A large part of my newsletter earlier this week discussed emergent scandals in the railway industry and their implications for the overinvestment debate, and this was even before the Alibaba scandals broke, but I think a lot more interest this week surrounded the inflation numbers. Last week the National Bureau of Statistics released inflation data for the month of January:
In January 2011, consumer price index rose by 4.9 percent over the same period of the previous year. Of which, urban area and rural area was up by 4.8 percent and 5.2 percent respectively; the price of foodstuff, non-foodstuff, consumable and services expanded 10.3, 2.6, 5.0 and 4.6 percent respectively. Compared with December 2010, CPI increased 1.0 percent. The price of foodstuff climbed 2.8 percent.
The market expected a much higher inflation number, but there was a revision of the CPI basket, which brought down what would have been 5.1% inflation year-on-year to 4.9%. Here is Caixin on the subject:
The January CPI figure was based on a newly-revised CPI basket which lowered the weighting of food prices by 2.21 percentage point and increased the emphasis of the housing sector by 4.22 percent.
I don’t think we should read anything sinister into the revision of the CPI basket (although the timing was perhaps a tad convenient) since rising incomes generally mean a declining food share in the consumption basket. At some point they had to revise the basket.
But even with the revision, the month-on-month increase in prices suggests that inflation is running at just under 13% annually, although month-on-month numbers are always suspect because they don’t correct for seasonality and one or two big numbers can have a disproportionate effect. Still, although the CPI inflation number was below market expectations it is nonetheless well above the PBoC’s comfort level, which is officially 4%. In December the year-on-year rise in prices was 4.6%.
This stubbornly high inflation number, coupled with good growth numbers and a surge in exports will, I suspect, give Beijing the sense that it has room to tighten, so I expect that we will continue to see measures such as interest-rate and minimum-reserve-requirement hikes to slow down economic growth. In keeping with this on Friday the PBoC announced yet another 50-basis-point hike in minimum reserves (making it the fifth hike in five months).
But will these measures bite? My guess is that they will at first, but that when they do they will be quickly reversed. Any real attempt to reduce the sources of overheating will cause economic growth to slow too quickly, and Beijing will change its mind, especially if, as I expect, inflation peaks soon and starts to decline.
Let’s face it – most Chinese growth is the result of overheated investment, and removing the sources of overheating without eliminating growth is going to prove impossible. I have been making the same argument for at least two or three years, and so far we have seen how Beijing veers between stomping on the gas when the economy slows precipitously and stomping on the brakes when it then grows too quickly. I don’t believe anything has changed.
And deposits were down
The most interesting number in the NBS release, perhaps, was January the level of bank deposits. They were down. Dong Tao at Credit Suisse says that this is the first time this has happened since January 2002:
What was more concerning was that it was corporate deposits that went backwards, not household deposits, as may have been expected around Chinese New Year. This gives us reason to believe that the fall in deposits is not seasonal.
One of my clients asked me two weeks ago about continued tightness in the interbank market and this was my response:
My interpretation of the liquidity tightness is also maybe a little different. If you check the latest NBS numbers you will see that deposits were actually down, and it was not household deposits that dropped, which could be explained by the holiday, but rather corporate deposits. One month does not make a trend, but this is pretty consistent with the argument that highly negative real deposit rates will cause depositors to take their money out of the banking system.
In that case there may just be a mismatch between the lending and deposit side. Loan officers are always encouraged to lend like crazy, and the funding side assumes the deposits are there, but perhaps they were caught off guard by the decline in deposits. I am just guessing, as are we all, but we are trying to keep an eye on the topic to figure it out.
So why did corporate deposits drop? My guess is that large businesses may be finding it much more profitable to lend money to other businesses, especially those who don’t have easy access to bank credit, than to deposit cash in the bank at such negative real rates. Both the Credit Suisse report and an email I got last month from a friend of mine at Bank of China suggests that there may be an increase in intercompany lending, and to me this would be a very plausible consequence of negative real deposit rates. And of course for those worried about systemic risks this would be very worrying news. As Japan showed us in the days of zaiteku, when corporations turn to speculative financial transactions as a source of earnings they tend to increase systemic risk.
