The stock market had a bad day today, with the SSE Composite down 3.62%, mainly on rumors that banks will be seeking to raise equity capital next year in response to their loan surge this year.  On Tuesday Bloomberg reported that the five largest banks were supposed to have submitted plans to regulators for raising money, after unprecedented lending eroded their capital.

I would argue that a more compelling reason to raise capital is the almost-certain surge in NPLs over the next three or four years.  In fact I am pretty surprised that these rumors caught the market by surprise.  Every time that banks have engineered a policy-induced surge in lending, they have followed up with a surge in NPLs, and it would be pretty extraordinary if this time were any different.  A refusal to raise capital levels would have been very imprudent, and it is pretty clear that the PBoC and the CBRC are already worried about the impacts of the credit expansion on the banking system.

Raising capital by selling equity is one way for banks to protect themselves from the consequences of bad lending, but I have been arguing for a long time that the main way banks have been recapitalized in the past has been the very wide spread between the PBoC-mandated lending and deposit rates.  This was more or less confirmed in an interesting but perhaps little noticed speech last week by Governor Zhou.  According to an article in Reuters,

China needs to maintain a certain spread between deposit and lending rates in order for banks to be able to support the economy, Zhou Xiaochuan, the governor of the People’s Bank of China, said on Friday. The central bank sets a ceiling on the rates banks may pay depositors and a floor on their lending rates. The built-in margin is a rich source of profit for Chinese banks that strengthens their balance sheets.

Speaking at a forum, the central bank chief also said China must ensure that its pro-investment policies do not lead to overcapacity, which he said was already plaguing some sectors.

The low deposit rates mean that Chinese savers are effectively being taxed to replenish bank capital.  Although this may be necessary in order directly to maintain the health of the banking system, it indirectly undermines the banking system in another way.  By forcing Chinese households not only to subsidize China’s very low cost of capital for producers and SOEs, but also to protect the banks from the effect of economically non-viable policy loans, Chinese households are bearing a pretty hefty share of the cost of China’s investment-led boom, and it is these same households whose surging consumption will be necessary to absorb the increased production resulting from the investment boom.

Given the increased financial burden being placed on them, I doubt that they will be able to do so.  After all, it is because of lesser versions of these same policies in the past that the enormous gap between production and investment exists in the first place.  And if they cannot raise their consumption sharply to absorb all this additional excess production, the banks will be stuck financing rising inventory and unprofitable companies.  It’s a vicious circle.

There is no easy way to resolve this problem, and it is pretty clear that Governor Zhou understands this, at least this is how I interpret his warning about pro-investment policies leading to overcapacity.  Interestingly enough around the same time as his speech the Financial News , a government newspaper, published a PBoC opinion piece that argued, according to an article in the South China Morning Post this week, that the “mainland should immediately halt some of its real estate stimulus policies, or risk inflating a bubble that in its bursting would wreak financial and even social trouble.”

On the same day the CBRC also struck.  According to an article in People’s Daily,

China’s banking regulator on Monday asked the country’s commercial banks to better manage risks and avoid year-end volatility in lending. Commercial banks should ensure that lending increase was kept in a stable and sustainable pace, the China Banking Regulatory Commission (CBRC) said.

Financial institutions with low capital adequacy ratio and no practical remedy plans would face restrictions in various sectors such as overseas investment, branch increase and business expansion, it said.  The CBRC called for enhanced inspections in financial system to detect problems after surging loan extends between the fourth quarter last year and the second quarter this year.

There seems to be a real tug of war.  On the one hand much of China’s industrial and exporting sectors along with provincial and local leaders, are eager to see a continuation of the financial policies that have goosed employment and GDP growth at the expense of domestic consumption.  On the other hand the macro and financial specialists are worried about the growing imbalances and their impacts on the financial sector.  Professor Yu Yonding of the CASS Post-Graduate school, a former member of the Monetary Policy Committee and one of the smartest analysts on China, gave a speech in Melbourne yesterday in which he warned about China’s over-reliance on exports and investment and suggested that the imbalances are worsening, not improving.  I strongly recommend that interest readers check out the speech for themselves.

