The stock market had its best day in a long time, with the SSE Composite rising 7.6% on the day to close at 2522.  Most of the run-up came in the morning, and several financial sector firms, which were the best performers, had to stop trading when they hit their 10% price-change limit, suggesting that tomorrow there will be early upward momentum.  Add today’s rise to yesterday’s 1.1% gain, and since Monday the market has recovered more than half of the 14.9% drop it suffered since the beginning of the Olympics.

There is less here than meets the eye, I think.  Two things seemed to have driven the market up today.  First there are a lot of rumors going around that the securities regulators are planning an important meeting with China’s major stock brokers tomorrow, to discuss market-boosting measures.  Regulators actually made announcements over the weekend about steps they were taking to support the market, but these had almost no positive effect on the market at all – on the contrary they were judged to be so disappointing that Monday’s market was down 5.3%.  In fact none of the measures announced during 2008 have affected the market by more than a few days.  Perhaps rumors about an announcement are far more powerful than any actual announcement. 

Second, Frank Gong, JP Morgan’s chief China analyst, sent a note to clients in which he claimed that China’s leaders are considering a RMB 200-400 billion stimulus package and further easing of monetary policy.  With GDP of around RMB 30 trillion, this would represent a stimulus of around 1% of GDP.

I am not sure a 1% stimulus – which was not exactly unexpected given all the fears of an economic slowdown – should have had such a massive impact on the market, but after plummeting so quickly perhaps it was time for a bounce, and participants just needed a good excuse.  We have seen lots of big 10% or more bounces in the past several months, and it will be interesting to see if this time around it lasts longer than the others.  I am skeptical.

According to the South China Morning Post’s article on the JP Morgan note:

On the perpetual debate of how China should manage its US$1.81 trillion of foreign-exchange reserves, Gong said Beijing may have intensified sales of some dollar assets. But it aims to keep the bulk of its reserves in dollars – even if they are not invested in the debt of US mortgage agencies Fannie Mae and Freddie Mac – because it favours a strong US currency.

Gong said it was unlikely that China would diversify into the euro, yen or commodity currencies in a big way as these currencies may already have peaked.  Instead, policy makers were studying a number of suggestions put forward by government researchers, including: Repatriating the money and investing it in on physical and social infrastructure to boost consumption; Using some of the money to set up a fund to stabilise the stock market, which is down 62 per cent from October’s record high; Diversifying into dollar-bloc currencies such as the Hong Kong dollar and other Asian markets.

I think there is an awful lot of confusion about what can and cannot be done with the PBoC reserves.  The authorities cannot take the reserves and use them for the first two suggestions – spending on physical and social infrastructure, or supporting the local stock markets – simply because foreign currency cannot be spent in China.

Let us assume for a moment that the government wanted to take $100 of reserves and spend them domestically – whether to build hospitals or to buy stock.  Once it received this money from the PBoC it would have to exchange these $100 dollars into RMB before it could spend them, and since the market is a net seller of dollars, who would do the exchange with them?  The PBoC, of course, who would have to buy the dollars back and pay for them either by creating or by borrowing RMB.  The net result would be no change in the total amount of foreign exchange reserves held by the PBoC. 

So where did the money come from?  If the government purchased the dollars from the PBoC, either taxes or its net domestic borrowing would have to increase by that amount.  If the PBoC were forced to donate the money, either its own debt would rise (if it borrowed the RMB by issuing central bank bills) or the domestic money supply would rise (if it simply created RMB).

Either way, the Chinese government could only spend the money if it financed it by raising taxes, by borrowing – either directly or through the PBoC – or by simply creating money.  It turns out that no matter how high or low the level of reserves, the Chinese government can only fund domestic spending by raising taxes, borrowing, or inflating.  All three of these things the government can do without the need for PBoC reserves.