By the way, and as an aside, in my newsletter I discuss an important recent PBoC release Thursday on the true amount of new lending in China, including off-balance sheet items. According to the PBoC, not only is new lending far greater than the official new loans number, but it actually increased from 2009 to 2010 – contrary to what the official new loans numbers imply. This was not unexpected but nonetheless a little shocking.
QE2 and asset bubbles
One final note before closing, my former student Chen Long in an email to me said the following about a new SAFE report:
SAFE calculated the total amount of “hot money” in a report released on Thursday, coming in at $35.5 billion for the last year and $250 billion for the last decade. This accounts for only 7.6% of new foreign reserves in 2010 and 9% during 2001-2010. The calculation made by SAFE is: hot money = total increased amount of foreign reserve – (trade surplus + FDI + investment gains + overseas stock offerings).
These numbers are much smaller than the market estimated because the market was unaware of the previous investment gains from SAFE. The number is too small to affect either China’s economy or the A-Share stock market. The Hong Kong RMB market is growing very quickly, but it is also too small to affect the Chinese market. It also shows that the correlation between hot money inflows and the stock market is not very positive, as the market dropped in 2008 and 2010 when hot money inflow was quite large. All the bubbles in China are still there because of robust monetary supply growth in 2009 and 2010.
There are at least two conclusions from this. One of them is brought out, perhaps surprisingly, in a People’s Daily article:
China has only seen a moderate growth in speculative “hot money” inflows in 2010, said the government’s foreign exchange regulator yesterday, despite the extraordinary loose monetary policy by the US Federal Reserve to prop up its flagging economy.
A good number of Chinese economists have criticized the Federal Reserve for releasing the so-called “quantitative easing” policies, but the State Foreign Exchange Administration (SAFE) said yesterday that it only detected $35.5 billion of hot money slipping into China, which was relatively “very small-scale” as compared to the size of China’s economy.
It has been almost an article of faith here that the Fed’s QE2 was responsible in large part for Chinese monetary expansion and asset bubbles because it has created massive hot money inflows. According to an article in the Financial Times:
In the run-up to the G20 summit in South Korea last November, when it looked that China might come under attack for artificially depressing the value of the renminbi, Beijing joined several other governments in accusing the US Fed of causing huge capital flows and inflation in the developing world.
Zhu Guangyao, a deputy finance minister, said that the Fed “did not think about the impact of excessive liquidity on emerging markets by having launched a second round of quantitative easing at this time”.
“If you look at the global economy, there are many issues that merit more attention – for example, the question of quantitative easing,” said deputy foreign minister Cui Tiankai, when asked about US proposals to limit current account surpluses.
I think I agree with deputy minister Zhu that QE2 does cause liquidity growth in developing countries, but mainly for those countries that intervene in their currency markets – no intervention, in other words, and no liquidity growth. But the idea that it was QE2 that caused China’s asset bubbles was always pretty questionable because they long pre-date QE2, and more importantly any impact of QE2 had to be minimal compared to the sheer explosion in lending.
The ant-hill of hot money
To return to the SAFE report, hot money inflows have actually been negligible, they say, and so perhaps QE2 didn’t matter at all. I am not sure I agree completely. SAFE’s calculation on hot money inflows assumes that everything called the trade surplus and FDI really is FDI and the trade surplus.
But is it? FDI has surged recently, as it always seems to do whenever the market increases its RMB currency appreciation expectations. Pretty funny, right? As the People’s Daily article goes on to say:
Also yesterday, the Ministry of Commerce said that foreign direct investment rose 23.4 percent in January from a year earlier, as the country attracted $10 billion. The January figure compares to growth of 15.6 percent in December, when $14.1 billion in investment flowed into China.