In part the debate resolves around the issue of financial sector reform, especially of the banking system.  This is an extremely important topic because most economists and analysts, including me, believe strongly that financial sector reform will be one of the most important steps forward for the healthy development of the Chinese economy.  The Chinese financial system misallocates capital on an heroic scale.

A few days ago I was in a debate with a friend of mine about whether or not there has in fact been financial sector reform and liberalization in China, even after the US financial crisis gave anti-reformers what seemed like an unanswerable argument against financial liberalization.  My friend argued that instead of taking the easy way out and backtracking, China has in fact deepened financial sector reforms.  In support he referred to numerous statements by regulators to this effect, and other moves to liberalize finance in China.  For example there is no question that the Chinese bond market is growing.  According to an article in Tuesday’s Financial Times,

Emerging east Asia’s local currency bond markets have tripled as a proportion of the global market since the Asian financial crisis, but remain plagued by poor liquidity, according to a report published on Tuesday by the Asian Development Bank.  It says the region’s local currency bonds outstanding accounted for 6.2 per cent of the global total in the first quarter of this year, compared with 2.1 per cent in the fourth quarter of 1996, on the eve of the 1997-98 Asian crisis.

The $3,658bn of bonds outstanding amounted to nearly seven times the value in 1996, reflecting efforts by governments in the region to strengthen and deepen local bond markets to avoid the pitfalls of extensive borrowing in foreign currencies.

The bulk of the increase reflects a surge of local currency bond issuance in China, which accounted for 3.7 per cent of the global market in the first quarter of 2009, from just 0.2 per cent in 1996.  China remains the fastest-developing market for local currency corporate bonds, growing 87.7 per cent year on year, but the Philippines was second, with 65.8 per cent growth year on year, according to the ADB’s Asia Bond Monitor.

Perhaps more excitingly, foreign firms are likely to be welcomed into China’s domestic bond markets.  Rumors about this started on Monday with a CICC report and then seem to have been confirmed in an article in today’s People’s Daily:

Foreign companies may be able to sell bonds in China within a year as the government expands its domestic capital markets, according to China International Capital Corp (CICC), the No 2 underwriter of yuan debt this year.  ”The first group of future international issuers is likely to be blue-chip companies,” John Cheng, CICC’s investment banking managing director, said in an interview on Tuesday.

Overseas “firms will increase their presence in China and they’ll need to match their growing yuan assets with instruments in yuan, be it debt or equity,” he said.  China is urging domestic companies to tap bond and equity markets for funding and reduce reliance on banks after regulators said record loan growth poses risks. Authorities will consider allowing sales of high-yield corporate bonds to provide new sources of funding, People’s Bank of China Deputy Governor Hu Xiaolian said on Nov 18.

But in spite of the good noises, I am very skeptical about whether there has been real reform or liberalization in the financial sector, especially during the past year.  Why?  Because for me this would involve two main types of reform, on neither of which has there been any advance.  First, interest rates would have to be decontrolled and liberalized in order to remove the financial repression implied by extremely low interest rates.  I see no evidence that this has happened.  Interest rates are as controlled, and as much a policy tool, as ever.

Second, there needs to be substantial improvement in bank governance, so that the lending and investment decision is a function of economic rather than non-economic factors.  This is another way of saying that there must be a reduction in the process that leads to such massive capital misallocation.

Although there have been a series of baby steps in that direction, I would argue that these were completely undermined – reversed, in fact – by the surge in lending this year.  Any chance that the financial system is getting better at making the capital allocation decision was blown away by the events especially of the first half of this year.  The Chinese financial system, I would argue, is less liberalized, and certainly less efficient, today than it was one year ago and even five years ago.  This may sound like an outrageous statement, but reform has to be more than tinkering on the side.  To matter it must address the fundamental problems in the financial sytem – which I believe to be distorted interest rates and weak governance – and I don’t believe either has been addressed.

