It is a real toss-up as to which generates more bizarre comment in the international press: Beijing’s long-feared dumping of US Treasuries, or the use and value of the PBoC’s central bank reserves.  The revelation last week that Chinese holdings of US Treasury obligations fell in December by $34.2 billion, to $755.4 billion, generated a frisson of fear and excitement, leading one prominent newspaper to worry that “If there is one thing that gets investors twitchy, it is the fear that China is losing its appetite for US government bonds.”

And shouldn’t they get twitchy?  After all this reduction in Chinese holdings of Treasury bonds comes from the USG’s TIC data, so it must be true that China is dumping dollars, right?

No need to twitch, it means no such thing.  First of all, the data from which this was derived indicates national ownership of USG bonds only to the extent that foreigners are directly registered holders.  It says nothing about what happened to the large amount of bonds held by the PBoC and other Chinese investors indirectly or in street names. Those could have easily gone up by more than the reduction in bonds directly held by Chinese investors in their own name.  If the PBoC had let maturing Treasury bonds get repaid, for example, and reinvested the proceeds into the USG bond market through another account, or in a street name, its total holdings would have actually increased even though its registered holdings would have declined.

More importantly, the TIC numbers completely fail to disclose whether China’s reduced holding of USG bonds was matched by increased holding of other dollar assets, thereby increasing the pool of capital available to fund USG bonds by an amount equal to its reduced Treasury holdings.  If Chinese investors decide to take on more risk, for example, they might sell USG bonds and use the proceeds to buy corporate bonds.  Of course the seller of these corporate bonds will then have cash, which must be put to work, and ultimately this ends up back in the USG bond market.

China did not reduce its dollar holdings

So was China a net seller of dollar assets in December?  Almost certainly not.  Just look at the PBoC balance sheet.  PBoC reserves rose in December by $61.3 billion, of which $39.0 billion was the trade surplus.

Remember that China has a large current account surplus which necessarily must be recycled abroad, and the US has a large current account deficit which necessarily must be funded abroad. It would be astonishing if, under these circumstances, total Chinese holdings of USD assets declined, and of course it is impossible that they declined faster than the willingness of other foreigners to replace them.

Of course if the US current account deficit declines, net new foreign purchases must by definition decline too.  If the US wants its current account deficit to decline so that the USG can reduce the fiscal spending needed to generate any fixed number of jobs, this cannot possibly happen without a concomitant decline in net foreign, including Chinese, purchases of dollar assets.  But it need not result in any difficulty in funding the new, lower amount of debt issuance.  Depending on why it happens, reduced purchases by foreigners should probably be seen as a good thing for the US Treasury market, not a bad thing.

Confused?  How can a reduction in foreign purchases help the USG fund its massive fiscal deficit?  Because the purpose of the fiscal deficit is to create jobs in the US by boosting US spending.  Since some of the jobs that higher USG spending creates will accrete outside the US, via demand that “leaks” abroad through the deficit and creates employment for foreign manufacturers, a smaller trade deficit can itself be expansionary for the economy.  That means the USG will need to borrow less to create the same number of jobs. Fear of Chinese “dumping” of US treasury bonds, even if it were possible, should be a non-issue, but since it plays easily into various geopolitical conspiracies, we seem to love to worry about it needlessly.

Among other strange comments the TIC data generated last week were those by the Financial Times, arguing that “if the latest numbers mark the beginnings of a diversification by China away from US Treasuries and other dollar assets, a widely speculated rise in the value of the renminbi against the dollar is on the cards.”  Aside from the fact that it marks the beginnings of no such thing, it still wouldn’t be an indication of any future RMB strategy.  A rise in the value of the RMB may very well be in the cards, but this has absolutely nothing to do with what Beijing did with its USG bond holdings in December.

Why?  Because if China had intervened less in December, the RMB would have already shot up – in December, not at some time in the near future.  Of course if the PBoC believes that a rise in the RMB will cause the dollar to fall against the euro, it might have swapped out of dollars into euros as a clever trade based on its inside knowledge of the RMB strategy, but since the opposite is almost certain to be the case, it is hard to believe that any PBoC net sales of Treasury bonds would indicate its plan to raise the value of the RMB.

The TIC data in December tells us almost nothing about what will happen to the RMB.  To see why, it makes sense to discuss a little how and why the PBoC has accumulated dollars, and what those dollars mean for China and the central bank.  Here, the first thing to recognize is that the PBoC does not “decide”, as a banker, to lend money to the US.  It basically has very little choice.

Beijing is not Washington’s banker

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit.  And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets.  Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision.  It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar.  Why?  Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price.  What it does is far simpler.  It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price.  That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency.

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market.  Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest.

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar.  In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear.  The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value, as the FT article suggested.

Of course the PBoC must fund the purchase of these dollars.  It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars.

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets).   Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits).

Here is where things get interesting.  China’s reserves are often thought of as if they were a treasure trove available for spending.  They are not.  They are simply the asset side of the mismatched balance sheet.  If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100.  To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes.  Reserves are effectively borrowed money.

Can PBoC reserves protect China?

So the PBoC cannot give away the reserves without causing an increase in its net indebtedness.  This is why I have often said, to the confusion of some of my readers, that Beijing cannot just recapitalize the banks with reserves.  A substantial amount of NPLs will one way or another increase government debt.  The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes.  Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.

So what are reserves good for?  As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China.  They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption.  They can only be used to purchase or pay for things from outside China.  This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically.  It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.

Here is where a great deal of confusion arises.  The US crisis of 2007-08 notwithstanding, we seem implicitly to believe that a financial crisis is always caused by an inability to repay foreign debt and investment, in which case having huge amounts of reserves certainly should protect a country from financial crises.

