Economics: China’s Loss, China’s Gains, China’s Plan, China’s Risk & Your Play Book


  • Too Slow A Move
By

Michael Pettis is a professor at Peking University‘s Guanghua School of Management

The PBoC has just announced that it is hiking the one-year lending and deposit rates by 25 basis points. Here is what Bloomberg says:

China raised its benchmark lending and deposit rates for the first time since 2007 after inflation accelerated to the fastest pace in 22 months. The one-year deposit rate will increase to 2.5 percent from 2.25 percent, effective tomorrow, the People’s Bank of China said on its website today. The lending rate will increase to 5.56 percent from 5.31 percent, it said.

China’s inflation quickened to 3.5 percent in August, highlighting overheating risks that have prompted the government to curb credit and clamp down on the real-estate market this year. Higher interest rates may encourage inflows of speculative capital from abroad, complicating management of the fastest-growing major economy.

This is definitely good news. It increases household income by raising the return on savings, which is a necessary part of the rebalancing process. It (very slightly) reduces the incredible incentive to borrow money and splurge on manufacturing capacity, investment and real estate development. And it signals that the PBoC is concerned about overinvestment.

But it is a pretty small move and very late. The PBoC has been, very unwillingly I think, behind the curve on interest rates. Most of us believe the PBoC has wanted to slow investment growth and to raise rates for quite a while now, but it isn’t easy to do so. One of the problems is that the economy – especially local and provincial governments and SOEs, not to mention the central bank itself – is so dependent on artificially low interest rates to remain profitable or viable, that even a small increase in interest rates can put pressure on cash flow and financial distress costs

Beijing hasn’t raised interest rates in nearly three years (December 2007), even though deposit rates are clearly negative and the lending rate may well be close to zero or even negative – depending on what you consider the right measure of inflation. There have been rumors about a rate hike for the past three weeks. Earlier this month Chen Long, my assistant at SWS, told me that there was a lot of talk about a hike in the deposit rate some time this month.

We thought it would be very unlikely that the deposit rate would be hiked without an equivalent hike in the lending rate. The very wide spread between the two (306 basis points for one-year maturities, which does not take into account the typical maturity mismatch between depositors and borrowers) is the main part of a bank recapitalization process which many believe necessary to protect the system from an anticipated surge in non-performing loans.

But Chinese borrowers are too dependent on artificially low interest rates for their viability, so we felt there really wasn’t much room to raise the lending rate. Our conclusion: the PBoC might raise both deposit and lending rates by up to 25 basis points, mainly as a way of reversing some of the decline in real lending rates during the past year, but they wouldn’t be able to do anything more aggressive.

The key is to see if they follow this up in the next month or so with more rate hikes, which I doubt, but it depends on what the balance of power is between the various economic views. More rate hikes would be great news for the medium term rebalancing process. Real rates in China have declined rapidly this year and, as I have argued many times before, this is a real problem for the economy. Declining real rates exacerbates China’s already serious over-reliance on excess investment. But I don’t think there is much they can do about it without causing a serious slowdown in growth, and before the leadership transition in 2012 I don’t think there is much appetite for a slowdown, no matter how badly needed.

New lending

On a related note the most interesting piece of news last week for me was the new lending number. Net lending grew in September by RMB 596 billion, a lot more than the expected RMB 500 billion. This may have helped convince Beijing that they needed to do something more drastic and probably helped the decision to raise rates.

New lending totaled RMB 6.3 trillion for 2010 year to date (84% of the RMB 7.5 trillion quota). To get a sense of comparison, in 2009 new lending in September was RMB 517 billion, with the year-to-date total being RMB 8,7 trillion (90% of the year’s RMB 9.6 trillion total). In 2008 new lending in September was RMB 378 billion, with the year-to-date total being RMB 3.5 trillion (71% of the year’s RMB 4.9 trillion total).