The only reason the reserves matter in this case is that if China were to reduce its net savings significantly by a large amount of government-related spending, so that total consumption exceeded total production, the result would be that China would run a trade deficit, which would draw down reserves.  With reserve accumulation running at 20% of GDP, however, it would have to be a pretty large dollop of spending before it began to cause a decline in reserve growth, and with $2 trillion of reserves, China could survive a large trade deficit for quite a long time.

I am not arguing that China cannot or should not spend much more aggressively at the government level, although I would not want to see such spending directed at the stock market, since that would pretty much ensure that China’s stock markets would be inefficient and ineffective for several years more.  On the contrary, although I am less optimistic than most other analysts are about the strength of China’s fiscal position, nonetheless I think China badly needs to alter the balance of factors affecting economic growth, and clearly domestic spending needs to be much stronger – preferably consumer spending.  The point is that this spending cannot come from PBoC reserves.

In a few days the Olympics will be over, and we will probably see more serious measures and debate on economic issues.  Over the last few days there has been a flurry of front-page articles and speeches by government officials assuring everyone that the economy will do very well after the Olympics.  They seem worried.  Electricity prices are moving up and fuel prices will probably do so too, given how severe the shortages have been.  A number of analysts are arguing that hot money inflows are slowing and will perhaps even begin to reverse very soon, but I think they are wrong.  The RMB is still undervalued, and if the economic stimulus measures have any impact at all, in the short term they will fuel the kind of growth that creates monetary pressure for revaluation and profit opportunities for investors.  RMB non-deliverable forwards traded up sharply today, perhaps in response to news about the fiscal stimulus.  The monetary debate has been put on hold, but it is far from resolved.

On a related note I got an interesting email today from one of my former students.  He says (with some editing on my part):

I just talked to a friend in a city in the south.  Interestingly, he tried to pay back his mortgage loan last week, and get another 3 year loan again (many entrepreneur there rely heavily on this kind of financing as working capital, sometimes, from informal banks of course).  However, he was told that the term of next loan had to be just 1 year instead of the usual 3 yrs, and he has to go through the application process again every year.

Collapsing property and other assets prices in some cities like Shenzhen seem to have made banks cautious of a probable rise in default risk, and the tightening will hurt these small enterprises further.

I don’t know how widespread this shortening of maturities is, but a common problem in banking is that when risks are perceived to have risen, lenders often respond (rationally, in the case of each individual bank or investor) by readjusting their portfolios in ways that increase overall riskiness in the system.  

For example as lenders became increasingly worried about the risks in Mexico in 1994, one of the consequences was a surge in short-term borrowing by the Mexican government as creditors became increasingly reluctant to extend long-term loans.  This of course increased the risks of a liquidity contraction to the Mexican government, and when that contraction happened, the Mexican government came close to defaulting.

This happens all the time as the perception of risk rises.  I wouldn’t be surprised – if there were an effective way to measure loan maturities for all loans in the system, including those extended by the informal banking sector – to see that average loan maturities in China have declined substantially in the past several quarters.  This, of course, increases the overall liquidity risk in the system.

Meanwhile the stock market continues to plunge.  On Friday the market experienced its first and only up date since the Olympics started, rising 0.9% to close at 2451.  Today it changed direction dramatically and dropped 5.3% to close at 2321.  The Thursday before the Olympics started, the market closed at 2728, so we have seen a total decline of 14.9% during the past eleven Olympic days (seven trading days).  I wrote in an August 11 entry that before the Olympics had ended we might see the market test 2300, the level below which their have been rumors that the government will intervene.  We are now less than 1% away from that level and we still have the rest of this week to go.

It is not completely clear why the markets have behaved so poorly in the last week, although the answer is probably multiple.  A lot of analysts are worried about a slowdown in economic growth, the possibility of an increase in inflation still scares many (as it should), and there is a lot of concern about dilution effect of a possible upcoming sale of non-tradable shares as these become tradable.  There is also worry that hot money inflows may have already begun to reverse themselves (for example see this article).  This perception comes from the widespread belief that the increase in foreign exchange reserves in June was substantially less than the combination of FDI, trade surplus, and other identified inflows.

