China Translated

The People’s Bank of China (PBOC) is  not a super-transparent organisation.  The Federal Reserve and European Central Bank publish fairly detailed and regular read-outs of their monetary policy discussions.  All you get from the PBOC is a few paragraphs once a quarter saying that they will continue to follow the guidance of the State Council and implement an ‘appropriate’ monetary policy.

One of the reasons it would be useful to know more about the PBOC is because it is one of the main actors in the most exciting global economic drama - the CNY - USD exchange rate.  In the first act of the drama, which ran to July 2005, the CNY was pegged to the dollar.  In the second act, which ran from July 2005 to the start of the financial crisis, the CNY appreciated against the USD and everyone held their breath, wondering how far it would rise.  The third act has run for the last year and has been extremely boring, with the CNY once again pegged against the USD.  The audience is now eagerly awaiting the 4th act, and wondering when, how fast, and how far, the CNY will appreciate in the year ahead.

So far, the PBOC has offered no clue as to the answer.  But an article in today’s 21st Century Business Herald pointed to some interesting signs of a renewed focus on the exchange rate within China’s Central Bank.  The article suggests that the PBOC is on the verge of creating a new department with responsibility for managing exchange rate issues.  This is my translation of the main points:

‘The Central Bank is in the process of creating a new department with responsibility for managing exchange rate issues, sources familiar with the process have revealed.  It will probably be called ‘Monetary Policy Directorate 2′

A decision by the State Council on the organisation of the PBOC taken last year paved the way for the creation of the new Directorate

The existing Monetary Policy Directorate’s responsibilities include researching the objectives of monetary policy, advising on the choice of monetary policy tools, advising on the interest rate policy, the evaluation of the exchange rate, the reform of the exchange rate, open market operations, and the secretarial support of the Monetary Policy Committee.

According to people familiar with the matter, the new Directorate 2 will take over responsibility for the exchange rate aspects of Directorate 1’s work, and in addition  have several new responsibilities.

New responsibilities will include management of China’s foreign exchange market, adjusting supply in the internal and external foreign exchange market, overseeing the internationalisation of the CNY and the operation of offshore CNY markets, and projects related to the the convertibility of the capital account, monitoring international exchange rate movements, and international capital flows.’

All of this could be just reshuffling the bureaucratic deck of cards.  But at the same time, it might signal a renewed emphasis on exchange rate policy, in advance of moves to allow the CNY to resume its much-anticipated appreciation against the USD.

You can see the original article in Chinese here.

Exchange rate, Monetary Policy, US-China Relations

For China economy watchers, the Canton fair is a bellweather of the health of the export sector.  With September’s data pointing to the first signs of a recovery in exports, this year’s fair will be more closely observed than many.  Caijing has the inside scoop and this is a few of the main points from their report:

‘The general mood seems to be one of cautious optimism, with agreement that business at this fair is better than the last two (the fair is held twice a year), but uncertainty about how quickly orders will pick up, and whether they will again reach the elevated levels seen in the first half of 2008.

A representative of Midea (home electronics) said ‘we are more optimistic about next year than this year, but it’s too soon to talk about a recovery trend, all we can say is the worst is over.’

One maker of electric cars said that they had been getting lots of questions, but not many orders.  They had noticed a switch from developed markets to the middle east as the main source of orders.  He also said that, in the past, they had not been receptive to customers’ requests for customization, now they are prepared to do a lot more to win orders.

A maker of air conditioners also noted that exports to the EU had fallen considerably this year, where sales to the Middle East, Asia Pacific, and Africa have all increased.

Exporters have become concerned about the potential for the CNY to appreciate.  A representative of Hisense Kelon - a household electrical goods company - said that they were moving to secure finance in the US to insure against exchange rate fluctuations, and trying to lock in orders at the current exchange rate.

A manufacturer of car parts said that they competed with Italian companies for market share.  They currently had a 20% cost advantage, but a shift in the exchange rate could erode that very quickly.

Exporters were united in believing that the government’s export support policies - a rebate on VAT on exported goods and the peg against the US dollar - remained an essential support.  A representative of the Ministry of Commerce is said to have told exporters at the fair that these supports would not be removed lightly.’

The three key points I take away from these various quotes and anecdotes are:

1. Exporters remain cautious - and rightly so - the outlook for consumption in the US and other major markets remains uncertain

2. To a certain extent, other emerging markets have taken up some of the slack left by the US and EU.  But even if growth in these markets is rapid it is also from a very low base.

3. If exporters get their way, there will be no early exit from export support policies - especially the exchange rate peg.