We are talking some pretty big numbers. Last week the PBoC also raised the minimum reserve requirements for the six biggest banks by 50 basis points. Here is what my assistant at SWS, Chen Long, said at the time:

The PBoC unexpectedly lifted the reserve requirement rate for two months by 0.5% for the 6 largest banks, which will freeze RMB 200 billion in the banking system. The PBoC’s open market operations had injected RMB 181 billion into the market with 3-month, one-year, and three-year bills and notes. Short-term money market rates dropped while long-term rates rose.

The RMB accelerated its appreciation this week, and we believe it will continue. USD remained very weak, but the RMB actually depreciated again a basket of currencies in the last week as other currencies (AUD, JPY, SGD and EUR) rose. What is happening now is exactly what we expected: Beijing is appreciating RMB, but does not dare to tighten the credit. Liquidity is very loose and is the main reason driving up the stock market.

It looks like there has been a lot of unsterilized money creation in the third quarter, driven at least in part by what seems to be a pick up in hot money inflows, and the reserve hike was probably aimed at mopping up some of that money. There is some concern that today’s raising of the deposit rate might cause an increase in hot money inflows, but I am skeptical. I don’t think 25 basis points one way or the other is going to drive hot money in such a volatile economy.

I suspect the PBoC actions on minimum reserves also represent what seems to be a split among policymakers. On the one hand for many, especially in monetary circles in Beijing, loan growth is already excessive and they are very worried about the implications of yet more investment. I discuss why both in last week’s Financial Times article and in an article in Monday’s South China Morning Post, where I talk about the implications for China of Japan’s post-Plaza Accord policies.

On the other hand many policymakers, especially I suspect provincial and municipal leaders and SOE heads, are opposed to any slowdown in loan growth that may cause a real decline in the growth rate of investment and so in GDP and employment growth. They have made it very difficult for the monetary “conservatives” to tighten their leash on new lending, and I wonder if the PBoC reserve hike, which probably doesn’t require state council approval, reflects PBoC worries. The small interest rate hike is also probably part of this tug-of-war.

Net new lending has to average 400 billion a month for the rest of 2010 if we are to make the quota. Let’s see if that happens. It averaged RMB 310 billion a month in the last three months of last year, although that number was distorted downwards by the explosion in disguised short-term lending earlier in the year.

I am betting that policymakers will be hard pressed to keep the numbers within the quota, but who knows? They may be determined this time around. There are very strong rumors that next year’s quota will be only RMB 6 trillion. This would be a good thing over the longer term (and may represent lobbying by the next generation of leaders), but it will automatically mean, unless we see an explosion in the fiscal deficit or in disguised lending, a sharp slowdown in growth – even more so if the trade surplus is forced down, as I expect it will be.

Michael Pettis picture
Michael Pettis is a professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate… More
  • China’s Loss
By

Scott Grannis was Chief Economist from 1989 to 2007 at Western Asset Management Company

The Chinese own about $1 trillion worth of Treasury securities, whose average yield is now probably in the range of 1-1.5%, and they are being forced to take a beating on those holdings. They are in a real bind, because they are being pressured to appreciate their currency by U.S. politicians who are sadly ignorant of how global trade and capital flows work, and by the Federal Reserve, the architect of the ongoing loss of the dollar’s value. In the past four months, China’s central bank has allowed the yuan to appreciate over 8% against the dollar in an attempt to alleviate those pressures.

China’s reasons for doing this are twofold: to appease U.S. policymakers who are arguing for a much more dramatic appreciation of the yuan, and to minimize the inflationary impact of being tied to a weak and falling dollar. Pegging its currency to the dollar is the cornerstone of China’s monetary policy, and if the dollar weakens, then the yuan also weakens, and this is equivalent to a monetary ease which will sooner or later show up as higher Chinese inflation. In fact, China’s CPI has already risen, on a year over year basis, from a low of -1.8% in July ’09 to 3.5% as of August ’10. The weakening of the dollar, which has carried the yuan down with it, is the proximate cause of this reflation.

