak of about $1.9 trillion, Cai told a trade forum in Beijing over the weekend, the English-language wire service said. He didn’t specify which period he was referring to or give a figure.

I am not really sure what is going on. We used to get regular and reliable monthly leaks about reserve figures but these have pretty much dried up since June, just as we needed the numbers more than ever. The last official numbers were released for September – they are released on a quarterly basis – and put reserves at $1.9056 trillion. The latest “leak” claims reserves are at $1.89 trillion, which with rounding suggests that reserves declined in two months by somewhere between $10 and $20 billion.

Of course we are all very eager to get a better breakdown of the recent figures so that we can estimate hot money flow directions. But given the we have had two world-record-smashing trade surplus months in a row since September, amounting to $75 billion (and three monthly world records before that), not to monition positive FDI inflows of $14 billion and about $10 billion of interest income in the past two months, it is very unlikely that the dollar value of the various non-dollar reserves can have declined by even a significant fraction of $99 billion increase in reserves from trade, FDI and interest income in the past two months (or the $110-120 billion implied by the new reserve numbers). Does this mean there has been significant hot money outflow? Perhaps, but without real numbers it is tough to want to conclude anything. January’s central bank data release promises to be very, very interesting.

But there’s more. My friend Victor Shih published a very good Op Ed article in the Wall Street Journal Asian last week. You can find it on his blog. He discusses how the new fiscal expansion plans – which are seriously constrained by structural impediments in the economy – are likely to cause significant pressure for bank “participation,” and this pressure is unlikely to lead to improved banking practices. He concludes:

In any event, everyone is too preoccupied with their own losses to comment on Chinese policies. Which is a problem, not least for China itself. With enormous political pressure from the central government to pump money into the economy and silence from the rest of the world, much of the work in the past decade is being undone.

What will happen to all this money? Stephen Green – one of the best bank research analysts on China, in my humble opinion – just published a research report called China – The best-laid plans of mandarins and ministers in which he tries to tabulate the various spending plans being proposed at the national and provincial levels. Not surprisingly, he has a hard time figuring out the numbers – one section of his report is titled “CNY 4trn, CNY 18trn, or CNY 320bn?”

The government is so worried about a slowdown that there is almost a feeding frenzy over who can proclaim the most spending – with very poor Hunan proposing $1.2 trillion in expenditures that surpass the entire US fiscal plan, as Green notes. Even if most of these proposals are rejected, clearly an awful lot of money is going to be spent awfully quickly with an awfully small amount of oversight. Elsewhere in the report Green notes:

One suspects that corners are now being cut to get the money flowing again. The bureaucracy must also be exceedingly happy; it is commonly believed that 15-30% of the cost of a project is absorbed by ‘administrative’ fees, ‘consultancy’ fees, and the like (which raises the question of whether we should be discounting the CNY 4trn by 20% or so, and assuming these other funds will form part of 2009’s FX capital outflows). The Party’s corruption inspectorate is already preparing teams to monitor the use of public and bank funds. But it is, as they say, a big country.

It certainly is. And yes, we should be increasing our estimates of hot money outflows next year.

Happy holidays to all my readers. Unless there is a lot of important news in the next few days I will probably not post anything for a week. For those living in Beijing, we do have an outstanding Christmas Eve show at my music club, D22, and another outrageous night on New Year ’s Eve. If you want a good feel for some of the best new music in China (and the world), don’t miss these two nights. Sorry for the advertisement, but the Beijing music scene is truly exciting.

Tags: Eichengreen

The government was actively buying stocks today and as a result, not surprisingly, the market surged on hopes that they are serious about putting an end to the bear market. After declining yesterday by 0.3%, the SSE Composite jumped 76 points today to close the day at its high of 1965, up 4.0%. Central Huijin, a subsidiary of the CIC, increased its stake in China Construction Bank, as it said it would do last September. If this is sustained, it may help relieve a little of the gloom, but it is not clear to me that the rally has stronger legs than previous government-inspired rallies.