Here’s the Chinese article.

Exchange rate, Financial Crisis, Fiscal Policy, Trade

One thing that is clear from the events of the last year is that banking is a risky business.  If lots of people who have borrowed from a bank default on their loan at the same time, the banks themselves can go bankrupt.  When banks go bankrupt, everyone is in trouble.

To try and make sure this doesn’t happen, regulators around the world require banks to hold capital equal to a certain amount of their assets.  Typically, that ratio is 8%.  So if China’s banks make CNY100 in loans they would be required to have at least CNY8 in capital.

The next question is what counts as capital?  In China, till now, one type of capital that banks relied on is debt they have sold to other banks.  Bank 1 sells debt to Bank 2 and Bank 2 sells debt to Bank 1.  Both banks can claim their capital base has increased (and can therefore make more loans).  The problem is that, in fact, the total capital in the banking system has not changed, all that has happened is that the banks have shuffled it round a bit.

Clearly this practice is not a healthy one for the stability of the banking sector.  The China Banking Regulatory Commission (CBRC) has a long standing objective of clamping down on it.  But in the face of the economic slowdown, with bank lending playing a key role in the stimulus, the State Council had little time for any regulatory changes that might dent the banks’ lending ability.

Now, with the worst of the crisis apparently over, the CBRC has been emboldened to come forward with a regulation to deal with the problem.  Caijing has managed to get hold of a copy of the regulation.  This is the main points from their recent article on the subject:

‘After a long period of uncertainty, the dust has settled on the question of how to deal with banks’ cross holdings of subordinate debt.  The CBRC has decided to follow a method of ’separating the old and the new’.

Any subordinate bank debt issued after 1st July 2009 cannot be included in the purchasing banks’ calculation of their capital base.

The fact that the CBRC is not requiring the banks to completely eliminate their cross holdings of subordinated debt will remove some of the pressure on the banks’ capital adequacy ratio.

One bank insider said that ‘the fact that new holdings of subordinated debt cannot be included in banks’ calculation of capital will have a large effect on the market, banks will now have little incentive to buy subordinated debt, and this will have an impact on the structure of their capital base.’

A source close to the CBRC said that sorting out the cross holdings of debt, and reducing banks’ reliance on that method to replenish their capital is a long standing objective of the CBRC and has not changed.

The regulation, issued on 25th August, adopted the ’separate old from new method’ not the ‘grace period’ approach. The grace period method was favoured by the banks and would have given them a certain period of time to reduce their relaiance on subordinated debt.

During the consultation period on the regulation, the banking industry said that excluding all cross holdings of subordinate debt from the capital base would reduce their capital adequacy ratios by 1%.

In the first 8 months of 2009, banks issued CNY231.65bn in subordinated debt, three times the CNY72.4bn issued in all of 2008.  According to notices from listed banks, there were plans to issue a further CNY238bn.

According to the source close to the CBRC, the regulator took account of the banks’ concerns, recognising that requiring the banks to eliminate all their cross holdings of subordinated debt would lead to operational problems.

A further requirement of the regulation is that issuance of subordinate debt cannot exceed 25% of a bank’s core capital.

The regulation also imposes a more stringent planning requirement, requiring bank directors to discuss and approve a plan for their capital base which must then be reported to and approved by the CBRC.’

China’s banks are clearly in much better shape than their peers in the US and EU.  But the lending spree so far this year will certainly be a strain on the adequacy of their capital base.  With the door to an easy replenishment through the issuance of subordinated debt now closed, the banks will have to think of other methods to meet the regulatory capital adequacy requirements.

Here’s the original Caijing article.

Banking, Financial Crisis

Communist Party

Every end of quarter, before the economic data for the last three months has been released, the State Council get together to decide what it all means and to realign economic policy priorities for the months ahead.

For the last year that task has been fairly straightforward.  With the world economy in crisis, the focus has been straightforwardly on maintaining growth.  Every three months, and fairly often in between, Wen Jiabao and other senior figures in the government have said that ‘the recovery remains unstable’ and reassured the markets that they will maintain an ‘appropriately relaxed monetary policy and active fiscal policy.’

This month, with the recovery apparently on more solid ground, the message has been subtly realigned.  The language on an ‘appropriately relaxed monetary policy and active fiscal policy’ is still there, but it has moved down the list of priorities.  The headline objective for the remaining months of the year is now to ‘correctly handle the relationship between maintaining the steady rapid growth of the economy, adjusting the economic model, and controlling inflationary expectations.’

