Although I am often surprised by how eagerly foreign commentators have embraced the Chinese fiscal stimulus story and see it as a great, shining success, I am happy to say, mercifully, that in China there is a lot more skepticism.  There seems to be a serious debate among Chinese policymakers over the stimulus package.   

The debate lists, on one side, people centered on the PBoC, the CBRC and the National Bureau of Statistics, who are worried that the stimulus may be exacerbating Chinese imbalances.  On the other side are people in the State Council, the Ministry of Commerce and in the provincial and municipal leadership who are more worried that any half-heartedness will lead to a significant rise in unemployment.   

In the past week or so the former, with whom I am of course in complete sympathy, seem to have become increasingly worried and have been making a lot of noise.  The formidable Hu Shilu, editor of Caijing, (and by the way Evan Osmos wrote a very interesting article about her in the current New Yorker) recently made a strong case against continuation of the current fiscal program when she wrote in an editorial this week that “a policy that encourages loose lending and investment is driving China’s economic engine down an old, unsustainable path.” 

Various signals suggested China’s economy had returned to a stable track by the end of the second quarter, giving us an opportunity to reassess macroeconomic policy.  Data released by the National Bureau of Statistics showed that China’s GDP rose 7.1 percent in the first half of the year, and 7.9 percent in the second quarter alone. Apparently, China’s economy has bottomed out. 

Arduous efforts contributed to this upward trend. External developments have had a much more serious impact on China’s economy recently than during the Asian Financial Crisis a decade ago. However, first half growth was only a bit below the level recorded in 1998. And although heavily dependant on exports, China may yet achieve its 2009 growth target of 8 percent, even while other major export countries report contractions. 

These achievements could intoxicate Chinese policymakers. But we see no miracles here. In fact, economic growth recovery in China is being driven by investment. Some 6.2 percent of the country’s first half GDP growth rate can be credited to investment, while consumption accounted for 3.8 percent. The net export business contributed a minus 2.9 percent to the growth rate figure. 

Hu makes the point that the “surprisingly high” Chinese growth is neither surprising nor cause for celebration.  It is the automatic outcome of a huge stimulus, and the real question, as I have argued many times, is not whether high current growth indicates that China has turned the corner on the crisis (it most certainly has not, in my opinion), but whether the cost of achieving this growth is excessive and will lead to more difficult conditions in the future. 

It’s long been acknowledged that China’s traditional methods of achieving economic growth cannot be sustained. However, we are now racing down this traditional path of economic development.  

Dramatic increases in the currency supply and lending have been backing this investment, the single most important engine of economic growth. M2 increased 28.5 percent and yuan-based lending rose 34.4 percent in the first half, setting new records for each. But nominal GDP growth was only 3.8 percent during the first six months of 2009. And these astronomical increases in currency and lending are a double-edged sword that can support GDP growth as well as endanger the economy. 

…It’s high time we re-emphasize the actual policy of moderation. A moderately loose monetary policy is necessary for an unpredictable, downward-sloping economy. However, monetary policy that’s too loose will have more drawbacks than merits once an economy levels out. It’s only a matter of time before loose monetary policy leads to inflation and asset bubbles. 

She concludes, very diplomatically I think: 

In the current economic environment, the more quickly China’s economy grows, the greater the effort needed to adjust future methods of economic development. Now is the right time to consider the timing of exit from stimulus. The third quarter can be a crucial juncture. 

She is not alone in criticizing the stimulus.  Another formidable lady, Wu Xiaoling, former People’s Bank of China vice governor, was interviewed by National Business Daily on Wednesday, and warned that the combination of excess capacity and excessively loose monetary policy was leading to asset bubbles.  According to an article in yesterday’s South China Morning Post, 

“Under conditions of overcapacity, excess money supply will not lead to rises in price indexes, but it could generate asset bubbles,” she said at a forum in comments reported by the Chinese-language National Business Daily.  ”The money has really gone out and if it is a time when there is no investment in the real economy and no one will put the money in banks to earn interest, then the funds will flow into the property market and stock market,” she said.  

China’s central bank may have to raise banks’ reserve requirements to mop up excess liquidity, she said, adding that this was simply a tool for managing the money supply and should not be misunderstood as monetary tightening. 

…Ms Wu said that China faced a dilemma in easing the rate of loan growth. Inflationary pressures would arise if lending continued at the same pace, but without sustained lending, many big projects may wind up unfinished because they are contingent on longer-term financing.” 

Although an increasingly large number of Chinese academics and think tank researchers have been raising warning cries, I think she is the first official or ex-official to go so public with her worries.  That doesn’t mean other public officials don’t act as if they are worried.  The CBRC for example announced this week the good news that the NPL ratio declined from 2.42% at the end of 2008 to 1.77% at the end of June.   

Part of this reflected an actual decline in NPLs, and most of it of course reflects the surge in new loans, but the CBRC is not acting complacent.  They have reinforced credit control policies on second-home purchases and their spokesman insisted earlier this week that there would be “strict enforcement” of the CBRC’s mortgage lending policy.  

According to another article in Caijing, “the authorities have consistently been encouraging banks to raise their loan-loss coverage, reflecting fears that the massive surge in new credit extended in the first half may lead to a rise in bad loans.”  The South China Morning Post had this to say on that subject: 

Beijing has required banks to raise their bad-loan reserve ratio to 150 per cent at the end of the year, forcing the lenders to set aside an additional 70billion yuan ($79HK.4 billion) as provision amid deteriorating asset quality, a fresh sign of China’s mounting worries about a backlash from its stimulus package.  

Liu Mingkang, the chairman of the China Banking Regulatory Commission, told a government working conference over the weekend that all mainland-based banks including local units of foreign giants such as Citigroup  and HSBC Holdings must boost their reserve ratio to 150 per cent, as risks were increasing amid a torrent of imprudent loans in this year’s first half.  

“Rapid growth in banking loans has led to accumulated risks,” Mr Liu was quoted in a CBRC statement as saying. “Reckless operations of banks were seen as some banks rushed to extend loans without due diligence.” 

The article goes on to quote She Minhua, a banking analyst at China Jianyin Investment Securities as saying “The requirement is basically a message that asset quality deterioration is deepening.  A serious problem will probably surface in 2010.” 

And Zhu Hongren, spokesman for the Ministry of Industry & Information Technology, said earlier this week that China, the world’s largest steel producing nation, should curtail “reckless investments” in the industry by withholding project approvals.  According to an article in Bloomberg: 

China’s demand for steel is about 500 million metric tons, less than the annual output capacity of 660 million tons, Zhu Hongren, spokesman for the Ministry of Industry & Information Technology, said at a conference in Beijing today. Zhu is reiterating figures given by the China Iron & Steel Association in February for last year.  

Crude steel output in China rose to a record 266.6 million tons in the first half as the nation’s $586 billion stimulus package spurred demand from builders and carmakers. Annualized, this would beat the 460 million tons output forecast by the steel association for this year.  

“The industry must produce according to market needs, and avoid adding to the excess capacity,” Zhu said. “They should avoid reckless investments. The government must also take action to curtail additional investments by companies that are already in excess.”  

Even Justin Lin, the World Bank’s chief economist, and someone who has been more of a cheerleader for China’s economic model than a critic, made a statement that suggests to me an indirect criticism of the fiscal stimulus package, although he (and others) may disagree with my interpretation.  According to a July 15 article in the Telegraph:  

But for all the warnings I don’t want to exaggerate my account of rising skepticism among Chinese economists and regulators.  In spite of possible back-door attempts by the PBoC and the CBRC to manage the excesses associated with the fiscal stimulus, it is pretty clear I think that policy is still being managed largely by policymakers who are far more worried about rising unemployment in the short term than about asset bubbles and an exacerbation of the unbalanced development model. 

The front page of today’s People’s Daily, for example, makes this clear.  They cite Finance Minister Xie Xuren’s insistence that “China will stick to proactive fiscal policy in the second half.”  According to the article, which is also carried in Xinhua: 

China will continue its proactive policy and reform its economic structure in the second half of this year to boost economic growth, Finance Minister Xie Xuren said Thursday.  Xie told local financial bureaus at a conference in Beijing on Thursday that the proactive policies, which included increased investment from government, tax cuts and subsidies to low income families, had taken effect in stimulating a recovery of the national economy. 

Xinhua today also prominently cites Peking University professor Li Yining as saying that “China should stick to its proactive fiscal policy and moderately easy monetary policy to fuel the economic growth as the foundation for recovery is not solid yet.”  I was not at the conference, so I wonder if professor Li’s comments were spun a little, because according to the Xinhua article he also said that “the current economic advance was pushed by investment, which was not the final demand – stable economic recovery should be sustained by increased consumption,” and warned that Chinese banks should “improve credit quality and structure.” 

So for all the rising skepticism among policymakers and scholars I think there is little doubt that we are going to see still more fiscal stimulus along the lines we have already seen.  If there is indeed global excess capacity, as Justin Lin says there is, I cannot see how an investment-driven program to increase capacity, and one which is almost certain to involve a huge additional misallocation of capital (after all, 8% growth given the sheer size of the fiscal and banking stimulus is actually a disappointingly low level of growth), can be much more than a short-term stop gap.  On the contrary, I think it will make the medium term adjustment even more difficult. 

On that note I want to recommend Victor Shih’s excellent OpEd piece in the Wall Street Journal – Asia yesterday.  He argues that: 

Should this pace of credit expansion continue for the remainder of the year, China may well face a difficult trade-off down the road. The economy is unlikely to face a financial crisis because most of the debt is owed to domestic investors and depositors and China can still prevent large-scale capital flight. However, if inflation spikes next year, the central government will have to choose between shutting off credit, which will reveal a massive nonperforming loan problem currently obscured by a torrent of new loans, or an unprecedented level of inflation. High inflation is destabilizing, as it has caused major runs on the banks before. If additional credit expansion in the face of rising inflation is not an option, the greater the extent to which lending is uncontrolled at the moment, the bigger a nonperforming loan problem the central government will face in the future. 

An often overlooked ingredient to China’s success story is that generations of top-level central technocrats like Chen Yun, Yao Yilin and Zhu Rongji time and again used their political influence to constrain local investment bubbles, thus forestalling high inflation and major financial crises. Past retrenchment campaigns were unpopular and controversial, but senior technocrats nonetheless maneuvered to stop uncontrolled local investment. As credit continues to rocket toward the stratosphere, China is in increasing need of such leadership again. 

