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

The People’s Bank of China (PBOC), like central banks all over the world, is more hawkish on inflation than the rest of the government.  It’s a crude stereotype, but if the mantra that best sums up the objective for the majority of the government is ‘growth’, the mantra for the PBOC is ’stability.’

Inflation has popped back up, with the latest reading for the CPI 3.3% yoy in July, up from 2.9% in June.  But with growth heading south, and the heat coming out of the economy, even the Central Bank are not worried about inflation in the short term.  The PBOC’s own leading indicators for the economy and for consumer prices are both pointing sharply downward.

In the medium term, however, the PBOC are not so relaxed.  The Central Bank’s second quarter report on Monetary Policy made the case for continued vigilance on inflationary pressure.  The three main points from the PBOCs argument are:

1. The economy has not yet paid the price from the massive increase in the money supply in 2009 - there may be a lagged impact on inflation

2. There are structural pressures for wages to rise - including a depleted supply of agricultural workers and an ageing workforce - higher wages will start to put upward pressure on prices

3. Inflationary expectations - as measured by the PBOC’s own household survey - remain at an elevated level.  The index of satisfaction with current prices fell again in the second quarter, with less than 20% of households satisfied with current price levels.  The index of future price expectations rose again, suggesting that the majority of households expect prices to rise in the future

You can see the PBOC’s Monetary Policy Report, in Chinese, here.

Labour markets, Monetary Policy

I had an opinion piece on China’s FX reserves in the WSJ China on Monday.  Chinese readers can see the original here.  For everyone else, the English version is below: 

The Real Drivers of Diversification in China’s FX Reserves

Where is China hiding its USD2.5trln in foreign exchange reserves?  The answer to that question is one of the best kept secrets in the world of finance.  The State Administration of Foreign Exchange (SAFE) - the organisation charged with the management of the USD2.5trln - certainly isn’t telling anyone, and for good reason.  When you are moving around the kind of money that SAFE is moving around,  telegraphing intentions to the market can make everything you want to buy terribly expensive and everything you want to sell awfully cheap.

But in the absence of real information, rumours proliferate, and sometimes fire the imagination of the markets.  This is one of those times.  First, at the end of May, came reports that SAFE was growing tired of the ups and downs of the euro, and reconsidering its holdings of European debt.  Those rumours were enough to send the euro plunging 1.5% against the dollar over the course of a single day’s trading.  A denial from SAFE calmed the markets.  But a few weeks later, rumours from Tokyo suggested that, despite its protestations to the contrary, SAFE was indeed growing weary of the euro, and was switching to Japanese government debt, with purchases of USD6.3bln over the first four months of the year.  The next week, another rumour, this time suggesting that SAFE was back in the euro game, with a purchase of E400mln (USD516mln) in 10-year Spanish bonds. 

Japanese bonds one week, Spanish bonds the next, if the press is to be believed, China is buying anything but US Treasury debt.  But what have we really learned from the  claims and counterclaims of the last few weeks?  Not a lot that we did not know already.  If China’s FX reserves are allocated in roughly the same proportions as global FX reserves as a whole - a reasonable assumption - then around 61% should be parked in dollar debt, with 27% in euro debt, 3% in yen, and the rest invested in other currencies.  That means that SAFE has something like USD675bln in euros, and a smaller but still sizeable USD75bln in yen.  In this context, the purchase of a few million in Spanish bonds and a few billion in Japanese government debt can hardly be regarded as anything other than business as usual.

A continued focus on dollar debt by China’s FX managers should come as no surprise.  Advocates of greater diversification point to risks to the value of China’s FX reserves from an excessive concentration in US Treasury debt.  Fair enough.  Inflation in the US, or a depreciation of the greenback, would both impact the purchasing power of China’s dollars.   But value is only one consideration, and not the main consideration, in the allocation of China’s FX reserves.  The fundamental reason for the allocation of China’s FX reserves to dollar debt is Beijing’s decision to manage the exchange rate against the dollar.  As long as China wishes to continue running a massive trade surplus with the US, whilst holding the yuan stable against the dollar, the brutal logic of supply and demand in foreign exchange markets dictates that every cent of that trade surplus be recycled into dollars. 