In other words, the single minded focus on maintaining growth will now give way to a more balanced set of economic policy priorities.  The markets are expecting tomorrow’s set of economic data - which includes GDP, investment, and retail statistics, to be positive.  This announcement by the highest level of the government, is confirmation that it will be.

The other point I took away from the statement is that there is explicit mention of local government debt, with the promise to ’standardise regulations on borrowing and guarantees of debt by local government’s and local government investment platforms.’

You can see the Chinese here.

Financial Crisis, Fiscal Policy, GDP, Monetary Policy, Regional

The third quarter growth in China’s FX reserves was smaller than in the second quarter, but still bigger than lots of people expected.

Zhang Ming of the Chinese Academy of Social Science has an interesting article about the reserve growth on his blog.  The main points he makes are:

-Third quarter FX reserve growth was bigger than people expected, in large part because hot money flows in September exceeded expectations.

-In the second quarter hot money inflows were all about investors chasing easy returns on the Chinese stock markets.   But in the third quarter, the stock markets were volatile so that explanation doesn’t work.

-The reason hot money flowed into the country is because investors now have an expectation of CNY appreciation.

-If the CNY really does start to appreciate, then the trickle of hot money will turn in to a flood, increasing the already ample supplies of liquidity in the financial system.

-One implication of this is that the outlook for real estate prices in major coastal cities, even if they are already over-priced, is positive.  The main reasons are: ample liquidity, a government attempt to have real estate replace government investment as a driver of growth, limited building activity in the last half of 2008 and the first half of 2009 which has dented supply, and institutional investors moving into real estate as a hedge against inflation.

Zhang’s piece pulls together a few of the key issues impacting the Chinese economy and plausibly points to how they might be connected. You can see it in Chinese here. It’s worth a look if only for the graph breaking down the composition of China’s FX reserve growth.  For those with limited Chinese, the blue is the trade surplus contribution, the red is FDI, the green is the effect of movements in the exchange rate, and the purple is the unexplained portion attributed to hot money flows.

Exchange rate, Monetary Policy, Property

One of the sleeper issues for the Chinese economy is local government debt.  With little concept of fiscal responsibilty, and a hand-in-glove relationship with local banks, county and township governments have been racking up debt at an alarming rate. 

The National Development and Reform Commission (NDRC) has announced the results of new research which put the local government debt level at CNY5trn.  2008 GDP was CNY30trn so that puts local government debt at 16% of GDP - lower than some other estimates I have seen. 

Xu Lin of the NDRC points out that according to Chinese company law, a company can’t take on debt that adds up to more than a percentage of its total assets or average annual profit.  This way of controlling credit risk could usefully be applied to local government.

He also says that credit agencies give excessively optimistic ratings to borrowers backed by local government guarantees, which means that they can borrow too easily.

Xu Lin also says that according to the latest estimates there are 3,800 local government investment vehicles managing CNY8trn in debt.  (I assume the point is that this debt is guaranteed by local government and is additional to the CNY5trn they have on their own books).

He also notes that debt issued by local government investment vehicles accounts for 38% of total debt in the first half of the year, vastly more than the 13% of the total in the same period of 2008.  One implication of this is that local government borrowing is crowding out borrowing by the private sector (though a more optimistic reading would be that, in the downturn, government is picking up the slack from the private sector).

Xu concludes that there is a risk that local governments will not be able to repay the money they borrowed.  That’s certainly a conclusion I agree with.  Local governments borrow against the future revenue stream from tax income and land sales, as well as revenue from their investment projects - for example tolls from use of roads or other infrastructure built with the loans.

What we have seen in the fiscal data so far this year is that tax revenue has collapsed and it is non-tax revenue from land sales and elsewhere that is propping up local exchequers up and down the country.  What we have also seen is a massive infrastructure build out which many people believe is running way ahead of demand - a fact which bodes ill for infrastructure projects’ ability to generate the revenue necessary to repay loans.  Land sales have been a mainstay of local government revenue, but they are dependent on the state of the housing market - an area where many people believe the stimulus has only delayed a serious correction in prices.

None of this spells imminent catastrophe, but it does call into question the revenue stream on which local governments rely to repay their debts.  If local governments start to default, first the banks and then, if the problem is sufficiently severe, the national government, will end up footing the bill.

You can see a news report based on the NDRC work here.

Banking, Financial Crisis, Fiscal Policy, Infrastructure, Regional

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

A few reflections on China’s national day parade, before it fades into memory.

First, why no spectators?  As the complete absence of onlookers in this picture makes clear, ordinary people where not able to view the parade in person, only on CCTV.