Foreign direct investment (FDI) hit a full-year record of $105.8 billion in 2010, the ministry said last month, reflecting growing foreign confidence in the economy.
Perhaps it does reflect growing foreign confidence, as the MoC says. But perhaps it simply reflects growing Chinese eagerness to speculate on the RMB. I suspect FDI may be including a lot of disguised hot money inflows.
The same by the way is true about the current account surplus numbers. It is very easy to disguise hot money inflows or outflows by under- or over-invoicing imports and exports, especially given the ease with which guanxi and cash can subvert the regulations. This was clearly supported by another part of the article:
Illicit cash inflows were more like “ants moving home”, coming in bits and pieces via multiple deals and transactions, the regulator said.
It turns out, according to most interpretations of the SAFE report, that the speculators creating the hot-money inflows are not the much-vilified foreign hedge funds – surprise, surprise – but Chinese businessmen bringing money into the country in dribs and drabs.
Of course this wouldn’t have surprised anyone who has actually seen how hot money works. The most destabilizing hot-money flows are almost always those generated by local businessmen, who understand better how to navigate the rules and constraints and who have a better sense of changes in risk and return. Hedge funds matter in certain kinds of markets, but their only important role in a country like China is to serve as the scapegoats when China begins to see severely destabilizing outflows.
This is an abbreviated version of the newsletter that went out Tuesday. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me. also at that address.
From your articles it becomes apparent that the Chinese government is loosing, at least partially, the control they exert in monetary policy (hot inflows involving chinese businessmen), lending practices (businesses lending businesses), and probably on inflation. It seems to me that even an extremely powerful govenment can loose rein in the economy when imbalances are kept for long.
I’m thinking Ignacio means losing not loosing, lose not loose. Otherwise the statements are confusing.
Hi Michael,
I think the translation was misleading. Deposits did not decline, their rate of growth declined.
In 2009 deposits went from 49 to 61 tr yuam, growth 13 tr
in 2010 deposits went from 61 to 73 tr yuan, growth 12 tr
check out PBOC website
http://www.pbc.gov.cn/publish/english/963/index.html
So the yearly flow of savings went down, not the stock.
In my reading this might mean, the corporations are running out of steam. They piled money into losing projects and now their loans are growing quicker than their savings -> they are losing money.
Similiar sort of stuff happened in the beginning of the 2008 crisis, when US bank’s reserve’s were going down – the gap between their borowing and lending widened.
Probably the same is happening to Chinese coporations. We ‘ll see.
Thanks a lot!
We hope you enjoy our thoughts on Chin RE
http://apeakunderthehood.blogspot.com/
Smoking Crack(s) in China (Real Estate)
Do they track core inflation in China?
Prof Pettis
If you may entertain a question from one of you casual readers.
If China begins to experience any sort of money outflows from its Real Estate and financial markets and China is forced to step in with more domestic stimulus what does that mean for the US? Will borrowing costs (interest rates) for the US rise in the Future? Will The US be forced to buy more of its bonds? (QE). Will the US fed be as successful as Japan in keeping down interest rates?
In addition to what you said, wouldn’t decreased business savings also be the result of declining profits? Capital investments stand at over half of GDP, which strongly suggests overinvestment with a concomitant squeze on profits. In other words, they pour their savings into investments but rate of returns have declined markedly, and this means they can’t replenish their depleted savings.
Huggy,
You are correct. Sorry about my written english.
Regards
All this mess is being financed somewhere. I don’t buy the rate of growth and massive trade surpluses and capital exports at the same time. China is buying up the bulk of the materials around the world. They aren’t buying it with the income they are getting from the cheap crap they sell around the world. Money is coming in under the table. What is it? 50% to 65% of GDP is expansion? A work force that barely would make enough to eat in Western nations is supposed to eat, buy expensive homes and save a huge slice of their income? The numbers don’t add.