Actually this perception is incorrect, and represents mistakes in the way most analysts count the rise in PBoC reserves.  I discuss why true growth in June’s foreign exchange reserves actually exceeded the identifiable inflows in several entries, most recently on July 14 (“June headline reserve growth was $11.9 billion, but real growth was actually much higher”).  I don’t think hot money outflows are likely to be the main culprit behind the declining stock market, but I don’t discount the possibility that, as the perception of China’s riskiness increases, and as concern about the imposition of further restrictions on short-term inflows and outflows, we may begin to see at least some hot money reverse direction and leave the country.

On a related topic, I was talking today to a large fund manager, and he asked whether or not it made sense to buy Chinese stocks at these levels.  From a short-term trading point of view I am not sure I would be in a hurry to buy because I still think we are going to face a post-Olympic hangover that may affect the markets.  I think at least part of the surge in consumer spending last month and this month will have been Olympic related (new TV sets and entertainment units, Olympic souvenirs, sports equipment and clothing, flags, traveling to Beijing, and the kind of spending that comes from exuberance at China’s sporting triumphs), and this is likely to be reversed in the September and October numbers.  That should keep downward pressure on the market.

On the other hand over the medium term a number of Chinese stocks probably represent good value.  I haven’t looked at the discount between A-shares (which only Chinese nationals can buy) and B-shares (which foreigners are permitted to buy) in several months because I closed out all my positions much earlier this year (thank the gods!), but because of lower liquidity B-shares have typically traded at a 30-40% discount to A-shares.  If this continues to be the case, I think a very strong case can be made for the selective and gradual acquisition of a diversified portfolio of B-shares, especially in the more defensive industries and less leveraged companies.

Today is an anniversary of sorts.  Thirty-seven years ago, in 1971, President Nixon stunned the US by announcing the imposition of extensive wage and price controls in an effort to reverse rising inflation in the US.  In retrospect it is pretty clear that the price and wage controls were unlikely to reverse several years of booming money creation, and even the WIN buttons (“Whip Inflation Now”) distributed by President Ford a few years later weren’t enough to do the trick

The EconReview gives a short, potted history of the time:

In a move widely applauded by the public and a fair number of (but by no means all) economists, President Nixon imposed wage and price controls.  The 90 day freeze was unprecedented in peacetime, but such drastic measures were thought necessary.  Inflation had been raging, exceeding 6% briefly in 1970 and persisting above 4% in 1971.  By the prevailing historical standards, such inflation rates were thought to be completely intolerable.  The 90 day freeze turned into nearly 1,000 days of measures known as Phases One, Two, Three, and Four.  The initial attempt to dampen inflation by calming inflationary expectations was a monumental failure. 

…The wage and price controls were mostly dismantled by April, 1974.  By that time, the U.S. inflation rate had reached double digits.  While there were skeptics in August, 1971, there were a great many who thought "temporary" wage and price controls could cure inflation.  By 1974, this notion was thoroughly discredited, and attention gradually turned toward a monetary approach to inflation.  In a complete reversal, the policy to curb inflation in now thought to be an increase in interest rates rather than an attempt to hold them down.

A quick look at inflation rates in the US show that inflation had reached a temporary peak of 6.19% in 1971 Q1, and had been declining when Nixon imposed the controls in the middle of Q3 (5.46% and 4.26% over Q2 and Q3).  It continued to decline thereafter for several more months, reaching a low of 2.18% in 1972 Q2, before reversing course and marching upwards over the next two years to hit a second temporary peak of 12.38% during the third quarter of 1974.

After another period of improvement over the next two years (inflation declined to 4.21% by the second quarter of 1976), prices began another surge, which took inflation up over four years to a high of 10.36% in the fourth quarter of 1980 (it actually peaked in March at nearly 15%), after which time the very sharp and brutal economic contraction engineered by Paul Volcker of the Fed brought inflation back down again.

