I just got back to Beijing three days ago and am still seriously jet-lagged, but I wanted to post a piece today anyway.  Last night I celebrated the new year at D22, where a group of very cool musicians (including the amazing Snapline, for one of their very few shows this year and perhaps one of their last ever) serenaded the passing of 2009.  What a great show.

I suppose it is traditional to dedicate the new-year piece to evaluating the “year that was”, or to make predictions for the coming year, but my only concession to this tradition will be to make the very (I think) obvious prediction that trade tensions are going to rise dramatically in 2010, and even more so in 2011 as interventions initiated in 2009 and 2010 come to fruition.  I am no expert on the subject of criminal law or the environment, and so have little to add beyond all that has already been said, but the huge amount of angry criticism China has received on the very visible subjects of the Copenhagen meeting and the execution of a British subject caught smuggling drugs will make it easier for tariffs and restrictions aimed at China to generate popular approval in Europe, North America and the developing world, especially since protectionists can easily add a “moral dimension” to their arguments.

I am not sure Chinese policymakers fully understand how vulnerable China is to trade war.  This is perhaps because the “success” of the stimulus package has convinced them that they are less vulnerable to external demand than they originally thought.  But this would be a serious misreading.  The stimulus package has postponed the effect of declining net foreign demand on Chinese unemployment, but has actually increased its vulnerability by increasing the future gap between what China produces and what it consumes.  China needs foreign demand to keep absorbing its excess capacity for several more years while it engineers the difficult transition to domestic consumption-led growth, but I don’t see either China taking the necessary steps to force the transition or foreigners looking very eager to help China through the process.

As if to confirm my pessimistic trade expectations, the US on Tuesday announced that it would impose tariffs on Chinese steel grating.  According to press reports this is a pretty tiny market, so it won’t seem to matter too much to the overall economy, but even though US trade measures against China have generally been so far much milder than Asian or European measures, US measures have far more symbolic meaning and will affect behavior elsewhere.  Here is what the South China Morning Post had to say about it:

The US Commerce Department said overnight on Tuesday it has set preliminary anti-dumping duties of up to 145.18 per cent on steel grating imported from mainland to offset unfairly low prices.

The United States imported about US$91 million worth of the product from mainland last year. Steel grating is used in industrial floors, docks, ramps, drainage covers, staircases and other applications. The trade case is one of about a dozen brought by US companies this year against goods made in mainland, saying they have benefited from government subsidies or are being sold in the United States at less than fair value.

Worse yet, the very influential Paul Krugman has been focusing more than ever on China’s role in the imbalances, and he is clearly arguing that Chinese trade interference (via industrial policies and the currency regime) must be met with US protection.  His most recent piece in the New York Times makes the case that the supposed costs of protection are fictional.

China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.

Krugman has an enormous amount of influence in the US and Europe, so his arguments should be worrying a lot of people.  Even more worrying to me however was an alarming article in yesterday’s Xinhua which discusses the incredibly difficult year SME’s faced in 2009.

China’s small and medium-sized enterprises (SMEs) are facing an alarming credit and economic crisis that, by one estimate, has driven at least 20 percent of them to the wall since the global financial crisis began.  Officially the numbers are relatively low, and Minister of Industry and Information Technology (MIIT) Li Yizhong said in March that 7.5 percent of SMEs went bankrupt as a result of the global economic downturn in 2008.

However, a report by the Chinese Academy of Social Sciences (CASS) said 20 percent of SMEs had crashed and another 20 percent went to the brink of bankruptcy during the climax of the global financial crisis from October 2008 to March this year.  “According to my research, to date, most of the 20 percent on the brink of failure have been revived thanks to the recovering economy,” said Chen Naixing, an economist and director of the SME research Center at the CASS, on Wednesday.

Chen, also deputy executive director of the China (Hainan) Reform and Development Research Institute, said most SMEs, especially small businesses, were financially overstretched by falling orders at home and abroad.  The impact of the economic downturn on SMEs has been compounded as they were squeezed out of the massive credit flow unleashed by China’s banks.

There has been a lot of discussion within China about the impact the fiscal stimulus has had on accelerating a process that by some accounts began in the mid-1990s, and by others in the early 2000s, in which the entrepreneurial private sector in China has been squeezed out in favor of the SOE sector.  This seems to have found confirmation in the PBoC numbers, according to the article:

The crisis seems to fly in the face of the government’s “relatively loose” monetary policy introduced to battle the economic downturn.  However, the explosion in bank credit has been weighted toward large, state-owned companies, and the small firms’ share has been shrinking, despite their vulnerability in the economic crisis.

According to the People’s Bank of China, the central bank, new loans to SMEs totaled 3.08 trillion yuan (451 billion U.S. dollars) in the first nine months, accounting for 45 percent of the 6.83 trillion yuan corporate loans.

…However, in 2008, SMEs accounted for 51.9 percent of corporate loans, said governor of the central bank Zhou Xiaochuan in March.  However, capital-deprived SMEs, mainly small businesses, contributed 60 percent of GDP, 50 percent of tax revenues and 80 percent of jobs in urban areas, according to the NPC report.

“Less than 20 percent of small businesses have access to bank loans,” said Yin Zhongqing, deputy director of the Financial and Economic Affairs Committee of the NPC. “This is unreasonable given their contribution to the economy and their pressing need for funding.”

Unless you manage an SOE, it is getting tougher than ever to do business, it seems.  Separately, two days ago Premier Wen warned again about the “bumpy road” ahead for China, and yesterday Governor Zhou (of the PBoC), rather than celebrate the end of the crisis, worried publicly that “2010 is a crucial year in strengthening the stabilization and recovery of the economy and defeating the international financial crisis.”  Here is what Bloomberg says about the latter:

Chinese central bank Governor Zhou Xiaochuan said that 2010 will be a crucial year for strengthening the recovery in the world’s third-biggest economy and “defeating” the financial crisis.  Zhou’s New Year message, posted on the central bank’s Web site today, reiterated that a “moderately loose” monetary policy will continue.

Here is what Xinhua says about the former:

Premier Wen Jiabao Sunday urged the Chinese people remain aware of possible hardships and crises in the upcoming year and to work hard for a more promising future.

Wen told Xinhua in an exclusive interview that the way ahead for the Chinese people would be “a bumpy road,” but the nation had made transparent achievements in tackling the global economic downturn.   ”The Chinese people have gone through so many disasters. And one eminent tradition of our nationality is to be independent and indomitable without fear,” he said.

Meanwhile the People’s Daily reported yesterday that Fan Gang, member of the central bank’s monetary policy committee, said that the rising inflow of speculative capital, or “hot money”, into China could lead to “asset bubbles”, a topic that seems to generate discussion every day in the financial press here. In the same edition the People’s Daily also warns about a related risk, inflation:

China’s CPI growth rate may widen to 1.5 percent in December, after the CPI picked up its upward trend in November, said some experts.  Ha Jiming, chief economist of the China International Capital Corporation Limited, predicted that December CPI may grow 1.6 percent year on year, spurred by hiking food prices. Qi Jingmei, a senior economist with the State Information Centre, earlier noted that the CPI growth rate would be higher than 1 percent.

“Judging from price rally in November, CPI may increase more than expected,” said Jiang Chao, an analyst with Shanghai-based Guotai Junan Securities Co. (GTJA). He predicted that due to holiday factors, food prices will continue to rise in January. Meanwhile, non-food prices will also add pressure to consumer prices.

So far in this entry I haven’t provided a lot of good news.  It would be totally curmudgeonly to begin the year on a pessimistic note, and I won’t, but before moving on to two more hopeful pieces, I do want to mention an article in yesterday’s South China Morning Post by my friend Jack Rodman, in which among other things, he warns that the true exposure the banking system has to real estate may be underreported, and may be as high as 40% if correctly recorded.  He says:

Most of this lending is policy-directed with an implicit government guarantee. Despite thousands of closed factories in South China resulting from the global financial crisis, and hundreds of empty office buildings, retail centres and hotels that are not meeting their debt service payments, banks are still not foreclosing on these properties nor calling the loans due.

The banks prefer to rollover or extend the loans to avoid having to report an increase in non-performing loans. It is not uncommon for Chinese banks to extend a loan for as much as one year without interest payments if the lender “believes” the ultimate recovery value of the assets will be greater than the outstanding principal and interest. However, it is nearly impossible for a bank to value an empty office building, in a market with a reported vacancy rate nearing 40 per cent (30 to 40 million square feet) and declining rents.

Bank exposure to the real estate sector has been at the root of previous financial crises worldwide including the savings and loan crisis in the United States, Japan’s bubble economy, the Asian financial crisis, and now Dubai World. All these crises share in common aggressive and exuberant real estate lending, an abundance of liquidity and the false belief that real estate can only rise in value.  If total exposure to real estate secured loans was transparent within the Chinese banking sector, it would approach 40 per cent of total lending – the same level of total loan exposure reached in Japan in 1989, when it was believed Japan would dominate the economic landscape for decades.

So much for year-end pessimism.  The first piece of good news is that a recent revision shows that China’s economy, and more importantly its service sector, was larger than originally thought, even though the service sector is still much too small to support healthy Chinese growth.  According to an article in last week’s Financial Times:

China on Friday revised up its 2008 growth rate to 9.6 per cent, taking it well above the originally reported 9.0 per cent after calculating that the service sector had been more productive than previously thought.  The upward revision underscored that China was well on track to surpass Japan as the world’s second-largest economy in 2010, if not sooner, and has burnt through less energy to deliver each additional ounce of growth.