But this is only partly true.  Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility).  As I pointed out two weeks ago, there are many cases of countries with huge amounts of reserves that nonetheless suffered from all kinds of financial crises.  It is just that they never suffered from external debt crises.

When it comes to domestic debt crises, large levels of reserves actually can make things worse.  Why?  Because financial crises are always caused by mismatched and highly inverted balance sheets, and the central bank’s accumulation of reserves is exactly that kind of balance sheet.

Of course when the rest of the country has an equally mismatched balance sheet in the other direction – like when South Korean companies in 1997 had huge amounts of won assets financed by dollar debt – the central bank mismatch enhances financial stability.  It acts against the mismatch carried by the rest of the economy, and the net impact is that the economy is less vulnerable to financial crisis.  In that sense reserves are a kind of insurance to protect against excessive foreign borrowing.  Because South Korea, unlike China today, had too few central bank reserves against the rest of the country’s too-large dollar obligations, its overall balance sheet was mismatched and it was susceptible to a collapse of the won.

But China has very little external debt – certainly very small compared to its reserves – and so this clearly isn’t an issue for China.  But then could the huge mismatch on the PBoC’s balance sheet create the opposite risk for China?

Balance sheet mismatches

Yes and no.  And this is where another great misperception occurs.  Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves.  After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms.

This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency.  Unfortunately this kind of confused thinking is nonetheless the source of some strange claims.  One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.

Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become.  The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings.  Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt:

If the arguments presented for RMB revaluation by the US administration have no factual basis, why are they being put forward? The real answer lies not in trade but in debt – as other writers, such as Daryl Guppy, have rightly pointed out. In asking for RMB revaluation, President Obama’s advisers were, in effect, asking China to donate $150-$300 billion in RMB to the US via debt reduction.

The arithmetic of this is simple. China’s holdings of US dollar assets, chiefly Treasury Bonds, are around $1.5 trillion, or 10.2 trillion RMB. A 10 percent devaluation of the dollar vis-à-vis the RMB would reduce the value of these holdings to 9.3 trillion RMB, and a 20 percent dollar devaluation would reduce their value to 8.5 trillion RMB. In either case the U.S. is asking for its debt to China to be reduced by 10-20 percent in RMB terms.  It may now be seen why President Obama’s advisers have a vested interest in not examining the factual situation of China’s trade. They are seeking a large debt relief package.

Sigh.  The arithmetic is apparently not as simple as it seems.  When one of my central-bank seminar undergraduates showed me this article in December, he was chortling with glee at its bad economics and suggested I used the article to teach the freshman class – the assumption being that no PKU finance student above the level of freshman could have ever made this kind of conceptual mistake.  Perhaps not, but certainly anyone writing about currency policy should have at least done the math first.

Although this article is more confused than most about the impact of an appreciation on central bank reserves, it is worth explaining why it is wrong so as to address the less excitingly conspiratorial mistakes made by the merely confused.  First, can an appreciation of the RMB reduce the cost to the US government of its debt obligations?  Of course not.

The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets.  Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt.  After all, if a revaluation of the RMB causes the euro to drop against the dollar (a highly plausible outcome), could it possibly be true that the USG would reduce its payments on $100 of obligations owed to Chinese investors while increasing its payments on $100 of obligations owed to European investors?  Exactly how would this work?

Are there no winners and losers?

It wouldn’t.  The claim is nonsensical and violates simple arithmetic.  But if the RMB is revalued are there no losses and gains anywhere?  Yes, of course there are, but the distribution of these gains and losses is completely different from what this article claims, and depends wholly on the structure of various balance sheets.  In a nutshell, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains.

First of all, will China as an economic entity lose?  Leaving aside the vigorous discussion about whether an RMB revaluation will increase or reduce China’s long term growth prospects (I think it will), the net balance-sheet impact of a revaluation depends on whether China is net long or net short dollars.  There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio.  The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.

Some people might make a more sophisticated argument that since China is a net creditor – i.e. it is net long dollars – it will lose by a revaluation of the RMB.  This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one.  It does not “realize” the loss, however, until it revalues the RMB to its “correct” value.

In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation.  It occurred the very day the trade took place.  When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB.  This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB.

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter).  Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that.  The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take.

So a revaluation of the RMB will not cause any real loss to any Chinese entity today.  The loss already occurred but hasn’t been realized.

But wait, if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms.  Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations.  And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss.  It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it.  So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

Wealth is transferred within China

But that doesn’t mean nothing at all happened.  Although the Chinese overall balance sheet is probably a little better off with the revaluation, within China there are a whole set of winners and losers. Which is which depends on the structure of individual balance sheets.  Basically everyone who is net long dollars against the RMB loses in an appreciation, and everyone who is net short dollars against the RMB wins.

Who loses?  Of course the PBoC is a big loser.  It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.

Exporters and their employees, too, are naturally long dollars and so they would lose.  They are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.

Chinese companies with more assets abroad then foreign debt might also lose.  Who wins?  Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life.  The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team.  Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB.

Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country.  Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption.  This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China.  But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them?  Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts.

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP.  This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss.  (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be).   In that sense it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.

I apologize for such a long post, but I promised several people that I would try to address some of these issues, and it is hard to do so briefly.  In short, what the PBoC does to the value of the RMB and how it invests its reserves matter a lot to China and the world, but not always in the way China and the world think.  To get it right, we need to keep in mind the functioning of the balance of payments, the PBoC and other balance sheets, and the way the two are interrelated.

Tags: Balance sheets, Policy, wages

I am still working on my piece on the global savings adjustment and will probably post it in the next week or so. The main point is to discuss what the implications are for China if we see simultaneously over the next few years an increase in US savings and a reduction in global investment. For today I wanted to discuss some of the economic data coming out of China as well as a couple of debt-related issues.