Before closing this long post I want to add three additional comments.  The first involves a conversation I had with one of my Tsinghua students who graduated in 2003 and now works as a currency trader.  Last year he bought a few apartments in Chengdu, the capital of Sichuan, his home province, for speculative purposes, and in spite of surging land prices he seemed to think it was a terrible trade.   

I asked him why, and he said that although real estate prices had gone up dramatically since he bought the apartments, and he needed the money back, he nonetheless found himself unable to sell the apartments.  That’s a little weird, I thought.  Rising prices should mean eager buyers, but he can’t get anyone to take the apartments off him?   

Has any other of my blog readers experienced anything similar?  Of course the historian in me remembers that during the final two years of the Japanese bubble, when land prices soared to levels never before seen in history, there were complaints by sellers that transaction volume was so thin that they couldn’t actually sell their land. 

My second comment concerns university unemployment.  I have been writing for three years that unemployment among college graduates in China was soaring, and that authorities were understandably nervous.  So nervous, it seems, that they have been putting pressure on university to do more to get jobs for their graduates by limiting their next-year enrollment to the number of graduates this year with jobs. 

There are, of course, two ways to improve statistics.  One way is to improve the underlying reality.  The second way is just to fake the numbers.  According to a Tuesday article in the People’s Daily:  

I had no idea that I already had a job,” the student, who had been hunting for work, wrote anonymously on a website.  In order to ensure a high employment rate and deliver a satisfactory work report during the global financial crisis, some Chinese universities have been faking work contracts or employment agreement for graduates, Southern Metropolis Daily reported yesterday.  

This kind of thing will mean that the college employment numbers, a very useful figure for understanding the effect of economic growth in China, are now much less useful.  Already the People’s Daily article cites differences between the Ministry of Education numbers and a private firm’s numbers. 

The Ministry of Education said that nearly two thirds of them [2009 college graduates] had already secured jobs before graduation in early July.  But this figure differs widely with an employment report from an independent consulting firm on higher education.  A report from MyCOS HR Digital Information Co said 58 percent of prospective graduates had not signed job contracts by the end of June and that 2 percent had contracts cancelled. 

By the way the article has an interesting graph on the number of college graduates over the past eight years, for those who are interested.  The total number of university graduates has surged from 1.45 million in 2002 to 5.59 million in 2008 and 6.10 million this year.  The intervening years saw 2.12, 2.80, 3.38, 4.13, and 4.95 million graduates. 

My third comment is about the great article in today’s Wall Street Journal on the explosive development of the Beijing music scene, a subject that all my friends know is one dear to my heart.  Anyone who is interested in knowing more about this scene should read it. 

Tags: Steundent employment, Victor Shih

Things have been so busy this past week with various writing commitments and with the celebration of the third anniversary of my music club (four amazing shows with some of Beijing’s greatest artists and a lot of support and coverage from local music scene participants an the press) that I have been neglecting my blog. For today’s entry I don’t have any major points to make but I did want to take a look at some of the anecdotal information we are getting about the bank-part of the fiscal stimulus package.

The context is last week’s post in which I argued that the almost certain reversal over the next few years of American ability to grow consumption at a faster rate than GDP will put huge pressure on the Asian development model, and will require Asian consumption to grow much faster than Asian GDP. However if the current loan explosion is mismanaged, this may itself sharply constrain Chinese consumption growth, thus locking China into a long transition period of turgid growth.

In that light two weeks ago The Economic Observer, one of the better local newspapers, had an interesting article titled “Millions of Small Businesses Still Starved of Credit”. The growth of smaller businesses, many of which are in the service industry, is one important way for Chinese net consumption to grow, but it seems that their ability to obtain financing is being sharply limited by formal or informal policies that are driving capital into the investment sector. The article suggested that even with the explosive loan growth in the banking system, smaller companies are finding it extremely difficult to get loans.

New loans in China for the first quarter of this year would amount to nearly 4.6 trillion yuan, but behind the staggering figure, millions of small and medium-sized businesses nationwide were still struggling to raise funds.

Data from the National Association of Industry and Commerce (NAIC) showed that in January of this year, private firms had 421 billion yuan in short-term loans, a 700 million yuan decrease from December 2008. That was despite 400 billion yuan in new short-term loans released that month.

The article goes on to mention a survey of businesses in Chongqing that indicated that 82% of small and medium-sized businesses there considered the lack of funds the main hindrance to their development. Quoting Chen Yongjie, an official with the National Association of Industry and Commerce, the article goes on:

The Chinese government has recently pushed measures to solve financing problems for small and medium-sized businesses – for example, China’s Banking Regulatory Commission has required banks to open loan departments exclusively for small companies. But Chen said it was hard to tell how effective these measures would be: “What we can see clearly now from the statistics is that loans for small and medium-sized businesses are still dropping.”

It would be normally be surprising that loans are expanding so rapidly (we have already increased net new lending in the first quarter of 2009 by more than all of last year’s loan increase) while whole sectors of the economy are struggling to find financing, but my friend Dan Rosen sent me a Bloomberg article from Friday with a line which he found very funny and a tad startling. According to the article:

The largest borrower in the quarter was government-owned China Aviation Industry Corp., or AVIC, the nation’s biggest aerospace company. The Beijing-based company received 236 billion yuan from 11 Chinese banks, including ICBC, China Construction and Bank of China. It won another 100 billion yuan of credit from Export-Import Bank of China on April 16, without specifying how the money will be used.

AVIC General Manager Lin Zuoming said in an April 16 interview with Beijing-based newspaper Economic Observer that his biggest worry is how to allocate the borrowings to increase returns.

It’s the last line, of course, which Dan marked out. The largest single borrower, it turns out, has taken out around $35 billion in loans but doesn’t seem terribly certain about why he borrowed the money. I don’t want to read too much into a single throwaway line, but it is certainly consistent with all the stories and rumors we hear about banks lending not because borrowers need money for specific (hopefully profitable) projects but rather because they want to show loan growth, and the safest way to do that is to convince large companies and projects with explicit or implicit government guarantees to borrow massive amounts of money. Of course it helps that managers aren’t terribly concerned about creating value for their shareholders, but this is almost certainly a recipe for future growth in NPLs.

Obviously I (along with most of the readers of my blog) am not the only ones to realize this. Friday’s South China Morning Post had this to say:

Citic Bank Corp, the country’s seventh-largest lender, is optimistic about this year’s earnings outlook and is reining in loan growth to safeguard against a rise in bad loans. Chief executive Chen Xiaoxian said the bank would adopt stricter loan checks and had sent inspectors to those branches that had recorded a surge in discounted bill financing in the first quarter. “Banks need to take more forceful actions to increase risk controls,” he told reporters.

The article goes on to say:

Total lending by mainland banks in the first quarter reached a record 4.58 trillion yuan, close to the government’s minimum target for the whole year of 5 trillion yuan. Asked about his top concern, Mr Chen said: “Of course, it is asset quality given such fast loan growth.”

Mr Chen called the surge unsustainable. He did not disclose how much Citic Bank had lent in the first three months, but he said the pace would slow. “No matter how complicated your businesses are, you must clearly know the default rate,” he said of lessons learned from the global financial crisis.

Of course Mr. Chen is right. The current rate of loan growth is unsustainable and the biggest concern must be the risk of a sharp rise in NPLs. One would expect that all of this would quickly cause the PBoC to put the brakes on lending. The always intelligent Jim Walker of Asianomics thinks this will happen, but is nonetheless so worried about continued loan expansion he asks in an April 14 report:

Exactly why is this process dangerous?

First of all, China has an extremely high M2 to GDP ratio to begin with. As Figure 2 shows, M2 in 2008 already represented 158% of GDP. Compare this with money conditions in the US where M2 accounts for just 54% of GDP (the US ratio is read off the left-hand scale). If the US’ monetary easing efforts are such that investors are convinced that the dollar is no longer available reserve currency then the conclusion must be the same as regards the renminbi – only much more so. The only reason that the renminbi is not nose-diving in world currency markets is because domestic economic actors are not allowed to sell it.

For Walker, the explosive growth in lending is exacerbating what was already a very big problem, China’s huge bank-funded overinvestment. He goes on:

The second word of warning is that this breakneck monetary expansion will have to cease soon. The PBoC says that it will support economic growth through easy monetary conditions. It has certainly been true to its word so far but the problem will quickly become one of having a ‘tiger by the tail’. In Hayek’s analysis of economic growth he concluded that the only way an economic system hooked on credit could maintain its growth rate was for it to add ever increasing amounts of credit to that already existing. Adding the same amount of credit would result in recession-like conditions.

This, in his view, was the road to hyperinflation. The alternative, putting the brakes on monetary expansion, would lead to economic depression. On the assumption that Beijing will not wish to risk a hyperinflationary outcome we suspect that it will slam the brakes on the banks (which are clearly out of control already) within the next few months, regardless of the comments being made by the PBoC today. The next move in monetary policymaking in China will be to tighten, a move that will be badly received by markets that are already starved off profits.

Perhaps, but most analysts are betting against Walker. Xinxin Li of the Observatory Group points out that Wednesday’s decision by the State Council (effectively the equivalent of the executive cabinet) to reduce the capital ratio requirement for financing capital spending for infrastructure “is a further effort by the central government to implement its massive fiscal stimulus plan, in order to boost investment demand and support economic growth.” In his opinion the current policy environment “makes any hawkish statement from the PBoC politically incorrect. Just a couple of days ago, Vice Premier Li Keqiang said that the global financial crisis is having a deeper impact on the Chinese economy, showing that the top leaders are unlikely to drop their guard on the economic difficulties until Chinese economy firmly is on a recovery track..” In his April 28 report he concludes:

While the PBoC is concerned about the current pace of money expansion, it is unlikely to impose tightening measures to slow lending growth in the near term, due to an unclear economic outlook and the political priority on economic growth. China’s loose monetary conditions will likely persist in Q2.