…The hidden strength found in China’s services sector was a modicum of good news for policymakers in China and abroad, who have said that promoting the development of the country’s non-tradeable sector is a key ingredient in rebalancing the global economy.

But it was still far from mission accomplished on that front.  China’s services sector accounted for 41.8 per cent of gross domestic product last year, up from the previously reported 40.1 per cent. In developed economies, services often contribute more than 70 per cent of GDP.

Needless to say it is very important that China’s service sector grows elative to the economy.  In a sense one can argue that Chinese overcapacity in the tradable goods sector comes with serious undercapacity in the non-tradable sector, and the rebalancing process involves a shift from the former to the latter.  Easier said, than done, of course, since a shift would require a real restructuring of both the banking system and the whole governance framework, but it will happen one way or the other..

The second last thing I want to mention is a lot more macro.  Last week on the day after Christmas (I wonder if many people read it), Robert Schiller published in the New York Times a very interesting piece on what he calls “trills” – bonds whose coupon would be determined by current GDP growth.  Here is how he describes them:

Each trill would represent one-trillionth of the country’s G.D.P. And each would pay in perpetuity, and in domestic currency, a quarterly dividend equal to a trillionth of the nation’s quarterly nominal G.D.P.

If substantial markets could be established for them, trills would be a major new source of government funding. Trills would be issued with the full faith and credit of the respective governments. That means investors could trust that governments would pay out shares of G.D.P. as promised, or buy back the trills at market prices.

In my book, The Volatility Machine, I discuss the same things, arguing that developing countries typically put on what I called “inverted” debt structures, which automatically exacerbate volatility.  The worst sources of this kind of inversion are either external debt, short-term domestic debt, or contingent liabilities arising out of the banking system.  All of these forms of debt perform better than expected during good times and much worse than expected during bad times, and so they are an important part of the reason why developing countries, especially highly indebted ones, seem to veer so easily from boom to bust.

One of the things developing countries need to do to help break this cycle is to restructure their balance sheets in order to reduce embedded pro-cyclical structures and so reduce volatility.  The best way would be somehow for countries to sell “equity”, the closest thing to which has been long-term, fixed-rate local currency debt.  Schiller’s “trills” are an even better example.  The main point is that these kinds of capital structures force the users of capital to pay more when times are good and less when times are bad.  This provides an important cushion for when times are bad, and the very existence of this cushion not only will reduce the tendency for capital to flee a country just when it needs inflows most, but it should reduce the overall cost of capital by reducing financial distress costs.

I think “trills” are a great idea, and I remember writing a piece many years ago for the Financial Times (“A stake in Argentina’s future”, July 2, 2003) in which I praised the attempts – however minimal – to embed such a structure in bonds issued by Argentina as part of its 2003 debt restructuring.  The Argentine structure was a tiny first step (it only involved a minimal amount of GDP warrants), but if a major developed country were to issue these “trills” and make them respectable, this would be very positive for developing countries who, like China, are much too volatile, tend to fly back and forth between periods of intense growth and intense despair, and have very few options for building hedges into their national balance sheet.  Schiller mentions other economists who have made similar proposals:

Proposals for securities like trills have been aired many times over the years. I argued for them in “Macro Markets,” my 1993 book. The Nobel laureate Robert Merton has had similar proposals. Other ideas for G.D.P.-linked securities have been advanced by John Williamson at the Peterson Institute, by a group at the United Nations Development Program, by Kristin Forbes of the Council of Economic Advisers under George W. Bush, and by Eduardo Borensztein of the Inter-American Development Bank and Paulo Mauro of the International Monetary Fund.

For what it is worth I enthusiastically add my vote.  For all of the associated problems (most importantly, bad data) “trills” are a great idea and would, if actively used, provide a huge boon for investors and, more importantly, risky developing countries.

The Shanghai stock market had a good day today – its last trading day before the May holiday and the very long four-day weekend.  The SSE Composite is up 4.84% and trading volume was up substantially too.  What seemed to propel the market today was a bunch of companies reporting good earnings, especially the banks – three of the Big Four reported very healthy first quarter earnings growth, perhaps a consequence of January’s huge jump in loans.  There are also more rumors about things the government might do to keep the market from falling.

Meanwhile it seems the fight over the currency is intensifying. Chinese Academy of Social Sciences economist Li Yang, formerly a member of the PBoC monetary policy committee and currently an advisor to the powerful NDRC, was reported by Market News International to have said in a lecture today that the government should stop allowing the RMB to appreciate because of the pain it is bringing to export companies.  He said that the RMB is currently at a “balanced level,” and elaborated: “One important factor to decide whether we’re at a balanced level is that our companies are making losses on this appreciation. So we shouldn’t move it any more.” 

I am not sure I understand his reasoning.  I have seen very little in the academic literature that suggests that a currency has reached an equilibrium level when some of its exporters are losing money.  I would have thought that any definition of equilibrium would have focused instead of the level of the trade surplus, the amount of central bank intervention, the growth rate of exports, or on any of a number of other factors that suggest that RMB is still not near an equilibrium level, but I suspect that Li’s argument actually has more to do with the terms of the debate within China than with economic reasoning.

There is a very deep, and reasonable I think, concern that a significant slowdown in the exporting sector might not be matched by a sufficiently large increase in domestic consumption in the short term, and so the result may be that China will not grow fast enough to absorb new entrants into the labor market.  If we see slower growth in fixed asset investment on top of that, the reduction in Chinese growth may be significant and may have adverse unemployment consequences – something the government does not want to have to deal with, especially right now.  I think there is a lot of pressure from exporters, provincial leaders and Ministry of Commerce officials to reduce the appreciation rate as a way of making life easier for Chinese exporters.  They are worried about its impact on growth, even though this probably reflects an excessive focus on the dollar – as has been pointed out many times, the RMB is not appreciating in general; it is only appreciating against the dollar.

By the way, and to support the argument that it is not the rising RMB that is hurting Chinese exporters, Gene Ma of ISI-CEBM sent me an interesting piece today.  In it his team argues that “he main driver behind China’s narrowing trade deficit is not slowing exports, but the changing terms of trade. In particular, prices of imports are rising much faster than exports.”  They also note that China’s export engine is moving northward.  “The share of the Pearl River Delta in total exports fell from 47% in 1995 to 30% today.  The share of the Yangtze River delta rose from 20% to 40%.”

What this suggests to me, as I have discussed often on this blog, is not so much that China’s exports are getting clobbered.  It suggests that China is evolving – very naturally I might add – so that its export performance is shifting as a consequence of development differentials across the country.  China itself is not losing out to other countries as much as exporters in the Pearl River Delta think.  China’s export competitiveness, instead, is shifting north.  If you keep your eyes to firmly focused on the performance of the southern exporters, it would be easy – but of course very mistaken – to conclude that something awful is happening to China’s export capability.  It isn’t.  Not yet, anyway.

I do think however that we may be seeing a gradual, and very positive, shift in the importance of exports to China.  I am currently reading a very interesting April 29, 2008, report by Credit Suisse called “China: the Beginning of the End of an Era.”  In the report the authors say:

We think the end of an era in terms of China’s mighty export industry has just begun. Current conditions will likely go beyond the cyclical slowdown caused by the US recession, in our view. After years of currency appreciation, wage increases, and material cost surges, we think the Chinese export sector has started to crack. The introduction of the Labor Contract Law this year is probably the straw that broke the camel’s back.

As part of their argument they note:

China’s private consumption is seemingly on the rise, led by service consumption and rural consumption. The “one-child generation” is emerging as an influential new force that may redefine Chinese consumer behavior. Our projections show China leapfrogging the US as the world’s largest consumer market before 2020.

If they are right, and their argument is certainly plausible, we may be at the beginning of a process of rebalancing the Chinese economy away from the export sector and towards the domestic market.  This is obviously a very healthy and necessary part of China’s long-term development, but it is worth noting that there is no reason to expect the process itself to be an easy one.  I have mentioned several times before on my blog how it took the very deep and painful crisis of 1798 to turn the US economy away from its dependence on exports towards a healthier domestic focus.  China’s refocus may also come with a difficult adjustment period.  Part of the reason for the fight over the appreciation of the RMB is, I suspect, the reluctance to pay the cost of this adjustment.

There is one fascinating piece of information that comes from the report that gives a sense of the scale of the demographic adjustment that China is undergoing: “Thirty-five years ago, for every one hundred people, representing new labor worldwide, thirty came from Chinese. Today, the number declines to thirteen and    is projected to be only three in thirty-five years.”  Wow!  This is a huge slowdown in the rate of growth of the working population – one of the inevitable consequences of the one-child policy.

One other thing worth noting that has nothing to do with trade: according to today’s China Daily a senior official from the NDRC, Xu Zhimin, director of the NDRC’s economic operations department, said that the government will not increase the price of refined oil or electricity until inflation is brought under control.  The NDRC has reportedly wanted for a while to deregulate the price of energy and resources, but they are too worried about inflation to do so now.

Needless to say, if you believe the inflation problem is largely a problem of expectations, they may be right to postpone deregulation.  If you believe it is a monetary problem, however, freezing prices of electricity will only cause the momentary pressure to show up in other kinds of inflation.

P.S.  For those who read my blog directly, once again the firewall here in China seems to have gotten worse, making it very hard for me to participate in the “Comments” section.  Sorry for not responding to comments, although of course I do read them.