But the management of the exchange rate and the decision on where to invest FX reserves is a two step process.  SAFE might have to buy dollars in the first step - to manage the exchange rate, but once it has those dollars could SAFE not declare ‘mission accomplished’ and use them to buy European or Japanese government debt?  Not really.  Let’s take diversification into European debt as an example.  Use of dollars purchased in the FX market to purchase euro debt would weaken the dollar against the euro.  As the yuan is managed with reference to the dollar, that also means that the yuan would weaken against the euro.  That implies a reallocation of some of China’s trade surplus from the fast growing and dynamic US to a sclerotic EU.  As the current European sovereign debt crisis makes clear, the old world’s capacity to live beyond its means is substantially less than that of the new. 

The choice on the allocation of China’s FX reserves is not simply dictated by SAFE’s much repeated commitment to the principles of safety, liquidity, and returns.  It is also dictated by China’s choice of exchange rate regime.  It is not the micro-level investment plays but the macro-level economic policies that determine the allocation of China’s FX reserves.  Chasing after rumours from London bankers or Japanese bureaucrats - sources that have their own self interested axes to grind - will not bring us any closer to the truth.  But careful attention to shifts in China’s exchange rate policy just might. 

The announcement by the People’s Bank of China (PBOC) of a shift to a more flexible exchange rate, set with reference to a basket of currencies, has far reaching implications for the growth and allocation of China’s FX reserves.  First, on the growth of reserves, appreciation of just 0.7% against the dollar in the month since reforms were announced is unimpressive.  But over time, a stronger yuan will be one of the factors changing the balance between China’s imports and exports, and reducing the size of the trade surplus.  At the same time, two way movement in the yuan dollar exchange rate will reduce the incentive for currency speculators to dodge China’s capital controls, and hot money inflows should also be reduced.  This does not necessarily have any implications for the way reserves are allocated.  But a smaller trade surplus and reduced capital inflows will slow down the growth of China’s FX reserves and reduce SAFE’s budget for Treasury purchases.  The US Treasury got a taste of what that might look like in May this year, when capital outflows contributed to a substantial fall in the value of China’s FX reserves, and China’s holdings of US Treasuries fell by USD32.5bln. 

On the allocation of reserves, a more flexible exchange rate will also break the mechanical link which requires SAFE to recycle the trade surplus into dollars, and constrains their choice of where to park those dollars once they have bought them.  That means Beijing can push forward with another innovation: the privatisation of China’s FX reserves.  The first move in this direction, a shift in policy to allow Chinese firms to retain a portion of their overseas earnings, was announced quietly and without fanfare in 2009.  This might seem like a minor technical change, but it signals something rather significant: the end of SAFE’s monopoly control of China’s FX reserves.  The intention is to shift toward something like the Japanese system - where only a fraction of FX reserves are held by the government and the majority are in private hands.  This is a transition that will happen over time, but the bottom line is less cash for SAFE to buy Treasuries and more funds for Chinese companies to make foreign acquisitions.  The Chinese government might end up with a smaller share of the US public debt, but Chinese companies will end up with a bigger share of the Fortune 500.  Diversification of China’s FX reserves is happening, but it is these structural shifts, not this or that investment decision by SAFE’s money managers, that are the real drivers.

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

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

China’s State Administration for Foreign Exchange (SAFE) has a difficult job.  They have to manage China’s massive reserves of foreign exchange - USD2.45bln at the last count and probably a few more billion when the figures for the second quarter of 2010 are released in the next few days.

SAFE is quite happy to tell the world how much FX reserves China has, but it is rather more cautious about revealing the details of where they are invested. 

A recent notice on SAFE’s website offers few details on where the reserves are stashed away, but it does provide some insight into SAFE’s thinking on the reasons for secrecy.  This is my translation of the main points:

‘The size of our foreign exchange reserves means that information about where they are invested could move global markets.  Publishing information about our transactions could lead to market turmoil. 

A higher degree of transparency could also negatively impact our ability to effectively implement our investment strategy.

The majority of countries are cautious in publication of data on their FX reserves, and do not publish information on specific transactions.  The IMF standards for data disemination in this area are not particularly stringent.’