Revaluing one’s currency doesn’t come cheap, however, especially when the currency you are revaluing against is also the currency in which the majority of your reserve assets are denominated. The appreciation of the yuan over the past four months has effectively wiped out a little over 3 year’s worth of interest on their dollar security holdings. Further yuan appreciation, which seems likely, will wipe out even more of the value of China’s foreign bond holdings. They are truly caught between a rock and a hard place.

This reminds me of the massive losses that Japan suffered as result of the appreciation of the yen, which rose from 250/$ in 1985 to 80/$ at its peak in 1995. This 200% yuan appreciation destroyed fully two-thirds of the value of the countless billions of dollar assets that Japanese savers had accumulated. Recall that Japan was a major export engine at the time, its aging population had a high savings rate, and the destination of choice for those savings—which were larger than could be accommodated by Japan’s own economy—was the U.S.

Remember the book “Rising Sun,” by Michael Crichton? His thesis was that the U.S. was monumentally stupid to allow the Japanese to buy so much of our real estate and so much of our industry. As a resident of Los Angeles, I recall that Japan’s purchases of a number of downtown office towers occurred almost precisely at the peak of real estate prices in the early 1990s. Prices then proceeded to drop by one-third, at the same time the dollar fell from 130 yen to the low 80s—real estate bought in the early 1990s lost over one-half its value when translated back into yen. Japan’s savers lost a fortune, thanks to the Bank of Japan’s extremely tight monetary policy. And as it turns out, Japan never acquired the nefarious control over U.S. industry that Crichton warned about in his book. On the contrary, we took them to the cleaners. We bought their cheap cars and cheap electronics; they invested their export earnings in the U.S., only to see a huge portion of those savings wiped out by the weak dollar/strong yen.

And so it is with the Chinese. They sell us mountains of cheap goods, then turn around and invest most of the proceeds (equivalent to our trade deficit with China) in U.S. Treasury securities. We get the goods, and we get to keep the money. Then we devalue the dollar, and they lose on their investment. Why we would want them to stop doing this is beyond me, though if I were a Chinese citizen, I would be furious with my government for directing such massive quantities of my country’s export earnings to Treasuries. The central bank of China has no need to further increase its already-massive reserves; instead, the government should be relaxing capital constraints, allowing Chinese citizens more freedom to save and invest abroad in the types of vehicles with which they feel most comfortable. China’s workforce is aging daily, and like Japan a few decades ago, China’s economy cannot accommodate all the savings of the Chinese people—they are essentially forced to save overseas.

Contrary to what you read in the press—which mistakenly believes that our large trade deficit with China is something we need to worry about—China is the one that needs to worry, not us.

Calafia Beach Pundit picture
Scott Grannis was Chief Economist from 1989 to 2007 at Western Asset Management Company, a Pasadena-based manager of fixed-income funds for institutional investors around the globe. He was a member of Western’s Investment Strategy Committee, was responsible for developing the firm’s domestic and… More

  • China’s Gain
By

John M. Mason formerly was on the faculty of the Finance Department, Wharton School

The Chinese central bank has announced that it will raise the one year lending and deposit rates by 25 basis points. This has been a major surprise to international financial markets.

One can assume that this move was done very deliberately and very intentionally. The Chinese do not make policy decisions unless they are well thought-out.

The immediate reason for the move at this time: later this week there will be a meeting of the G-20 finance ministers. Next month in Seoul, South Korea there will be a meeting of the G-20 leaders.

The move is not an accident!

The International Monetary Fund just completed meetings earlier this month in Washington, D. C. Before that meeting, the United States took a strong stand on the value of the Chinese currency and the behavior of the Chinese government with respect to this value. The United States made an effort to get other nations to criticize the Chinese position.

The result of the IMF meeting? Little to no pressure was put on the Chinese giving indication that the United States was having no luck in its campaign to bring the Chinese “into line” on the value of their currency. The United States looked weak. (See my post on this here.)

If China’s action on interest rates is followed up by China allowing for a faster climb in its currency, the yuan, the Chinese will strengthen the position of their government within the G-20. It would also strengthen the role of other Asian nations as well as other BRIC nations in negotiations concerning the future of the dollar as a reserve currency.