US debt and the dollar

But first, a quick digression. Today’s Financial Times has an article titled “Fears over US sovereign debts unfounded” which, as the title implies, argues that “Fears of a crisis of confidence in the US sovereign debt market – and a subsequent dollar collapse – are unfounded.” On a related note Bloomberg has an article today which notes that “Russian Finance Minister Alexei Kudrin said the dollar is in ‘good shape,’ further affirming that there’s no substitute for the world’s reserve currency.”

It’s great that commentators are coming back, however temporarily, to a sense of reality and common sense. There never was likely to be a crisis in the ability of the US government to fund its deficits, and all the pleading to foreign governments to continue purchasing dollar assets was based on very fundamental misunderstandings of both the form of the global adjustment and the functioning of the global balance of payments. For the former, the problem we are facing is that as Asian savings soared over the past decade, they were accompanied by a collapse in US savings. This is not a coincidence. An increase in savings in one part of the world requires a reduction in another, and causality can work either way, so please dear readers spare me the whose-fault-is-it outrage – it is not relevant here. The point is that without a marked increase in global investment, one requires the other.

The collapse in US savings was unsustainable, and it is now reversing. This creates a problem of excess global savings, which means financing deficits for creditworthy governments is not going to be a problem and will not result in soaring real interest rates. In fact Paul Krugman has a brief piece, based on numbers from Brad Setser, that shows the explosive rise in US government debt is more than matched by the contraction in household debt.

This is just another way of saying the same thing. Of course I will add my by-now-tiresome point that we do not have to worry about discretionary decisions by foreign governments as to whether or not they will continue financing the US fiscal deficit. Foreigners do not finance fiscal deficits. They finance current account deficits, and one (the current account deficit) cannot occur without the other (the financing). As long as the US runs trade deficits with China (or Russia or anyone else), those deficits will be financed, and the only thing that will stop that is a contraction in the US trade deficit, which is actually expansionary for the US economy and will reduce the need for fiscal expansion.

Remember, the US can force foreigners to invest $2 trillion a year in the US by the simple expedient of running a $2 trillion annual trade deficit. But this cannot possibly be a good thing. If we want the trade deficit to go down, we must also want foreign financing of the US to go down by exactly the same amount. This is not high-falutin’ economic theory, it is rather an arithmetical necessity. (By the way I tried to explain something related this Saturday when, on CCTV9’s Dialogue, two points were made – that the contraction in the US trade deficit was causing great pain in China, and that Chinese officials were warning the US government sharply to reduce its fiscal borrowing. China cannot ask both that the US slowdown its contraction in consumption and that the US government slowdown its fiscal expansion. It is precisely the growth of the US fiscal deficit that will cause a slowdown in the contraction of US net consumption.)

The second point, that the dollar is still in “good shape” as the world’s dominant reserve currency, should be obvious. I have not gotten around to writing why all these spectacular (or spectacularly reported) moves by China and others to “undermine” the reserve status of the dollar – announcements by Putin, currency swap arrangements between China and a host of countries desperate for cash, the announcement by a major Chinese banks that it will make the RMB available for international transactions, and so on – are all of almost no consequence except to the paranoid. At some point I will write more about it.

Debt and risky debt structures are rising

Let me turn to debt. Last week Andrew Batson had a very interesting, and very important, I think, article in The Wall Street Journal, discussing the impact of the stimulus on the government’s real debt position. “The cost of China’s stimulus program,” he writes, “is turning out to be much larger than official figures indicate, raising the stakes for the government’s attempt to restart high growth through massive borrowing.” He points out that a lot of the spending is being funded by provincial and municipal borrowings and by corporate borrowings, “virtually all of which are indirectly backed by local governments.”

He concludes: “As the central government is ultimately liable for those hidden debts, China’s total state debt is closer to 35% of GDP than the 18% shown by official figures.” In fact I have always argued that other not-yet-recognized liabilities, such as hidden municipal and government debt, the bankrupt AMCs, and other non-recognized debt, probably means that real government debt levels are higher than the official numbers by at least 15-25% of GDP, which suggests that, correctly counted, government debt levels may now be approaching 50-70% of GDP. If we throw in the possibility that the current bank-lending spree is also likely directly or indirectly to add to government debt burdens in the future (contingently, through a rise in NPLs), I would not be surprised if policy-makers are already starting to consider the possibility of a debt problem at the central government level. I am not saying that this must happen, but only that it is easy to construct some fairly plausible scenarios, involving the continuing global adjustment and the concomitant Chinese adjustment, that can easily suggest a debt problem.

My concerns of course were not made more palatable after I saw a very interesting article in last week’s Caijing (and what other magazine would have reported this?), with the unsettling subtitle “The property market bubble burst last year, but developers are still afloat thanks to governments, banks and a ’subprime’ solution.”

The article notes how unlikely it is that the massive contraction and the difficulties in last year’s property market were not accompanied by high-profile failures among property developers. This is because, they explain, “local governments and banks have intervened to prop up Chinese property developers following last year’s sharp contraction in the real estate market,” and they show how this has happened.

Focusing on the case of Greentown China Holding Ltd, a large property developer that nearly went bust, they write:

Greentown faltered in the fourth quarter 2008 and stood on the brink of liquidation early this year. But it survived after a bank agreed to refinance foreign debt and a local government approved a grace period for land payments. Moreover, trust funds that use what at least one expert called a “subprime” scheme offered flexible financing for development projects.

Shou said his company has dodged the crisis. But he admitted that pulling through 2008 was extremely difficult. Indeed, Greentown saw a 10 billion yuan gap between its 2008 sales target and actual results. And debt payments loom for 2009.

The article’s authors, Zhang Yingguang and Gong Jing, go on to draw the unwelcome conclusions:

Industry executives think similar, short-term rescues for major property developers have occurred more frequently in recent months than generally acknowledged. For evidence, they point to the absence of high-profile failures in the industry.