Finally, I want to mention two additional recent papers that have come out on the Chinese economy.  First is my misnamed “Brief” for the Carnegie Endowment, which discusses the tug-of-war between rising US savings and persistently high Chinese savings and what the consequence are for the global balance and international trade.  Second is a paper called “Overcapacity in China: Causes, Impacts and Recommendations,” released today by the European Union Chamber of Commerce in China.  Full disclosure: I was involved partially in the preparation of the paper.

And for those who celebrate my favorite holiday: Happy Thanksgiving.

Finally the numbers are in.  China’s CPI was up 6.5% in October, up from 6.2% in September.  This matches CPI inflation for August and, with that exception, is the highest monthly CPI inflation number since the 7.0% recorded in December 1996.

On the one hand October inflation slightly exceeded the consensus forecast of 6.3-6.4%, but on the other hand it is below the 6.8-7.0% that some people (including me) were worrying about. (However you can read my previous entry to see why I think October inflation may actually be over 7 %.)  This is the third month of inflation over 6%, and I think that given the recent cut in fuel subsidies it is hard to see what can drive CPI inflation below 6% for the rest of the year.

I think by now it is pretty clear that this is no longer just a food thing, although some analysts continue to say that it is.  For example they argue that the non-food component rose just 1.1% last month from a year earlier, the same pace as it did in September, whereas food prices were up 17.6%. 

That suggests that food is still the primary force driving prices upward, although in a poor country where one-third of the CPI basket is food, I would think that rising food prices must affect wages and, through wages, the rest of the economy.  More to the point today we were also told that PPI was up 3.2% in October, compared to 2.7% in September (and 2.6% in August, 2.4% in July, and 2.5% in June).  Food prices were a big part of that, but oil and raw materials were up 4.8% and mining was up 5.4%, (4.5% and 1.2% in September), and this doesn’t fully take into account the 8-10% increase in gasoline and diesel prices that was passed late last month.

There is a lot of disagreement on where this will go.  Goldman Sachs have just changed their 2008 inflation forecast from 4.0% to 4.5%, whereas Credit Suisse keeps saying that it is going to be very hard to bring inflation down next year.  In explaining their forecast, Goldman said to its clients in a note today that “We believe the central bank will likely respond with additional tightening measures including strict control on bank lending and two more rate hikes before the end of this year.”

I have a great deal of respect for my Goldman Sachs friends, but I have to go with Credit Suisse’s Dong Tao on this one. Goldman, and everybody else for that matter, is right in saying that the high CPI inflation number is likely to lead to additional tightening measures, but given China’s monetary policies I cannot see how these tightening measures will work to reduce inflation.  The whole point of tightening will be to reduce consumer demand as a way of putting a lid on inflation.  But if consumer demands moderates, what will that do to the trade surplus? 

Of course it will rise even faster, and as the PBoC is forced to purchase the additional inflow, China’s money supply will expand even more quickly.  In addition, whether or not you believe that speculative inflows are a serious problem for China (I think they are), it is hard to argue that raising interest rates won’t have at least some positive effect on inflows.  PBoC tightening, in other words, is likely to increase current and capital account inflows.  The only market tools they have to attack inflation will, perversely enough, increase monetary expansion, and if you believe as I do that the root cause of Chinese inflation is excess money growth, that cannot be a viable solution.

I think China is stuck and can do nothing about domestic inflation without fixing the currency problem.  This gets to the nub of the reason why I think China will be forced into a maxi-revaluation (or at least a significant speeding up of the daily appreciation).  The authorities have no control over monetary policy and never will until they address the currency regime.

This pessimism of mine was confirmed, I think, by other October data.  M2 was up in October by 18.5%, a very high number, and more or less in line with monthly growth over the past four or five months (and at record levels since 2003).  Bad as this is, it was exceeded by the 22.2% growth in M1 in October (also at or near record levels since 2003).  With M1 growing faster than M2 every month since November of last year, (before than for several years either the two grew at near-identical rates or M2 grew substantially faster) depositors seem to be shifting money into more liquid facilities so causing money velocity to rise.

Logan Wright, of Stone & McCarthy, in a recent uncirculated report finds even more to worry about in looking at October numbers for the composition of bank portfolios.  Not only is loan growth at near-record levels on a seasonally adjusted basis (loan growth in October tends to low or even negative, whereas this year it is up by RMB 136 billion), but banking deposits actually declined in October.

