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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tags: Inflation

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

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

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

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

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

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

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

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

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

Analysts: China’s inflation to continue easing in August

China economy “slowing but resilient,” HSBC report says

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

Crude oil plunge good for China economy, analysts

Economists: China’s economy still in shape

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tags: Consumer demand, Inflation, Inventories, Policy