This suggests that there are a lot of very dodgy debt deals out there that are based on nothing more than hopes and prayers. This doesn’t imply, of course, that all these deals will go bad. What I am worried about is something a little different – the highly pro-cyclical nature of these deals. If China recovers, these deals will probably do fine and will be repaid, and so will never show up as contingent debt, but if economic conditions deteriorate of course that is precisely when they will go bad.

And of course that is precisely when we most desperately don’t want them to go bad. Throughout history credit bubbles always end up, in their later stages, with these kinds of highly pro-cyclical structures (read about investment trusts in the 1920s for example, or the Japanese real estate and lending markets in the 1980s, or, in case you’ve already forgotten, the sub-prime market not so long ago). As long as economic conditions and liquidity-driven asset prices continue to improve, these highly unstable structures survive and prosper, but just when you most desperately want to avoid their breakdown, when conditions turn nasty, they come crashing down on you. These kinds of structures are what I call in my book (The Volatility Machine) highly “inverted” structures and they systematically increase volatility by reinforcing both good times and bad times.

Recent economic data

Finally, as everyone knows by now, a number of economic indicators were released last week, some good some bad. Some of the good news, according to an article in the South China Morning Post, was:

The National Bureau of Statistics said in Beijing that annual industrial output growth rebounded to 8.9 per cent in May from 7.3 per cent in April, outpacing a median forecast of 7.5 per cent. Annual growth in retail sales rose to 15.2 per cent in May from 14.8 per cent in April, slightly ahead of forecasts, partly due to a moderate pace of deflation.

For all of last year, retail sales were up 21.6 percent. Together, the two read-outs suggested a 4 trillion yuan (HK$4.5 trillion) government stimulus plan, allied with consumer spending, is starting to overcome weak global demand for the exports that powered the country’s breakneck growth in recent years.

Accompanied by the rise in US retail sales, this indicated to many that the Chinese stimulus package is working and that the global and Chinese economies may have bottomed out. In the author’s words, “A growing conviction that the global economy is starting to claw its way out of the deepest recession in six decades has seen stock markets rallying strongly from the depths plumbed in March, while hopes of burgeoning demand have driven prices of oil and industrial metals to multi-month highs.”

The next bit of good news was mainland investment levels. According to another article in the same paper:

Mainland investment surged in May on the back of government pump-priming and a recovery in the property sector, providing fresh evidence that the world’s third-largest economy is leading others on the path to recovery.

Investment in urban areas in fixed assets such as apartment buildings and roads rose 32.9 per cent in the first five months from a year earlier, compared with a 30.5 per cent rise in the first four months, t he National Bureau of Statistics said on Thursday.

Economists said that translated into a 40 per cent leap in May alone. Adjusted for inflation, the increase was even greater because mainland prices have been falling for several months.

Actually I think this is not good news at all. To me it indicates nothing more than that if you pump enough money into investment, investment will rise. A much more important question, and one of course not addressed by the data, is whether pumping money into investment is the best way to force the necessary adjustments in the Chinese economy, and whether this does not represent a ‘doubling up” of china’s bet on the global recovery. That is something only time will tell, and I have written about this enough times elsewhere to leave it at that.

The bad news is that, according to a release today by the Ministry of Commerce, foreign direct investment in the mainland dropped 17.8% year-on-year in May for the eighth straight monthly fall. Honestly I don’t think this is such a big deal except to the extent that it gives us a “businessman’s” view of economic prospects in China that is very different from the economic-recovery view so popular in the Chinese (and foreign) press, although of course it may simply reflect the desire abroad for cutting exposure and cutting capacity.

Much more interesting to me is the trade data. According to an article in Thursday’s People’s Daily:

China’s exports and imports shrank for the seventh month in row in May, the General Administration of Customs said on Thursday. Exports fell 26.4 percent in May from the same period a year ago to 88.758 billion U.S. dollars. Imports were down 25.2 percent to 75.36 billion U.S. dollars. The trade surplus was 13.39 billion U.S. dollars.

The decline in exports and imports in May were worse than the 22.6% fall in April’s exports and the 23.0% drop in April’s imports, although Goldman claims that the decline is more or less flat if measured on a seasonally-adjusted basis.

April’s and May’s trade surpluses ($13.1 and $13.4 billion) were substantially below the equivalent numbers last year ($16.7 and $20.2 billion), so from that point of view we can argue that China is finally starting to reduce the negative net demand it provides to the world. Two caveats are in order, however. First, for the first five months of the year, China’s trade surplus is still up more than 13% compared to last year – $89.1 billion in 2009 versus $78.6 billion in 2008.

Second, imports would have fallen much faster except for the surge in commodity imports. Jamil Anderlini at the Financial Times gives one, benign, explanation for the surge:

Chinese import volumes of many commodities and natural resources surged in May, indicating a rebound in infrastructure building. That supported figures on Thursday showing fixed-asset investment was 32.9 per cent higher in the first five months of the year, compared with the same period in 2008, an implied rise of 38.7 per cent in May alone from a year earlier.

Keith Bradsher, in an article in Wednesday’s New York Times gives possibly a very different explanation:

Strong buying by China has helped lift commodity prices around the world this spring, but growing evidence suggests that a sizable portion of this buying has been to build stockpiles in China, and may not be sustainable.

At least 90 large freighters full of iron ore are idling off Chinese ports, where they face waits of up to two weeks to unload because port storage operations are overflowing, chief executives of shipping companies said in interviews this week. Yet actual steel production from that iron ore is recovering much more slowly in China, and Chinese steel exports remain weak.

Commodities and shipping executives describe Chinese stockpiling in recent months of a range of other commodities as well, including aluminum, copper, nickel, tin, zinc, canola and soybeans. Starting in April, China began stockpiling significant quantities of crude oil.

