China Translated

What’s the outlook for growth and policy in the rest of the year?  With growth slowing and inflation ticking up, the government finds itself in a policy quandary.  Sheng Hongqing of Everbright bank sums up the outlook, and the challenges, in his latest note - this is my translation of the main points:

‘There are signs that the slowdown in growth is itself slowing, with a few bright points in the data.  Investment growth is countering the slowdown in industrial output and projects underway now will also support growth in 2011.

Inflation will peak in August at between 3% and 3.8%, with expectations centered on 3.4%.  We estimate inflation for the year as a whole will come in at 2.8%, with the highest inflation in the third quarter.

The  Central Bank has already started to reign in liquidity, but we think further moves in this direction will be limited, with continued use of open market operations to withdraw funds from circulation and use of the reserve requirement ratio on hold.

Even though medium term inflationary pressure remains, and real interest rates are in negative territory, in the immediate future inflationary pressure is mild and the chances of a move on interest rates before year end are slight.

On the exchange rate, the yuan will follow a path of slight appreciation against a falling dollar, and depreciation against a rising dollar, but the scope for appreciation is not great.  We think the yuan could end the year 2% up against the dollar.  The scope for a move to a basket regime in the immediate future is also limited.’

I think Sheng is a little more optimistic than most on the growth outlook for the months ahead, but on liquidity management, interest rates, and the exchange rate, his view is in line with the consensus.

Investment, Monetary Policy, inflation

Second quarter growth in China’s FX reserves was a tiny USD7bln, despite more than a USD40bln addition from the trade surplus.  Slight growth in reserves despite the robust trade surplus suggests hot money was flowing out of China in the last two months of the quarter.

Two years of stability in the exchange rate knocked hot money off the policy agenda for the government: with little chance of yuan appreciation there was less reason for speculators to bring capital into the country.  But the recent announcement of the next stage in exchange rate reform will bring hot money back into vogue. 

Either appreciation against the dollar will be rapid and one way and the result will be increased incentives to bring hot money into the country - providing the real estate and equity markets pull themselves together.  Or appreciation will be faltering with the possibility of two way volatility - in which case speculators will probably find somewhere else to park their cash.

The interest in hot money in China’s policy circles is partly a relic of the Asian financial crisis, and, to a lesser extent, the speculative attack which forced the British pound to crash out of the European Rate Mechanism in the early 1990s. 

Chinese policy markers were horrified by the ability of foreign speculators to bring the governments of Asian neighbours to their knees, and by the humiliation at the hands of the IMF and its austerity programmes that followed. 

China has a closed capital account, so the chances of a similar attack are slight.  But that does not stop the Chinese media worrying about attacks by ‘big financial crocodiles’ (金融大锷 jinrong da e) - as George Soros style currency speculators are referred to.

This is my translation of a short section from a recent SAFE Q&A on the subject:

‘Our investigations in the first half of the year reveal that the vast majority of capital flows were legal and legitimate.  We have not discovered any large organised attempts to circumvent capital controls.  Most hot money is brought into the country through small transactions. 

As for so called ‘big financial crocodiles’, as we still have controls on capital account transations,  any speculative attack would be illegal - and this means that hedge funds and other financial institutions would think twice before trying their luck.

Hot money mainly enters the country disguised as legitimate trade and investment flows.  There are many and various routes.  But typically speculators are not particularly skilled at disguising hot money flows, so it is not that hard to pick up the signs of irregular transactions: 

-Companies in the processing trade will often under price inputs and over price outputs - with the collusion of their customers - to bring hot money into the country. 

-Shipping companies will take payments early and make payments late to increase their holdings of foreign capital. 

-Service companies can charge foreign customers for transport or consultancy services that are never provided, in order to have an excuse to bring hot money into the country. 

-Foreign investment is often disguised hot money, with investment advisory companies playing the role of broker for foreigners who want to make investments in the real estate or equity markets.’

You can see SAFE’s statement here.