The key point here is the second one.  If you are moving USD2.45trln in funds around, and you telegraph your movements to the market, anything you want to buy is suddenly going to get very expensive, and anything you want to sell very cheap. 

Secrecy about the composition of China’s FX reserves is partly realpolitic, but there is also a real financial logic behind SAFE’s determination to play their cards close to their chest.

You can see the full SAFE announcement in Chinese here.

International Relations, Monetary Policy, Statistics, US-China Relations

I have an op ed in today’s South China Morning Post on the impact of the latest trade data and the European sovereign debt crisis on the outlook for China’s exchange rate.

SCMP readers can see the text here.  Or I’ve pasted it below:

Even the tea leaves some questions unanswered
 
 
When will Beijing loose its iron grip on the value of the yuan and allow its appreciation to resume? No one has a definitive answer to that question. But, until quite recently, the signs in the tea leaves suggested a resumption of appreciation was imminent and that a first move might even be on the agenda for this month or next.
Why so confident? Three factors seemed to suggest Beijing was gearing up for a policy shift. First, China’s exports are moving back onto an even keel. The factories of the Pearl and Yangtze river deltas are shifting up to full capacity, and exports for March and April have returned to pre-crisis levels.
 
Second, inflation has returned to the mainland’s economy. Increases in consumer prices might be contained but prices at the factory gate are way up, and one of the main reasons is higher costs for imported crude oil and iron ore. The appreciation of the yuan would help keep a lid on imported price rises.
Third, China’s trade partners are ratcheting up the pressure. A meeting of the US-China strategic and economic dialogue at the end of this month and a G20 summit at the end of next month will increase the volume of calls for appreciation. Beijing faces its own domestic pressures and nationalist sentiment might make it difficult to kowtow to the United States. But with the European Union and other emerging market economies like Brazil and India also calling for appreciation, China’s leaders might find themselves with few friends and many enemies round the G20 table.

The signs in the trade, inflation and political tea leaves seemed to point towards an imminent resumption of appreciation. But a vanishing trade surplus in March and April and the European sovereign debt crisis have thrown the tea leaves into a new configuration.
Central to the case for China’s trade partners is the idea that the appreciation of the yuan will help bring China’s trade account, and so also the world economy, back into balance. An undervalued yuan, the argument goes, gives China’s exporters an unfair advantage and cripples the competitiveness of exporters in the EU and US. The result is bumper trade surpluses in China and corresponding deficits elsewhere in the world.
But a deficit in China’s trade account in March and a tiny surplus in April have called this argument into question. If China’s trade account is moving back into balance at the current exchange rate, what is the urgency in resuming the yuan’s stalled appreciation?
The European sovereign debt crisis has also changed the calculation. For China’s leaders, the Greek drama signals that the international outlook remains uncertain. If the path to recovery is rockier than was previously thought or, even worse, might lead off another cliff, that is bad news for China’s exporters.
The EU seems to have moved decisively, if belatedly, to restore confidence and stability. But with the outlook uncertain, China’s leaders are hardly likely to kick away the main support for the most important sector of the economy.
The Greek crisis also affects the way the European side views the exchange rate. A silver lining to the Greek cloud has been a fall in the value of the euro against the yuan - strengthening the competitiveness of European exporters. With plenty to worry about at home and the exchange rate moving in their favour in any case, Brussels is likely to dial down the volume of complaints on China’s exchange rate regime.
All this changes the calculation on China’s exchange rate regime. The signs in the tea leaves are no longer as clear as they were. If the Greek drama develops into a European tragedy, or China’s trade account stays close to balance this month, it might even be time to brew a fresh pot.

EU-China Relations, Exchange rate, International Relations, Monetary Policy, Trade, US-China Relations

When will China raise interest rates?  That, alongside the question of the exchange rate, is the key focus for market attention.  In the view of Fudan University economics professor Sun Lijian, now is not the time.  This is my translation of the main points from his recent blog posting:

‘Today, China is faced with the problems of imported inflation from high commodity prices and a bubble in the property sector.  That is a similar situation to the one we faced in the second half of 2007 and first half of 2008.  Back then, academic and government economists were united in calling for higher interest rates.  What is the difference now?