One has to be careful about drawing lessons.  What happened to the US in the 1970s tells us nothing about what must happen to China today, but it is worth remembering a couple of important points.  First, following a period of rapid monetary growth, which at first was able to deliver rapid economic and productivity growth, booming stock and real estate markets, and low inflation, the consequences of excess money creation only later led inexorably to higher prices.  Although a number of economists proposed higher interest rates and tighter money to combat the rising prices, the first instinct of Nixon’s economic advisors was to protect economic growth by using administrative measures to rein in inflation.  This didn’t work.

The second important point is that the process of rising inflation is rarely a straight line.  The US saw several fairly long-term reversals of the upward inflation path, but these reversals were temporary as long as the root cause of inflation – excessive growth in money – was not addressed.  In the end, however, the overall trend was upward and the cost of reversing it was significant – and it probably lost the election for Jimmy Carter.

One of the things we are wrestling with here in China is the extent to which the US experience is relevant.  Today the National Bureau of Statistics released a report that had total investment in fixed assets for the first seven months of 2008 at RMB 7.2 trillion.  This represents 27.3% increase over the same period last year.  For the six months before July, FAI grew by 26.8%, and most analysts were expecting July’s number to be a little below that.  FAI is clearly very high.

I have been discussing the implication of these recent figures, including PPI and CPI inflation numbers, with several of my friends.  One of the questions that is always raised is the transmission mechanism from high PPI inflation to rising CPI inflation.  On the face of it the surge in FAI suggests a future surge in industrial production that, especially given faltering global demand, is like to create an oversupply of manufactured goods in China, which should make it more difficult for producers to pass rising cots onto consumers.  In that sense, it seems that the reduction in CPI inflation may be sustainable, even with last months’ unexpected jump in PPI inflation.

But I have to confess that I have a problem – perhaps instinctual – with this line of reasoning.  It is true that an excess of manufactured goods should put downward pressure on prices of those goods – or at least limit the ability of producers to raise prices – but is this enough to eliminate inflation?

The way I see it, excess money growth creates excess demand for goods and services at current prices.  This excess demand isn’t necessarily uniform, but it exists, and it should result in rising prices on average.  During the past year in China, the excess demand coincided (perhaps) with problems in the food supply, so that food prices soared.  Rising food prices absorbed all or most of the excess demand, so that there was little upward price pressure on the non-food sector.  In fact, there should have been significant downward price pressure on the non-food sector given the huge run-up in food prices, but we actually saw non-food inflation low but rising. This, by the way, is why I believed and still believe that inflation in China was caused by monetary conditions, and not by a food-supply problem.

What happens if rising FAI and surging industrial production now put downward pressure on the prices of manufactured goods or, at the very least, make it hard for companies to pass on price increases?  One obvious thing is that profits will sag, bankruptcies will rise, and companies will eventually be forced to cut back sharply on investment and production (exports might also surge).

But what happened to the excess demand caused by excessively rapid money growth?  It still has to have an impact on the average price level.  One possibility may be that we will once again see food consumption surge and, with it, the price of food.  Another possibility is that price increases will show up in the service sector.  A third is that it shows up also in the price of manufactured goods that are not in oversupply, where there will be bottlenecks.

There is also another, perhaps even less benign, scenario.  It is possible for there to be no inflation because there is a sudden collapse in the money supply.  How could that happen?  In a worst case scenario rising bankruptcies could put so much pressure on the banking system that Chinese banks would be forced to cut back on lending and Chinese banks and businesses would begin to hoard liquidity.  This would result, I believe, in a sharp reduction in money supply (via a collapse in velocity perhaps?) that would force China to exchange the risk of inflation for the risk of deflation.  I think this is what happened in the US in the 1930s.  Following a period of rising inflation in the 1920s – and for many of the same reasons: a rapid expansion in the US money supply caused by massive reserve accumulation in the 1920s – the overextended banking system was unable to survive the economic downturn, and a previously inflationary period was suddenly converted into a period of sharp deflation.  There was even a 2-year period at the end of the inflationary period (1927-29) in which the US was absolutely swamped with speculative inflows.