The problem here is that Jim Walker’s analysis may be right but Xinxin Li’s prediction may also turn out to be right (and I suspect that Li doesn’t necessarily disagree with Walker’s analysis). Just because there is an urgent need for a policy doesn’t mean that it will happen. I remember that in early 2007 I argued aggressively that the PBoC would have to engineer a maxi-revaluation of the RMB because a slow revaluation would create huge hot money problems for the country. Of course the maxi-revaluation didn’t happen, and many of my friends seem to find my very wrong prediction a never-boring topic of conversation, but I defend myself by saying the analysis was correct, the prediction of huge hot money inflows was also correct, and soon enough the warnings about how destabilizing these inflows will be will also turn out to be correct. The global crisis intervened, and we will now see that China’s failure to have adjusted the currency much earlier, as a way of accelerating the transition from export growth to domestic-consumption growth when conditions were so good, will have a very painful cost.

So even if Jim Walker is right in that Beijing has no choice but to slow loan growth, he can still be wrong about assuming that they will. That of course would be the worst possible outcome.

Before ending, I wanted to cite a line from my friend Justin Winkle, who was responding to the comment discussed above that Dan Rosen found funny and startling. I am sure this has absolutely nothing to do with the topic under consideration, but here it is anyway.

My quote of the year is a line from Lewis Carroll appropriated by my stockbroker to describe the global economy: “If you don’t know where you are going, any road will get you there.”

As long as I am doing literary allusions I was just rereading PG Wodehouse’s classic Joy in the Morning, in which Lord Worplesdon explains to Bertie Wooster, in one of their very rare moments of camaraderie, why an American businessman they know seems so easily startled:

“Odd, this neurotic tendency in the American businessman. Can you account for it? I can. Too much coffee.”

“Coffee?”

”That and the New Deal. Over in America, it appears, life for the businessman is one long series of large cups of coffee punctuated with shocks from the New Deal.

I guess you can find economic history in the oddest places.

Tags: Lewis Carroll, PG Wodehouse, SMEs

I have recently finished reading Martin Wolf’s latest book, Fixing Global Finance, and I strongly recommend it for its very clear laying out of the global balance of payments issues behind the global crisis. I should warn my readers that Wolf and I have come to very similar conclusions about the underlying root causes of the crisis – we are both in agreement, for example, about the distorting effect of Asian policies to constrain consumption and boost investment in manufacturing output – but I am mostly impressed by the fact that we come to the same conclusion from such different angles.

Wolf begins with a model based on analyzing the financial architecture of the past forty years and brings to his analysis a very US-centric view of the world, whereas my conceptual model is based on my obsessive reading in the history of financial flows between rich and poor countries and starts with a China-centric view. Somehow we end up in almost exactly the same place, which suggests to me that we may be right or, at the very least, onto something important.

I won’t try to summarize the book but I do want to set out two paragraphs in which Wolf explains, far more clearly than I have ever been able to, how it is that reserve accumulation in Asia “forced” US households into overconsumption. One of the most common fallacies in popular economic analysis is to assume that countries are somehow analogous to households, and the factors that lead a household to consume “beyond its means” are similar to those that cause a country to do so. In that case if the US over-consumed, it is no different than if a stereotypical welfare family maxed out on its credit cards, and while we can fret at the stupidity of the bankers who gave them their credit cards, ultimately the blame for the mess must rest with the innate profligacy of mom and dad.

But this is not true at all when we are talking about overconsumption at a country level. As I have tried to argue many times, the global balance of payments must balance, and significant change in any component of the balance necessarily requires adjustments elsewhere. If Country A enacts trade policies that result in a surging current account surplus, for example, Country B must see its current account deficit surge by the same amount, and the way that happens will reflect a number of factors including the structure of its financial system. Country B could try to resist the growing deficit by engineering a recession and so causing total demand to drop, but this can be very painful for both countries.

Let us assume, then, that a group of countries, perhaps in response to the 1997 crisis, decide that in order to protect themselves from a repeat of that disaster decide to engineer polices aimed at accumulating reserves and limiting external debt. The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low, limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.) and direct credit to the investment and manufacturing sector. As a consequence growth in production would exceed growth in consumption and the balance would represent the trade surplus. Trade surpluses, of course, have to be recycled as investment flows (or reserve accumulation) back to the country against which they are running these surpluses. This is not a choice, or even a real lending decision. It is the automatic and necessary consequence of running a trade surplus.

Since the US is the largest and most flexible economy in the world, and since the primary world reserve currency is the dollar (more on this later), in practical terms only the US can be the deficit country for any period of time, and so the surplus countries must accumulate US dollar assets as the obverse of their trade surplus. Martin Wolf explains what happens next:

The rest of the world’s capital outflow supports the dollar. At the resulting elevated real exchange rate for the United States, the output of the sectors in the US economy that produce tradable goods and services shrinks, other things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States. This finally, appears in the trade and current account deficits.

One consequence of all this is that US domestic demand has had to grow faster than real GDP, to ensure that the latter grows in line with potential. The difference between the two is, of course, the increase in the current account deficit, in real terms. With trend growth in GDP between 3 and 3.5 percent a year, domestic demand has to grow even faster. That is precisely what has happened. US real demand (or gross domestic purchases) grew faster than real GDP in 1993 and 1994 and then again every year from 1996 to 2004 inclusive. Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent. That is how the current account deficit emerged. It is also how the United States absorbed the supply of excess capital from abroad.

In the face of a sharp contraction in those sectors of the US economy that compete with Asian manufacturers, in other words, the Federal Reserve must either permit a rise in US unemployment, in which case US consumption will decline and with it imports from Asia will decline too, or it must prevent the rise in unemployment by putting into place monetary policies that are consistent with rapid GDP growth. This argument, by the way, is not at all affected by the very common (and incorrect) argument that the main cause of the US trade deficit with China is the fact that China produces things that the US doesn’t want to produce, which I have tried to address in a March 9 blog entry.

Global savings glut

In either case US consumption must grow faster than US GDP, and the choice for the Fed is whether to target a “normal” growth in consumption, and permit rising unemployment, or a “normal” growth in GDP, and so permit rising indebtedness. The Fed must use US unemployment, in other words, as a tool to prevent Asian trade policies from leading to excess US indebtedness.

All this would have been bad enough if it hadn’t been for the need for the US to finance a very unpopular war, the Iraq invasion, in the way that unpopular wars have traditionally been financed – irresponsibly, through borrowing and money creation rather than taxes (remember that the Vietnam War was also associated with a credit bubble in the US). Asian policies, according to this view, definitely helped create the monetary distortions, but we must remember that there were plenty of bad domestic policies compounding the problem.

At any rate for the Fed to use US unemployment as a tool to prevent Asian trade policies from leading to excess US indebtedness is obviously politically very difficult, and it is also obvious that for the past ten year the Fed chose excess indebtedness. Since the 1997 crisis we have seen both household savings and the US trade deficit break out of their normal ranges and either collapse (household savings) or surge (trade deficit). This is a necessary consequence of the process that Wolf describes.

In that light, as U.S. fiscal spending surges in response to the crisis, increased attention will be placed on the way that U.S. fiscal spending leaks out through the current account to boost employment in China and elsewhere. And just as the Chinese complain bitterly, and rightly, that the West outsources polluting activity to China via the trade account, the U.S. will complain, as Martin Wolf pointed out in a March 31 editorial in the Financial Times, that China is outsourcing fiscal indebtedness to the U.S., also via the trade account. Surplus countries, he argues, “relied on the private sectors of deficit countries to do their irresponsible borrowing for them.” In response to the contraction in the borrowing among US households, the U.S. government, in other words, is currently choosing to borrow and spend the proceeds in order to generate job growth in the U.S. as well as in China. This can’t go on forever.

All of this is, of course, a variation on Ben Bernanke’s “global savings glut” hypothesis, and as everybody knows, Beijing wholly rejects this hypothesis as an explanation for the current global imbalances. For Chinese policymakers, the cause of the crisis lays firmly and totally within US monetary and financial policies (or lack thereof), and absolutely no blame can be apportioned to Asian trade policies.

Or is this really Beijing’s view? The extraordinary thing to me is that while Beijing has insisted almost desperately that any attempt to apportion blame to China is completely dishonest, they have nonetheless more or less welcomed Bernanke’s hypothesis, perhaps without realizing it, through the back door. I say this because the widely-discussed essay by PBoC Governor Zhou last week, in which he assailed the reserve status of the US dollar as being the main cause of global imbalances, is as far as I can tell nothing more than Ben Bernanke’s hypothesis viewed from a slightly different angle.

Why? Because Governor Zhou makes the claim that the reserve status of the US dollar gives the US an unfair advantage in that it can borrow nearly unlimited amounts simply as consequences of the need for foreign countries to accept dollars as reserves and for the purpose of international trade and investment. Of course he is almost certainly right, and he is just as certainly not the first person to make this claim. I think it was De Gaulle’s favorite economist, Jacques Rueff, who first discussed this “exorbitant privilege” as far back as the 1960s (NB: Martin Wolf corrects me — it was Valery Giscard D’Estaing who first said it — but I leave the mistake, and the correction, because it is one so commonly made).

But remember that if we make the very simple (and necessary) assumption that the ability of a country to run current account deficits is constrained mainly by a country’s ability to finance those deficits, then the ability to borrow unlimited amounts also means the ability to run unlimited trade deficits. It was the reserve status of the dollar that permitted the US to run the massive trade deficits it has during the past decade.

Had the US dollar not been the reserve currency of choice (in other words had Asian trade surplus countries not recycled their trade surpluses into purchases of US government bonds), the dollar would have had to decline against world currencies as a consequence of the rising deficit – Asian currencies too, and not just European – and the US trade deficit would have stabilized at much lower levels. This is also another way of saying, as Martin Wolf’s piece directly implies, that the Fed would not have had to choose between unemployment and indebtedness and that the binge borrowing that characterized US household behavior would have been much, much lower.

The world loves dollars because the US seems to love deficits

In fact I would go further. Because of the dollar’s reserve status, only the US could have possibly run the deficits necessary to absorb the huge surpluses that Asian trade policies were generating. Without the dollar’s status as a reserve currency, the Asian development model that stresses expanding production while constraining consumption – which among other things results in trade surpluses and net investment abroad (which of course is the same thing) – would have either required another reserve currency, or it would have failed.

Could there have been another reserve currency – and could it be that the dollar’s “exorbitant privilege” is something that Washington has enforced? Yes and no. The US economy comprises about one-quarter of the world’s economy and one-third of the rich-country economies. In principle it would have been very easy for any country to accumulate reserves of other rich countries – nearly all of whose currencies are easily convertible – so that there is no reason why the dollar portion of all developing-country central bank reserves might not have exceeded roughly one-third of the total, instead of the two-thirds or more that it currently occupies. Another third could be euros, and the rest a combination of the currencies of Japan, the UK, Switzerland, Canada, Australia, South Korea, and so on.