Deflation and debt
On Monday CPI and PPI numbers for February came out. CPI was down 1.6% year and year and PPI was down 4.5%, in line with or slightly below expectations and, according to Bloomberg, the highest rate of deflation among the 78 countries they follow. Some of this may be caused by one-off factors, especially declining food prices, and most of the press and analyst commentary suggested as much, but the figures are still too hazy to say with any certainty whether or not deflation is likely to become a problem. Qi Jingmi, an economist with the State Information Centre, a government think-tank, was quoted in an article in the South China Morning Post as saying “I worry about PPI. The sharp fall in PPI shows that the financial crisis is gradually spreading to the real economy.”

The PBoC’s Governor Zhou has already promised that China will do whatever it takes to prevent deflation, although at this point it is hard to find anyone who believes in the 4% target inflation for 2009. According to an article Friday in Bloomberg he said that “We would rather be faster and heavy-handed if it can prevent confidence slumping during the financial crisis.” The article goes on:

Chinese central bank Governor Zhou Xiaochuan pledged “fast and heavy-handed” policies to restore confidence and prevent the global financial crisis from deepening the nation’s economic slump. “If we act slowly and less decisively, we’re likely to see what happened in other countries: a slide in confidence,” Zhou said at briefing in Beijing. The central bank has “ample room” to fine-tune monetary policy after a record surge in lending in January, he said.

I continue to be very skeptical about the actual amount of control the PBoC has over monetary policy. Until last summer despite PBoC intentions to run “prudent” or “tight” monetary policies all the evidence suggested out-of-control money growth, and since then their promises to expand aggressively have been at least somewhat undermined by evidence of monetary contraction. I am convinced that given the currency regime, net foreign inflows or outflows more than other factors determine underlying money in the system, and since the PBoC has very little control over the net flows, and so little control over the rate at which it is forced to monetize those flows, monetary conditions are at least as likely to reflect external conditions as domestic policy.

That is why what interests me most about the inflation numbers is what they suggest about monetary conditions — a subject on which it is very hard to get complete data and for which we often need to draw inferences from other parts of the economy. In that light, it is worth noting that the money-versus-pork debate seems to have died down since last summer with the decline of inflation at year-end, but I suspect it is going to revive soon enough, as I discussed in one of my entries in December. For example, a Bloomberg article on Monday had this to say:

China isn’t yet facing “typical” deflation, where falling prices are accompanied by shrinking loans and money supply and an economic recession, central bank vice governor Yi Gang said, according to the state-run Xinhua News Agency. The central bank has “sufficient” policy tools to combat deflation, Yi said, without elaborating.

Maybe it is indeed true that falling prices are not accompanied by shrinking loans and money supply, but it seems to me that we can’t really say for sure. We think we know that loans aren’t shrinking because loan growth numbers in the official banking sector pretty clearly show rapid loan growth, but as I have written many times before, much of January’s loan growth represented either balance sheet rearrangements or other forms of loan growth that don’t represent real credit growth to the economy (and by now that is a pretty widely accepted interpretation of the January numbers, although many bank analysts continue to talk up the loan growth as effective).

In addition, there is still anecdotal evidence that the informal banking sector is having difficulty expanding and even that their balance sheets may actually be shrinking. Real credit in China, in other words, is expanding much more slowly than the headline numbers suggest and may even be contracting. We don’t really know. For those who care, the current issue of Forbes has a very interesting article by Gady Epstein on one part of the shadowy credit market in China.

By the way I assume that Vice Governor Yi is indirectly referring to Irving Fischer’s debt-deflation thesis. But in my opinion, and if I read Fischer correctly, the risk for China is not a financial collapse induced by excess and unstable leverage. In spite of the haziness of the debt accounts I really don’t think China has the amount and kind of leverage that is likely to lead to a collapse in asset prices (although my one caveat is that we don’t really know the relationship between asset collateral and debt in the informal banking sector). The risk instead — and a highly probable risk although the timing is a little hazy — is that China will see many years of sub-par growth as it works off its addiction to excess capacity and makes the tough and slow transition to a domestic-led economy. I think Nick Lardy’s warning of a “long landing” rather than a “hard landing” is what we should expect. I am only guessing here, and haven’t really worked it out, but perhaps monetary reflation, which I think would have been Fischer’s proposal for the US today, is not likely to be of much help to China.

Trade figures are out
Meanwhile, and back to the real world, February trade numbers were released today. As I guess pretty much anyone who reads my blog would know, the export numbers were terrible. Exports plunged 25.7% in February year on year, even though this year February did not include the Spring Festival holidays, and so was substantially longer than February 2008. The foreign press seems mostly to think that the sharp decline in exports came as a huge surprise to most experts, while the Chinese press seems to think it was largely expected (the SSE Composite declined on the news, but only by 0.9%). I have always believed that the fact exports were dropping much more rapidly in the rest of Asia than in China was clearly not sustainable, and that it was just a question of (very little) time before we began to see Chinese exports hit much more sharply. I do not believe the process is over.

According to an article in today’s Xinhua:

China’s exports plummeted 25.7 percent year-on-year in February, the fourth straight monthly decline, as global demand shrank, the General Administration of Customs said Wednesday. Exports contracted to 64.90 billion U.S. dollars, while imports slumped 24.1 percent to 60.05 billion U.S. dollars. The sharp declines reflected weakening external demand, which would persist throughout the year as the global recession deepened, said Zhang Junsheng, an economics professor at the University of International Business and Economics. “These huge falls were inevitable, given the global downturn,” he said.

…Exports of labor-intensive products contracted more moderately than total exports, reflecting the government’s moves to raise export rebates starting last July, the agency said. Garment and accessory exports fell 11 percent to 14.62 billion U.S. dollars, while those of toys sank 17.1 percent to 850 million U.S. dollars.

I have heard several times reference to the fact that the increase in export rebates has helped the textile sector, although I would have guessed that this wouldn’t be something policymakers would want to advertise to the outside world. Along that line I think we are going to see a lot more pressure on policymakers somehow to “deal” with the problems in the export sector. On Monday Commerce Minister Chen Deming announced a cut in export taxes. According to an article in Tuesday’s Financial Times:

China will reduce export taxes to zero and give more financial support to exporters as it tries to increase its share of global trade in the current crisis, the country’s commerce minister announced on Monday. China would “use all possible measures to ensure the stable growth of our exports and prevent a large drop in external demand”, Chen Deming said in an interview published by a Communist party newspaper. “We should increase our share of the global market… We must transform ourselves from a big export nation to a strong export nation,” he continued.

It’s probably not a good idea to announce a drive to increase China’s share of the global export market, especially since for the last several months, while the world has suffered a collapse in demand, China’s share of exports has risen dramatically, but this may have been said primarily for domestic consumption. Yesterday Chen spoke again about trade. According to an article in People’s Daily:

The pressure to fix the export sector is clearly rising. My friend Isaac Meng was quoted later on in the same People’s Daily article explaining why policymakers are taking a decision which is not likely to make already-difficult global trade relations much easier:

At a press conference on Friday Zhou Xiaochuan, the central bank governor, refused to rule out a devaluation in China’s currency, the renminbi. “If you can tell us clearly what is going to happen [in the countries where the financial crisis started], it would be easier for us to tell you what measures we will take,” Mr Zhou said when asked directly whether he would rule out a devaluation of the renminbi.

In a sign of how contentious the debate has gotten within China, the trade worriers put in a counterclaim. This from a Bloomberg article:

China should let the yuan rise 3 percent against the dollar in 2009 to deter capital outflows and help the country make overseas acquisitions, said Wang Jian, a researcher affiliated with the nation’s top planning agency. China’s foreign-exchange reserves grew by the least in more than four years in the fourth quarter as sliding exports prompted traders to step up bets on yuan depreciation. People’s Bank of China Governor Zhou Xiaochuan pledged last week to maintain yuan stability as investors pull money out of emerging- market assets because of slowing global economic growth.

“A weaker currency will prompt massive amounts of foreign capital to flee the country,” said Wang, secretary general of the China Society of Macroeconomics, a Beijing-based research institute under the National Development and Reform Commission that advises the government. “It won’t help exports. Foreign consumers still won’t have enough money to buy.” At least $1 trillion of “hot money” may have entered China, Wang estimated, as the yuan gained 21 percent against the dollar since the central bank ended a fixed exchange rate in July 2005. Depreciation would risk spurring a sudden exit of those funds, causing turmoil in the financial system, he said in an interview yesterday.

I think hot money flows are one of the potentially destabilizing factors we need most to worry about because the PBoC’s currency regime means that monetary conditions, as I discuss in the first half of this entry, are largely determined by net inflows or outflows. In that light it is worth noting that while imports in February were also very bad — they dropped 24.1% year on year — the February trade surplus was much, much lower than for any month in a long time. China’s trade surplus for February was $4.8 billion, lower than the $7 billion rumor I mentioned a few days ago and much lower than the roughly $34 billion average monthly surpluses of the past six months (and $39.1 billion for January).