More interestingly, the dollar market today was acting strangely. Since late yesterday there have been no bid-offers on dollars, until the PBoC came in late in the day to sell dollars (the PBoC is normally a buyer of dollars). This suggests that capital outflows, at least for this week, have outpaced current account inflows, although we don’t want to read too much into this as of yet. January’s 4th Quarter PBoC numbers should prove very interesting as we wade through the increasingly difficult-to-interpret numbers to estimate hot money behavior.

As far as I can piece together today’s currency-market activity from conversations with some of my former students, now trading, and my friend Logan Wright, at Stone & McCarthy, the market has been very short of dollars in recent days as corporations over the past three days have been net buyers from banks. Since banks are not allowed to be net short, there were rumors that they had reached their dollar limits yesterday and were refusing to post prices for fear of being lifted.

Why have corporations been buying dollars? Part of the reason seems to be the NDFs in Singapore are pricing in a depreciation of the RMB, and corporations who can get around the capital control rules are finding it profitable to buy dollars in China and sell them in the NDF market. This is a great arbitrage if you can do it. But part of it may simply reflect the fact that talk of currency depreciation has increased in recent weeks, and until today the RMB has been depreciating. Today the central parity appreciated by 0.0025 to 6.8501, although the RMB closed the day at the weak end of the 0.5% band.

It is not irrelevant that Secretary Paulson will be here tomorrow for two days as part of the Strategic Economic Dialogue. His call for a stronger RMB yesterday signals that the currency is still likely to be at the heart of the debate. There has been more and more talk over the past few days about the possibility of RMB depreciation, and of course President Hu’s comments on Sunday about China losing its competitive edge strengthened the talk, but until there has been no real reason to think that there has been a policy shift.

Still, the possibility that pro-depreciation constituencies in China may yet gain the upper hand in the debate is very worrying. At first depreciation might seem like an obvious policy move – if export growth is slowing, and if unemployment pressures are rising, why not engineer demand expansion by increasing foreign demand for Chinese goods? After all, the outlook is increasingly grim. A “Blue Paper” by the prestigious Chinese academy of Social Science forecast GDP growth for next year at 9.3% – insanely optimistic, I think – but they did list some of the problems facing China. According to today’s Xinhua:

The Blue Paper also notes that housing prices will fall dramatically in a short period of time, and subsequently enter a rather long adjustment period in 2009. Economists from CASS believe the real estate industry will be bogged down throughout 2009 as demand weakens under high prices and the global financial crisis. Homebuyers and investors will be more prudent in their activities. Suppliers will also experience a chilly season next year as some small and medium-sized enterprises with limited capital are forced to leave the market.

Risks will increase as some homebuyers become unable to pay their mortgages and some builders will not be able to pay workers to complete projects. On the country’s employment front, the Paper adds that one million college graduates will be unable to find jobs by the end of 2008, a problem that will be exacerbated when more people may lose their jobs in 2009 as more than five million new graduates begin seeking employment the same year.

But remember that Chinese overcapacity is part of the global problem, and as interesting as they may seem at first, capacity-boosting measures only make the global imbalance worse. Yesterday Vice Premier Wang Qing made a speech on the subject in which he both called for consumption enhancing moves as well as export-enhancing moves. An article in Xinhua reported:

Chinese Vice Premier Wang Qishan has called for more concrete measures to tap China’s domestic consumption potential to sustain economic growth. External demand for Chinese goods has fallen markedly amid the global financial crisis, while domestic consumption power also fell, Wang told recent meetings on foreign and domestic trade.

…The vice premier urged a reduction of burdens for businesses, help for them in getting finance and promotion of mergers and acquisitions. He also called for more measures to optimize the export structure and explore new markets to offset the negative impact on the export sector of the global economic slowdown

That last paragraph worries me if it indicates the direction of policy. I really do believe that we are on the brink of a very ugly period for trade relations, and anyone in China who thinks that trade conflicts will not be devastating for China does not understand China’s role within the global balance of payments. This is not the time to try to strengthen exports at the expense of trading partners without a significantly larger increase in imports.

On that note, the EU Observer had the following piece earlier this week:

EU-China relations usually revolve around trade, with the EU buying €231 billion worth of goods from China last year and exporting €72 billion in return. But human rights concerns came to the fore during the Beijing Olympics, when scores of EU leaders stayed away from the opening ceremony after Chinese troops shot Tibetan protestors.