Exchange rate, IFIs, Investment, Monetary Policy, Property, Stocks, Trade

There are many sensible arguments to be made on whether China has a house price bubble or not. I belong to the school which thinks the whole structure of the market looks very shaky, but I do tend to agree that without a big change in some of the fundamentals (like a property tax, or interest rate reforms) a crash is unlikely. What virtually all observers can agree on though, is that calling the property market right is one of the most important questions if one is to forecast where the economy’s going to go over the next 18 months or so.

Which is why it’s so important for the government to manage the message on housing policies and mortgages. Cue the desperate scramble to stamp out the rumour that seemed to be gaining ground in the last few days that policies - notably those on third house mortgages and buying by people from outside the local region - were set to be adjusted. Even the China Banking Regulatory Commission was called in to stress that “the policy requirements and standards have not changed at all”.

Really, this should come as no surprise. It’s true that the sudden drop in housing transactions since the tough measures were imposed in April has made policy makers nervous about their potential to send the economy into a double-dip downturn. But although even the government’s rose-tinted house price index is showing a monthly drop in national prices (down 0.1% in June from May), the downturn doesn’t yet seem to have hit real estate investment, which by my calculations was rising at about the same rate in June as the average for the first half of the year. Until there’s a drop off in investment I think it’s going to be tough to sell a relaxation of policy.

Even then, the real challenge is to break the current binary situation in the property market, where sales are either feverish or non-existent. To me this suggests policy may have to be kept tighter for longer than many currently suspect - having a real estate policy that swings every six months is frankly worse than not having one at all. Worryingly, I’m not confident that the government will have the nerve to do this. Export growth is set to slow sharply in the next 18 months as the rest of the world tightens fiscal policies, just the domestic economy is cooling as a result of the housing cycle and the easing of the infrastructure investment boom. This all sounds a little bit like 2008-lite, and we all know how policymakers responded then.

Duncan Innes-Ker is a senior economist with the Economist Intelligence Unit

GDP, Guest contributor, Investment, Property, Statistics

Carnage on the mainland’s stock markets yesterday, with the Shanghai Composite Index falling more than 5% to close to 2500.  You can take your pick of possible explanations, with fears of tighter economic policy, concern about the outlook for the real estate sector, and uncertainty about the global outlook in the wake of the European sovereign debt crisis the favourites.

One intriguing alternative which has been doing the rounds in the Chinese press, is the idea that the introduction of index futures has created an incentive for big investment funds to push the index down.

The idea is that if you have a significant enough share of the market, you can short sell futures contracts at a value for the index of say 3000, then start selling your equity holdings to drive the level of the index below 3000, exercise your futures contract, and buy back your holdings at the lower price point - making a tidy profit in the process.  Liaowang has a lengthy article explaining how it all works here.

Deliberately manipulating the market to increase profits for your firm is obviously pretty dodgy.  But it gets even worse. This article suggests that some fund managers are actually short selling futures on their own account, then using the fund they manage to drive down the value of the index - profiting themselves at the expense of their customers.

Investment, Stocks

Where now for the dollar?  That’s the key question capital markets, exporters, and individual investors will be asking in the weeks and months ahead.  China has a bigger stake than most in the answer to that question.  The value of China’s foreign exchange reserves, the fortunes of China’s exporters, and the amount of hot money flowing into the country all dependent to a large extent on the USD/CNY exchange rate.

China’s government might be tight lipped on the subject, but China’s investment community is not.  In an article in the latest edition of Caijing, Ye Xiang of Huixin Capital, sets out his views on the future direction of the dollar.  This is my translation of the main points:

‘There are two views on the future value of the dollar, one is that it has already touched the bottom of the current cycle, the other is that it has further to fall.

Advocates of the ‘further to fall’ view note that the Federal Reserve has issued USD1trn in new money, that the US fiscal deficit is pushing 10% of GDP, and that the US economy has entered a period of long term decline.