This may be a very good thing for China as it goes into the G20 meeting, since it takes a little of the sting out of China’s growing export of overcapacity, but one month of “good” numbers after a long series of absolutely awful numbers won’t mean much, and we need to figure out more about the composition of imports. In particular I am interested in seeing whether imports include a lot of one-off rebuilding of commodity reserves. By the way with last month’s “low” trade surplus, some people are arguing that the era of massive monthly surpluses are over. This is from MarketWatch:

Trade and industrial policies
I hope Simpfendorfer is right. The Washington Post seems very worried about the trade-policy outlook. In an article titled “US to Toughen its Stance on Trade,” it warns that US policy seems increasingly dissatisfied with global trade and says that “the Obama administration is aggressively reworking U.S. trade policy to more strongly emphasize domestic and social issues.” Today’s New York Times also had a worried editorial on President Obama’s trade agenda, which included the following:

Trade will play an important role in the world’s eventual recovery, transmitting economic growth from one country to the next. Protectionism leads to further protectionism, and yielding to its temptation could unleash destructive trade wars that would crush any chance of recovery. Unfortunately, few politicians are willing to tell their constituents that unpopular truth. Instead, governments are succumbing to protectionism’s dangerous lure. In recent months, Russia has jacked up import barriers on cars, farm machinery and other products. The European Union has reintroduced subsidies on dairy products. Europe, India and Brazil raised tariffs on imported steel.

…If ever there was a need for collective action — on fiscal stimuli, monetary policy, aid to the developing world, fighting protectionism — it is now. A place to start the rethinking is China and how to encourage increased domestic consumption and investment in China and other cash-rich Asian countries so they can start pulling the world out of recession.

China’s leaders, in particular, need to understand that export-led growth no longer works for them or for the world. The United States will have more influence if it stops beating on Beijing for its foreign-exchange policy and engages China’s leaders as partners, not rivals. Vigorous trade will help the world recover. For that to happen, the United States will have to provide strong leadership and a clear commitment to fighting protectionism. Any sign of ambivalence from Washington will only make things worse.

The whole debate over trade is going to be framed within US and European discussions about fiscal stimuli since it is not at all clear that Chinese policymakers are contributing much more than some fairly smug, and perhaps hypocritical, statements about how everyone must embrace free trade. But the US and European discussions don’t seem particularly positive right now. According to today’s Financial Times:

Disagreements between the European Union and the US over how to combat the global recession widened on Tuesday as EU governments made clear they had little appetite for piling up more debt to fight the collapse in output and jobs. Finance ministers from the 27-nation bloc insisted in Brussels that it was doing enough to support world demand and did not need at present to adopt another fiscal stimulus plan, as Washington is urging.

I hesitate to enter these very deep waters, but I think the Europeans, at least as described in this article, might be right. There is a real need for an adjustment in consumption in the US, and I don’t think it makes sense for the US to attempt to replace excess household consumption with excess government consumption. One way or the other the US, along with China and most other countries that have contributed to one side or the other of the global imbalances, is going to have to accept a demand contraction.

Trade friction is an issue that will not easily go away. Not all the information released this week was bad, however. Some was good and some was neutral — by which I mean it could be read either as bad or good depending on your economic model. According to an article in today’s Bloomberg:

China’s investment spending surged as the nation poured money into roads, railways and power grids to counter a plunge in exports, which a separate report showed fell by a record in February. Urban fixed-asset investment climbed a more-than-estimated 26.5 percent in January and February combined to 1.03 trillion yuan ($150 billion) from a year earlier, the statistics bureau said today in Beijing.

The fact that fixed asset investment surged might suggest that the fiscal stimulus plan is having an effect and will counteract to some extent the slowdown in other parts of the economy. A worrier (me) would be very nervous however that the stimulus ended up worsening the overcapacity problem, in which case any benefit would be more than paid for next year. More unambiguously good news involved February car sales, which are up substantially and suggest that some government policies are getting consumers to go back to buying cars, although this was accompanied by bad numbers on car exports.

…However, despite the apparent rebound in China’s own car market, a slump in demand is crimping sales overseas: exports in January fell 33.5 per cent from a year earlier, to US$2.66 billion, the group said. The impact was most severe for domestic-brand cars, with January exports falling 64 per cent from a year earlier to 16,300 units, it said. Imports of vehicles also took a hit amid the deepening economic downturn, falling 20.3 per cent from a year earlier in January to US$1.73 billion, it said.

Finally before closing, and for an indication of rationality that sometimes seems to be missing from foreign expectations about China, few analysts in China seem to buy the idea so popular in the West that somehow Chinese policies may be enough to pull the world out of its economic crisis. Tuesday’s People’s Daily had a long article on the subject. Among other things it said:

Tags: Art, Irving Fischer

In all the worry about the trade numbers I haven’t discussed another data release last week which, until recently, would have been the most important piece of economic news for me. It was only a few months ago that we were intensely debating the cause of rising inflation in China. Now, inflation is clearly receding. PPI and CPI figures for November were released Wednesday and Thursday, and they showed an unexpectedly high decrease in inflation, with month on month numbers implying actual deflation. Year on year PPI prices rose by 2.0%, compared to 6.6% in October and around 4.5% expectations. CPI inflation declined from 4.0% in October to 2.4% in November, also well below the 3.0%expectations.

What does this say about monetary conditions? First of all let me take a radically contrarian position. I think the latest numbers, far from confirming the view that Chinese inflation in the period until this summer was caused by food supply constraints, actually indicate that the money explanation was right. Inflation in China earlier this year, in other words, was caused by too much money, not too little pork, in Ken Rogoff’s famous formulation.

For those of us in the money camp, inflation was the all-too-expected reaction to explosive money creation caused by China’s currency regime, in which the country’s central bank purchased a torrent of inflowing dollars in order to maintain the value of the currency. In order to fund the purchase of all these dollars, it created RMB, which was intermediated by the formal and informal banking systems into rapid credit growth.

For the pork camp, however, this monetary explanation of inflation was wrong. The cause of Chinese inflation, they argued, was temporary food supply constraints, including harsh winter storms and blue ear disease, which seriously affected pork and grain production. These caused food prices to surge. Inflation, in their view, was nothing more than the temporary consequence of rising food prices, and would end as soon as the supply constraints ended.

While we in the money camp of course acknowledged the sharp rise in Chinese food prices because of harvest problems and pig diseases, we felt that this was as much a coincidence as anything else (especially since food prices were rising around the world). I believed that if monetary policy in China were consistent with low inflation, the brutal surge in food prices would have caused Chinese households to divert so much spending away from non-food items that there would be significant downward pressure on non-food prices. I calculated that non-food prices should have declined by 5-7% if Chinese monetary conditions really were consistent with the 1-3% inflation targeted by the PBoC.

But non-food inflation was not negative. It was low, but we were actually seeing rising non-food inflation for most of the year while food prices were soaring. There was not even disinflation in non-food items, which is the least I would have expected if Chinese inflation was not money-based. That is why I rejected the food-supply constraint argument.

Of course based on our very different analyses, each camp had different predictions for the inflation trajectory. The money camp claimed the still-rapidly growing central bank reserves would ensure that inflation continued through the end of 2008 and into 2009. The pork camp argued that as food supply came back onto line by the end of the year, the food supply constraint would ease and inflation would quickly come down to manageable levels.

As we all know, inflation stayed high through the summer but subsided very rapidly thereafter as food prices declined sharply. In fact they declined far more rapidly than anyone predicted. Year-on-year CPI fell to 2.4% in November and year on year PPI fell even more to 2.0%. So the pork camp’s analysis must have been correct, right?

Not quite. The first clue should be the speed at which inflation fell. Last summer even the most hard-core members of the pork camp didn’t believe that the official target of 4.9% inflation for 2009 would be met. I, frankly, wrote it off as silly even to pretend it was possible (note to self: nothing is impossible). The pork camp made their food price projections based on the removal of supply constraints, and the optimists among them were arguing that we might see inflation between 5% and 6% for this year and a little lower next year.

In fact although food prices declined in line with their predictions, CPI and PPI inflation fell way below what anyone expected, and what is more, now everyone is worried about deflation in China. This to me isn’t necessarily consistent with the idea that Chinese inflation was all about food.

But there is a more technical problem with the idea that the drop in inflation was simply a consequence of declining food prices. In the standard inflation model the rapid decline in food prices should have automatically caused Chinese households to spend less on food and more on non-food consumption. If monetary policy was not deflationary, this would cause the price of non-food goods to increase as the price of food decreased.

But that didn’t happen. From September to November, CPI inflation has declined from 4.6% to 4.0% to 2.4%. As expected, food inflation declined from 9.7% to 8.5% to 5.9%.

But non-food inflation also declined. It dropped from 2.0% in September year on year to 1.6% in October to 0.6% last month. If monetary conditions were stable, just as non-food prices refused to behave the way they should have when food prices were rising, they still refuse to behave correctly when food prices are declining. This suggests to me that the pork camp still has to do a lot of explaining, or else the conclusion must be that Chinese inflation has not been caused by changes in food supply, but rather by changes in the money base.

If this is the case, it has very worrying implications. China’s reserves continue to rise, so the central bank has been continuing to create yuan at a rapid pace, but somehow money supply is contracting rapidly, as indicated by the decline in inflation. What could be happening?

Before answering, let me digress. About two months ago I had dinner with an old friend of mine, Arminio Fraga, the former head of the Brazilian central bank and one of the smartest finance guys I know. During our dinner we talked about conditions in China and I wanted his advice on monetary conditions. I had always felt that monetary aggregates in China did not seem to be explaining what was really happening in underlying money. My instinct was reinforced by a piece I had read by Ronald McKinnon and Gunther Schnabl titled “China’s Financial Conundrum and Global Imbalances” in which they say:

Why didn’t China rely more heavily on domestic financial indicators? With rapid financial transformation and very high saving, the velocity of money – whether based on M0, M1, or M2 – was (is) too unpredictable for any monetary aggregate to be useful as an intermediate target. And the velocity of money, defined as GDP/M, becomes even more difficult to predict when nominal GDP itself is subject to large revisions. Indeed nominal GDP was revised sharply upward in 2006.