China is also unhappy that the EU continues to uphold an arms export embargo dating back to the 1989 Tiananmen square massacre. The latest summit and death penalty row could play into the hands of European leaders keen to restrict the flow of Chinese imports during the EU’s economic downturn, experts warn.

“Protectionist sentiment toward China in Europe has been growing for a while,” Center for European Reform analyst Katinka Barysch wrote in the Wall Street Journal. “Anti-China sentiment is on the rise in Germany …Even in traditionally liberal Britain, people who see China as an economic threat outnumber those who see it as an opportunity by four to one.’

The meetings between the Dalai Lama and European leaders is once again inflaming passions both in China and in Europe, and this is not the kind of atmosphere in which trade disputes are easy to resolve. There is (yet again) a movement afoot in China to boycott French goods, but I am not sure countries running large current account surpluses should be talking about boycotting countries who are running deficits with them.

This kind of talk can easily backfire. An interruption of the trade relationship between the two countries is actually likely at the macro level to be good for France in the short term (or, in what amounts to the same thing, it is easy enough politically to make the argument), and bad for China in both the short and long term. Remember, for France any interruption of international trade means they need to increase production to meet domestic demand. That means hiring workers. For China it means reducing its ability to export overcapacity, and this usually means closing down factories. I know, I know, France is not necessarily likely to produce at home what China sells, but in this world, finding a new supplier is a lot easier than finding a new customer.

At any rate this evening rumors have been swirling through the markets that November’s exports have declined year on year by 7%. One of my former students, now a currency trader in Shanghai, just told me this. I have no idea if it is true, but it gives a sense of how nervous markets are.

Tags: Dalai Lama, USD/CNY

I always seem to be traveling when exciting things are happening. I just got back this morning from four days in Paris, where I had to go for our annual Board of Directors meeting (and took the opportunity in addition to meet a number of investors and government officials), and so I was in a Paris hotel for the US elections.

I am delighted with the results, of course. Obama is a brilliant thinker and a charismatic figure, and has shown himself to be willing to listen to people who know more than he does, however without fobbing onto them the ultimate responsibility for making the decision. More importantly, he graduated from Columbia University, and so he definitely owns my loyalty. But like many others I seriously worry about whether he can even come close to realizing some of the fantastic expectations placed on him by Americans and by people around the world.

It was interesting to see the results in France. Of course in discussing this I am stepping away from any discussion of Chinese financial markets, but this seems to be enough of an historical event that it merits some digression. Most French seem to support Obama, but perhaps he has unfortunately become almost a messianic figure to some. I watched a television report from one of the poorer northern towns heavily populated by immigrants and their children, and the rapture and excitement of his election exceeded even the happiness in Hyde Park. Men and women were screaming with happiness, the halls exploded with dancing and cheering, and hundreds of those present chanted “We have our president, we have our president!” But he is not their president, and they may be seriously overestimating what Obama can do for them.

In the program the journalists interviewed two young Frenchmen – one black and one Muslim. They were very smart, very serious, and the point they were making worried me a lot. They explained that for years France was way behind the US in racism and its treatment of ethnic minorities. With the election of Obama, they said, the US had taken a huge step forward, leaving France even further behind, and they expected that France, too, had to take a major step forward. Obama was their inspiration to expect more from France (I suspect this kind of thinking is happening everywhere in Europe).

Of course they are right, but in the US the discourse on race and ethnicity is an old and fiery one, and far more advanced than any in Europe – when I grew up in Spain and France we were able to say and do things without thinking that, I later learned when I moved to the US for university, should have been completely unacceptable. Saying or doing many of those things still isn’t unacceptable in most of Europe.

I am enough of a realist to know that racism isn’t resolved by friendly dialogue and feel-good announcements by official bodies, but rather by confrontation, disputation and hard work. (That is why, by the way, I am afraid that the racism and discrimination in a country like China will persist for a painfully long time – it is practically forbidden even to acknowledge racism here, let alone fight over it.) But here is the problem. The world is in the midst of a financial crisis – one that will almost certainly see a significant reduction in global growth. Historically, disadvantaged minorities do worse during periods of low or negative economic growth than does the population as a whole. During these periods anti-immigrant feelings almost always rise.

