China Translated

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

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

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

China’s stock markets have continued to veer wildly up and down as investors waver in between hope that relaxed monetary policy will sustain another rally and fear that valuations are unrealistically high.  More than a million retail investors have  opened trading accounts every month this year since January.  Anyone who bought into the market after the middle of June (and more than 2m new retail trading accounts were opened in July) has lost money. 

With so many retail investors, there is a growing number of investment pundits who offer their advice on the markets on television, in newspapers, and on the web.  One such is Zhu Daming, whose blog focusses on the mainland’s stock markets (as ‘Daming’ translates as ’speak your mind’ it’s possible its a pen name).  This is a rough translation of his latest post which discusses where the Shanghai Composite Index is headed:

‘At the end of July the markets entered into a prolonged period of correction.  The Shanghai Composite Index (SCI) fell from almost 3500 down to around 2800.  In my view, 2800 is the bottom for the markets in this period of adjustment, and a fall below 2800 will trigger policy support from the government.

The origins of the sudden fall in the SCI lie in the government’s micro-moves to adjust monetary policy.  Even more, they lie in the fear of anti-inflation policies that have left the matrkets as cold and shivering as a cicada in winter.

Today, Shang Fulin, the head of the China Securities Regulatory Commission (CSRC), has said that the movements on the markets and the developments in the real economy are identical, and factors promoting the healthy development of the markets are gathering in strength.  In many people’s view, Shang’s words indicate that the CSRC will intervene to support the markets at the current level.  In my view, the CSRC should act decisively to support the markets if they fall below the current level.

The first reason is that 2800 is the level of the markets before the current wave of Initial Public Offerings (IPOs) started.  One of the reasons for the fall in the markets is that the CSRC misjudged the pace of IPOs and the markets couldn’t take the weight.  That is especially true of the State Construction IPO, which people are calling a second Petrochina.

The second reason is that the economy is still recovering.  The markets are the weathervane of the economy.  If the government allows the markets to fall too much, it will erode consumer and investor confidence and damage the recovery.

Third, there are arguments against regulators intervening in the market.  One reason is that the current falls are correcting the violent rise on the markets in the first half of the year.  But that correction has its proper limits, and if psychological factors start driving the markets outside of those limits there is a strong case for intervention.

[...]

Inflation is still a long way away.  Industrial overcapacity means the problem facing us is rather deflation.  So we ask those who manage the markets to stick with a relaxed monetary policy.  That’s what the markets need.  And to intervene decisively if the markets fall again.’

The difference in appraoch to the regulation of equity markets in the USA or EU and in China is striking.  In the USA and EU it is accepted that there is no proper level for the markets.  Shares are worth how much people are willing to pay for them, not how much the regulator judges they should be worth.  So the regulator would not step in to support the markets at a particular level. 

In China, as Zhu Daming makes clear, investors have every expectation that the regulator can and will step in to support the markets at a certain level.  The question for investors then becomes not how much a particular share is worth based on the expected future performance of the underlying company, but how much it is worth based on a best guess as to the future intentions of the government.

Original article here.

Financial Crisis, Monetary Policy, Stocks

It’s been a wild ride on China’s equity markets.  Back at its peak in October 2007, the Shanghai Composite Index (SCI) was over 6000.  By the beginning of this year it had fallen to about 1800.  In the first seven months of the year, liquidity and confidence drove a rise back up all the way to 3500.  But in the last couple of weeks the market has veered wildly up and down.  The market ended today at about 2,950.

The Chinese government pays pretty close attention to the value of the equity markets, and sometimes intervenes directly in the markets in ways that would be unusual in the UK or USA.  One of the milder forms of intervention is newspaper articles in the official press talking up the markets.  This is my rough translation of the main points from one recent article in the China Securities Journal.

‘The Shanghai Composite Index is following a positive trend, but in the last ten trading days, a sharp fall from 3500 to 2800 has bruised investors’ confidence and panic fills the air.

Against a background of economic recovery and with the government’s supportive policies still in place the sudden fall in the market can only reasonably be explained by a change in investors’ expectations. In a situation where expectations were too high and investors move to take profit, a sharp correction in the markets can naturally occur.

At a time when warmth is returning to the national and global economy, there is no chance of continuous downward slide on the markets of the sort we saw last year.  The equity markets remain an ideal investment opportunity.

In the first half of the year, with a recovering economy and supportive macro-economic policies, it was difficult to say which shone more brightly, the recovery in the equity markets or in the real economy.  As we entered the second half of the year, some of abundant liquidity from the real economy started to leak into the equity markets and expectations became too elevated.  With prices high, there was a higher level of risk, but the sudden downward turn still took investors by surprise.

The experience in developed countries is that the capital markets and the real economy have to stay in step.  Sudden rises on the capital markets that are not consistent with changes in the real economy will sooner or later be brought back to earth.

For most of the first half of the year, movements in equity prices were consistent with movements in the real economy.  But from June onwards the equity markets were excessively optimistic about the prospects for the real economy.