Advocates of the ‘already touched the bottom’ view hold that the US is a safe haven in a risky world - if the global economy dips again the dollar will strengthen.  The dollar will also benefit from its role as an international reserve currency.  And as exchange rates reflect the relative strength of different currencies, a slower recovery in the EU and Japan will also strengthen the dollar.

In my view, the key to understanding the forces influencing the future value of the dollar is to keep in mind the fundamentals of supply and demand.  The three main areas where the play of supply and demand will be evident are the US current account, the US capital account, and the demand for dollars from international trade and financial markets.

A trade deficit for the US would mean that the supply of dollars increases (pushing down the value of the dollar).  Capital inflows to the USA and use of the dollar in international trade settlement and financial markets would increase demand for the dollar (pushing the value of the dollar up).

Looking first at the current account.  Excluding oil, the US trade deficit has already shrunk to USD10-15bn a month - around the same level as in 1998-99.  Taking account of oil, the deficit is around USD30bn.  Will the deficit disappear entirely?  That’s a difficult question to answer.

The US savings rate has increased, but even in the 1980s, when the US savings rate was at its highest post-war level, the US still ran a trade deficit.  Aside from consumption patterns, key factors will be commodities imports and the cost of oil.  In my view, the chances of the US moving to a trade surplus position, or even significantly reducing the deficit, are limited.

Even more important will be flows of capital into and out of the US.  What are are the chances of private capital starting to flow back into America?  Without a long term revival in the US property market, there is little chance of large quantities of private capital flowing back into the country.

Another factor that will affect private flows into the US is the interest rate.  Many economists believe that when the Federal Reserve raises the interest rate, this will attract inflows of capital and the dollar will strengthen.  With US interest rates already near zero, the question is when and to what level the Fed will raise rates.

The two factors influencing the Fed’s decision will be the speed of recovery of the US economy and the risk of inflation.  Either signs of a recovery or of inflation would mean interest rates embark on a long period of upward adjustment.  But in the early days, only short term capital will be attracted back into the US.  Long term capital will wait till rates are all the way back up before coming back into the country.  Compared with rapid growth rates in emerging markets, the US capital markets have limited appeal.

So we can foresee that, even if private capital flows into the US are not negative, they will be limited, and maybe not enough to cover the trade deficit.

That just leaves official capital in the form of government controlled foreign exchange reserves.  These fall into two categories: the FX reserves controlled by China and other emerging market countries; and oil exporting countries’ FX reserves.  As the US trade deficit gets smaller, the growth in FX reserves for China and other emerging market countries will also be reduced.

Emerging markets have an interest in a strong dollar to support their export industries.  Oil exporters have an interest in a weak dollar to push the value of oil higher.  If emerging markets start investing more in each other and less in the US, this will also mean official capital flows provide less support for the dollar.

The final factor to consider is demand for the dollar from international trade settlement.  If emerging markets continue to trade more with each other, and to settle their trade in their domestic currencies rather than in dollars, demand for the dollar will also fade in this area.

Summing up, even if there is not a complete collapse in the US balance of payments, it seems that demand for the dollar is entering a period of decline.  In the short term, this will result in a downward trending but fluctuating value for the dollar.  If emerging markets can demonstrate relatively rapid growth, even without a strong recovery in the US, EU, and Japan, this would lead to more rapid outflows from the US, and a more rapid fall in the value of the dollar.  Of course, if that happened, government’s might step in to to support the dollar.’

This seems like a pretty clear sighted view of the main factors at work.  One of the key unknowns is the policy decision  that will be taken by governments in emerging markets - especially China - on how to spend their FX reserves.  So far there has been no evidence of a substantial move away from the dollar by China’s FX reserve managers.  As the author suggests, the interest of China continues to be in a strong dollar.

Here’s the original article.