I am afraid that for those two young men in France – and for many of those others who screamed and sang with delight and thankfulness Tuesday night – the next few years are not only going to see their welfare decline in nominal terms, but also even in relative terms. But expectations are for the opposite, and it seems to me that they have gotten so far ahead of reality that the next few years are going to be politically very difficult in the many parts of the world.

In the long run this is a good thing. Let minorities and the systematically excluded demand more everywhere, no matter how good or bad economic conditions are. It is only by demanding that they will get anything. In the short term, however, it won’t be easy.

But enough pontificating – Obama’s election has been so exciting that it has made philosophers of us all. There was a lot happening in terms of China’s economy and financial system, too, although not a whole lot of good things. I will disucss more of the really interesting stuff I have been looking at over the next week, but for now I will bring up just a few general points.

The first thing I want to bring up seems at first to be a good thing. The IMF says that China will be an oasis of stability in the global turmoil, and it sort of reaffirms its 9.3% prediction for 2009 GDP growth, but there may be less here than meets the eye. This, of course, is the same IMF that predicted in November 1997 that in spite of the surrounding turmoil South Korea was immune from the troubles afflicting its neighbors and in 1998 it’s economy was going to grow by 5-6% (fortunately they managed to pull the report just before it was due to be released, after the won collapsed). For those who are interested, South Korea’s 1998 growth rate was actually -6%.

Cheap shot, maybe, but the IMF – perhaps because it is a political institution – has a very weak track record in predicting trouble. Their economists also, I am afraid, have had an even worse track record in understanding the relationship between the economy and the structure of the national balance sheet – even though they did write an interesting report in 2003 or 2004 on the subject (which I suspect none of them subsequently read). Here is what the South China Morning Post said on Tuesday:

David Burton, the head of the IMF’s Asia-Pacific department, said that despite China’s own economic slowdown, the country had many ways to shore up its economic growth. Mr Burton said China’s export-driven economy had been dragged down by dwindling demand from the United States and Europe, and it could even miss the IMF’s forecast of 9.3 per cent growth next year. But the country was still sitting on almost US$2 trillion in foreign exchange reserves and had a relatively strong financial system.

“The global economy is slowing sharply and [the mainland] and Hong Kong are going to be significantly affected,” Mr Burton told the South China Morning Post before meeting Chief Executive Donald Tsang Yam-kuen yesterday. “With its robust reserves, I have no major worries about China, which will be a source of stability for the globe for the next year or two.” He said both the mainland and Hong Kong would be well positioned to get through the crisis.

I have no doubt that 2009 growth expectations are going to be sharply revised downward several times. They are probably going to lag the investment banks, who themselves are going to lag the independent analysts, but ultimately I expect all of us will soon reach the point where no one is predicting anything above 7%.

Meanwhile Bloomberg yesterday had the following article:

The yuan completed its best week in more than two months on speculation policy makers are allowing some gains to prevent money leaving as overseas investors pull out of emerging markets amid the economic turmoil. Bonds rose.

I hadn’t heard these rumors but of course after the third quarter PBoC numbers came out it was pretty clear that not only was China no longer seeing massive hot money inflows, but in September it was seeing outflows. I am curious to see the fourth quarter numbers. It would be worrying if hot money outflows really were becoming a problem.

Finally I saw another interesting Bloomberg article on Friday.

China’s Finance Minister Xie Xuren was called back from an international economic conference in Peru before the meeting began, following orders from Beijing to help resolve problems at home, an organizer of the event said.

Xie left Trujillo, Peru, where Asia-Pacific Economic Cooperation finance officials are meeting this week, shortly after arriving at 11:00 a.m. on Nov. 5, Gladys Otero de Swinnen, protocol director for the conference, said in an interview. “They told him he has to resolve an economic problem and that he’s the only one who could do so,” de Swinnen said.

…Deputy Finance Minister Li Yong stayed in Trujillo. Li declined to comment on measures to boost China’s growth. Xie arrived in Beijing to take care of some “urgent business,” two finance ministry officials, who declined to be named, said today. They didn’t elaborate.

I have no idea of what this is about, and I have not been able to find any further references, but in the cloaked, gossipy world of Chinese politics I am very curious to know why he was suddenly called away. I suppose we may hear more in the next few days. Perhaps one of my readers may have better information than I do.