I’m not an economist but wouldn’t years of over investment be unsustainable, especially profitable investments because there can only be a limited number of profitable projects…
Secondly, I think it is back to basics – negative real rates are disincentive for capex and as Michael & @Lemiwinks rightly said…zaiteku or intercompany lending might be increasing…
Whenever a corporation engages in profiteering through financial management, it ends in disaster (Enron, Worldcom, GE Capital, GMAC, etc)
professor pettis,
thank you for your blog. reading it, i always learn something about china that is not available anywhere else.
i wonder if you have seen this recent letter to investors from paul tudor jones. he discusses the effects of the yuan peg to the dollar.
http://cache.dealbreaker.com/uploads/2011/02/paultudorjonestowardequilibration.pdf
Vow, seems like I missed the 2011 january statistics from the PBOC
http://www.pbc.gov.cn/publish/english/955/2011/20110225150315146600408/20110225150315146600408_.html
according to which, the deposits indeed did decrease in January, although marginally.
Notable is the rise in rates:
In January, the monthly weighted average interbank lending rate stood at 3.70%, up 0.78 percentage points from the previous month. The monthly weighted average interest rate on bond pledged repo registered 4.29%, 1.17 percentage points higher than the previous month.
Cash crunch?
Same in India
http://www.businessweek.com/news/2010-12-27/deposit-war-fails-to-ease-record-cash-crunch-india-credit.html
Ignacio, for many years there has been some question as to how much control the authorities really have over monetary policy. Certainly they have very little ability to fine-tune monetary policy.
Lemmiwinks, as you note later, deposits did indeed go down, and yes, there is something of the feel of a cash crunch in some sectors of the economy.
RS, no I don’t think the US will be able to keep interest rates low if there is a serious shift in savings available. Americans have a wide variety of alternative investment and little in the way of regulatory or cultural restrictions, so it is very difficult to repress interest rates in the US. The key is the evolution of the various current account balances.
That could be the case, Collins, I haven’t check the most recent profitability numbers, but remember that SOE profitability is largely a function of the cost of capital (the borrowing subsidy is several timers bigger than total profits in the SOE sector) , so with a declining real interest rates I expect corporate profitability to rise.
Mannfm11, actually Chinese purchases of assets abroad are pretty minimal. They tend to be blown up by the press, but China’s global rank in outward FDI is much lower than its global rank in GDP.
Bob, thanks for the link. I hadn’t seen the letter but find a good deal of it persuasive.
Mr Pettis
Thank you for the response to my question. If I may ask another. What do you think will be more beneficial to growth in the US, low interest rates or higher interest rates? Thanks
Mr Pettis
Are we to assume that if Interest rates in the US rise that would mean a net negative flow of investment to the United States?
Thanks
From the WSJ:
“China’s large external imbalances, combined with its interventions in the foreign -exchange market, are the “root cause” of the country’s current inflation problem, Yi Gang, vice governor of the People’s Bank of China, said Saturday.”
http://online.wsj.com/article/SB10001424052748703796504576167593708301706.html#articleTabs%3Darticle
Me thinks Mr. Yi reads Pettis. Good show Professor! I hope China takes this to policy rather than using it as a propaganda device to deflect criticisms.
wouldnt it be advisable to provide a bit more chunky detail before characterizing current big business lending as zaitekuesque.
as a longstanding advocate of small business interests, i must say that i can only see the opening up of further sources of investment as a good thing. as such. after all, cash-starved sectors aren’t typically prone to adventurism, regardless of what you might say of their more privileged lenders.
lastly, you’ve been quiet on the underground music scene. how’s that all going?
Michael, your post is spot-on. Indeed QE2 is resulting in a substantial increase in the money supply and, of course, this will lead to inflation pressures in countries which artificially hold down their currency exchange rates. The Chinese are well aware of this.
The annualized inflation rate that you cited is startling. China is indeed caught between the proverbial rock and a hard place, inflation verse weaker growth. There is no easy answer, and as monetary and political policy in China is driven principally by the need to maintain stability among the working class, I suspect they will continue to walk the line carefully until that line evaporates entirely.