Since 1990, Figure 5 shows that these monetary aggregates grew faster than nominal GDP—with M2 growing twice as fast so as to approach 200 percent of nominal GDP in 2008. The high growth in M2 was largely a natural result of China’s very high saving rate when bank deposits are the principal financial asset open to Chinese savers. Thus, the authorities had, and still have, no firm idea of what the noninflationary rate of growth in M2 should be.

I asked Arminio based on his tenure at the Brazilian central bank what he thought about the monetary aggregates (M0, M1, M2 and so on) to judge money growth. He responded that from his experience McKinnon was right and the traditional monetary aggregates were not terribly useful in evaluating money conditions. It was far more useful, he claimed, to look at credit growth.

But in China there is a big problem with the credit data. We don’t have good numbers on credit growth. We know what is happening in most parts of the formal banking system because the PBoC has fairly good numbers there, but we have only a vague idea about off-balance sheet transactions, about financing involving municipalities and provinces, and about inter-company lending. Most importantly we have very little idea about the informal banking sector.

But let’s get back to inflation. During the inflation period, officially credit growth was not too high, but there is strong evidence that during the period of explosive credit growth, when the central bank limited the amount of credit creation permitted to the banking system, the market responded by accommodating explosive growth in off-balance-sheet items and within the informal banking system. Anecdotal evidence suggests that much of China’s huge mot money inflow before this summer may have ended up in the informal banking sector. This (and the explosion in reserve accumulation) is consistent with the idea that inflation in China was money based.

It is the opposite now. Banks don’t want to lend and this implies that credit is contracting. Now that banks are not willing to lend, and companies not willing to borrow to invest (they mainly borrow if they are desperate for liquidity), credit growth is mainly being caused by government pressure to maintain credit growth. But of course credit growth in China is not just a function of the size of commercial bank portfolios. These may be growing, even if very slowly, but transactions that were once off-balance sheet may be coming back on balance sheet to give the illusion of credit growth. More worryingly, the informal banking sector, which may consist of as much as one-third of total loan assets, may be contracting rapidly. That is what the anecdotal evidence suggests. As an aside, in today’s weekly meeting of the Guanghua Students Monetary Policy Committee, one of the members, Gao Ming, reported that he had been getting a huge number of phone text messages from informal lenders offering him money. The other students agreed that they had seen a big rise in these kinds of text messages. Perhaps informal lenders are having trouble finding borrowers?

Certainly if inflation is a monetary phenomenon, this would be the implication of the near-collapse of inflation, which occurred more rapidly than even the most optimistic members of the pork camp expected. So what does this mean if true? It means that money is contracting, and perhaps at an alarming rate. Just as too-rapid money expansion until this summer was showing up as inflation, too-slow expansion (or perhaps even contraction) is showing up as disinflation and even deflation.

I can’t prove it, of course, but I think Chinese inflation is a money-based phenomenon and I am guessing that if China is experiencing deflation it is also experiencing rapid contraction in outstanding credit – much more rapid than we think. In China like in most developing countries, as I have written many times before, the structure of balance sheets tends to reinforce trends, which increases underlying volatility. We may have suddenly swung from ferocious credit expansion to ferocious credit contraction. The fear of deflation next year, in that case, is well founded.

Tags: Arminio Fraga

On Sunday I suggested that the newly-announced RMB 4 trillion fiscal package would cause markets to surge, but that the rally would not last very long as analysts began examining the numbers more closely. In fact the duration of the rally was even shorter than I expected. On Monday the markets did indeed surge, with the SSE Composite rising 7.3%, but by Tuesday markets had again turned bearish. After running up 0.7% in the first two hours of trading, the market once again lost its legs and the SSE Composite ended at 1844, down 1.7% for the day.

According to an article in Bloomberg the decline was led by financials and consumer companies “on concern a government stimulus package will fail to arrest an economic slowdown.” In fact all day analysts around the world have been weighing in on the fiscal package, with some arguing that this was a major event that would provide a serious boost to Chinese and global growth and others arguing that anywhere from RMB 1 trillion to RMB 2.5 trillion was old spending or overly optimistic projections and that the timing of the disbursements would not have a big enough impact on the immediate contraction in demand faced by Chinese businesses.

Standard Chartered’s Stephen Green, one of the bank analysts for whom I have a lot of respect, says that his reading of the package (and he warns that there are still big holes in his reading since details are so sketchy) suggests that government spending will contribute about 3.5 percentage points of real GDP growth to the Chinese economy in 2009. Since it contributed about 2.5 percentage points in 2008, this means that the total additional impact of the new package will be to boost growth next year by about 1 percentage point – not far from his original expectations.

Deutsche Bank’s Jun Ma was slightly more optimistic than Green about the additional impact of the fiscal plan (he thinks it will contribute an additional 2 percentage points to 2009 GDP growth). His optimism however was more than compensated for by his concerns that the economy is slowing faster than expected, and he actually cut his 2009 GDP growth forecast today from 8.0% to 7.6%.

Meanwhile the government seems clearly to recognize that timing is a problem. According to an article in today’s China Daily:

Premier Wen Jiabao Monday urged local governments not to “waste a single minute” in implementing the 4-trillion-yuan ($586 billion) stimulus plan unveiled on Sunday. “In expanding investment, we must be fast, effective and forceful. We must focus on priorities and adopt a down-to-earth attitude to implement the measures,” he told an executive meeting, which was presided by him and attended by provincial leaders and Cabinet ministers.

For those who are more optimistic about the effects of the stimulus package, one of the key arguments is that previous fiscal stimulus packages have worked in China. For example today’s South China Morning Post has a fairly optimistic report titled “Spending will offset falling external demand” in which the argument is explicitly made:

The mainland’s massive economic stimulus package would rouse the country’s slowing economy by offsetting flagging external demand brought on by the global financial crisis, analysts said yesterday. Shenyun Wanguo Securities macroeconomist Li Huiyong said the success of a similar programme in 1998 indicated that expanded government spending would stimulate fixed-asset investment and economic growth in the short term.

Maybe. But I think we need to be a little cautious about comparing fiscal expansion in 1998 and fiscal expansion ten years later. In the 1990s economic conditions were much tighter and fiscal activity likely to have a larger impact. It was relatively easy for a smallish country to benefit from stimulating fixed asset investment since the world could easily absorb higher production. At that time the US was receiving massive capital inflows – especially from Asian countries looking to shore up reserves after the great scare of 1997 – and its financial system was finding ever new ways to intermediate liquidity to consumers eager to take advantage of rising real estate and stock market prices to increase spending. The US, in other words, seemed able to absorb almost unlimited expansion in Chinese capacity.

But, as I argue in Sunday’s entry, conditions have changed dramatically. First, China’s GDP is about 2.5 times bigger today than it was back then, and exports have grown much faster than GDP, so China is far from being a “smallish” country. More importantly, the world is looking for more demand right now, not more supply. In a global system with so much excess capacity, and with a marked tendency to excess savings (Americans have to save more, Asians don’t want to consume more), I am a lot more pessimistic about the domestic impact of China’s fiscal expansion, especially if the goal is to increase investment. The world will not simply absorb a lot more Chinese capacity. This package is only useful to the extent that it boosts real demand, especially if it boosts household demand, but that doesn’t seem to be in the cards.

At any rate we need to wait a while longer before we can really judge the potential impact of the fiscal package. And we also need more time to see exactly how fast other parts of the economy contract. In that sense my guess is that the government rushed to announce the package partly as a shock to confidence, perhaps because the numbers they are seeing are much worse than what we have been able to see so far.

Of course part of the rushed timing is probably to head off potential trouble at the upcoming G20 meeting. By announcing such a large headline package, China can argue that it is contributing both to the global monetary easing as well as to global fiscal expansion. This will take the pressure off other demands – for example one way China can contribute to global expansion is by a more radical reforming of the currency regime, and it clearly does not want to do that. October’s trade surplus – announced today – was 20% higher than September’s all-time record. This won’t make it easier to argue that they desperately need to keep the RMB from rising too much.

In all the hoopla about the fiscal package, two economic numbers slipped out almost unremarked. Yesterday the National Bureau of Statistics announced that PPI inflation had declined from 9.1% year on year in September to 6.6% in October. Today they announced that CPI inflation declined from 4.6% year on year in September to 4.0% in October.

I am going to be accused of unrelenting pessimism, but I will explain nonetheless why even this “good news” worries me. As regular readers of my blog know, I tend to have a very monetary view of inflation, and I was convinced until two or three months ago that China’s furious money expansion of the past few years was going to lead inevitably to rising inflation. As I see it, when money growth outpaces the needs of the economy for a sustained period of time there are only three ways to adjust. The most benign way is that over a period of time the central bank engineers slower-than-warranted growth in money so that, in exchange for a temporary slowdown in economic growth, money supply and the real economy can get back into line.