First, the real economy is growing fast, but it’s a feverish, not a healthy growth.  With the real economy still in recovery phase, using the blunt instrument of interest rates to raise the cost of capital might actually have the impact of forcing capital out of the real economy and into the capital markets - making the property bubble worse.  Quantitative measures - like the reserve requirement ratio - are the best way to clamp down on asset price bubbles without impacting the recovery in the real economy.

Secondly, raising interest rates would not be interpreted by the markets simply as a tightening of monetary policy, but rather be seen as a withdrawal of the stimulus.  If panic gripped the markets, the good work of the twin fiscal and monetary stimulus might be undone.  At the same time, by increasing the interest rate differential with the USA, raising rates might attract hot money inflows, putting more pressure on the currency to appreciate.

Third, for Asian countries - Thailand, Korea, Indonesia - the problem is containing property bubbles caused by rapid inflows of capital.  Containing inflationary pressure and asset bubbles resulting from capital inflows is the most important economic problem facing Asian governments, including China.  Raising rates would attract more capital inflows and make that job more difficult.

Summing up, the risks to the real economy, worsening asset price bubbles, putting more pressure on the exchange rate, and attracting capital inflows suggest that the government should focus first on the use of quantitative tools (the reserve requirement ratio, lending guidance to banks), and that the time for raising interest rates is not yet right.’

You can see the original here.

Exchange rate, Financial Crisis, Monetary Policy, Property

In my last post on pig production and inflation I argued that though pork prices do have a big effect on China’s consumer price index, the underlying cause of inflation is not too few pigs but rather too much money.  But that does not mean that food prices are not important.

I think this extract from a story called ‘Pounds, Ounces, Meat’ by Zhu Wen, is an interesting illustration of the importance of food prices in Chinese life.  I read the story in translation and I believe the original was written in the mid 1990s, but having visited a few Chinese vegetable markets, I can attest that Zhu’s account still rings true today.

The story takes place in a vegetable market.  An old lady whose newly purchased tomato has just been crushed by another shopper is demanding compensation:

‘The old lady said she had bought 6 tomatoes, costing 2.5 yuan altogether, making each tomato 0.41666 yuan on average.  Rounding it up, he owed her 0.42 yuan.  After a brief stunned pause, the man demanded to see the other 5.  The old lady brought over the basket from the ground and, one by one, rummaged out the tomatoes from in amongst the potatoes, cauliflower, asparagus, lettuce, ginger, onions, long chillies, and pickled garlic.  I disagree, the man pronounced after thorough investigation, these 5 are all quite big, but the one I squashed was obviously much smaller.

The old lady glared upon her adversary, suddenly realizing he was not yet a spent force.  Well, what do you say?  The man pulled out from his bicycle trailer a carrot and laid it in front of the old lady: Look, I bought 4 carrots, 625 grams altogether.  At 2.4 yuan a kilo, they cost me 1.5 yuan which makes each carrot 0.375 yuan on average, but because this one is the thickest and the longest, it’s bound to be worth more than 0.42 yuan.  Take this and we are even.

The old lady closed her eyes a while, out of habit, then grabbed the hostage carrot and tucked it into her own basket.  But take it from me, she added as an afterword, though the current official price for carrots is 2.4 yuan, you can sometimes get them down to 2.3.  As I’m running late and I’ve got to get home to cook for my children, I’ll leave it here for today.’

Zhu’s underlying point is that reform era China is obsessed with money and material things.  In one of his other short stories, entitled ‘I love dollars’, a young man bargains his father out of a good time by refusing to pay the going rate for a prostitute.  But even though Zhu is using the old woman’s haggling to illustrate a wider point, a visit to any food market in Beijing would be enough to indicate that his fictional account is not too far from reality.

Food makes up around a third of the average Chinese person’s consumption basket, and with incomes low, even small changes in food prices can mean the difference between keeping your head above water, or going under.

Agriculture, Culture, Monetary Policy, Retail

How much for a pork chop?  In China, that’s an important question.  With the money supply exploding last year, and growth accelerating this, all eyes are on consumer prices, to see if the unwanted side effect of last year’s stimulus is a nasty bout of inflation.

About a third of the consumer price basket is food, about a third of the food basket is meat, and pork is the most popular meat.  Add all that up and it turns out that the price of pork accounts for a fair few percent of the CPI basket.  And with the price of that pork chop pretty volatile, it is often the price of pork that is the determining factor in movements in the CPI.