There have been rumors and some evidence of stockpiling for months, and if this is the case, and of course if the stockpiling is not sustainable, then the import numbers are likely to have been artificially boosted. Real demand by China for foreign goods will have actually been much lower.

Of course all of this has a trade impact. Regular readers don’t need me to rehash the arguments. Suffice it to say that the Chinese fiscal stimulus, rather than an adjustment to the new economic realities, in my opinion, is still based on boosting production and investment and constraining consumption, in spite of statements to the contrary (for example today’s People’s Daily has another front page article in which Premier Wen “stressed the importance of promoting domestic consumption”).

Unless the world recovers rapidly and sustainably and, more importantly, US consumers return to the heady days of financing their consumption by binge borrowing, we are going to need to see a greater trade adjustment in China. Trade tensions are not improving. Last week I had dinner with a very senior China manager at a large German company and he told me expected anti-dumping suits to surge in the first quarter of next year. As if to beat him to the punch yesterday’s Financial Times came up with this story (“China accused of predatory pricing practices”):

India’s small and medium enterprises have warned that they are suffering because of cheap imports from China. They are urging New Delhi to accelerate anti-dumping investigations and impose tougher safety and quality checks on Chinese products.

The appeal for greater government protection came amid rising tensions between New Delhi and Beijing over trade, after a high-profile dispute over an Indian ban on Chinese made toys. India’s Federation of Chambers of Commerce and Industry said on Sunday that a survey of 110 small and medium-sized manufacturers found that about two-thirds had suffered a serious erosion of their Indian market share over the past year, because of cheaper Chinese products.

In its statement, FICCI said the Chinese imports were between 10 and 70 per cent cheaper than comparable Indian products, a price differential that it said was “huge and difficult to explain”. Amit Mitra, the FICCI’s secretary-general, said Indian industries were being hurt by “typical Chinese predatory pricing” intended to drive rivals out of business so that Chinese companies could capture the market – and then raise prices to more normal levels. The bite was felt by companies in a range of sectors, including processed food, light engineering, building materials and heavy engineering, chemicals and textiles, FICCI said.

The fact that Indian wages are lower than Chinese wages is probably not enough to compensate for China’s much better infrastructure, but there are other reasons for the price differential. I discussed some of these reasons in an entry earlier this month.

Tags: Greendown

Beijing music and art

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

So what does the New York Times article say?

 

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

 

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

 

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

 

A new reserve currency

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Unemployment

 

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

 

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

 

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

 

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

 

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

 

The article goes on to say:

 

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

 

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

 

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

 

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

Tags: Art bubble

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

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

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

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

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

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

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

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

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

According to an article in today’s Xinhua:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tags: Art, Irving Fischer

Yesterday in a meeting I was asked by an investor why, even while I have been writing maniacally about the crucial importance of global cooperation, I was so consistently pessimistic about the possibility of the major economies arriving at a “grand bargain” that will minimize over the long term the cost of the current crisis. I think, in fact, that a nasty fight over trade is very probable and I worry that not only will trade conflict come as a huge shock to China’s economy, but also that Chinese actions and public statements are actually contributing more to that probability than all the buy-America, buy-Europe talk filling the air.

Let me pluck one reason from the headlines of today’s People‘s Daily, the official mouthpiece of the country’s ruling party. The article, titled “Buy American can’t save the US economy”, is based on interviews with a number of Chinese commentators. One question:

Why does the US, which has always advocated trade liberalization, put forward such a clause? Can the “Buy American” provision offer effective solutions to the US’ economic problems? What impacts will the implementation of this economic plan produce?

All the responses are the same. The US, according to this article, is playing dangerous games with global trade even while Chinese policymakers are trying to hold back the tide of protectionism. The response by Song Hong, Director of the Research Section of International Trade at the Chinese Academy of Social Sciences (CASS):

The US is a country that has a tradition of free trade. But the US Congress has tarnished its own reputation with narrow-minded and selfish acts that place US interests above global interests. During the 1930s, the Smoot-Hawley Tariff Act enacted by the US Congress greatly aggravated the global economic crisis. Today’s situation seems to repeat that historic tragedy.

It is really worrying that the stupid and destructive Smoot-Hawley Act, which was terrible not because it was passed by the US but because it was passed by the country with the largest export of overcapacity in the world at the time, is perceived by some as something that can only happen in the US, and not in China. On the contrary, US policies can be extremely unhelpful, of course, and it would come as no surprise to me that many of their policies turn out to be harmful to US and global interests, but the US cannot possibly engineer a repeat of Smoot-Hawley’s disastrous impact on global trade and the US economy. As the largest trade deficit country in the world anything that results in a contraction in net US demand is not only not bad, it is a necessary part of any adjustment.

The US cannot give us another Smoot-Hawley. In 2009 only China and Germany are really in a position to enact the current version of Smoot-Hawley – to engineer polices that expand their massive export of overcapacity or, what amounts to the same thing, their massive import of demand – and if you want to figure out who might be doing it, you need only to look at the direction of trade surpluses.

The response by Li Quan, Deputy Director of the Department of International Economy and Trade at Peking University, to the questions posed by the People’s Daily was:

The reason why the US emphasizes the protection of the steel industry is that its steel sector is a declining industry that does not have any international comparative advantage. At the same time the sector is of strategic importance to the US, as evidenced by the fact that Steel City Incorporated, based in Florida, has close relations with the US government. As a matter of fact, in 2002, following the September 11 attacks, the US openly raised the rate of import duties on iron and steel in order to protect its own steel sector. EU countries complained about US protectionism and submitted the case to relevant institutions of the WTO for judgment, eventually leading to the US’ defeat.