Looking forward to the next period on the markets, the ongoing recovery of the real economy, and the maintenance of an appropriately relaxed monetary policy will be two main factors supporting stability of the equity markets.’

The not-so-subtle message is that the government thinks that movements in the SCI after June reflected excessive optimism.  At the beginning of June the SCI was at 2650 so equity prices might have a bit further to fall before the government steps in with any more substantive support.

Original article here.

Financial Crisis, 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

Massive increases in money supply and new lending have super-charged the Chinese recovery.  But they have also brought with them new risks, most notably the risk of asset rice bubbles and inflation. In an article in its latest issue, Caijing reviews the evidence.  This is my translation of some of the main points from the article:

‘Most of the experts we spoke to said that though the process of tightening a very relaxed monetary policy has already begun, a significant correction will not take place till the final quarter of 2008 or the first half of 2009.

Fan Jianping from The State Information Center’s Economic Forcasting unit says that the chances of a significant turnaround in monetary policy in the second half of the year are slight.  One reason for this is that many stimulus projects are still half way through their course and in need of ongoing funding.

But alongside the benefits, the risks of the massive monetary stimulus are becoming more evident, most obviously in the formation of asset price bubbles.

Having taken the anxiety-relief pills the government offered, the Shanghai Composite Index (the main index for the mainland’s stock markets) rose above the 3400 level in July.  But two days of falls took it back down to 3266.  The market is being driven by confidence and liquidity, rumours of reserve requirement ratio hikes and the return of stamp duty payment on transactions are enough to spark sell-offs.

But the problem with the mainland’s stock markets isn’t the day to day fluctuations, it’s the abundant risk of another asset price bubble.  One securities analyst we spoke to said that investors were well aware of the risk of share prices collapsing, but the government’s repeated assurances of no change to the relaxed monetary policy was enough to keep money coming into the market.

Asset price bubbles are already easy to see.  In contrast, inflation has yet to emerge.  But inflationary expectations are already present, and they are already starting to have a negative impact.  Inflationary expectations contribute to the formation of asset bubbles (people invest in rapidly rising stock and property markets as a hedge against inflation).  They also drive up the yield on goverment and corporate debt, making it more difficult for the government to execute fisal policy and for corporates to borrow.’

The article also makes the point, and I think that it’s a good one, that this is an important symbolic year for China, the 60th anniversary of the foundation of the People’s Republic.  That anniversary falls on 1st October.  The government will certainly not want any stock market collapses or hints of a double-dip downturn at what is meant to be a time of national celebration.  The people who make the economic decisions in China (the State Council) have this concrete political consideration, as well as more abstract economic  concerns about asset bubbles and inflationary expectations, in their minds.  This is another reason why the liquidity taps will stay turned on till toward the end of the year.

You can see the Caijing article in Chinese here.

Banking, Financial Crisis, Monetary Policy, Social Policy, Stocks ui

The recovery in China’s economy so far this year has been driven in large part by a massive expansion in new lending, some CNY7.3trn in the first half of the year and rumours of another CNY500bn in July.  All of that new money floating around naturally brings with it the risk of inflation.  Bubbles are already emerging in the mainland’s runaway equity markets and the property sector may be set to follow suit.

The Economic Observer - one of China’s more serious business papers - has a fairly forthright article in today’s edition on the risks of China’s monetary stimulus.  This is my translation of some of the main points:

‘China’s growth is accelerating.  Quarter on quarter growth was about 0.4% in the last quarter of 2008, 1.5% in the first quarter of 2009, and 4% in the second quarter.  4% qoq growth annualised is 16%.

There are more and more positive numbers in the economic data, but there are also dangers in the ambundant liquidity which has kept the recovery afloat.

In my view we need to start to confront this danger.  In particular, we need to strictly control approval for new investment projects, and the amount of new loans, once again restrict loans to the housing sector, and burst the bubbles in the equity and housing markets whilst they are at an earlier stage of development.

Another reason we need to start early with a tighter monetary policy is that investment from the US and elsewhere has already started coming back into the country, and in my view this is just the beginning of the trend.  Hot money inflows will add to the problem of controlling the money supply.

Inflationary expectations, or maybe we should call them inflationary dread, has already started to build.  You can see it in the trend toward households keeping their savings in short term deposite accounts.’

The article continues for some time in this vein, suggesting that its important to act early against the threat of inflation, and the time to rein in the massive monetary stimulus which has driven the recovery is now.  The author is Liu Yuhui, a researcher at the Chinese Academy of Social Sciences.  His is a view which has been circulating for a while now, and it has a lot of truth in it.  What’s interesting is to see it move further into the main stream.

The other interesting point to note in the article is the figures for quarter on quarter growth.  The official year on year growth figures show a gradual slowdown at the end of 2008, with a trough in the first quarter of this year, and a gradual acceleration in the second.  Liu’s quarter on quarter figures show that the low point was actually the fourth quarter of 2008, the recovery started in the first quarter of this year, and accelerated rapidly in the second.