The less benign ways consist either of a surge in inflation that causes the nominal value of the economy to rise sufficiently to meet the money supply (which is what I was expecting), or of a rapid and unexpected contraction in the money supply, which usually takes place in the form of a collapse in credit and in asset prices. If the former isn’t happening, then my model says that the latter must be happening, especially since the decline in inflation isn’t just because of food prices. Non-food inflation dropped from 2.0% in September to 1.6% in October.

We know that some of this contraction is indeed happening. Real estate and stock market prices are definitely falling. Loans in the banking system aren’t growing as fast as the government would like to see. But these aren’t new enough, or dramatic enough, to explain the rapid fall in inflation. Could it be that real credit growth is much lower than we think – that perhaps there has been a sharp contraction in off-balance sheet loans and in the informal banking sector? We don’t know, but we need seriously to consider that this indeed may be happening.

The just-released trade numbers have little to bring cheer. Export growth continues to slow (19.2%, compared to September’s 21.5%), but as a warning of how bad domestic demand conditions might be import growth slowed much more sharply (15.6%, compared to September’s 21.3%, and less than half of July’s 33.7%). The consequence was a surge in the trade surplus, which rose by one-fifth over last month’s record number. This is the third month we have broken world records, and this certainly isn’t going to please China’s trading partners who are struggling with their own domestic slowdown.

Money continues to pour into China via the current account – I wonder what is happening in the rest of the country’s balance of payments. Is hot money outflow accelerating? I guess we won’t really know until January’s fourth quarter data release.

Tags: Fiscal package

There’s still no respite for Chinese stocks. The market bounced around violently today with the SSE Composite making at least eight or nine up or down moves of more than 1%, before closing the day at 1720, down 0.5% for the day. This is the lowest closing in over two years (it closed at 1722 on September 15, 2006). The declines were led by industrial companies this time – not the usual banks and real estate developers – because of Friday’s data release suggesting the development of problems in the industrial sector (which I discussed in a Saturday posting).

Amid attempts at reassuring the public (“China’s economy in good shape despite global financial turmoil”, say the main business-related headlines today on Xinhua and in the People’s Daily), it is clear that policy-makers are feeling anything but reassured. Xinhua reports that “Wen sees worst year for growth”, and even through the soothing noises in the article it is clear that policy makers are in a quandary:

The government should find the right balance between curbing inflation and maintaining a stable economic growth, Premier Wen Jiabao said on Saturday. “We must be aware that this year would be the worst in recent times for our economic development,” Wen said in an article published in the Qiushi journal.

Curbing inflation is still a challenge, even though it fell from a 12-year high of 8.7 percent in February to 4.6 percent in September, he wrote.  In his article, Wen said that the global downturn will continue to pressure the Chinese economy, which already faces a number of problems.

Given the situation across the world, “it is very difficult to maintain high growth and a low inflation rate in the long run,” the premier wrote. “The (global economic) situation is worsening,” and the negative impact of the volatile international market on the Chinese economy would become more obvious as the days go by.

The main task of the macro-economic policy is “to successfully maintain a balance between stable and relatively fast economic development and curbing inflation,” Wen said.

In many of my conversations with Chinese and foreign analysts recently there has been a growing consensus – shared by me, by the way – that since inflation is politically easier in the short term than a sharp banking contraction (although likely to be worse in the medium term), there would probably be excess monetary easing to “fix” the banking problem, and that this would lead to inflation down the road, and not just in China.

But nearly every statement I have seen by senior Chinese officials continues to make a big deal about the inflationary threat. I am not sure if this is because the monetarists are desperate to convince an unconvinced majority of policy-makers, or if because there is a real acknowledgement of the dangers of an upsurge in inflation as the world races to create money, but if it is the latter it is undoubtedly a good thing. The temptation towards inflation is one that is likely to be hard to resist, and of course even harder to reverse.

Meanwhile one of the reasons most likely to create a pre-disposition towards inflation is the possibility of rising college unemployment. A recent survey of more than 1,000 Chinese university students graduating this year reported in China.org.cn claimed that

Only 12.1% had “successfully” found jobs, indicating that the employment situation for educated young people presents an ever-growing challenge. The survey found that by the end of August, nearly 80 percent of newly-graduating job hunters were jobless, while about 10 percent were dissatisfied with the jobs they had found and planned to seek better employment.

I have been writing about rising unemployment among college graduates for more than a year now, and it struck me that even with GDP growth well into double digits there had been a real problem with the economy’s ability to absorb college graduates. With enrollment up and the number of graduates surging (I think it is growing by more than 15% a year), it is hard to see how an economic slowdown will not make this a major problem for the authorities.

One of the most widely agreed-upon “solutions” for dealing with slowing Chinese growth is to switch the country’s focus towards domestic consumption rather than investment and exports. Today, again, the point was made by a number of policy-makers. According to an article in today’s Xinhua:

China’s government should continue efforts to expand domestic consumption amid the global economic uncertainty, said Liu Tienan, Vice Minister of the National Development and Reform Commission, in remarks published on Monday.

The fundamentals of China’s economy were sound, but the country also faced challenges, Liu said during an industry meeting in Beijing at the weekend, according to Monday’s China Securities Journal. China should step up efforts in industrial restructuring, innovation and changing its development mode.

He called for more support for farmers and more public resources allocated to improve social welfare. Su Ning, deputy governor of the People’s Bank of China, the central bank, said at the meeting that there was “still room to tap more domestic consumption” and the central bank would adopt a flexible and prudent monetary policy.

There is almost no question that the transition to domestic consumption is necessary for China’s long-term development, but I am concerned that too many people seem to think that this is a rather easy and straightforward process, and that it can happen quickly enough to bail China out of the global slowdown.

It isn’t and it won’t. The transition will be very difficult and will take several years, perhaps even longer than a decade. There is no relevant precedent I can think of in history in which a large economy has made the transition quickly and in benign conditions. I was in a meeting today with a Japanese economist (who prefers not to be identified because of his affiliation) and we discussed this very issue in the context of Japan. He confirmed that Japan has been in a similar transition basically since the early 1990s and still has a long way to go to complete the transition..

Japan may not be a totally relevant comparison because its transition took place in a period of rapid growth in international trade, thereby putting less pressure on the country to adjust quickly. China’s transition, on the other hand, is likely to take place in a period in which the rest of the world will not be nearly as accommodative. But that just underlines the fact that these transitions are tough. China may be forced to adjust more quickly than Japan only because the rest of the world will see a sharp drop in its ability to absorb Chinese production. This will make the transition more difficult.

The Japanese economist and I discussed China and the Japanese experience in much greater detail, and I hope to present some of his findings later after I have had a chance to look at them further.

One last thing before closing, Shang Ning, one of my students who focuses on monetary issues (he is the Secretary of the Guanghua Students Monetary Committee) sent me an email yesterday. According to him (with slight editing on my part):

There are rumors that the MoF has prepared a report saying municipal governments are under liability management difficulties, and passed the report to the State Council. People are guessing that issuance of provincial government debt may be coming soon.

I asked him to track this for me, and the next day he wrote the following:

Normally in the past the most important resources for regional governments are sales of lands (ranging from 40% to 60% of total regional budget as said) and fees (not taxes). But now land sales have sunk with the decline in real estate. This obviously violated the regional budgets.

I am guessing the regional budgets are thought to be facing pressures both from declining income and expanding expenditures as a part of fiscal expansion. The rumors was first quoted by China Security Journals yesterday, and then spread widely today. It is also said that MoF has established a sub-dept focusing on regional liability management under their department of budget.

This is all very interesting and I will certainly be trying to keep track of it. I think there are at least two important issues here. First, the fact that municipal-level budgets are under such strain suggests that real fiscal expansion is going to be harder than we think since there is likely to be fiscal contraction at the municipal level. Second, and I have discussed this often before, I am willing to be that there is a lot of unrecorded and uncollectible debt at the municipal level that should be aggregated to government debt levels when we try to figure out the government’s debt position. Remember that municipal and provincial debt is implicitly central government debt. If municipals are allowed to borrow I wonder whether they will be able to borrow in their own names or under government guarantee. There are very strong reasons for arguing either way.

Tags: Inflation

There is still no respite for the Chinese stock market (or, for that matter, of any of the other global stock markets).  On Thursday the SSE composite fell more or less in a straight line, losing 72 points, or 3.3%, rising a single point on Friday to close at 2079.  We are now less than 4% away from 2000, yet another barrier that may not prove to be much of a barrier. 

There is no lack of bad news on the economy to drive the stock market down.  Thursday saw the release by the PBoC and the National Bureau of Statistics of another big batch of data, and it seems pretty clear that the economy is slowing, and perhaps very rapidly.   

Industrial output grew by 12.8% year on year in August, versus 14.7% in July, and 17.5% last August.  There was weakness in almost every sector, with iron and automobile production actually contracting versus one year ago.   Clearly the industrial sector is slowing, and this puts all the more pressure on rising consumer demand to keep the economy strong.   

At first glance consumers seemed to be doing their job.  Retail sales, the main measure of Chinese consumer spending, grew by 23.2% year on year in August, slightly less than July’s 23.3% but substantially better than last August’s 17.1%.  This growth, however, may have more to do with Olympics spending than with long-term trends, and we will probably need to see September and October numbers to get a real sense of how consumers are responding, although I suspect these will be excessively low because at least part of July and August’s robust growth in consumption probably consisted of anticipated spending for the Olympics. 