Although I agree with Professor Li about the value of the steel industry to the US, what depresses me about the prospects for trade war is that there doesn’t seem to be any recognition on his part that boosting steel production by any country is harmful to the global adjustment process. Apparently only American boosting of steel production is. I just don’t think this makes sense.

Very ironically the same issue of People’s Daily has another headline: “China announces stimulus plans for nonferrous metals, logistics.” The article starts:

China’s State Council on Wednesday announced support plans for the country’s nonferrous metals and logistics sectors. Presided over by Premier Wen Jiabao, Cabinet members agreed to promote company restructuring and will offer subsidized loans to support technical innovations within the nonferrous metals sector. The export rebate rates of nonferrous products should be adjusted, said the Cabinet without elaborating.

That’s not all. Today’s Xinhua helpfully lists China’s stimulus package for ten different sectors announced between January 14 and today. These consist of machinery, textile industries, shipbuilding, autos, steel industries, electronics and information industry, light industry, petrochemical sector, nonferrous metals and logistics.

Nearly all of these products are in global oversupply, so the full focus must be on boosting consumption, right? Wrong. A quick run-down of the related article shows that some of the measures are certainly pro-consumption:

• provide subsidies for home appliances for rural buyers
• boost demand for petrochemical products
• lower the purchase tax on cars
• provide one-off allowances to farmers to upgrade their three-wheeled vehicles and low-speed trucks
• improve the credit system for car purchase loans

But too many of them are actually likely to decrease Chinese contribution to global consumption (i.e. increase its negative contribution) by acting more to boost production than consumption:

• promote company restructuring and offer subsidized loans to support technical innovations within the nonferrous metals sector
• adjust export rebate rates of nonferrous products
• lift processing trade restrictions on some labor-intensive, technology-intensive, energy-efficient, and environment-friendly products
• provide more credit access for firms in the petrochemical sector
• boost innovation in information technologies (whatever that means)
• increase financial input for the country’s electronics and information industry
• give tax rebates for electronics and information product exports
• encourage large auto companies, as well as major auto-part makers, to expand through mergers and acquisitions so as to optimize resources and improve their competitiveness on the international market (does this mean prevent bankruptcies?)
• increase credit support for ship builders
• suspend construction of new docks and the expansion of slipways (which doesn’t increase production but, I think, might slow investment-based consumption)
• increase export rebates for textile producers
• help auto manufacturers raise their share of the auto market in China from 34% to 40%
• create a special textile-industry fund for structural adjustment and technological upgrading

The problem, as I see it, is while an awful lot of experts here are busy explaining why the US must be careful about how quickly it reduces its contribution to global demand, which the US absolutely must do as part of its adjustment process, they seem to miss the point that China must increase its contribution to net demand, but it is actually reducing it. It may be confusing to many if I claim that subsidizing credit to steel producers or auto manufacturers is the 2009 equivalent of Smoot-Hawley – after all isn’t Smoot Hawley all about tariffs? – but the point is the reason Smoot-Hawley was such a disaster is because it involved an attempt by the largest trade surplus country in the world to increase its trade surplus in spite of collapsing world demand, and the 2009 equivalent must necessarily be Chinese or German moves that have the same effect.

And for my Chinese readers whose hackles are being raised by all this “criticism” of Chinese policy, please know that I am not pointing all this out in order to provide ammunition for trade warriors in the US and Europe. I am only pointing it out because there is a real and growing risk that while busily crying “Smoot-Hawley” at the US, China is going to blunder its way into the same terrible mistake the US made in 1930, and my conversations with US and European officials convince me that frustration levels are already too high. Needless to say it is not just readers of my blog who have noticed that China’s trade surplus has risen inexorably during the time this crisis has taken place, and even a very superficial reading of the world press suggests that this is causing rising anger. Trade conflict would be terrible for China, and I don’t see how it can end well for China if something doesn’t change soon.

It’s not that no one in China understands this. Nearly all of the non-government economists I speak to (ok, maybe not a representative sample) are worried by the direction events are taking and many of them are even more pessimistic than I am about the prospects for trade conflict. The WSJ blog translated a very interesting comment by the PBoC. According to their translation:

China has a problem of high savings and low consumption. For a long time our country’s economic growth has been mainly driven by investment and exports, and the ratio of final consumption [in gross domestic product] has been in a gradual declining trend. The share of investment [in GDP] has steadily risen from 36.6% in 1992 to 43.5% percent in 2008, while the share of consumption has dropped from 62.4% in 1992 to 48.6% in 2008, well below the world average. The high share of investment and exports and the low share of consumption are not conducive to the healthy and stable development of the economy.

The significant slowdown in global economic growth and the great downside risks for the future will directly affect China’s exports and investment in the tradable [goods] sector. Since external demand is inadequate, the driver for economic growth must come from increasing investment or consumption. Because the investment-led model of economic development increases the pressure on resources and environment, leads to a widening of the income gap and urban-rural inequality, and can easily lead to large fluctuations in economic growth as serious excess capacity emerges in some industries, it cannot be sustained for the long term. Therefore it is necessary to, in accordance with the requirements of the “scientific outlook on development,” speed up the transformation of our economic development model, and strengthen consumption as a driver of economic growth, in order to achieve a balanced growth pattern based consumption, investment and exports.

The PBoC is right, of course, but what I would add is that they need either to speed up the process very rapidly so as to head off rising trade frictions (very difficult at best), or they need to get together with the US and Europe and work out a viable long-term plan that will allow them to adjust at a reasonable pace while heading off trade conflict.

Meanwhile more of the wrong kind of news comes from Goldman Sachs, via an article in today’s Bloomberg:

China investors should be “defensively positioned” as a decline in the nation’s tax receipts signals a steeper slowdown in spending than retail sales figures show, according to Goldman Sachs Group Inc. “Tax data show much sharper deceleration in income and consumption in the past few months than suggested by official retail sales or income growth figures,” Goldman Sachs analysts Joshua Lu, Caroline Li and Fiona Lau wrote in a note today.