But it can’t just rest there. When a central bank chooses which currency to buy, unlike when you or I make our own portfolio decision, it is also determining the direction of net trade flows. Those other countries would have had to match the investment surplus (net inflows on the capital account) with an equally large current account deficit. If China had followed this balanced policy of reserve accumulation, in other words, the only thing that could possibly have stopped them, and a very big impediment it would have been, was the political or economic willingness and ability of those countries to run the corresponding trade deficits with China.

That, of course, is the problem. Given their much more limited economic flexibility and their less ebullient financial systems, those other countries probably would have never been able to sustain the necessary levels of trade deficit, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to hold US dollars not because the US government has somehow enforced reserve status on the US dollar and denied it to other currencies (Washington could never have prevented China from buying euros or yen or anything else), but simply because no other country is able to run deficits of the necessary magnitude.

The argument, then, that the dollar’s status as the reserve currency and brings an exorbitant privilege is simply the other side of Ben Bernanke’s savings-glut coin. Without the dollar’s reserve status, the global savings glut would have never occurred, or rather it would have never resolved itself in the way it did, and Asian development models aimed at engineering trade surpluses would have had to fail.

So is Governor Zhou a closet Bernanke-ite? He would probably be surprised at this question, and even more surprised at my answer, I think, but I cannot see how you can separate the two arguments – his on the perils of the dollar’s dominant reserve currency status and Bernanke’s on the impact of high Asian savings on the US balance of payments. He and Bernanke agree fundamentally on the roots of the imbalance.

By the way, the model I have been using to explain the imbalances also addresses another contentious question between the US and China which I did not really think about until I read a fascinating short piece by MIT’s Simon Johnson on his blog, more in reference to Europe but relevant nonetheless. China, as we know, is very worried that the US will resort to monetary policy rather than fiscal policy to address collapsing demand in the US. The former hurts China (supposedly because it might cause an erosion in the value of the dollars the PBoC holds), whereas the latter helps by slowing the contraction in US net demand and giving China more time to adjust its overcapacity problem.

It turns out that there may be another reason, even more powerful, and as soon as I read this paragraph by Johnson I had one of those “Aha!” moments that means I am going to have think much more seriously about the implications:

Remember this. If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus. But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I’ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.

This may be why monetary rather than fiscal stimulus makes sense for the US, and less sense for trade surplus countries. It prevents, or at least reduces, the leaking-out of employment generation effects of US borrowing and spending.

The other China

Talking about BMWs, my argument, of course, is not so much about China and the US as it is about trade surplus and trade deficit countries. In that light there was a very interesting article in Monday’s Financial Times about the difficulties Germany is facing in adjusting to the changes in the global balance. Many people assumed that Germany, which was in a very “strong” position (high savings, large trade surplus, low debt – which are all more or less the same thing, really), would weather the crisis easily, but of course it should have been self-evident that a crisis that affects the deficit sides of the global balance of payments must also affect, by the same amount, the surplus sides:

The risk is that – like Japan in the 1990s – Germany faces a “lost decade”, or a protracted period of economic malaise as it waits for the global economic tides to turn and struggles to find domestically generated sources of growth. “I am convinced it is going to be a slow recovery,” says Mr Staake. “Who is going to be buying anything?”

This downfall is all the more galling because, even a year ago, the country could have expected to weather the global economic storms. There was no danger of a housing crash; prices had been flat for a decade. Consumers had saved; companies had not increased leverage dramatically. “From a structural point of view, this recession should never have happened,” says Commerzbank’s Mr Krämer.

With hindsight, however, Germany was a sitting target after the collapse of Lehman Brothers investment bank in mid-September. Its exports were equivalent to more than 47 per cent of GDP last year – compared with less than 20 per cent in Japan and about 13 per cent in the US. Its industrial base is skewed towards producing machinery and equipment – “investment goods” account for more than 40 per cent of its exports – and towards emerging European and Asian economies.

While the crisis was focused on US housing and capital markets, Germany was unaffected. But after Lehman’s failure paralysed banks, and confidence nosedived globally, companies around the world shelved investment plans – leaving German factories turning out goods nobody wanted to buy. Industrial production in January was more than 20 per cent lower than a year before; overseas orders for investment goods had almost halved.

“Who is going to buy anything?” Good question, and one that must be answered by policymakers planning to export their way out of the crisis.

I especially love the statement “From a structural point of view, this recession should never have happened.” One of my standard complaints about most economists, especially those who focus on a single country or group of countries, is that they ignore balance-sheet and balance-of-payments effects. Of course it should have been obvious that a crisis in the deficit countries would affect the surplus countries – in fact it should have been obvious that the impact on the latter should have been worse.

Meanwhile, and as a continuing part of how the crisis will evolve, there is an interesting article in today’s Bloomberg about one of the ways in which the Chinese fiscal response to the crisis risks making the imbalance, and China’s long-term adjustment, worse.

China’s shipbuilding industry may be about to get a bailout — from its customers. The government may force state-owned shipping groups to buy more vessels as foreign carriers scrap orders, according to Steve Man, an HSBC Holdings Plc analyst in Hong Kong. That risks increasing costs and overcapacity among shipping lines grappling with a collapse in global trade.

“They ‘encourage,’ but my thinking is it’s more of a directive,” said Man. “It hurts every player in the industry and creates excess capacity that will take longer to absorb after an upturn.”

As I have argued many times, the constraints of the Chinese development model and limitations in the financial system mean that it will be very hard for China to shift its behavior quickly enough to match the possible adjustment in the US and elsewhere. Bailing out the ship-building industry is one way in which Beijing’s fiscal reaction – while understandable from an employment point of view – may exacerbate the adjustment. Washington’s bailing-out of the automobile industry is the same sort of mistake, I think, but in the US case it is much easier to justify. The US must reduce its net consumption, and if boosting production is economically inefficient in the long term, at least it fits within the overall adjustment in the short term. This is not the case with China – it should be boosting consumption directly, and not indirectly by boosting capacity.

There is a lot more I wanted to discuss today, but this blog entry is getting to be way too long. But just one quick thing, yesterday I was having coffee with some visiting friends from Goldman when one of them received a notice that there were credible rumors on the March increase in new loans. We had all been expecting a very big March number – between RMB 1.3 and RMB 1.6 trillion.

It turns out that the true number may have been an astonishing RMB 1.9 trillion.

That means that for the first three months of the year we have had loan increases of RMB1.6 trillion, RMB 1.1 trillion, and RMB 1.9 trillion. This amounts to RMB 4.6 trillion for the first quarter of 2009, compared to RMB 4.5 trillion for all of 2008. Notice to my students: learn more about how to resolve and restructure bad loans. This will be a great career option for you over the next few years.

Tags: Exorbitant privilege, Zhou Xiaochuan

Note: In response to many complaints by people who were confused by the headline — I was being sarcastic. Puerile humor, perhaps, but the point is that over the last year it seems that we hit absolute bottom roughly every fifth week.

Have we reached a bottom? A lot of analysts are pointing to the improvement in both measures of Chinese PMI to suggest that Chinese manufacturing may finally have reached a bottom, even though both PMI measures are still well below 50 and so indicate a contraction in manufacturing. More impressively the stock market has rebounded, with the SSE Composite bouncing off its January 13 close of 1863 to reach, as of yesterday 2108 (up 13.1%). Today it traded up another 2.0% in the morning before giving it all back, and more, during the afternoon to close down 0.5% for the day. Before the market turned Bloomberg today reported a very optimistic fund manager:

“Stocks continue to be lifted by speculation more stimulus measures are on the way,” said Michiya Tomita, a Hong Kong-based fund manager of Chinese stocks at Mitsubishi UFJ Asset Management Co., which oversees $61 billion. “There’s a growing perception that China’s economy will recover surprisingly fast.”

Surprisingly fast? I’ll take that bet. Aside from the normal excitement we all get from the right kinds of stimuli, part of the recent optimism seems to reflect the huge upsurge in bank lending I reported last week – with loans in January rising by RMB 1.3 trillion. Nearly one-quarter of that was provided just by ICBC. According to an article in today’s Bloomberg:

Industrial & Commercial Bank of China Ltd., the nation’s largest, said it offered 252.1 billion yuan ($36.9 billion) of new loans in January in response to the government’s stimulus plan to avert an economic slowdown. The bank lent 69.3 billion yuan to power grid, railway, roads, and hydroelectric power projects, and 135 billion yuan in discounted bills to small and medium-sized companies, the Beijing-based firm said in an e-mailed statement, without giving comparisons. New loans to individuals, including mortgages, amounted to 16 billion yuan.

China dropped lending quotas and unveiled a 4 trillion yuan stimulus package in November to maintain economic growth and counter the global financial crisis. Banks have responded by raising lending targets and focusing on railways, roads, power grids and other infrastructure projects with stable returns. Domestic banks offered a record 1.2 trillion yuan of new loans last month, representing almost a 50 percent gain from a year earlier, the China Securities Journal said yesterday.

ICBC aims to advance 530 billion yuan of new loans in 2009, about the same as last year, the 21st Century Business Herald reported today. The bank plans to complete 45 percent of the loan target in the first quarter. ICBC attracted 271.2 billion yuan of deposits in January, equivalent to a quarter of the total increase in 2008, according to today’s statement.

I have long argued that credit is a much better gauge of money supply in China than any of the monetary aggregates, so this explosion in bank lending should suggest at least that China is making the right moves from a monetary point of view – pumping liquidity into the system to avert a contraction in money supply that would exacerbate the contraction in demand. But I have three very serious problems with the optimism associated with the latest numbers on credit expansion.

First, this credit expansion is not all that it may seem. Aside from the fact that a lot of this new credit has consisted of an increase in bill discounting, in order to understand what is really happening to total credit in the Chinese economy we need much better data. There are persistent rumors that part of the increase in bank lending consisted of putting back on balance sheet loans that were taken off balance sheets in 2007 and 2008 when the PBoC was trying to constrain bank lending. It isn’t really new credit. We also don’t have a very good feel for what is happening in the informal banking sector, and in the past there was evidence that contraction and expansion in the informal banks counteracted what occurred in the formal banking sector.