CPI inflation numbers were released today by the National Bureau of Statistics.  As expected, they showed a continued decline in the year-on-year CPI inflation, although at 6.3% the figure was better than market expectations of 6.5%.  Given the trajectory of food prices so far this month CPI inflation for August could fall below 6%.  On average prices in July rose 0.1% month on month.

This is great news, but it is not unambiguously good.  The non-food component of CPI rose from 1.9% year on year in June to 2.1% in July, so although it is low, it is rising – not a good sign, in my opinion.  We are also hearing more and power about power shortages and rationing outside the Olympic-blessed city of Beijing.  World fuel prices may be declining, but they are still substantially higher than they are in China, thanks to price freezes.  This can’t help but put continued upward pressure on the cost of energy.

So now we’re caught in the bind that I discussed yesterday.  Declining CPI inflation will encourage those policy-makers who are mostly worried about slowing growth to insist that China back away from the various monetary and credit tightening measures it had tried to impose over the past nine months.  High and rising PPI inflation will strengthen the concerns of those who think China’s main risk is from excessive monetary expansion.

Nothing has really changed to shift the argument decisively in one direction or the other, and I suspect we will continue to see tentative policy moves in both directions.  The most amount of effort – or at least visible effort – seems to be that expended on tightening capital controls, but it is hard to know what this portends.  If the capital controls are very successful – and I am doubtful they will be – it might create breathing space and give the authorities reason to speed up RMB appreciation again, with the controls preventing an accompanying surge in speculative inflows.  If not, it puts greater pressure on them to regain control of monetary policy via a one-off maxi-revaluation.  Either way I still think China cannot resolve its current imbalances without a significant currency adjustment.

As for the stock market, at first it seemed pretty unambiguously in favor of the CPI data which, among other things, suggested that the authorities are more likely to be inclined to relax the “tightening” measures.  After a very bad opening that left the SSE Composite down by a little more than 1.5%,  the mid-morning release of CPI data turned the market around sharply, so that by lunch it had regained all it had lost, plus an extra 0.2%.

But the happiness didn’t last.  Perhaps there were rising worries that the huge gap between PPI and CPI inflations would hurt corporate profits, or perhaps investors are just to depressed to enjoy a rally (worrying, among other things, about unrest in Xinjiang province, where the death toll over the last week is up to 31), but immediately after lunch after a quick 7-point jump in the first five minutes the market suddenly lost its legs and began sliding.  It bounced around all afternoon, with the SSE Composite ending the day at 2457, just over half a percent below Monday’s close.

I think it is going to take a major effort to get this market to regain confidence, but even with a major government intervention I think there may be more bad news on the earnings front.  Today’s Emerging Markets Economics Daily (produced by the research guys at Credit Suisse) has this to say about car sales:

Total vehicle sales growth in China moderated sharply in July to 4% yoy.  According to the China Association of Automobile Manufacturers, sales of commercial vehicles contracted 3% yoy in July (to 177,600 units), the first contraction since January 2006.  Passenger vehicles sales managed to maintain 7% yoy growth (to 488,200 units), but this was the first single digit growth since August 2006.  The data reflect weakened domestic demand in China.   

Credit Suisse goes on the say that their equity analyst, Michele Mak, believes commercial vehicle sales will slow even more dramatically over the rest of they year.  

Three weeks ago on my blog I cited a Bloomberg article that said that “China's stockpile of unsold new vehicles rose about 50 percent in the six months ended June, hitting a four-year high, as automakers expanded production and sales growth slowed.”  In the article some commentators brushed off the rise in inventory saying that they were expecting a surge in car buying later in the year.  If it doesn’t happen, I suppose we will necessarily see rapidly rising car inventories.  Rising inventories is one of the main warning signals we have to watch for as evidence that the over-investment cycle is finally about to end.