Value-added tax has “de-linked sharply” from retail sales figures, the analysts wrote. VAT rose 1 percent in the fourth quarter from a year earlier, while retail sales gained 21 percent, according to the note.

…Growth in China’s individual income-tax receipts “slowed down significantly” in the second half and shrank in December and January, the Goldman Sachs analysts wrote. This compares with nominal wage growth of 21 percent in the third quarter, the report said. “We think the government’s fiscal stimulus package announced so far may help create jobs, but may not necessarily help boost wages which, in our view, is the key driver of consumption growth,” the note said. “As such we are not hopeful that China’s consumption slowdown will bottom out soon.”

I am not smart enough to figure out whether or not Goldman’s methodology makes sense, but the furious drop in imports relative to exports makes me anyway doubt any evidence that Chinese consumption isn’t slowing sharply.

Tags: Goldman Sachs, People's Daily

The LA Times came out Saturday with a widely-noticed article on Beijing real estate, which features my friend Jack Rodman. Jack, who runs a firm called Global Distressed Solutions, is a bad-loan and distressed real-estate expert who has spent the last several years in China, and somehow has the energy to poke around among all the spectacular buildings in Beijing and other cities, worm his way in, and see if behind the beautiful façades there is actually some semblance of economic viability.

Apparently not. According to the article:

By Rodman’s calculations, 500 million square feet of commercial real estate has been developed in Beijing since 2006, more than all the office space in Manhattan. And that doesn’t include huge projects developed by the government. He says 100 million square feet of office space is vacant — a 14-year supply if it filled up at the same rate as in the best years, 2004 through ‘06, when about 7 million square feet a year was leased.

…To its credit, the government recognized in 2007 that the real estate market was headed toward a bubble, economists say. In an attempt to make real estate more affordable, restrictions were introduced on ownership of second homes and on foreign home buyers. But the measures came too late, accelerating the crash of an already weakening market.

The Beijing Municipal Bureau of Statistics reported this month that housing sales in the city dropped 40% last year. Chinese economists have predicted that housing prices will drop 15% to 20% in Beijing this year. Shanghai has experienced a similar decline.

Any conversation about Chinese real estate with Jack is likely to be depressing because his terrible stories aren’t much relieved by vagueness. Unfortunately he probably knows as much about the real estate market as anyone, and his conversation tends to be pretty specific and avoid the kinds of generalizations that we often make here, given the difficulty of getting hard data about some of the problems. When Jack talks about empty buildings he gives actual addresses.

And it’s not just foreign newspapers that are warning about real estate trouble. China’s leading independent business weekly, Caijing, also has an article this week that discusses the real estate mess:

Battered by global financial turmoil, foreign investors are moving quickly to liquidate stakes in Chinese property developers. The market is sinking, and investors are eager for a way out. Real estate developers, including some of the nation’s largest, are fighting to stay afloat. And so far, none have declared bankruptcy.

But key developers who snapped up land and, sometimes in a desperate scurry for cash, signed deals with equity funds and investment banks during China’s property market boom are now slipping toward loan defaults and failure.

Worries about the real estate sector are nothing new, of course. The important issue, for me, is the impact of problems in the real estate sector on the banking system. The LA Times article goes on to explain why:

The situation could get worse. Most of the real estate has been financed by Chinese banks, which have avoided writing down the loans. Eventually, they will be forced to, and that probably will have a ripple effect throughout the economy.

The problem is actually a little messier than that. There have been rumors for over a year that with the forced credit contraction of last year a lot of the riskier real estate developers had to turn to the informal banking sector for loans, and it is not at all clear to me how these get resolved in case of payment difficulties. I am assuming – like, I think, most others – that the government will want to avoid a rapid liquidation of bad loans by the banks. They will not want banks to seize collateral and sell it off for fear that this would cause the market to collapse and would result in the kind of debilitating debt deflation that Irving Fischer described in the 1930s, in which assets are liquidated to meet loan payments, causing asset prices to fall, which puts additional downward pressure on loans, and so on in a self-reinforcing cycle.

Now it is not clear to me that this kind of liquidation is always harmful. A strong argument can be made, and has often been made, that the liquidation process makes a crisis feel worse in the short term, but results in a much faster recovery because at some point very low prices create economic value to businesses of owning the assets, and their use of these assets can fuel a rapid recovery.

The classic case is the massive railroad building program in the US in the 1860s and early 1870s, which left the railroad owners saddled with expensive assets which required passenger and cargo rates that were too high to be useful to most potential passengers. Many of the railroads were never able to stop losing money. When these railroads went bankrupt after the 1873 collapse, and were subsequently liquidated, new owners were able to buy them for pennies on the dollar, and so were able to make them profitable while charging much, much lower freight and passenger rates. These lower rates sparked an economic boom by sharply reducing transportation costs, and the final value to the economy was much greater than the initial losses on the railroad assets.

The worst case, by this thinking, is if assets that are not viable at current prices are effectively taken off the market because the owners are not forced to liquidate, in which case they become a pure deadweight for the economy. The counterargument, of course, is the Fischer argument – that forced liquidation is inherently less stable because it causes a self-reinforcing cycle of price collapses.

I am not able to say which argument is correct, and anyway this sounds as much like a political argument as an economic one, but it is worth considering what might happen in China. The consensus, and I agree with it, is that the government is far more concerned about avoiding short term instability than about promoting long term viability, and so will make every effort to force banks to stretch out the restructuring process, avoid panic liquidations, and take assets off the market.