What is more, there is clearly an increase in lending games aimed at making policymakers happy by showing fat loan books. One of my students just visited me today with an example that involved his father. I don’t want to get into too much detail, for obvious reasons, but the net effect of the transaction involving his father was that an entity was created to borrow money from a bank, the proceeds of which were deposited in a CD, which was then assigned in ownership to the real borrowing entity, which then used the CD as collateral for the “real” loan. Aside from the complications used probably to get around credit restrictions, one single loan was recorded as two loans plus a CD deposit. Apparently the lending bank knew about all the intermediate steps. Surprise, surprise! It turns out that if your career prospects depend on increasing the total amount of loans outstanding, with less focus on the quality or structure of the loans, in fact it isn’t hard to show very nice, fat loan book.

One of the readers of this blog, yesterday gave another very interesting example of what might be included in this new lending. He says:

As for the sudden surge in lending, this looks to me to be an accounting exercise, clearing or otherwise funding non-bank debts piled up by SOEs. Many large SOEs (not central ones, regional/local ones, though the central ones win no prize themselves) are behind on paying wages, suppliers etc, and the stimulus provided by this lending surge is really just to ease the log-jam of triangular debts. This implies that there will not be much “bang” for all of this lending

Second, exploding credit may provide a fillip to growth in the short term, but if it leads to a future increase in bad loans, it will have exactly the opposite effect in the near future. As I discuss in my previous blog entry, this represents a big bet on the duration of the slowdown.

Third, the biggest problem has to do with how much credit expansion will make a difference. Andrew Batson at the Wall Street Journal (sorry, I don’t have the link) makes this point when he discusses the “string of dire profit warnings has signaled a rapid deterioration in the financial health of Chinese companies.” His relevant paragraphs:

Corporate investment is hugely important to China’s economy, where capital spending accounts for more than 40% of annual output, one of the highest ratios in the world. The profit decline will have major effects across the economy as companies have less money to buy new equipment or expand their businesses.

…Economists have long warned that Chinese companies’ heavy reliance on retained profits would tend to exaggerate swings in the nation’s investment cycle. Official statistics show that 63% of investment in China last year was financed by what are called “internally generated” funds, which include retained profits. That’s up from just below 50% a decade ago.

Basically Chinese corporate profitability in China is dropping sharply, and nearly everyone expects the trend to continue over the rest of 2009. If nearly two-thirds of investment in China was funded by retained earnings, a sharp drop in profitability should result in an equally sharp drop in investment funded by retained earnings. I don’t know the magnitude, but I would guess that a very large increase in real bank lending aimed at real investment, far more than has been reported, would be needed just to make up for the decline in investment out of retained earnings. This, by the way, is an argument that has also been made by my friend Sam Baker at TNR.

For these three reasons (and a few others), I am not as impressed as many others are by the recent expansion in credit. I acknowledge, of course, that I may be hemming myself in intellectually because of my very strong belief that China will be forced one way or the other to make a necessary but difficult adjustment from export orientation to growth based on domestic consumption, and so I am blind to the good news, but for now I am sticking with my belief.

Aside from doubting the beneficial impact of credit expansion a larger part of the reason for my continued skepticism is that I am much more impressed by the expectations of hordes of workers returning to work after the Spring Festival and not finding jobs. Today’s South China Morning Post starts off an article today

One of the world’s leading luxury furniture makers has folded in Shenzhen amid the economic crisis, leaving more than 2,000 unpaid workers blocking traffic in protest until the local government paid more than 10 million yuan (HK$11.3 million) in back wages. DeCoro, the Shenzhen-based Italian sofa manufacturer employing nearly 3,000 people, had gone into liquidation with all assets seized by a local court in Longgang district, the National Business Daily reported.

Less anecdotal is another article, also in today’s edition:

Guangdong authorities are expecting millions of unemployed migrant workers to pour into the province in search of work, despite official warnings that the prospects are slim. Provincial labour authorities say 10.25 million migrant workers left for the Lunar New Year holiday, and of the 9.7 million expected to return soon, about 20 per cent would find it extremely difficult to find work.

But the biggest problem I have is that anyone taking a global view, and not just a very local view, cannot fail to be impressed by how bad the numbers out there are. For one thing, US GDP contracted by 3.8% in the fourth quarter of 2008. Normally that would be a horrible piece of news, but most analysts were pleasantly surprised because they expected something closer to 5.5%. Does that suggest that the US, too, is bottoming out? No, because apparently what saved the US from a much larger contraction was heavy orders from factories, including foreign factories, based on a surge of optimism during the summer. According to an article in Monday’s Wall Street Journal (I don’t have the link because I read it in the plane, but for those interested the article is titled “US Economy Dives as Goods Pile Up”):

While the fall wasn’t as steep as expected – most forecasts had GDP falling by 5% to 6% — output was boosted somewhat by a rise in inventories of goods that were produced but not sold in the fourth quarter. Excluding the inventory adjustment, GDP fell at a 5.1% rate, which economists say more accurately reflects the nation’s weakness.

Rising inventories, in other words, accounted for the better-than-expected US economy in the fourth quarter of 2008. But now those inventories have to be sold. That means however bad we expect US demand to be in the next few months, US companies will buy even less because they have excess inventory that needs to be run down. The unexpectedly good results for the last quarter will cause an unexpectedly bad result this quarter (not unexpected, of course, but you know what I mean).

And there is more. The US savings rate dropped to below zero in 2005 and 2006 but since then has been rising as Americans are forced to pay down debt and save more. Savings rose to nearly 3% of disposable income in the fourth quarter, from 1.2% in the previous quarter, according to the same article. But 3% is not enough. My guess is that this represents less than a third of the total adjustment that needs to be made. Remember that every dollar the US saves is a dollar that doesn’t go towards consumption.

Here is another way of looking at the same data. David Pilling has a very sober piece in yesterday’s Financial Times in which he argues that “China should raise wages to stimulate demand.” Of course he is right and of course they should (at least this is what I have been arguing for a while), even though it seems completely counterintuitive. Most analysts both in and out of China are arguing that China should try to increase the competitiveness of its manufacturers and the profitability of its businesses, and in this light raising workers’ wages seems stupid, but in fact I would argue that this is the best medium-term strategy to minimize the cost of the downturn to China. I will argue this more fully another day, but I do want to extract two paragraphs from Pilling’s article:

To see why, look at US personal consumption, which hovered around 67 per cent of gross domestic product in the last quarter of the 20th century. That was already high by the standards of the previous 25 years. But from 2000 to 2008, it shot up again to an unprecedented 72 per cent. That trend has now gone into painful reverse. As Stephen Roach, chairman of Morgan Stanley Asia, notes wryly: “We are already all the way down to 71 per cent.” In other words, it will be a very long time before Americans are again filling up their shopping carts.

…In 1980, 65 per cent of output of developing Asia was accounted for by consumption. Today it is about 47 per cent. The main reaction to the Asia crisis of 1997-98, when economies’ vulnerability to financial flows was exposed, was to build up exports. In doing so, Asia has swapped one kind of dependence for another.

US consumption dropped from 72% “all the way down” to 71%. Of course Stephen Roach is joking. US consumption has to decline by a lot more than that, and it will. Any attempt to understand China’s economy without situating it firmly within the global context, and especially within the contraction in global demand (remember as a major trade-surplus country China needs foreign demand to absorb its huge overcapacity) will not get the picture right.

By the way, on a related note, the US “Buy America” plan, which has been both widely criticized and widely replicated – explicitly or implicitly – by a lot of countries including China, is an example of how things are likely to turn when it comes to trade prospects. The good news, I think, is that those of us who worry about an explosion of protectionism are getting so alarmed that there may be a concerted fight to ward it off.

One other piece of mild good news, China yesterday increased the tax rebate for textiles. According to an article in today’s People’s Daily:

China will increase the tax rebate rate for textile and garment exports from 14 percent to 15 percent, an executive meeting of the State Council (Cabinet) announced Wednesday. The move would reduce exporters’ costs and support the textile industry, the Council said.

Increasing the tax rebate is actually a bad thing, in my opinion, since it seeks to improve the trade “competitiveness” of Chinese textiles and so increase China’s ability to export overcapacity, but the increase was much less than the industry expected. Thank god for small favors.

P.S. The day after I posted this the South China Morning Post provided a bit more clarity on the composition of ICBC’s loan expansion. According to an article in today’s edition:

Routine “bill financing” accounted for more than half of the loans the mainland’s largest bank by assets granted last month, underscoring concerns that the lending upsurge Beijing recently hailed as a sign of economic recovery may be inflated. Industrial and Commercial Bank of China extended 135 billion yuan (HK$153.12 billion) in “bill discount loans” and 117.1 billion yuan of other loans last month, the lender said yesterday. In discounting a bill, the bank takes on a company’s bill to a buyer before it is due and credits the value of the bill, after a discount charge, to the customer’s account.

Analysts said that of the 1.2 trillion yuan in loans made in January, about 65 per cent or 780 billion yuan were estimated to be “real” loans. That was slightly lower than last year, meaning the loan surge was largely illusory. “Banks are snapping up quality clients and projects,” a credit officer at a large bank said. “The more an enterprise does not need money, the more willing banks are to lend to it.”

…Banks generally only lend to quality small enterprises with loan yields of 6 per cent to 7 per cent, or 10 to 30 per cent above benchmark loan rates, according to Goldman Sachs. With the share of discounted bill financing in monthly incremental loans rising sharply from 5 per cent to 33 per cent over the past five months, the proportion of medium to long-term loans has shrunk from 50 per cent to 32 per cent.

Thus, the strong lending growth’s boost to fixed-asset investment was limited, China International Capital Corp said in a report. The truth may be a blow to mainland officials who are eager to see the economy on track to a recovery, but it could offer relief to bank shareholders in the short term.

P.S.S. On Friday afternoon I had an email discussion with Standard Chartered’s Stephen Green, one of my favorite research analysts, in which I asked if numbers provided by the PBoC branch in Wenzhou (Wenzhou is widely known as the capital of the informal bank sector in China) suggested that the informal banking sector was contracting loans. His answer: “Yep, that seems to be the thrust of it. In Wenzhou informal pool around CNY 600bn in recent years but new report by Wenzhou’s PBoC reports that between Jan and Dec ‘08, total deposit in Wenzhou’s banks rose 27.9% to CNY 208.5bn, indication they say that unofficial lending has slowed down. Certainly that was what seemed to be going on when we visited in September, large number of financiers had shut down for various reasons.”