In 30 minutes we have the weekly meeting of the Guanghua Students Monetary Committee. Last week’s meeting was pretty good and I am very interested to see what the students conclude today about monetary and credit conditions in China. I will of course report anything that comes out of there

Tags: Hot money, IMF

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

We’re starting the holiday week – October 1 is the anniversary of the 1949 revolution – so markets were closed today and will be closed for the rest of the week, and there’s a pretty good chance not a whole lot will happen on the policy front until the end of the holiday schedule.  Much of official public attention has been focused on the successful return of Shenzhou VII, whose flight included China’s first space walk.  Unofficial public attention is still on the milk scandal, whose social repercussions are likely to be fairly deep.

 

On that note I thought it might be useful to recount an interesting discussion I had last night with a group of six young Chinese friends.  The foreign media has made a lot of noise in recent months about the ugliness of China’s ultranationalist youth, and I get the impression that a lot of people abroad are worried by the spectacle of China’s being overwhelmed by mobs of goose-stepping youth proclaiming hostility to the rest of the world.  There is no question, of course, that this country has its fair share of flag-addled nationalists, but in China, like in most other countries, it is too easy to mistake the views of a very loud few for the views of the general population.  The reality here, it seems to me, is not a youth population teeming with aggressive nationalists but rather a great deal of very worried questioning about China and her future.

 

Last night my club presented a show by a well-known folk singer in his mid-30s from Shandong province.  After the show I sat down with him to chat, and was joined by five young people in their early to mid-20s who represented a pretty decent cross-section of young Chinese.  One was a software engineer from Hubei, another a college student from Fujian, a third was a bar manager from Dongbei, a fourth was a kid from Xinjiang who had just moved to Beijing a few months earlier to get a job, and the fifth was a Beijing college student majoring in design.  Although half of them were college educated none of them were graduates of elite colleges, and a few of them came from fairly poor circumstances – and so in that sense are perhaps more representative of ordinary youth than some of the nastier types we often see charging through the Beijing streets in their flag-bedecked SUVs.

 

With the help of plenty of beer we had a wide-ranging discussion, and at one point the young Hubei engineer asked me what I thought of the Beijing Olympics.  I gave him the standard response – a great success for China, wonderful show, etc. etc.  He interrupted me and said that in his opinion it was good for Beijing and terrible for China.

 

That started off a very long and impassioned discussion in which the people at the table – with the folk singer being the most demure, interestingly enough – launched into a very brutal attack on China and especially on the government.  The milk scandal was presented by everyone as proof of why China was, and was destined to be forever, a failure as a nation.  They gave many other examples and would not hear of anything good I might say.  When I tried to argue that China would inevitably experience difficult problems in the process of its growth, and that the milk scandal was one of them, they very politely but very firmly explained to me that I could only say this because I was a foreigner and knew nothing about the real China (although I had been to more parts of China than any of them except the folk singer).  They especially pointed out that as a Peking University professor the only students I meet were the ones who would run and benefit from the system, and so my views about Chinese were distorted (they said this very politely, as young Chinese are likely to be with professors, but quite firmly – they had little use for the elite).  They were utterly demoralized about prospects for ordinary Chinese and scathing about their leaders, even Grandpa Wen.  I found myself in the position (and not for the first time) of defending China and its government from very critical young Chinese.

 

I can’t discuss the whole conversation and of course I don’t want to suggest that these young people represented the totality of young Chinese opinion – after all the fact that they were at a bar to see the performance of a folk singer famous for his social concerns suggests some form of non-random selection – but it was a very striking version of a conversation I have had many times before in the past few years, both with elite college students and with less exalted types.  Often under the outpourings of pride there can still be a real despair among many young people about the prospects for their country, and many are far more skeptical about the official story than one might suppose from reading the press.  In fact I suspect the nationalistic rage of the feng qing, the so-called angry youth, may be as much a reaction to that skepticism as it is to perceived foreign slights.

 

What does all of this have to do with China’s financial markets?  I would argue that one thing it suggests, and I have made this comment before, is the brittleness of government credibility.  The idea that Chinese youth mostly follow the dictates of the official media is simply not true, even though you would have to be very naïve not to acknowledge the media influences the debate. 