This policy can work with the formal commercial banks, but what is less clear to me is how the liquidation process will work in the informal banking sector. I am not sure whether pressure can be placed on the informal banks to prevent liquidation without seriously interfering with a wide range of market and governance mechanisms. Certainly rumors about some of the fairly brutal collection mechanisms in parts of the informal banking sector suggest that creditors might not be too eager to confront lenders. Unfortunately I do not have much of a sense of whether this process is already taking place. If any of my China-based readers knows more about this, I would really appreciate some help.

For those who find this topic of great interest, there was a fascinating article in Friday’s South China Morning Post.

With the mainland economy tanking to its slowest growth rate in seven years and banks wary of lending as defaults rise, small business operators are hocking belongings and company assets for loans from pawnshops. “Banks are reluctant to lend,” says Huang Jing, deputy business manager at Shanghai Oriental, the city’s second-biggest pawnshop. “But we have a lower threshold and can provide loans much more quickly and with shorter terms.”

Banned at the start of the Cultural Revolution, pawnshops were considered a form of capitalist exploitation that preyed on poor and desperate people. They were outlawed for two decades, until 1987, but now they do a brisk trade. From gold bullion to houses and factory equipment, customers offer a variety of assets to get loans from pawnbrokers.

Quoting Wang Fuming, chairman of a pawnshop with about $1 billion in loans, two-thirds of which are to small and medium businesses (Chinese pawnshops are huge compared to their Western counterparts and can include hundreds of branches and are actually, funnily enough, among the most efficient parts of the country’s banking system), the article goes on to say:

“About 90 per cent of small businesses in Shanghai fail to get bank loans,” Wang says. “The problem is more severe with a weak economy.” The central government has eased its monetary policy and urged banks to lend, with January lending showing a record rate of growth. Yet most new loans are directed at the country’s 4 trillion yuan economic stimulus plan and state-owned companies.

This quote about the difficulty of small businesses in Shanghai to get loans reminds me of the point, very forcefully made, by MIT’s Yasheng Huang in his excellent new book, Capitalism with Chinese Characteristics, about the difficulty small entrepreneurs have had after the reforms in the 1980s. For Huang Shanghai is Exhibit A in his claim that there has been a reversal away from a market economy to a state-led economy in the past fifteen years. He especially mentions that as the commercial banks turned mainly to funding SOEs, it was the informal banking sector that took on the bulk of the financing for SMEs.

Meanwhile, speaking of funding SOEs, there is a lot of talk in the markets about second big stimulus package aimed at delivering more consumer spending (“A second big stimulus package?” some unkind folk may wonder, “Did I miss the first?”). The front page of today’s People’s Daily has an article with the large headline “Communist Party leadership warns of ‘austere’ year for China.” It goes on to say:

The ruling Communist Party of China (CPC) said Monday the country will launch a comprehensive economic package to tackle an “austere and complicated” year ahead.

“We will increase large-scale government investment, implement and readjust a plan to revive industries, make great efforts to boost innovations, and greatly enhance the level of social security,” said a press release issued after a meeting of the Political Bureau of the CPC Central Committee. The meeting was presided over Hu Jintao, general secretary of the CPC Central Committee.

Meanwhile Xinhua yesterday reported PBoC concerns about deflation:

China’s central bank on Monday warned of deflation in the near term caused by continuing downward pressure on prices. Commodities prices were low and weak external demand could exacerbate domestic over-capacity, the People’s Bank of China (PBOC) said in an assessment of fourth-quarter monetary policy. “Against the backdrop of shrinking general demand, the power to push up prices is weak and that to drive down prices is strong,” the PBOC said. “There exists a big risk of deflation.”

While assuring us that it would ensure ample liquidity in the banking system and promote the reasonable and stable growth of credit, the PBoC, along with the CBRC, also stated three days ago that it was planning to investigate the lending spike. According to an article in the current Caijing:

A dramatic increase in bank lending in January has attracted attention from investigators with China’s central bank and regulatory agencies, Caijing has learned.

The China Banking Regulatory Commission plans to investigate the huge cash flow after banks issued 1.62 trillion yuan in loans during the month. Notes trading represented 38 percent of the total credit. Some analysts have claimed companies may be using government-encouraged bank loans to invest in the Chinese stock market, which has rallied since the start of the year.

Until today the stock market had continued its upward surge – although the SSE Composite suffered a dizzying 7.5% drop last Tuesday and Wednesday on concerns that the PBoC investigation, if it determines that a primary cause of the recent market surge was bank lending to stock speculators, may pull the rug out from under the market. The overall surge, largely on speculation about which sectors are going to receive bailout packages from the government, has made China the top performer among global stock markets this year, with the SSE Composite rising about 20% year to date.

A lot of my Chinese financial market friends are very worried that small investors are rushing in too quickly and are likely eventually to get hurt, since what is driving the markets – as always – is not changes in fundamentals but rather rumors of government intervention. The game seems to be to guess which sector will receive the next set of rumors about government bailouts and to buy accordingly.

Even if the rumors are true, I think the market is ignoring how difficult it will be for profitability to revive and how even more difficult it will be for asset prices to stabilize. Even real estate companies have seen stock prices benefit from rumors, although the sector is in serious trouble and it is only because they are in such trouble that the government would consider supporting them. Still, this is always how the stock markets work here – it ain’t about fundamentals, its all about government rumors.

At any rate today, the market may have suddenly refocused on how bad the news outside is, falling straight down after its opening, led by commodity producers and insurance companies, with the SSE Composite losing 4.6% to close at 2200.1. If the next couple of days the market remains bad, the government will almost certainly make supportive noises, so I don’t know if this drop is a temporary fall before prices move up again, or if it is the beginning of a longer decline, but either way I think the market rebound has far exceeded any real basis for optimism. It will be much lower in a few weeks or months.

Tags: Jack Rodman, Pawnshops

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tags: Eichengreen

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tags: Eichengreen