Exchange rate, Investment, Monetary Policy, Trade, US-China Relations

I was in a meeting not long ago with local officials in a county-level city in Chongqing municipality. Chongqing is moving fast – according to official numbers its economy has grown 14% this year, approximately twice the national average. There are natural reasons for this: Growth has been moving inland from the coasts, while at the same time the city has been fairly insulated from the international recession. But the main reason for the boom, as everyone there cheerfully admits, is government support. The central government is very anxious to even out the huge development gap between the coasts and the interior, and Chongqing has been designated a “growth pole” for western China. It has been a recipient of favorable policies and public investment at least since it was split off from Sichuan province and made a provincial level municipality twelve years ago. Most recently, Bo Xilai, formerly head of the Ministry of Commerce, son of former Politburo member Bo Yibo and a high profile official, was made party secretary of Chongqing, and it’s understood that his brief for the job is to open the throttle on economic growth.

In Chongqing city itself the boom is most apparent in the new downtown taking shape across from the historic center, on the north bank of the Jiading river, and in the new high class towers and hotels shooting up on the other side in the Nan’an district. As with much new construction in China, the scale of development is overpowering. As you drive down the immense boulevards between one half finished patch of towers after another, the unavoidable question is, “Who is going to use all this?” But for all its Brobdingnagian scale, it’s not Chongqing’s new downtown that gives me pause. I worry instead about the new downtowns of the small city where I was, an hour’s drive away through the rugged hills, and its cousins all across China. It seems nearly every city in the country has a “new city” or “new district,” often at least as large as what’s already there. I don’t know how to estimate the amount of planned space in all the new districts across the country, but I guess it would give economists and government planners a cold sweat.

Of course, planned is not the same as built. But a significant amount of space in these new districts is in fact under construction. Some of it is government offices, some is public facilities, some is relocation housing for people whose former homes are becoming reservoirs, highways, railroads, or denser and more expensive housing. And a lot is market rate housing. Chinese demographics can support an immense amount of housing development. The population is simultaneously growing and urbanizing, and the average living space per person is still quite low. Sure enough, there is an immense amount of housing being built – but there is reasonable doubt whether it matches the demand. Despite the dizzying amount of construction, China’s major cities have a housing affordability problem, and during the recent downturn developers showed they were generally more willing to sit on empty units than to lower prices. In vacation markets (existing, planned and hopeful) luxury villas and second home condominiums are everywhere.

Still, all this new housing is finding buyers. After a bumpy couple of years, the housing market is sharply up this year. But how many of the units sold are just speculative investments, subject to a western-style price collapse? The Chinese public has a high savings rate and is simultaneously facing very low interest rates and fears of inflation. With almost the only alternative investment vehicle available the notoriously fickle and opaque domestic stock markets – and with the government determined to support the housing industry as a bulwark against recession – intense speculation in the housing market is hardly to be wondered at. As previously noted here, a lot of the tremendous bank loaning in the first part of the year has leaked into property markets as well. Anecdotally, it’s clear as you travel around China that a lot of new housing sits empty, waiting for appreciation – the investors have not even bothered to rent it out.

If there is a housing bubble, the question is how big it is, and whether it can be safely deflated once the immediate danger of recession is past. Central economic planners are watching this carefully, and while the official line is that the economy is still weak and that a moderately loose policy will be maintained through the end of the year, I guess that once it’s decided that it’s safe to pull back that more restrictive housing policies will be among the first out the door.

- Don Johnson

Guest contributor, Infrastructure, Investment, Property, Regional

On Tuesday of this week, China took another small but significant step toward promoting an international role for the CNY by announcing plans to sell CNY denominated sovereign debt in Hong Kong.  The 21st Century Business Herald has a review of some of the implications of the move in today’s edition.  This is my translation of some of the main points of their article:

‘This week, the Ministry of Finance has announced that they plan to sell CNY6bn in soverign debt in Hong Kong.  As there is no problem selling sovereign debt at a reasonable price on the mainland, most experts we spoke to saw this as a move to promote Hong Kong as an offshore CNY market.