Second, who designed the women soldiers’ outfits?  Fuschia pink, with inappropriately short skirts, white leather boots, and machine guns.

Third, blue skies in evidence - but how sad that Beijing can only manage blue skies when the eyes of the world are watching.

Communist Party, Culture, Environment

The 17th Congress of the Communist Party concluded a couple of weeks ago.  Expectations for the meeting were relatively high.  On the personnel front, it was expected that President in waiting Xi Jinping would be inducted into the top ranks of the committe that controls the military.  On the governance front, further steps to reinvigorate the Communist Party’s governance capacity were widely expected. 

In the end, there was no annoucement on personnel changes and Xi Jinping will have to wait a while longer before being allowed to drive one of the People’s Liberation Army’s many tanks.  On the governance front, hopes for an extension of village elections to the township level where frustrated, but there was some evidence of progress in another area - improving the transparency of governance.

In the report of the meeting, the Party promises to take another step to require top leaders and, crucially, their relatives - including those living overseas, to disclose their financial affairs.  The idea is that the discipline of transparency will prevent the worst excesses of corruption.  This is what Caijing editor Hu Shuli had to say on the subject (my translation of the Chinese, though I see from the Cajing website that they also have an English version):

‘The recent meeting of the Communist Party top leadership concluded with some stern words on the capacity of the party to govern.  The public document concluded that the party’s ability to innovate, to maintain meaningful links to the people, and to consolidate its governance of the whole country have been seriously weakened.  With the country preparing to celebrate its 60th anniversary, these are words to rouse the deaf and bring enlightenment to the benighted.

The report of the meeting also said: ‘firmly opposing corruption is the first, last, and most important governance task of the party.’  It goes on to promise: ‘thorough implementation of the regulation concerning ‘leadership cadres reporting of their important affairs’ including rental and investment income, and the financial affairs of spouses, and children, including those who are living overseas.’  Improving transparency in this way, and placing a higher requirement on the Party, is an important step toward addressing corruption.

This system of throwing light on the affairs of government leaders, and holding them to public account has a long tradition in European government and is now used in many countries around the world.

In its ‘regulation concerning inner party supervision’ and ‘compendium on constructing a healthy system of punishments and precautions to prevent corruption’ the Party has already made a start in its fight against corruption.  In 1995, there was a regulation concerning reporting of leaders salaries.  In 1997, there was a regulation on reporting the important financial affairs of Party leaders.  In 2001, there was a regulation  requiring provincial leaders to report on their family’s financial affairs.  Another regulation in 2006, on disclosing leaders important financial affairs, continued to strengthen the framework.  This step by step process has delivered the system on reporting leaders financial arrangements that has now been consolidated in this year’s regulations.

From the beginning of 2008 to today, Xinjiang, Zhejiang, and Hunan have all published first attempts at disclosing leaders’ financial affairs.  These are early attempts and there is considerable room for improvement.  But the enthusisatic support of the public will provide the encouragement for continuing to improve on these early efforts.

The extension of the regulations to include families and especially those living overseas is an important development.  5 years ago, a Commerce Department report revealed that 4000 corrupt officials have, over the years, escaped the country with more than USD50bn.  Many of them did so whilst still in office in China by channeling resources to relatives working or studying overseas.  The new regulation will expose this practice to public scrutiny.

Reform is progressive, but it must continue to progress.  There is still a consisderable gap between the standard of transparency represented by the new regulation and that enjoyed in other countries around the world.  In the scope of reporting of leaders’ financial interests, and the availability of the reports to the public, there is still a considerable distance still to go.  Practice and experience will improve performance in this area.

But perhaps more rules governing transparency don’t get at the root of the problem.  China is not lacking in well written rules.  What we are lacking is an organic system for maintaining proportion in our governance.’

I think the final point is the crucial one.  Efforts to improve party self governance are all well and good.  But an ‘organic system for maintaining proportion in governance’ would require the party to be open also to public supervision. 

In the absence of independent supervision of the party there are two reasons why transparency will be of limited value.  First, who will ensure the rules on transparency are followed?  The Party itself.  And leaders are hardly likely to publish reports saying ‘last year I stole $1m and sent the proceeds to my brother in the USA.’  Corrupt cadres will do their best to hide their misdeeds and the only people able to hold them to account will be their fellow party members. 

Second, in other countries, transparency in governance equips citizens to better decide who they wish to govern them.   In China, it is not clear to what end transparency will aim.  Even if it transpires that all the Party’s leaders are venal, absent the ballot box to what use will the people it governs put this information?

You can see the complete text of the editorial here.

Communist Party, Law