Tags: Inventory, wages

The Shanghai stock market capped yesterday’s 1.5% decline with a further decline today of 0.7%.  It’s still been a great week, up nearly 8%, but the party, at least for a while, seems to have ended.

 

At least one government official is, alarmingly enough, wondering if there are ways to manage the process better.  According to an article in today’s China Daily:

 

It’s necessary and urgent to set up buffer funds to confront big speculators and stabilize the mainland market, a senior official said.  Jiang Lianhai, head of Jilin provincial securities regulatory bureau, published an article in Shanghai Securities News yesterday, which pointed to the necessities, functions and capital resources of launching a buffer fund. Later, an official from China Securities Regulatory Commission reiterated the view in an interview with China Daily.

 

In the article, titled “The capital market with Chinese characteristic calls for a buffer fund”, Jiang said that in recent years, international hot money has flooded into China’s stock market and real estate sectors. Some international speculators are planning to buy cheap stock when the market is sluggish and close out in a high price. “If the government does not have an effective tool in hand, it will be dangerous.”

 

One of my Peking University students sent me the article, highlighting the last two sentences.  His sardonic comment: “Nothing can be worse for China than to allow foreigners to make money.”  

 

He was being sarcastic, of course, and I am glad to see that my students are sophisticated enough to laugh at this kind of comment (a very widely held view here, by the way), but it is a little dismaying that a senior government official would say something that even an undergraduate would find so silly.  There is plenty of evidence that hot money inflows are driven mainly by Chinese at home and abroad, but even if that weren’t the case, foreign buyers during a time of market collapse are a force for stability, and the fact that they may profit shouldn’t be a driving factor in determining policy.

 

But I digress.  Here is what today’s South China Morning Post says about the article:

 

A senior official at the mainland’s securities regulator has come out in favour of setting up a fund to help stabilise the volatile stock market, the first time a government official has openly advocated the controversial idea.  In an unusual and bold move that may press top decision makers to consider the issue, Jiang Lianhai, the head of the China Securities Regulatory Commission’s Jilin branch, wrote an article in Modern Bankers magazine calling for the launch of a non-profit-making fund.

 

The government had no reason to stay on the sidelines of the troubled stock market, and its intervention could help stem destabilisation of investments, Mr Jiang said.  Unlike their more outspoken counterparts in the west, mainland securities officials rarely comment on policies, to avoid media attention that might not sit well with leaders.

 

We have heard these rumors before, in 2006 I think, before the market took off, but this is the first time a government official has made the point.  It may be a good short-term political move to bail out middle class investors, but these kinds of comments only reinforce the pessimism of those of us who do not expect to see a well-functioning capital market in China for many more years.

 

On a separate note, Paul Cavey of Macquarie has an excellent new research piece out on China called “China’s great Monetary Con” in which, among other things, he torpedoes the idea that Chinese monetary policy is tight.  His piece starts out:

 

Macquarie analysts. Global investors. Ordinary people. Everybody believes China’s monetary policy is tight. As a result, the market has sold off, and savings rushed into the banks. But why? Rates have fallen further behind inflation. The stronger currency has been offset by bigger capital inflows. Reserve requirements have been hiked, but credit growth has hardly slowed.

 

The only thing that has really changed is rhetoric, notably the announcement of a “tight” monetary policy. The impact of what has been purely a rhetorical shift suggests Beijing has more credibility than the Fed. Neither the US nor China has much ability to raise rates, but while attempts to talk up the USD have floundered, verbal threats in China have bought money back to banks.

 

With rhetoric a lot less disruptive than real policy changes, conning investors – more politely, the guiding of expectations – is a key central bank tool. As an example, China’s talking down of CPI will probably work. With households putting their money away, domestic inflation will indeed likely ease.

 

I have often referred in my blog to “tight” (quotations included) monetary policy in China, but after reading Paul’s piece I wonder if I may have been a little aggressive in assuming that everyone would know that what I meant by those quotation marks is that I don’t believe monetary policy in China is tight at all, or for that matter has been tight during any of the nearly seven years I have lived here.  China has a very loose monetary policy, and this was an inevitable consequence of the combination of ample global liquidity, an undervalued currency, and the country’s ongoing decision to manage the dollar value of the RMB, which almost automatically precluded its ability to manage domestic monetary policy.

 

How can I say that money is loose, not tight?  Except for the assurances of the central bank there is no other good evidence that money is tight:  Interest rates are negative, inflation is rising, and credit growth is actually very high and growing from a high base.  Remember that officially credit growth is supposed to be limited to 16% this year (from 18% last year), which already doesn’t seem particularly tight, especially given the high base, but this growth limit doesn’t apply to the policy banks, the informal banks, and to dollar loans, and all of these, to the extent that we can measure, have surged.

 

Even the growth of monetary aggregates, which in yesterday’s entry I explain why I don’t consider too seriously, is high, again especially considering they are also growing from very high bases.  My student undergraduate Liu Bing kindly interrupted his internship at Van Eck in New York to send me the following data.  In May the year-on-year growth in M_O, M₁, and M₂ were, respectively, 13%, 18% and 18%.  For reference purposes, according to Deutsche Bank, M₂ is expected to be 164.0% of GDP this year, up from 156.3% last year.  That is a pretty high base from which to grow.  The growth in PBoC liabilities, by the way (and this is the indicator that most impresses me), was 31% in May, from an already astonishingly high base.

 

So far none of these numbers seem to indicate anything approaching “tight” monetary conditions.  Perhaps the reason why many people believe, according to Paul, that Chinese monetary policy is tight is conflated with concerns about an economic slowdown. 

 

These two issues are very different.  I think it is possible for China to have excessively loose monetary policy and for the economy nonetheless to be at risk of a slowdown.  In fact I think both are highly likely.  Next Monday I have been invited to speak on CCTV’s Dialogue, the country’s main current events program, on the topic of stagflation.  I have found that this program often discusses issues that are being widely debated among the country’s leadership and analyst community, and in the five shows I have done this year, stagflation has been one of the main topics of discussion (the others being inflation and the currency regime). 

 

Clearly stagflation is a problem that worries a lot of people, and with reason.  Yesterday Human Resources and Social Security Minister Yin Weimin said, according to an article in today’s South China Morning Post, that the country was facing “unprecedented pressure” on employment.  Among other things the article cites a release on the ministry’s website that claims that the record 5.6 million students graduating this year (there were 4.9 million last year) are competing for jobs with 0.7 million of last year’s graduates who still have not been able to find a job.  That means that even as the number of graduates has increased by 13% from last year to this year, nearly 15% of last year’s graduates are still unemployed, a year after graduating.  You don’t need to be a political scientist to wonder about the political implications of rising student unemployment.

 

Because of recent years of overinvestment and overproduction, with the attendant massive misallocation of capital, I think it was inevitable that China’s sizzling growth rates would have to decline, especially given a global economic slowdown.  As I’ve discussed many times this seems to be causing officials to shift focus away from monetary concerns and towards growth concerns.  I am not smart enough an economist to say what polices the government can and should implement to shore up growth and prevent rising unemployment, but I am pretty certain that monetary loosening is not the answer.  This will only postpone a slowdown slightly while increasing the riskiness of China’s balance sheet and so making the subsequent contraction more damaging.

 

Logan Wright and I have a piece in next Monday’s Financial Times that partially addresses why.  Our argument is that not only has monetary expansion continued at an alarming rate, with reserve accumulation doubling again so far this year (at the rate of nearly 30% of GDP), but, more importantly, the composition of that reserve growth has made the process much more volatile.  Logan’s numbers show that two and three years ago, the trade surplus, FDI and interest income accounted for 80-90% of reserve accumulation.  This year, even ignoring the huge amount of hot money likely to be buried in those numbers, they account for less that 40%.

 

One of the things that I have argued repeatedly, including in my book, is that it is not just aggregate debt levels or capital flows that matter to instability but, more importantly, the structure of those debt levels or flows (i.e. whether they are counter- or pro-cyclical).  For example it doesn’t make sense just to look only at raw debt levels – i.e. the ratio of debt to assets – to understand the vulnerability of a system to breaking down.  What is just as important, perhaps even more important, is whether the value of the debt is positively or inversely correlated with the value of the assets.  Argentina in the beginning of 2001, for example, had debt to GDP levels of only around 53%, which doesn’t seem high, but because the combination of its very rigid exchange rate regime (which is always highly pro-cyclical) and the fact that most of its debt was denominated in dollars, its balance sheet was too inverted to allow it to withstand any but the gentlest of shocks.

 

Unstable balance sheets, in other words, are not just balance sheets with lots of debt, but they are also balance sheets with lots of highly pro-cyclical “volatility machines” imbedded in them.  These self-reinforcing processes in the balance sheet improve good times and exacerbate bad times, and they do so in a very mechanical way that can sometimes dumbfound observers.  South Korea’s astonishing crack-up in 1997-98, for example, was almost wholly a function of the way domestic corporations were forced by their very unstable balance sheets to respond to the unexpected won depreciation. 

 

As the won depreciated and the need to hedge their dollar debt grew, they were forced to sell won assets (in a rapidly declining market) and use the proceeds buy increasingly expensive dollars, thereby exacerbating won depreciation further and putting even more balance sheet pressure on them to continue the process.  This kind of process can go on for a long time before it finally works itself out, usually in bankruptcies and enormous financial distress, leaving observers shocked at the sheer irrationality of markets that cold so far overshoot any reasonable “equilibrium”.  But the process was not one of reverting to fundamental equilibrium, but rather of unwinding imbalance in the balance sheets, and so fundamentals have nothing to do with it.  Overshooting can occur, and will occur to the extent that balance sheets are very unstable.

 

So it is not only the sheer size of capital inflows into China that are worrying, but the increasingly pro-cyclical nature of those inflows that are exacerbating the problem.  If we wait too long to repair the balance sheets, the ultimate adjustment will be far greater and more damaging than anyone expected because of forced adjustments. 

 

By the way, FDI numbers were released today.  FDI inflows for the first six months of 2008 were $52.4 billion, up 64% from last year’s $31.9 billion.  I suspect that around $20 billion of this represents either disguised hot money, or an acceleration of future expected investment, which from the PBoC money-creation point of view is not a whole lot different.