More alarmingly from the perspective of the central bank is the data on banking system deposits, which reveal that absolute levels of overall deposits in the banking system fell on a month-on-month basis for the first time since July 2001. Renminbi deposits in the banking system fell by 449.8 billion yuan, and total deposits fell by 434.2 billion yuan. Renminbi deposit growth fell sharply to 14.9% year-on-year from 16.8% in September and 16.5% in August…

…Household deposits are now rising at only a 3.7% rate year-on-year, and these deposits have traditionally been the primary source of banking system liquidity. Interestingly, enterprise deposits, which have been rising much more rapidly in recent years, declined month-on-month as well, by 194.7 billion yuan. Enterprise deposits are still growing at a 22.7% rate year-on-year, and this constitutes the bulk of the growth in banking system deposits throughout 2007, meaning that the banking system is becoming even more dependent upon the profits of Chinese enterprises and the macroeconomy as a whole. We should caution that this is only one month of data, and a somewhat distorted one at that, being October, but the central bank is unlikely to be pleased with the flows of deposits out of the banking system and into the equity market, given its previous statements about the importance of maintaining positive real deposit rates.

It is hard not to look at all of this and not conclude that the fears that some of us had as far back as 2003 – that China’s currency regime was locking it into a monetary trap – were unjustified.  Monetary conditions have played out almost exactly as expected.  In my opinion, as this thing continues to unfold the logic of a maxi-revaluation will only become clearer, but it is probably too late to undo all the damage.

On Wednesday Zhou Xiaochuan was interviewed by a newspaper published by the PBoC, of which he is the governor, in which he insisted that the PBoC would stabilize inflationary expectations, curb excess liquidity and pull real interest rates out of negative territory.  One-year deposits at 3.87% and inflation for the past year has three months has been 6.4%.  He also said, probably in reference to October’s seasonally high growth in credit, “We must implement appropriately tight monetary policies, continue to take comprehensive measures, improve and innovate in policy tools, and appropriately step up macro controls in order to maintain reasonable credit growth.”

I don’t want to read to much into these particular tea leaves, but from what Zhou has said and from what I am hearing elsewhere it seems to me that a number of recent issues have caught Zhou’s eye.  First, most obviously, CPI inflation is not moderating, and there is reason to fear that it might be spreading.  Second, the RMB 449.8 billion drop in RMB banking deposits in October may be indicating an acceleration of capital flows into the stock market – in part because of a few very large (and crazily successful) IPOs but also perhaps because of negative real interest rates.  Third, new loans expanded by RMB 136.1 billion in October, which is an historical high for a normally very weak month.  Clearly commercial banks are still eager and able to expand their loan books in spite of several minimum reserve hikes and lots of moral suasion.

Zhou has already said last week that the first priority of the central bank was to curb inflation and maintain price stability.  Maintaining employment would take a back seat in monetary policy.  Xinxin Li of the G7 group has this to say:

“- The PBoC is inclined to define the current problem as an overall inflation pickup, and the conclusion is it is a monetary phenomenon caused by accumulated effects of external imbalances and money supply growth… 

“- By comparison, the National Development and Reform Commission (NDRC, the economic planning committee) still sees the CPI jump as a supply shock of food and commodities.  By denying a full-scale inflation, the NDRC may have more flexibility to increase energy and utility prices, which are still heavily subsidized by the government. On November 1, the widespread shortage of diesel and gasoline finally forced the NDRC to increase the refined petroleum price by 10%.

“- The position of the National Statistics Bureau (NBS), another government agency capable of macroeconomic projection, is closer to the NDRC’s view. It is quite optimistic on the inflation outlook and believes that the CPI will moderate gradually in H1′07.”

The outcome of this policy disagreement is not at all clear in the short run.  My guess is that the PBoC needs higher CPI inflation numbers to strengthen its case for speeding RMB appreciation, although another few months of record trade surpluses and increasing anger from the US and Europe may also do the trick.