Loan and M2 growth were also slightly weaker than expected.  Given the existence of the large informal lending market I am not sure what that means for total loans in the system, and given the complications imposed by a rapidly changing society and a very inefficient financial system, I am not sure how valuable M2 or any of the other monetary aggregates are in explaining money supply.  Sill, I would argue that the continued rapid growth of foreign currency reserves at the PBoC is probably being countered by the sharp fall in real estate and stock prices to represent money growth below what we would have expected (and I wonder if we will soon begin to see hot money outflows).  The fact that loans in the banking system – much cheaper than loans available in the informal sector – grew by less than they could have under the loan caps, suggests that either companies are reluctant to borrow and invest because of concerns about the slowing economy, or that banks are reluctant to lend because of credit fears.   

Neither of these explanations is very comforting.  Morgan Stanly just released a report saying the real estate sector is on the point of an imminent collapse, which suggests even that perhaps both explanations might be true.  Needless to say a collapse in the real estate sector is one of the biggest risks in China.  Not only would it cause havoc in the banks’ loan portfolios, causing a sharp rise in NPLs, but it would contract one of the main pillars of Chinese growth, real estate development.  The one piece of good news is that I have heard anecdotal evidence that developers that reduce prices have seen very strong subsequent demand for apartments and offices, so perhaps the problem is as much one of high prices (which can be fairly easily fixed) as of oversupply (which cannot). 

One of the questions I have been getting a lot from my investor meetings in New York concerns the sharp split between rising PPI inflation and declining CPI inflation.  What does this indicate about inflation and financial conditions in China? 

I have already indicated my puzzlement in my entry of two days ago that CPI inflation has come down so quickly, and I worry that we may not be capturing all the inflation correctly.  But aside from that, if you assume that PPI inflation is a proxy for rising input prices among corporations, and CPI inflation is a proxy for rising output prices, the tremendous gap between them suggests that corporate profits are going to be killed.  This already seems to be happening, with corporate profits down and most analysts expecting them to decline further.

How do corporations react? I think there are two ways they can react.  First, if they are able, they will raise prices, and so PPI inflation will then cause a subsequent surge in CPI inflation to bring the two back into line.  This is what I always thought would happen, but now I confess I am not so sure.  If the economy is slowing, capacity rising, and demand falling off (although we have not yet seen the third condition), companies will have great difficulty in raising prices.  In that case we may see a sharp drop in profitability and even a rise in bankruptcies, to the extent that the banking system is forced to contract.

One way or the other the system has to adjust to the tremendous monetary expansion of previous years, and there are two ways it can do so.  We can see high inflation, which brings nominal demand and nominal supply back into balance by adjusting prices.  Or we can see an equivalent contraction in the money supply because of a contraction in banking. 

Neither of these is a good outcome, but excess money expansion – as we are seeing, by the way, in the US – must eventually cause something to adjust, and the adjustment is rarely benign.  Historically it almost always consists either of rising prices inflating away the growth in money supply or of a sharply contracting banking system reversing the earlier money contraction through debt deflation.  The key determinant of which path this takes, I think, is the fragility of the banking system and the response of the central banks.

I can’t rally predict which outcome we will see in China.  On the one hand I have been notoriously bearish on the quality of the banking system for so long – and, I suspect, to the annoyance of many of my colleagues in the market – that it seems to me very reasonable to me to expect real problems in the banks that lead to loan contractions and the hoarding of liquidity.  By the way, reducing minimum reserve requirements will have little effect on lending if banks don’t want to lend, borrowers don’t want to borrow, or if informal banks have acted to undermine the impact of lending constraints, which I believe has happened in China.   

On the other hand it is always easy to inflate your way out of trouble, and this tends to be the politicians’ preferred response to a banking contraction, especially in systems with limited central bank independence.  I suspect that in China we may see concerns about unemployment in the short term trump concerns about inflation in the long term.  The point is that if I am right in having argued for so long that we have seen out-of-control money growth in the past few years, we will inevitably have to see an adjustment that is as likely to be a sharp rise in inflation or a sudden debt deflation.  As Robert Frost might put it: 

Some say the world will end in fire

Some say in ice

I hate to sound so apocalyptical, but this week in New York everyone around me seems to have been filled with dread, and I – no stranger to worried pessimism, as all my blog readers surely know – am also being infected by the mood.

Another terrible day on the stock market saw the SSE Composite, led kicking and screaming by energy and financial companies, trade more or less straight down by 3.2% to close the day at 2203.  The brilliant autumn weather in Beijing (and the best week for air quality I have seen in seven years of living here) seems to have bypassed the market altogether.

Away from the weather there is plenty of bad news for those looking for it.  Yesterday Reuters cited a Lehman Brothers report on declining August car sales

China’s passenger car sales fell 10 percent in August from a year earlier, preliminary data showed, due to the impact of the Olympics and weakening consumer confidence, Lehman Brothers said in a research report on Thursday.

The report said auto sales in China, the world’s second-largest car market, were
expected to remain lacklustre for the rest of 2008 and possibly into early 2009.
Compared with the month before, sales were down 12 percent, the report said

Also yesterday the Financial Times warned that “Chinese steel consumption set to fall”:

Growth in Chinese steel consumption is expected to slow markedly in the second half of this year amid weakening demand from the construction, household appliance and automobile industries, according to industry experts.

Yang Siming, general manager of Nanjing Iron & Steel told a steel conference in Xiamen this week that most Chinese steel mills had cut output last month, because of shrinking demand and high costs of raw materials. ”We’ve been cutting production since last month, and according to my knowledge, most domestic mills are cutting output too,” Mr Yang said

One of the possible adverse consequences of excessively rapid money growth has been the channeling of this money via the banking system into excess production.  This was fine as long as a healthy world economy could absorb Chinese excess production, but a slowing global economy has meant that Chinese producers have been forced to turn to a domestic consumer market that hasn’t been able to take up the slack.  As I have mentioned many times before, rising inventories are one of the warning signals I am most concerned about.  I don’t think we are there yet, but I will be trying to keep an eye on the subject as well as I can

All this bad news is making policy-makers worried, and they seem eager to try to encourage some optimism.  I was struck by the list of top five articles under the “Macro-Economy” section in today’s Xinhua

Analysts: China’s inflation to continue easing in August

China economy “slowing but resilient,” HSBC report says

Noted Chinese official: Chinese economy not in downturn, but adjustments needed

Crude oil plunge good for China economy, analysts

Economists: China’s economy still in shape

Three of the top five articles today and all of the top five yesterday seem to be saying the same thing:  Don’t worry, things are still ok.

Still, not all the news is bad.  As I wrote Wednesday it looks like CPI numbers for August, which will be released next Thursday, are going to come in without too much implied inflation.  Most estimates are that CPI inflation will come in below 6% for August.  Today Xinhua reported that “China’s consumer price index (CPI), a key measure of inflation, was expected to show a rise of about 5 percent in August from a year earlier, said analysts on Thursday.”  They go on to quote Fan Jianping, chief economist of the State Information Center, as saying that “the CPI growth rate might sink below 6 percent in August.”  Logan Wright of Stone & McCarthy told me today that he expects it to come in around 5.5%.

Of course CPI numbers are pretty tainted by price controls at this point, but I am willing to bet that a low CPI inflation will make it much more likely that energy prices are allowed to rise again.  Shortages continue to be a real problem and energy producers are being squeezed mercilessly by rising costs and frozen prices.  In his comments yesterday Fan Jianping said he expected August PPI to rise by 10.0-10.3% (compared with the 10.0% rate posted in July).

On a separate note a very interesting article by Keith Bradsher in today’s NY Times discusses a predicament for the PBoC that many of us have been wondering about for a while.  As the RMB rises against the US dollar, the PBoC is forced to take losses on its currency mismatch – it buys dollars and funds them with RMB borrowings.  These losses have become so big that, according to Bradsher, the PBoC has been warned by the IMF that it may have too little capital.  The article says:

Now the central bank needs an infusion of capital. Central banks can, of course, print more money, but that would stoke inflation. Instead, the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.

The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts. This could heighten trade tensions with the United States. The Bush administration and many Democrats in Congress have sought a stronger yuan to reduce the competitiveness of Chinese exports and trim the American trade deficit.

The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

There is no need to worry about whether or not the PBoC is insolvent – the central bank is not a commercial stand-alone entity and its credit is at least as good as that of the central government (sometimes better), but the article is nonetheless interesting.  I hadn’t really thought of the political ramifications until I read the article, but if the PBoC needs to turn to the MoF to shore up its capital, and if this represents a transfer of power from the PBoC to the MoF, it may very well represent a further weakening of the monetary camp in China.

This might not bode well for the future of the financial system in the short term, although in the long term it is not clear to me that monetary soundness is necessarily correlated with more rapid growth.  I say this because I have seen no evidence that countries with very sound and conservative financial systems grow faster than countries will looser and riskier financial systems (although they do seem to have fewer financial crises).  I have more than once made reference to Belgian bank historian Raymond de Roover’s comment that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.”  Still, excess financial instability can significantly raise financing costs and in the case of China, where political credibility is always an issue, there may be other things to worry about if the guardians of monetary soundness are further weakened.

Astonishingly enough (but perhaps not surprisingly), a lot of mid-level policy-makers in China seem to believe that the PBoC currency losses are the “fault” of the US, according to my friend Victor Shih of Northwestern university.  The New York Times article goes on to say about Victor:

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

Many Chinese seem to be inordinately fond of conspiracy theories, but in this case it seems pretty obvious that if the RMB were indeed undervalued all these years – like the US government has been saying for a long time – then exchanging Chinese goods for massive amounts of US Treasuries by definition meant that China was subsidizing American consumption, and that this subsidy necessarily represented a loss for China.  If you exchange something below its fundamental value for something above its fundamental value, it is only an accounting trick that allows you to pretend you haven’t booked a loss.