After I posted yesterday’s entry, one reader (RebelEconomist) asked the following question:

 

You often say China’s money supply is growing fast because of its currency policy. Surely, if this was the case, base money growth would be strong. In fact, it appears to be very weak (growing about the same rate – 11%ish – as REAL not nominal GDP). It appears that sterilisation is completely successful. What indicator do you look at that makes you worry?

 

Since I have seen a lot of RebelEconomist’s writings and know him to be very strong on monetary issues, I hesitate to tangle with him on the subject, but it is a completely fair question and one I figured I should deal with formally in its own entry.

 

1.        China has a very high money base as a share of GDP.  I don’t remember the number (I will look it up some other time), but it materially exceeds that of most other countries, including most other large developing countries.  Increases, therefore, are from a much larger base, and any initial excess is likely to be multiplied.

2.        China sterilizes money creation by the issuance of central bank bills.  These are, however, extremely liquid and too close a substitute for money for them to reduce underlying liquidity in any significant way.  Corporations and banks hold them as cash and small investors eagerly buy up any on offer.  For these reason I see them mainly as a substitute of slightly more liquid form of money with a slightly less liquid form.

3.        I am very uncomfortable with the distinction between demand deposits and saving deposits, including long-term CDs, in the Chinese banking system.  I say this because a few months ago I purchased a 2-year CD at China Merchants Bank, which after one month I needed to convert (about one-quarter of it) into cash.  I expected a lot of difficulty and a penalty payment for breaking the CD (there had been no change in nominal rates, by the way), but it took less than 30 minutes, which is a dizzying speed for any transaction in a Chinese bank, and there was absolutely no penalty.  My only “cost” was I had to forgo the higher CD interest rate on the portion I cashed, although I still received interest on that portion at the demand deposit rate.  I have been told by friends that this is perfectly normal, so it seems to me that there is no real distinction, as far as I can see, between a demand deposit and any other kind of longer-term deposit except that you get a higher interest rate for the latter.

4.        In general for reasons I discuss below I tend to be very wary of the value of aggregates in determining money supply changes, especially in a country whose financial system is changing as rapidly as that of China, and more especially in a country that has a currency regime instead of a domestic monetary policy, so I prefer to use “gross” indicators like central bank liabilities.  This comes from many years of Latin American experience, especially in a country like Argentina with its “Convertibility Law”, a form of a currency board.  As money flooded into Argentina in the 1990s, it seemed to experience all the things we associate with a liquidity bubble far more than the growth in most of the higher-powered aggregates would have implied.  For this reason if PBoC reserve accumulation soars, I automatically believe money supply is soaring.

5.        Finally, the proof is in the pudding.  If I were to ask you what some of the consequences of excess money growth might be, you would probably tell me: rising inflation, low real interest rates, systematic overinvestment, highly speculative stock and real estate (and perhaps art) markets, rapid credit extension, and so on.  We are experiencing all of these things in China.

 

In general I tend to be a little Mundellian (at least according to my reading of Mundell) on the subject of money.  I don’t really think of liquidity as an aggregate, but rather as a quality.  All assets have greater or lesser degrees of “money-ness” and this can change over time.  What we usually call “money” is simply the asset with the most amount of money-ness, and although it is not always easy to decide what to include in our definitions of money, this reflects in part the problem of money as a quality rather than a quantity.

 

Even “money” can change its money-ness.  For example, not very long ago US dollars were a much more important part of China’s money base than they are today because they were – from what I have been told by old-timers – much more actively used as a medium of exchange and as a retainer of value.  People in China still have dollars (for example I do) but they are not used for everyday purposes at all, and they are costly to convert, so their impact on underlying liquidity in China is much lower.  When I lived in Haiti, however, dollars and gourdes circulated equally freely in shops and businesses at a constant exchange rate ($1 was then worth 5 gourdes – this was many years ago) and so it was only right to consider both of them equally as parts of Haiti’s high power money supply.

 

When an asset becomes more liquid and its value easier to ascertain at any given time, it becomes more money-like and it increases the underlying liquidity of the system.  A highly liquid and very widely traded and valued asset contributes more to the money base than one less so.  This was part of what Alexander Hamilton realized when he agitated for the creation of a single US national debt to replace the thousands of individual pieces of debt incurred by states and military during and after the Revolution.  His belief – well borne out by subsequent events – was that if these various obligations were assumed by the US central government, restructured into a single, large and fungible security, and given specific money functions (they could be used to pay taxes, as bank capital, etc.) they would essentially provide the US with a badly needed money base. It seems that he was right.

 

Perhaps a better example might be one cited by Charles Kindleberger.  After the Franco-Prussian War the victorious Prussians imposed on the French a 5 billion franc indemnity – then equal to about 25% of French GDP or 2-1/2 times the annual government budget – which the French were nonetheless able to raise fairly easily via a massive bond offering organized, I believe, by the Rothschild banks.  Kindleberger argues that the bond issue and subsequent huge transfer of (mostly) gold to Prussia represented a significant increase in European money supply because the bond itself fulfilled the function of money given its tremendous liquidity, high quality, and very diverse investor base.  Europe didn’t simply see a transfer of money from France to Prussia, in other words; it saw the addition of new asset that was a fairly close substitute for money and so a net increase in the “money supply”.  Not coincidently perhaps, immediately afterwards until the series of crashes and banking collapses that began in 1873, Europe and the world experienced a speculative frenzy that extended across the globe (in fairness the speculative frenzy began before the Franco-Prussian indemnity, but it reached its insane peak during and after).

 

When I lived in NY I used to discuss this often with the late Frank Fernandez, former Chief Economist at the SIA, and he often expressed his frustration at obtaining some reasonably reliable measure of global or domestic liquidity.  His conclusion, finally, was that there were no aggregates worth measuring.  In the end the best thing to measure was what he called the “shadow” of liquidity – such things as credit spreads, off-the-run Treasury spreads, bid-offer spreads for the most liquid assets, and so on.  I think I have absorbed his skepticism about the value of monetary aggregates as an accurate or even useful (in some contexts) measure of underlying money, especially in an unstable and rapidly changing financial system.

After I posted yesterday’s entry, one reader (RebelEconomist) asked the following question:

 

You often say China’s money supply is growing fast because of its currency policy. Surely, if this was the case, base money growth would be strong. In fact, it appears to be very weak (growing about the same rate – 11%ish – as REAL not nominal GDP). It appears that sterilisation is completely successful. What indicator do you look at that makes you worry?

 

Since I have seen a lot of RebelEconomist’s writings and know him to be very strong on monetary issues, I hesitate to tangle with him on the subject, but it is a completely fair question and one I figured I should deal with formally in its own entry.

 

1.        China has a very high money base as a share of GDP.  I don’t remember the number (I will look it up some other time), but it materially exceeds that of most other countries, including most other large developing countries.  Increases, therefore, are from a much larger base, and any initial excess is likely to be multiplied.

2.        China sterilizes money creation by the issuance of central bank bills.  These are, however, extremely liquid and too close a substitute for money for them to reduce underlying liquidity in any significant way.  Corporations and banks hold them as cash and small investors eagerly buy up any on offer.  For these reason I see them mainly as a substitute of slightly more liquid form of money with a slightly less liquid form.

3.        I am very uncomfortable with the distinction between demand deposits and saving deposits, including long-term CDs, in the Chinese banking system.  I say this because a few months ago I purchased a 2-year CD at China Merchants Bank, which after one month I needed to convert (about one-quarter of it) into cash.  I expected a lot of difficulty and a penalty payment for breaking the CD (there had been no change in nominal rates, by the way), but it took less than 30 minutes, which is a dizzying speed for any transaction in a Chinese bank, and there was absolutely no penalty.  My only “cost” was I had to forgo the higher CD interest rate on the portion I cashed, although I still received interest on that portion at the demand deposit rate.  I have been told by friends that this is perfectly normal, so it seems to me that there is no real distinction, as far as I can see, between a demand deposit and any other kind of longer-term deposit except that you get a higher interest rate for the latter.

4.        In general for reasons I discuss below I tend to be very wary of the value of aggregates in determining money supply changes, especially in a country whose financial system is changing as rapidly as that of China, and more especially in a country that has a currency regime instead of a domestic monetary policy, so I prefer to use “gross” indicators like central bank liabilities.  This comes from many years of Latin American experience, especially in a country like Argentina with its “Convertibility Law”, a form of a currency board.  As money flooded into Argentina in the 1990s, it seemed to experience all the things we associate with a liquidity bubble far more than the growth in most of the higher-powered aggregates would have implied.  For this reason if PBoC reserve accumulation soars, I automatically believe money supply is soaring.

5.        Finally, the proof is in the pudding.  If I were to ask you what some of the consequences of excess money growth might be, you would probably tell me: rising inflation, low real interest rates, systematic overinvestment, highly speculative stock and real estate (and perhaps art) markets, rapid credit extension, and so on.  We are experiencing all of these things in China.

 

In general I tend to be a little Mundellian (at least according to my reading of Mundell) on the subject of money.  I don’t really think of liquidity as an aggregate, but rather as a quality.  All assets have greater or lesser degrees of “money-ness” and this can change over time.  What we usually call “money” is simply the asset with the most amount of money-ness, and although it is not always easy to decide what to include in our definitions of money, this reflects in part the problem of money as a quality rather than a quantity.

 

Even “money” can change its money-ness.  For example, not very long ago US dollars were a much more important part of China’s money base than they are today because they were – from what I have been told by old-timers – much more actively used as a medium of exchange and as a retainer of value.  People in China still have dollars (for example I do) but they are not used for everyday purposes at all, and they are costly to convert, so their impact on underlying liquidity in China is much lower.  When I lived in Haiti, however, dollars and gourdes circulated equally freely in shops and businesses at a constant exchange rate ($1 was then worth 5 gourdes – this was many years ago) and so it was only right to consider both of them equally as parts of Haiti’s high power money supply.

 

When an asset becomes more liquid and its value easier to ascertain at any given time, it becomes more money-like and it increases the underlying liquidity of the system.  A highly liquid and very widely traded and valued asset contributes more to the money base than one less so.  This was part of what Alexander Hamilton realized when he agitated for the creation of a single US national debt to replace the thousands of individual pieces of debt incurred by states and military during and after the Revolution.  His belief – well borne out by subsequent events – was that if these various obligations were assumed by the US central government, restructured into a single, large and fungible security, and given specific money functions (they could be used to pay taxes, as bank capital, etc.) they would essentially provide the US with a badly needed money base. It seems that he was right.