Thus, the Chinese would build on the exhibited weakness of the United States at the meetings of the IMF in Washington and help to consolidate other nations around its leadership in world economic affairs.

Is the United States and China at war?

In one sense they are. Martin Wolf at the Financial Times of London has written, “In effect, the US is seeking to inflate China, and China to deflate the US. Both sides are convinced they are right…” (See here.)

How has this situation developed? Well, in a real sense, the world has bifurcated. Part of the world, generally the developed countries, are struggling to restart their economies from the Great Recession, while many of the emerging countries are doing just fine, thank you.

The Federal Reserve System in the United States and the European Central Bank seem intent upon buying massive amounts of bonds to carry out a “Quantitative Easing” in an attempt to “jump-start” their economies. The prospect of this has resulted in a weakening of the dollar. This has not been looked on favorably by the emerging nations who are experiencing economic growth and even a potential threat of inflation.

As a consequence, several of the emerging nations have already taken actions to protect the value of their currency from the weaknesses seen in the American position. These nations have already considered control techniques to protect themselves from the fall in the dollar exchange rate. They are considering the possibility having dual exchange rates, one for trade payments and one for non-trade payments.

The threat here is that world will break into two currency areas, one that is dollar/euro dominated and one that is dominated by China and the other emerging nations. And, certainly, the possibility of some kind of financial controls on foreign exchange is not a settling thought.

The reigning problem to me is the failure of leaders, especially leaders in the United States and in other developed countries, to appreciate the changes that have taken place in the world. The continued focus of the leadership in the United States on stimulating internal demand so as to achieve something, full employment of resources, that they really can’t achieve, is leading them down the path of isolation. By continuing to follow an economic philosophy that has proven itself to be ineffective (if it ever was effective) is only creating a fissure within the world.

In effect, the United States, by pursuing the same type of policy it has followed for the last 50 years, is not only weakening itself but is providing the stage for the Chinese to exert its own leadership to those the United States policy is hurting.

The Chinese are moving to achieve a position of prominence in the world of the 21st century. What they are doing is very intentional and when they do things, they do them in their own time and for their own reasons. They are not always right, but that is not the point.

The point is that the Chinese are very deliberate in promoting themselves and their country. The United States, however, seems to be helping them achieve what they want to achieve. This cannot continue.

Disclosure: None

John M. Mason picture
John M. Mason writes on current monetary and financial events. He is a professor at Penn State University and has taught in both the Management Division and the Engineering Division. He formerly was on the faculty of the Finance Department, Wharton School, the University of Pennsylvania. Dr…. More
  • Steady Trend of Rising Yuan
By

Hannah is a Research Editor at KCI Investing

Since the start of the global economic crisis in late 2008, the yuan has been pegged to the dollar. The Chinese government enforced a fixed-exchange rate to promote rapid economic growth through the nation’s export sector, but this policy has received much criticism from the US and other developed nations. Opponents argued that this policy gave China an unfair trade advantage.

Occurring just days before the G-20 Summit–where China would undoubtedly face political pressures about its currency policies–the announcement surprised many observers.

Revaluing the yuan is just a very small start to fixing China’s economy. The US believes that China’s trade imbalance was evident in its high gross domestic product, which expanded over 11 percent in 2007, indicating domestic structural problems from an excessive reliance on exports.

The currency change alone will not rebalance China’s economy; the country also will need to implement a wide range of fundamental reforms to support domestic consumption.

Examples of domestic-focused reform include increased spending on social services; deregulation of service markets to encourage more private investments in non-tradable sectors; and infrastructure expansion to better assimilate domestic markets.

China is taking a gradual approach to the currency change. The ultimate goal is to free float its currency, but that’s years away. And the country is cautious about such a move, as the ramifications can be detrimental–Thailand’s experience during the Asian financial crisis of 1997 is a case in point.

For the Chinese economy, the change means that its citizens will gain more buying power, which is a significant benefit for a rapidly emerging middle class of roughly 250 million people.