That means that the Chinese inflation numbers are vulnerable to shocks in the pig supply chain.  Back in 2008, a disease in the pig population pushed pork prices sky high and the CPI touched 8%. 

High pig prices, and some hefty government subsidies, encouraged farmers to start piping Marvin Gaye tunes into the sty, nature took its course and a few months later a glut of piglets hit the market and prices started to fall. 

But maybe they fell too far.  At least, that is the view of Xu Qiyuan of the Chinese Academy of Social Sciences.  Xu is evidently a man who has spent some time on the farm, and in a recent paper he gives us chapter and verse on the pig production cycle and the potential impact on the CPI in the year ahead.

This is my translation of the main points from his paper:

‘The pig sector is dominated by small producers.  According to Ministry of Agriculture figures, less than 1% of China’s pigs are produced by farms with more than 5,000 hogs.  Small producers are more vulnerable to changes in the market, and ramp up or down production in response to small changes in prices.

China’s pork reserves are just 300,000 tons, compared to annual consumption of 50m tons.  So the pork reserves do not provide a real cushion against sudden changes in production.

China accounts for 50% of global pig production, and so if domestic demand outstrips supply there is little possibility of raising imports to fill the gap.

It takes 8 months to get a pig to market - four months of gestation and four months of fattening.

Pork prices hit a low in the first quarter of this year.  The response from pig producers will naturally be to slow production. 

The result will be a dearth of pigs from around August onward.  With less pigs available, the price of pork will rise, and this will also push up the cost of other meat products. 

The combined effect could add 1-1.5% to the CPI from August on, and take the total past 4%.’

The counter argument is that it is too much money, not too few pigs, that is the cause of inflation. 

The vagaries of supply and demand in particular markets might mean that inflation is seen first in higher pork prices, rather than higher costs for electrical goods, train tickets, or some other good. 

But if the government was able to rationalise the pig production chain to prevent fluctuations in supply, the result would not be no inflation anywhere, it would be inflation in the prices of some other product.  Better animal husbandry will not solve China’s monetary policy problem.

Agriculture, Monetary Policy

Yesterday I spoke at Macquarie’s China conference, on a panel with He Liping of Beijing Normal University and Zhang Ming of the Chinese Academy of Social Science, moderated by Paul Cavey who is Macquarie’s China economist.

He Liping’s comments focussed on the March trade deficit, which was the first for several years and conveniently timed to head of complaints from trade partners about the exchange rate.  He made the comment that cyclical rather than structural factors explained the slide into deficit, which he expects to be a one off. 

He thought that one of the biggest risks to the growth outlook was a fall in consumption of automobiles.  Apparently there was already evidence that growth in auto consumption is slowing, with inventory piling up in dealers showrooms.  If growth slows, then one of the major supports to domestic consumption will be taken away.

Zhang Ming followed up with some broader comments on the outlook for the Chinese economy.  He noted that last year’s massive increase in new lending, combined with renewed inflows of hot money, has laid the basis for a return of inflation.  He expected the CPI to push up to 4% in July and August of this year.

A 4% increase in prices would be beyond the government’s target of 3% for the year, and Zhang expects a response from the government in tightening monetary policy.  He expects a first rate hike in the third quarter, and 2 or 3 hikes over the course of the year, taking the deposit interest rate up 100 basis points in total.

Zhang noted that the government had already moved against house prices.  He said that transaction volume in residential property markets has already fallen and he expected prices to start to come down.  The situation today is similar to that in the first quarter of 2008.  The danger for the government is that a collapse in house prices might precipitate an end to investment in the sector - which would have a serious impact on GDP growth.

Zhang also spoke on the introduction of a property tax - which the government has begun piloting in several cities.  He thought that introducing a tax would be extremely difficult.  Even though a tax would mean a steady flow of revenue for local government, local government officials preferred the massive slugs of cash they received from land sales.  This is because with a short tenure in any particular location, local officials want to increase revenue fast in the years when they can enjoy it, not have a dependable stream of income for the years after they had moved to a new post.

Fiscal Policy, Monetary Policy, Property