 

Perhaps a better example might be one cited by Charles Kindleberger.  After the Franco-Prussian War the victorious Prussians imposed on the French a 5 billion franc indemnity – then equal to about 25% of French GDP or 2-1/2 times the annual government budget – which the French were nonetheless able to raise fairly easily via a massive bond offering organized, I believe, by the Rothschild banks.  Kindleberger argues that the bond issue and subsequent huge transfer of (mostly) gold to Prussia represented a significant increase in European money supply because the bond itself fulfilled the function of money given its tremendous liquidity, high quality, and very diverse investor base.  Europe didn’t simply see a transfer of money from France to Prussia, in other words; it saw the addition of new asset that was a fairly close substitute for money and so a net increase in the “money supply”.  Not coincidently perhaps, immediately afterwards until the series of crashes and banking collapses that began in 1873, Europe and the world experienced a speculative frenzy that extended across the globe (in fairness the speculative frenzy began before the Franco-Prussian indemnity, but it reached its insane peak during and after).

 

When I lived in NY I used to discuss this often with the late Frank Fernandez, former Chief Economist at the SIA, and he often expressed his frustration at obtaining some reasonably reliable measure of global or domestic liquidity.  His conclusion, finally, was that there were no aggregates worth measuring.  In the end the best thing to measure was what he called the “shadow” of liquidity – such things as credit spreads, off-the-run Treasury spreads, bid-offer spreads for the most liquid assets, and so on.  I think I have absorbed his skepticism about the value of monetary aggregates as an accurate or even useful (in some contexts) measure of underlying money, especially in an unstable and rapidly changing financial system.

 

I just got back from my one-week trip having taken a very early morning flight, so I am a little too tired to write much for today’s entry, but I couldn’t let pass a media report earlier this afternoon that claims that China’s foreign currency reserves at the end of May reached $1.797 trillion..  Although these media reports are unofficial, they have in every case that I can think of been subsequently confirmed by the PBoC, and these are very likely to be accurate numbers.

 

If so, this means that China’s foreign currency reserves grew by $40.3 billion in the month of May.  After the blowout $74.5 billion for the month of April there is the obvious temptation to think this is a relatively healthy number for China’s reserve growth, but it isn’t.  This is a huge number, materially above the $38.2 billion monthly average for 2007, a number that at the time was almost impossible to believe.  May’s $40.3 billion only seems small because monthly reserve growth year to date has averaged $53.7 billion, and it is worth reminding readers that, like the headline reserve growth numbers for the rest of this year, May’s number almost certainly significantly understates the true growth in reserves.

 

To recreate the chart I have been running every month, a reasonable and very plausible description of the composition of inflows to China’s PBoC this year looks like this:

 

	January	February	March	April	May	Total
Headline reserve growth	62	57	35	75	40	269
Trade surplus	20	9	14	17	20	79
FDI	11	7	9	8	8	43
Currency gains	10	10	18	(12)	1	27
Interest	5	5	5	6	6	28
Unexplained amount	16	27	(11)	57	5	92
Reserve hike	22	-	24	22	22	90
Adjusted reserve growth	83	57	59	97	62	359
Unexplained amount	38	27	12	79	27	182
Transfer to CIC	-	-	75	-	-	75
Adjusted reserve growth	83	57	134	97	66	434
Unexplained amount	38	27	87	79	27	257

 

 

To explain the chart, the trade surplus and FDI numbers for May were reported as $20.2 billion and $7.8 billion respectively.  Interest income is broadly the same as last month and I think currency gains in May were quite low (I will check with my friend Logan Wright, who tracks this better than I do).  There was another 50 bps hike in minimum reserve requirements for banks, and probably about $22 billion of that was redenominated into dollars, thereby pulling headline reserve growth down, although the monetary impact is nil.

 

Add and subtract the relevant numbers and we are left with about $27 billion of unexplained inflows into China for the month of May.  This is not necessarily all hot money, but it is a good proxy for hot money, and anyway it is a pretty safe bet that a significant part of FDI and the trade surplus really consists of disguised hot money. 

 

Over the year, the unexplained part of total adjusted inflows, including the redenomination of reserves and the transfer to the CIC, may amount to as much as a whopping $257 billion, which is only slightly less than the headline growth in reserves.

 

Surprisingly enough, or perhaps not so surprising given the amount of pain many banks are reported to be feeling, according to today’s Bloomberg a recent survey of Chinese banks by the PBoC suggests that Chinese banks believe monetary policy is too tight:

 

Chinese bankers say monetary policy is too tight and their expectations for interest rates to rise have eased, a central bank survey showed.  Policy is “tight” or “too tight,” according to about two-thirds of 2,900 heads of financial institutions surveyed by the People’s Bank of China this quarter.

 

According to the survey the banks regard current levels of interest rates – well below zero in real terms – as appropriate.  These kinds of complaints are likely to make it difficult for the PBoC to raise rates, especially when it seems that consensus is again shifting to concerns that an economic slowdown is a much greater threat than monetary excess.

 

The CPI numbers released Thursday have created a wide variety of responses among analysts and economists, both inside and outside China.  Some are hailing the reduction in CPI as an indication that China may have turned the corner on inflation, whereas others see this as a temporary reduction that will soon reverse as inflation spreads into non-food goods and services, and may even return quickly to the food component of CPI as more bad weather in China puts pressure once again on food supplies.  I would add that there is some evidence that the authorities have been aggressively selling food from their reserve stockpiles, in part to keep prices down, and, aside from the fact that at some point these reserves have to be replenished and so will once again put upward pressure on food prices, this means that the impact of any more supply interruptions will be more severe than they have been in the past.

 

Fortunately the authorities don’t seem convinced yet that the problem is over.  President Hu had a meeting yesterday, according to Raymond Li of the South China Morning Post, in which the top leaders were summoned to discuss China’s economic problems.  A statement released by the group cited increasing risks and uncertainties that made macro-economic management more complex, and pledged to use “a thousand ways and a hundred plans” to control prices.  As the Li points out, this is the first time this particular phrase has been included in the macroeconomic management toolkit.

 

What does this mean?  Unfortunately it sounds to me that it means an increase in administrative measures, probably including more price freezes, to manage prices.  As it is I think these kinds of measures used previously probably have more to do with the decline in May’s CPI than any real release of inflationary pressures.  I say this because, as I pointed out in yesterday’s entry, all the other indicators seem to indicate that inflationary pressures all still there

 

One such indicator is what otherwise should be very good news – retail sales are up strongly.  Paul Pankhurst at Bloomberg had this to say in an article today:

 

China’s retail sales rose 21.6 percent in May, close to the fastest pace in nine years, as the strongest earthquake in half a century, a stock-market slump and the scrapping of a week-long holiday failed to cool demand.  Sales soared to 870.4 billion yuan ($126 billion) after gaining 22 percent in April, the statistics bureau said today. Last month’s 7.7 percent inflation rate swelled the numbers.

 

Given all the problems Pankhurst correctly cites – the earthquake, the collapsing stock market, the scrapping of May’s “golden week” holiday – plus a few more, such as the rising economic uncertainty, nervousness about real estate, the general sense among many in China that something is not going right, it is interesting that retail sales expanded so quickly.  This is good news of course because it does mean that if there is a slowdown in exports China has another part of its economy taking up the slack.  The thing is that exports don’t seem to be slowing.  Says Bloomberg in the same article:

 

The retail sales data came two days after statistics showing exports surged 28 percent in May after a 22 percent gain in April. In a June 3 statement, the central bank played down the threat that overseas shipments will collapse, causing an economic hard landing. A “drastic” export slowdown won’t come soon, it said.

 

It seems to me that all the circumstantial evidence is showing the same thing.  China’s money growth is still pounding though the financial system and showing up as increased industrial production – which results in more strong export performance – and it is also causing surging consumer demand.  The CPI statistics are becoming less and less useful as a gauge of future inflationary pressure because of the combination of price controls and the selling of food reserves (and perhaps even, I have heard, because of the reluctance of some institutions to record price increases that go beyond the officially sanctioned ones).  Meanwhile we hear increasing talk of power and fuel shortages.  As I tried to explain Friday night on Dialogue (the current events program on CCTV), if you spend an extra half hour every week waiting at the gas station to fuel your car, the price at the pump might not have changed, but your living standard has nonetheless declined, and that is as much a form of inflation as paying more at the pump but not waiting half an hour in line.

 

Pankhurst’s point about the stock market is worth stressing.  Yesterday the SSE composite dropped another 3.0% to close at 2869, only three points above its low for the day, and this weekend Chinese newspapers are filled with articles about the unhappiness of investors who have seen a 13.8% drop this week – the biggest weekly decline in 12 years.  The nominal cause of this week’s awful results was the PBoC decision to raise minimum reserve requirements last Saturday by 100 bps, and this decision has generated some uncharacteristic anger.  There were reports of a small demonstration in Shanghai by investors angry that the government wasn’t protecting them, and more importantly, according to the Observatory Group’s Xinxin Li, economists with ties to the government have also protested.

 

The surprising 100 bps reserve ratio hike over the weekend immediately caused strong complaints from other government agencies, banks and industrial firms.  A reserve ratio of 17.5% seems close to a tipping point that may seriously damage the profitability of some small?and?middle?sized commercial banks.  Note that Wang Jian, a well?known economist with close ties to the influential National Development and Reform Commission, publicly criticized this latest reserve ratio hike as “a wrong move”.  Such strong talk by such an economist has rarely happened in the past. Both banking and securities regulators are also increasingly unhappy with a tougher and tighter market environment.

 

Of course it goes without saying that rumors are swirling about new government actions aimed at propping up the market since it is clearly below the 3000 level below which it was not supposed to fall.  The biggest hopes are placed on the supposedly imminent launch by the CSRC of stock-index futures and margin trading rules, although as I have already noted in an earlier entry it isn’t clear to me why these should push the market up in any serious way.

 

I think the government is very determined to address the myriad problems and uncertainties China’s financial system is facing, but they are growing increasingly frustrated that nothing is really working.  That is not surprising.  The basic problem is monetary policy, which is driven by the currency regime and which, right now, is mainly an expression of massive speculative inflows.  Until this is addressed, and policy-makers are still very reluctant to do so, I don’t see that things will improve much.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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