‘Issuing CNY bonds in Hong Kong is about expanding the range of CNY financial products available offshore and encouraging foreign investors to hold them’ said Ding Zhizie of the International Economics University.

The Bank of China and the Bank of Communications are amongst the various mainland finance industry companies that have issued CNY bonds in Hong Kong, with total issuance so far of CNY22bn.  The 7 CNY bonds so far issued in Hong Kong by mainland companies have maturities between 2-5years and yields between 3-3.4%.  They have been oversubscribed.

The Ministry of Finance have said that the issuance of sovereign debt in Hong Kong is intended to establish a benchmark for pricing CNY debt in Hong Kong, which will make it more straightforward for more corporates to issue debt there.

Ding Zhizie says that with the increasing use of the CNY in trade settlement, trade partners will have CNY on their books.  The development of the offshore CNY debt market will give them more options for investment, and encourage them to hold CNY for a longer period of time, rather than immediately converting their holdings into US dollars.

Zhang Ming of the China Academy of Social Sciences says that as the RMB is not a convertible currency, and as instruments to hedge against exchange rate movements are not available, the expectation of CNY appreciation is a precondition for the willingness of foreigners to hold CNY.  As soon as the expectation of CNY appreciation ends, the motivation of foreign business and investors to hold CNY will be clearly weakened.

Another point is that the interest rate in Hong Kong at present is unattractively low.  CNY bonds will give investors the option of holding their CNY in a higher yielding instrument.

Zhang Ming says that at present there is no intention to open the mainland’s capital account or change the exchange rate regime.  The internationalisation of the CNY will therefore have to proceed through offshore markets.

One barrier to the development of Hong Kong as an offshore CNY market is the limited availability of CNY funds for investment.  According to the latest data, CNY deposits in Hong Kong are currently just CNY55.9bn.  Zhang Ming says ‘a market of a few 10’s of billions of CNY is pretty small.’

Here’s the original article.

Banking, Exchange rate, Investment, Monetary Policy, Trade

The Shanghai Composite Index (SCI), China’s benchmark equity index, fell 6.7% today, ending at 2667.75.  The index has fallen 23% from its August 4th peak and crashed through the 3000 and now the 2800 barriers which were expected to trigger government support.  After the markets closed, I spoke to someone who works in Shanghai to get their view on why the markets are falling so sharply.  The main points they made were:

First, the economic data so far in August is as expected, so the falls in the markets are the result of falling confidence, not a change in the fundamental performance of the economy or listed companies.

Second, the main driver of falling confidence is concern that the new loans that have provided ample liquidity to the markets in the first half of the year will dry up in the months ahead.  This concern was reinforced by an article in Caijing today suggesting new loans for August might be just CNY200bn (down from CNY355bn in July).

Third, Premier Wen Jiabao remains publicly committed to an ‘appropriately relaxed monetary policy’ but there are market rumours of a divide within the top level of the government which means it is more difficult for the Premier to implement his preferred policy.

Finally, press reports of weaker than expected Christmas orders for manufacturers in Guangzhou provided a negative economic data point and reinforced weak investor sentiment.

Another factor that has been mentioned in the press is the coming wave of IPOs.  China Metallurgical Group will start subscriptions tomorrow and aims to raise CNY16bn.  IPOs are a massive drain on liquidity as investors scrabble to subscribe.

An article published on the Economic Observer website after the markets closed today quotes one investor as saying that IPOs along with lower levels of new lending are the main reason for the collapse in the markets.

The article notes that between the end of June and the end of August, 106 companies have raised capital amounting to CNY300bn from the mainland’s markets, either through IPOs or through new share issues.  The Economic Observer believes that this drain has been more than the market can bear and has contributed to the slide.

With more companies lining up to raise capital in the weeks ahead, including CNR (a train manufacturing company), Vanke (real estate), and China Everbright Bank, the markets may have further to fall.

You can see the Economic Observer article here.