These quarterly figures, of course, support Liu’s argument, because if the recovery is already 2 quarters old and accelerating rapidly, the need for a strong stimulus is less.

You can see the article in Chinese here.

Banking, Financial Crisis, GDP, Investment, Monetary Policy, Property, Stocks

Back in the first half of 2008 ‘hot money’ was the hot topic for Chinese economists.  Everyone was concerned about speculative capital flowing into China to take advantage of 1) the one way bet on the appreciation of the CNY and 2) easy profits to be made on rapidly rising equity and property markets, or simply by arbitraging low interest rates in the US and high interest rates in China.

With the financial crisis, the stability of the CNY against the dollar, and the collapse in the mainland’s equity markets there was no reason for hot money to come into the country.  Hot money flows dried up and maybe even reversed for a short period at the end of 2008.  Now, with the recovery in China stronger than elsewhere, and equity and property markets rising again, hot money has made a comeback.

One of the signs of speculative inflows, in 2008 and today, is the increase in lending in foreign currency by Chinese banks.  If you think the CNY is going to appreciate against the dollar then borrowing money in dollars today is always a good idea.  Chinese investors borrow money in dollars, immediately convert the loan into CNY, invest the CNY on the equity markets or simply hold it in a bank and wait for the CNY to appreciate, then when the loan comes to term make the repayment and pocket the risk-free profit.

Back in 2008 this was such a big problem that one of the leading researchers at the Chinese Academy of Social Science (CASS), Peng Xingyun, wrote an article about it.  This is my translation of the main points he makes:

‘There is a marked trend toward higher borrowing in foreign currencies and lower foreign currency deposits.  The fact that this trend started in September 2007 is no accident.  The timing coincides with the decision by the US Federal Reserve to start lowering interest rates, and the decision by the People’s Bank of China to begin raising intrerest rates.  At the same time, a change in the management of China’s exchange rate regime seemed to offer borrowers a risk free profit if they converted their foreign currency loans into CNY.

There are three reasons for borrowing in a foreign currency.  First, there might be legitimate business investment or operational reasons.  Second, exporters may borrow in foreign currency to hedge against the risk of movements in the exchange rate.  This reflects the fact that more advanced hedging instruments are not available in China.  Third, investors can use the loans to earn a risk free profit from the appreciation of the CNY or arbitraging interest rate differentials.  It is impossible to know which of these reasons is driving the surge in foreign currency lending, but it seems likely that the third reason is having a big impact.

At a time of concern about the pace of lending, asset price bubbles in the equity and property markets, and rising inflation, this increase in foreign currency loans is a big problem for monetary policy.  At a time when the PBOC is using all the policy tools at its disposal to clamp down on domestic currency lending, foreign currency lending continues to rise.  Many of these foreign currency loans are converted back to CNY, contributing further to inflationary pressure, and complicating the PBOC’s sterilisation operations.  The use of foreign currency loans to bet on the appreciation of the CNY also actually makes the CNY appreciate faster.

The final negative impact is the build up of risk in the financial system.  Commercial banks are using short term borrowing in foreign currency to meet the demand for long term loans in foreign currency.  This mismatch between short term liabilities for the banks and long term assets is a source of risk, and not dissimilar to the volatile balance sheet structure which preceded the 1997 Asian Financial Crisis.

The PBOC has already taken steps to try and stem the flow of foreign currency lending.  But these administrative measures are not enough.  They are not enough because they do not change the underlying reason for people to demand foreign currency loans - the expectation of a continued appreciation of the CNY.  To change that expectation we need to allow the exchange rate to move down as well as up for certain periods of time.  Then CNY appreciation would not be a one way bet and there would be less reason for speculative inflows or the foreign currency loans that fuel them.

We also need to improve the range of exchange rate derivative products that are available, allowing businesses and individuals to better manage foreign exchange risk.  This would also remove one of the reasons for foreign currency borrowing.’

Peng Xingyun has a blog and you can see this essay in Chinese on that blog here.

Banking, Exchange rate, Investment, Monetary Policy, Stocks, Trade

There’s a story that John D Rockefeller got out of the stock market before the 1920s crash because a bellboy asked him for a stock tip. He reasoned that when the boys who work the elevators are going into the stock market then it’s time for the smart money to get out.

The Shanghai and Shenzen indexes are up about 50% from the beginning of the year, at the same time as corporate profits are down and the economy is growing at the slowest rate for many years. The widespread belief is that some of the liquidity the government is pumping into the system to get the economy going is being used to play the stock market and this, rather than company performance, is driving stock prices.

Today, I paused at our local illegal DVD shack to see if they had any new films in stock, and found - to my surprise - that the woman who runs it had a computer screen installed and was busy day trading. The stock trading halls - where retail investors can go and trade - are humming with activity and the China Business News TV channel has a phone in section where retail investors can call to get tips on particular stocks. When the DVD vendor is trading stocks, it’s time for the smart money to get out of the market.

Banking, Monetary Policy, Stocks