 

But the fact that the government regularly directs the media and tries to limit the debate is not lost on most people, and there is a lot more skepticism, distrust, and even hostility than we might think to the China that many of us see in the press.  The government, in other words, can mobilize opinion relatively easily up to a point, but underneath it all this is a population a lot more sophisticated and a lot less malleable than we think, and when anger or frustration breaks, it can break pretty quickly (I remember this happening during the SARS crisis).  That is probably good for China in the long run (I tried to explain to my very doubtful young friends that the very fact of their skepticism undermined their pessimism, and that China was much worse off when people uncritically accepted of the official line) but suggests more instability in the short run than we might otherwise expect.

 

Again, I want to stress that these ruminations are not the result of one conversation, but that last night’s conversation was simply a very strong version of many conversations I have often had before, and although my participation in it may have colored it to some extent, it was pretty clear that these were things that these kids had thought about and argued about among themselves often.  It was the beer and feelings of bonhomie that allowed them to be so openly critical of themselves in front of the foreign professor.  

 

I suppose I shouldn’t take on topics about which I have little expertise, so to move away from my attempts at trenchant social analysis I will return to something about which I can pretend more knowledge.  I was asked today to write an Op Ed piece about the state of the Chinese financial system, and although I have committed to writing two other pieces this week (so much for the holidays), I agreed to do it.

 

I think the point of this Op Ed piece will be to argue that much of the analysis of the banking system in China is a little like the old joke about the drunk who one night loses his car keys in the middle of the road, but spends the night searching for them on the sidewalk because the light there is so much better.  Most discussions of credit and monetary policy focus on the impact of PBoC policies on the banks and the formal sector, mainly because that is where we have data, even though the real action may be going on elsewhere.

 

So for example when the PBoC raises minimum reserve requirements or imposes lending caps so as to slow loan growth, we duly note that RMB lending by commercial banks slows.  But does that mean that total credit in the economy is slowing, or does that simply mean that more rapid loan growth is now occurring in the informal banking sector and off balance sheet?  When the PBoC raises deposit and lending rates, does that mean that the cost of credit has gone up, or is that increase mitigated by a shift in lending from the more expensive informal sector to the cheaper formal sector, as deposits shift to the now-higher-paying commercial banks?  We don’t know the answer to either of these questions, but we still make assumptions about the efficacy of monetary policy based on what happens in the data we can see – and sure enough there the PBoC regulations do seem to have the desired impact.

 

However if you start from the assumption, as I do, that China’s capital controls are too leaky to be effective, then China must face the so-called impossible trinity, which argues that by managing the currency the PBoC cannot have any real control over domestic monetary policy.  In that case rather than assume that specific monetary policies will have the same impact in China as they might in the US, and seeing confirmation of that assumption in the official data, it might be more helpful to look for the types of leakages that automatically undermine the impact of that policy. 

 

I have been congratulated a lot of times recently for getting a number of forecasts right – about hot money, about the growth in off-balance sheet lending, about the stress in the banking system and growing NPLs, about the growth of the informal banking sector – but to tell the truth none of those predictions arose from any deeper understanding of China’s financial markets than other analysts have.  In fact I usually turn to much better informed friends to get a sense of what is actually going on.  

 

All that happened was that when new monetary policy was implemented, and seemed to have the intended effect, I assumed that it could not have had that effect and looked for counterbalancing changes in other parts of the financial system.  In other words I almost begin with the assumption that what drives monetary policy in a system determined by the currency regime is primarily net capital inflows, not domestic central bank policies, and then look for evidence that supports that thesis.  That means taking every bit of data with a lot of skepticism – not because the data are incorrect, but rather because what information is missing is likely systematically to counter the data we have.  

 

On a completely separate topic, Tuesday the 3-day Modern Sky Festival begins in Haidian Park, just west of Peking University.  Many of Beijing’s best indie, underground, folk and experimental musicians will be taking the two stages, including some of who I think are the freshest young bands in the world today (especially on the third day, Thursday).  Those living in the Beijing area should check it out for a very different and pleasant view of China.

Tags: Milk