Question to all
In light of the latest news will China take more aggressive inflation measures?
http://www.washingtonpost.com/wp-dyn/content/article/2011/02/27/AR2011022700606.html?wprss=rss_world
Hi Michael,
I believe the trends in deposits are linked to banks trying to hit targets for certain prudential ratios involving deposits. There was a lot of talk at the end of last year that deposits might be slightly overstated as banks were cramming deposits in via various short-term measures to hit the CBRC targets. Looks like the moment the new year passed these policies fell off. The underlying issue remains: negative real deposit rates are hardly likely to draw in sane investors.
This is interesting. If deposits are coming down in China, this kind-of confirms an environment where the burden of dollar debts and other dollar liabilities is rising. Since the renminbi is ‘good for’ dollar assets, US monetary dynamics are essentially levered in China. If the burden of dollar liabilities is rising, then the burden of liabilities in dollar-backed fiat currencies is rising with great intensity.
Mr Pettis – I wondered what you thought about the UK’s announcement today to cut aid to China? Do you think it will make much difference to anyone?
Prof Pettis
Agreeing with the point about local businessmen and their role in disguising hot money. In fact, would go one step further, the litmus test is when the crap hits the fan and people suddenly have to think of an exit strategy. How to work those channels in the face of reaction form the government (capital controls included) would surely flush out the culprits.
Another thought, how about foreign funds and local “snakes” (literally translated from Chinese) working together? Frankly, doubt if foreign funds are really so circumspect in their dealings.
Intercompany banking or the growing evidence of it only points to more dominos being added to the chain and it won’t be pretty when adjustment kicks in (as optimists term the lower growth target numbers) or when things turn ugly, the whiplash will be painful for all involved.
Michael, I continue to enjoy and appreciate your work. How can i get on an institutional list?
Michael, I continue to enjoy and appreciate your work. How can i get on an institutional list? Regards, Steve
Sorry, meant “How they work those channels in the face of reaction from the government (capital controls included)would be a showcase of their ingenuity but at the same time would surely flush out the culprits.”
apologies, bad day, make that bad week or whatever.
SAFE serves as a great example of government inertia. Even with the gigantic foreign exchange reserves, SAFE still makes it extremely difficult for any business to repatriate money to its overseas parent or investors.
RS, your questions are hard to answer because they depend on so many other unspecified factors.
Crispus, I would love to take credit, but as I have said many times before, the analysts (mainly foreign) who think that people like me are skeptical because we don’t “get” China are just not paying attention to what is happening. The quality of debate and analysis here is China is quite high and plenty of people know what is wrong.
You may be right, Duncan. I have been in meeting after meeting in which various attempts at figuring out the underlying deposit dynamics were proposed. There are some strange thongs going on in the banks. I expect we will begin to see a lot of consolidation in the banking sector in the next three to five years in an attempt to forestall bankruptcies.
Austerity Bill, I don’t think it is a surprise. There has been a lot of criticism, both within and without China, about the huge expense associated with Expo, the Olympics, etc. and I have heard many people wonder about aid under those circumstances. By the way I think Japan has just announced, or is about to announce, the same thing. It’s too bad because there is real poverty out here.
Steve, at the bottom of each entry I list an email address. Please write to me there.
http://apeakunderthehood.blogspot.com/2011/03/bond-smokers-please-stand-up.html
Bond Smokers Please Stand Up
Different take that we hope you find interesting and amusing.
Michael,
Is this a sign that the brake is the pedal du jour?
http://abcnews.go.com/Technology/wireStory?id=13089638
“Finisar executives said on a conference call with analysts that the slowdown is part of an “industrywide phenomenon.” They said they’ve seen the dramatic reduction in orders in China for a couple of months and weren’t sure when it would ease. They emphasized that the weakness was with multiple customers in China, and that Finisar isn’t losing market share.”