Banking, Investment, Monetary Policy, Stocks

Who is driving the new wave of investment in China’s property sector? In a recent article, Caijing provides an interesting character sketch of the new generation of property investors, looking especially at investors in the Shanghai luxury residential market. These are the main points from the article translated by me:

‘In the past, outsiders accounted for 70-80% of investment in China’s luxury housing market. Today, Shanghaiers are making 50% of the investments.

Aside from the rich Shanghai residents, there are also investors from Zhejiang (a neighbouring province). Zhejiang’s private sector businesses are looking for somewhere to park their capital and the Shanghai property sector is a good bet.

Zhejiang businessmen have seen their export markets dry up and so they don’t want to make investments in building more production capacity. If they have cash on hand they are putting it to work in the stock markets, property markets, buying shares on the Hong Kong exchange, buying steel.

One commentator from the Shanghai Academy of Social Science said that the flow of new bank lending and businesses own capital into the property sector had a lot to do with the lack of investment opportunities in the real economy.

One property sector insider told us about his relative, a business woman in Zhejiang. She had ended the lease on her factory, paid off her workers, sold her equipment, and invested everything in the Shanghai property sector, aiming to get a quick return and then take her profits and restart her business when external demand has picked up.

Another Zhejiang businessman, a shipbuilder, has recently pulled CNY20m from his equity investments and put it into property investments.’

I think there’s a few interesting take aways from these anecdotes. First, the new boom in the property sector is being driven in part by speculation. Second, concerns about overcapacity in the industrial sector might be overdone. Business people continue to make rational proft maximizing decisions about how to run their business. They won’t build a new production line if there is no demand for their products. Three, business people are also investors with a dynamic and resourceful approach to managing their portfolio and a willingness to shift their productive resources to where the returns are highest. That might mean bubbles in the equity and property sector markets when there are no investment opportunities in the real economy, but it also suggests that business people will shift resources back to their enterprises when the time is right.

Banking, Financial Crisis, Industry, Investment, Property, Regional, Stocks

China’s coordinated fiscal and monetary response to the slowdown was very effective and enabled the mainland to recover faster and stronger than the EU and US.  But as the focus shifts from funding the recovery to exiting from the extraordinary period of stimulus, co-ordinating fiscal and monetary policy may be slightly more complicated.  I have an article on the subject on the WSJ China website which you can read in Chinese here.

The main points from the article are:

With revenue below expectations and spending above expectations the Ministry of Finance (MoF) has to rely on borrowing money from the bond market to close the gap in the public finances.  Unfortunately, in July, three MoF bond auctions failed as the markets were unwilling to buy bonds at the yield (interest rate) the MoF was willing to offer.

The reason is that as the People’s Bank of China continues to fine tune monetary policy, there is uncertainty about the future direction of interest rates.  Participants in the bond markets do not want to buy a low yielding bond from the MoF today if there is a chance that interest rates will continue to rise and they could buy a higher yielding bond tomorrow.

In its latest auction, the MoF solved the problem by 1) auctioning less bonds and 2) paying a higher yield.  But this does not solve the underlying problem of co-ordinating fiscal and monetary policy as the government moves toward an exit from the stimulus. 

In the short term , uncertainty about the future direction of interest rates will mean the MoF has to pay a premium on market rates if it wants to shift its bonds.  In the longer term, the cost of the extraordinary period of relaxed monetary policy will be the higher interest rates necessary to control the inflation that would otherwise emerge.  As a consequence, the MoF can look forward to higher interest payments on the bonds it will need to sell to plug the holes in the public finances in the months and years ahead.

As a side note, a researcher with one of the government think tanks recently suggested that the MoF would be running a stiimulative fiscal policy (ie borrowing money to fund public spending) for the next three years.  This would mean the future fiscal cost of today’s easy monetary policy would be even higher.

Banking, Financial Crisis, Fiscal Policy, Investment, Monetary Policy