On the other hand, export prices may rise, which is bad news for China, one of the largest exporting hubs in the world. Smaller manufacturers that rely solely on low costs to compete will suffer, and the sector will go through a period of consolidation.

China’s central bank asserted that “large-scale appreciation” of the yuan would not occur, but currency experts expect a 0.2 percent increase per month against the US dollar as Europe’s credit problems persist. To take advantage of China’s announcement, investors are piling money into the WisdomTree Dreyfus Chinese Yuan (NYSE: CYB).

But the yuan may not rise as much as people think; thus far, investors have seen little reward for their enthusiasm. This fund doesn’t invest directly in the currency but buys forward contracts with a range of maturities; its performance may lag the yuan’s movement. Unless the yuan soars, investors probably won’t enjoy lofty returns. It may be profitable over the long haul, but for the short term investors should focus on Chinese companies that benefit directly from an increase in domestic demand.

Because of aggressive economic development, the average household income in China has steadily increased. This should support the growth of domestic companies; exposure to firms such as Growth Portfolio holding China Mobile (NYSE: Hong Kong: 941, NYSE: CHL) may generate higher profits for investors.

The company has a subscriber base of around 539 million and generates 80 percent of the Chinese telecom industry’s mobile-related revenue. Although competition has escalated, the company’s growth potential is still huge. The penetration rate for the country’s mobile telecom market is just 50 percent and continues to grow. And the barely touched rural markets provide huge expansion opportunities for the firm.

With superior network quality, strong brand recognition and a solid management team, China Mobile has a competitive edge. The firm is well positioned to take advantage of the opportunities afforded by higher household incomes and greater domestic consumption.

Belle International (Hong Kong: 1880), recommended by PF Associate Editor Yiannis Mostrous in the July 8, 2009, issue, is also sure to benefit from the change. Belle is China’s largest retailer of ladies footwear based on sales revenue. It also boasts one of the strongest brand names and 8,000 distribution outlets.

Last year the company experienced low double-digit growth, and this year the prospects are even better. This is especially the case for ladies fashion, which is rapidly emerging as a profitable market in China. As the country’s per capita consumption rises, Belle should get a piece of the action.

Disclosure: No positions

Hannah Hsu picture
Hannah is a Research Editor at KCI Investing, a division of Capitol Information Group. She conducts research and analysis for income and growth stocks in portfolios of newsletter Personal Finance (www.pfnewsletter.com).
  • Your China Play Book
By

Mr. Roche foresaw many of the events that led up to the crisis

There was an onslaught of news yesterday, but one story got lost in the shuffle – the Chinese raised interest rates for the first time since 2007. This is a very real signal that they are concerned about overheating. From Bloomberg:

“China would be wise to raise rates,” Dariusz Kowalczyk, a Hong Kong-based senior economist at Credit Agricole, said ahead of today’s announcement. “It has led the global recovery and yet is one of only a few emerging Asian nations that have not begun to reverse the steep rate cuts orchestrated during the crisis.”

Chinese officials are grappling with the risk created by last year’s record 9.59 trillion yuan ($1.4 trillion) credit boom that fueled the nation’s comeback from the global recession. China’s property prices in 70 cities rose 9.1 percent in September from a year earlier, according to the statistics bureau.

China will speed up the introduction of a trial property tax in some cities and then expand the levy to the whole country, the government said Sept. 29, without giving a timetable. The state also told commercial banks to stop offering loans to buyers of third homes and extended a 30 percent down payment requirement to all first-home buyers.

These sorts of actions are certainly going to put a damper on economic growth in the coming months – a necessary step in containing larger problems, but also a near-term headwind. Morgan Stanley has previously provided the historical playbook for a tightening phase:

Cullen Roche picture
Pragmatic Capitalism (http://pragcap.com) was founded by Cullen Roche in the midst of the financial crisis of 2008. Mr. Roche foresaw many of the events that led up to the crisis and felt that the government was slow to react and when it did finally react, responded with the wrong medicine…. More