Revaluing the RMB does not create the loss.  It simply forces recognition of that loss.  And as long as China continues to accumulate US dollar assets purchased with undervalued RMB, the PBoC will continue to run losses, whther or not they are fully recognized.  Perhaps you need to be a trader, and not a government official, to get the point.

Talking about Victor Shih, I should highlight another very interesting commentary by him on RGE Monitor.  He starts his entry:

Due to strong political pressure at the highest level and seemingly declining inflation, the State Council caved and increased the credit quota by some 200 billion RMB.  Well, that only goes so far, and much of it still goes to larger firms.  So, how are they dealing with the continual liquidity problem?  Bundling!!  Local governments, including Sichuan, Chongqing, Henan, Beijing, Liaoning, Zhejiang, and Shenzhen, are all planning to issue tranches of corporate bonds whose cash flow comes from a group of small and medium enterprises (SMEs).  Each province will issuing 1 to 2 billion RMB of notes for the approved SMEs.

The local governments will guarantee these notes, which have 3-5 years maturity!! This is a familiar scheme of borrowing to fulfill current policy needs and leaving bad debt for future leaders of a province or city.  This is why the central government banned local governments from issuing debt, but it is coming back in a latent form.  Granted, it is on a small scale now, but it can really take off.

I think the NDRC is backing this effort, though I am not sure if the financial regulators in Beijing like this.  This will also create good business for domestic investment banks, especially those with local government ties.  It might also give a boost to state owned asset management companies which are trying to transform themselves into investment banks

When we all start trying to figure out how much debt the central government really has (something that will become a popular sport sometime next year, I suspect), it will be useful to remember that these notes are going to be guaranteed by the local municipalities, and these municipalities in turn are guaranteed by the central government

On Sunday I am off to New York for a week where I will have a number of meetings and presentations which will give me the chance to gauge the mood of investors and financial policy-makers outside of China.  It’s been over a year since I went back, and I suspect the gloom and worry I saw last July hasn’t fully lifted, to say the least.

Tags: Consumer demand, Inflation, Inventories, Policy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Today is an anniversary of sorts.  Thirty-seven years ago, in 1971, President Nixon stunned the US by announcing the imposition of extensive wage and price controls in an effort to reverse rising inflation in the US.  In retrospect it is pretty clear that the price and wage controls were unlikely to reverse several years of booming money creation, and even the WIN buttons (“Whip Inflation Now”) distributed by President Ford a few years later weren’t enough to do the trick

The EconReview gives a short, potted history of the time:

In a move widely applauded by the public and a fair number of (but by no means all) economists, President Nixon imposed wage and price controls.  The 90 day freeze was unprecedented in peacetime, but such drastic measures were thought necessary.  Inflation had been raging, exceeding 6% briefly in 1970 and persisting above 4% in 1971.  By the prevailing historical standards, such inflation rates were thought to be completely intolerable.  The 90 day freeze turned into nearly 1,000 days of measures known as Phases One, Two, Three, and Four.  The initial attempt to dampen inflation by calming inflationary expectations was a monumental failure. 

…The wage and price controls were mostly dismantled by April, 1974.  By that time, the U.S. inflation rate had reached double digits.  While there were skeptics in August, 1971, there were a great many who thought “temporary” wage and price controls could cure inflation.  By 1974, this notion was thoroughly discredited, and attention gradually turned toward a monetary approach to inflation.  In a complete reversal, the policy to curb inflation in now thought to be an increase in interest rates rather than an attempt to hold them down.

A quick look at inflation rates in the US show that inflation had reached a temporary peak of 6.19% in 1971 Q1, and had been declining when Nixon imposed the controls in the middle of Q3 (5.46% and 4.26% over Q2 and Q3).  It continued to decline thereafter for several more months, reaching a low of 2.18% in 1972 Q2, before reversing course and marching upwards over the next two years to hit a second temporary peak of 12.38% during the third quarter of 1974.

After another period of improvement over the next two years (inflation declined to 4.21% by the second quarter of 1976), prices began another surge, which took inflation up over four years to a high of 10.36% in the fourth quarter of 1980 (it actually peaked in March at nearly 15%), after which time the very sharp and brutal economic contraction engineered by Paul Volcker of the Fed brought inflation back down again.

One has to be careful about drawing lessons.  What happened to the US in the 1970s tells us nothing about what must happen to China today, but it is worth remembering a couple of important points.  First, following a period of rapid monetary growth, which at first was able to deliver rapid economic and productivity growth, booming stock, real estate and art markets, and low inflation, the consequences of excess money creation only later led inexorably to higher prices.  Although a number of economists proposed higher interest rates and tighter money to combat the rising prices, the first instinct of Nixon’s economic advisors was to protect economic growth by using administrative measures to rein in inflation.  This didn’t work.

The second important point is that the process of rising inflation is rarely a straight line.  The US saw several fairly long-term reversals of the upward inflation path, but these reversals were temporary as long as the root cause of inflation – excessive growth in money – was not addressed.  In the end, however, the overall trend was upward and the cost of reversing it was significant – and it probably lost the election for Jimmy Carter.

One of the things we are wrestling with here in China is the extent to which the US experience is relevant.  In many ways it is not.  For example, today the National Bureau of Statistics released a report that had total investment in fixed assets for the first seven months of 2008 at RMB 7.2 trillion.  This represents 27.3% increase over the same period last year.  For the six months before July, FAI grew by 26.8%, and most analysts were expecting July’s number to be a little below that.  FAI is clearly very high.

I have been discussing the implication of these recent figures, including PPI and CPI inflation numbers, with several of my friends.  One of the questions that is always raised is about the transmission mechanism from high PPI inflation to rising CPI inflation.  On the face of it the surge in FAI suggests a future surge in industrial production that, especially given faltering global demand, is likely to create an oversupply of manufactured goods in China, which should make it more difficult for producers to pass rising costs onto consumers.  In that sense, it seems that the reduction in CPI inflation may be sustainable, even with last months’ unexpected jump in PPI inflation.

But I have to confess that I have a problem – perhaps instinctual – with this line of reasoning.  It is true that an excess of manufactured goods should put downward pressure on prices of those goods – or at least limit the ability of producers to raise prices – but is this enough to eliminate inflation?

The way I see it, excess money growth creates excess demand for goods and services at current prices.  This excess demand isn’t necessarily uniform, but it exists, and it should result in rising prices on average.  During the past year in China, the excess demand coincided (perhaps) with problems in the food supply, so that food prices soared.  There was a lot of talk a few months ago about food hoarding, and this talk has all but disappeared, so it may very well be that rising food prices were at first exacerbated by speculative hoarding, but at some point this behavior in turn put downward pressure on food prices as speculators sell off stocks (I am only guessing that this might have happened but have no real proof).

At any rate rising food prices absorbed all or most of the excess demand, so that there was little upward price pressure on the non-food sector.  In fact, there should have been significant downward price pressure on the non-food sector given the huge run-up in food prices, but we actually saw non-food inflation low but rising. This, by the way, is why I believed and still believe that inflation in China was caused by monetary conditions, and not by a food-supply problem.

What happens if rising FAI and surging industrial production now put downward pressure on the prices of manufactured goods or, at the very least, make it hard for companies to pass on price increases?  One obvious thing is that profits will sag, bankruptcies will rise, and companies will eventually be forced to cut back sharply on investment and production (exports might also surge).

But what happened to the excess demand caused by excessively rapid money growth?  It still has to have an impact on the average price level.  One possibility may be that we will once again see food consumption surge and, with it, the price of food.  Another possibility is that price increases will show up in the service sector.  A third is that they show up also in the price of manufactured goods that are not in oversupply, where there will be bottlenecks.  Inflation, in other words, won’t disappear.

There is also another, perhaps even less benign, scenario.  It is possible for there to be no inflation because there is a sudden collapse in the money supply.  

How could that happen?  In a worst case scenario rising bankruptcies could put so much pressure on the banking system that Chinese banks would be forced to cut back on lending and Chinese banks and businesses would begin to hoard liquidity.  This would result, I believe, in a sharp reduction in money supply (via a collapse in velocity perhaps?) that would cause China to exchange the risk of inflation for the risk of deflation.  

I think this is what happened in the US in the 1930s.  Following a period of rising inflation in the 1920s – and for many of the same reasons: a rapid expansion in the US money supply caused by massive reserve accumulation in the 1920s – the overextended banking system was unable to survive the economic downturn, and a previously inflationary period was suddenly converted into a period of sharp deflation.  There was even a 2-year period at the end of the inflationary period (1927-29) in which the US was absolutely swamped with speculative inflows. 

There are lots of different periods in US economic history to look at to get a sense of some of the issues that China needs to deal with.  Unfortunately none of this makes prediction easy, but I think there is one prediction I can safely make: so many years of wild money growth must result in an adjustment and this adjustment is not going to be easy.  Whether the adjustment results in inflation or deflation depends crucially, I think, on the state of the banking system and the reaction by banks to an economic downturn.

On another note, the stock market had its first good day in a while.  It closed at 2461, up 0.9%.  Most of China is still focused on the medal count, although I should mention that we’ve had our first day of really beautiful weather in Beijing today.