Yesterday I suggested that July’s PPI inflation might be a little higher than June’s already-high 8.8%.  Most other analysts seemed to agree with me, with the median estimate according to Bloomberg at 9.0%.

The actual number, which was released today by the National Bureau of Statistics, was a bit of a shocker.  PPI inflation in July rose to 10.0%.  Raw material, fuel and power were the biggest reasons for the jump in prices which, according to an article in the South China Morning Post, is the highest year-on-year PPI number since 1995’s 14.9%.  Much of the increase can be blamed on rising global commodity prices, which seem to have turned around a little recently, but with continued high prices internationally and shortages domestically, there is a risk that producers will eventually be forced to pass higher prices onto consumers.  

CPI inflation numbers are expected to come out tomorrow and I think most of us still think they will be substantially lower than last month’s 7.1%.  My expectation has been that we would see moderate CPI inflation for the next couple of months before it picked up again towards the end of the year.  The moderation would give further ammunition to those policy-makers more worried about slowing economic growth then about the consequences of unabated money expansion, and I assumed that their current dominance in the policy-making debate would only be strengthened, until inflation reared again late in the year, causing the balance of power to shift once again to the monetary alarmists.

But this PPI number may make up for a declining CPI in its effect on the policy debate.  It is very clearly a warning signal that inflation has not disappeared, although falling commodity prices world-wide may relieve some of the PPI pressure in the coming months.  As an aside, I have heard several times recently that a very senior policy-maker who has lost a lot o credibility in the last year, a leader of the monetary camp, was going to lose his post in a post-Olympics shuffle (I don’t want to mention who he is because it could get me into trouble, but I suspect a lot of readers know who I mean).

China’s trade surplus for July, also released today, came in a lot higher than expected.  Here is Xinhua’s report:

China's trade surplus fell to 123.72 billion U.S. dollars in the first seven months, down 13.1 billion U.S. dollars, or 9.6 percent year on year, the General Administration of Customs said on Monday.  Analysts said the fall was partly a result of China's policies to tame surplus, but was also in part due to the rising prices in energy and resources China imported.

The Jan.-July exports had increased 22.6 percent year-on-year to 802.91 billion U.S. dollars, however, imports rose 31.1 percent to 679.2 billion U.S. dollars.  The total trade volume in the first seven months stood at 1.4821 trillion U.S. dollars, a year-on-year rise of 26.4 percent.  

July's trade volume rose 29.8 percent to 248.07 billion U.S. dollars with exports totaling 136.68 U.S. dollars, up 26.9 percent. Imports were up 33.7 percent to 111.4 billion U.S. dollars. The July trade surplus stood at 25.28 billion U.S. dollars.

The trade surplus for July of $25.3 billion, versus $24.4 billion last July, was much higher than the $20.3 billion median estimate (also much higher than June’s $21.3 billion).  On Friday a Bloomberg article titled “China Trade Surplus Likely to Narrow for Fourth Month” had the 17 economists it surveyed predict that exports in July would climb “only” 16.8% year on year.  In fact the National Bureau of Statistics release recorded a 26.9% year-on-year increase in exports, a big increase over June’s 17.6% gain.  

These kinds of numbers would seem to strengthen the skepticism that analysts like CFE’s Brad Setser have expressed over the story of China’s collapsing export sector.  Given the slowdown in the world economy I would have thought that a 16.8% jump in exports, if the pessimistic expectations of most analysts had turned out to be true, would have nonetheless been pretty impressive,  In fact I think the woes of a small but powerful segment of the export industry – low-value-added processors in the south of China, who have been hit primarily by rising wages and a welcome shift in the southern economies towards higher-value-added goods and services – have created a false impression about dire conditions for China’s exporters.  For such a large exporter to see its exports grow so rapidly, and during a global slump, does not suggest to me an export industry in its death throes.

The good trade numbers and the bad PPI numbers (which will hurt corporate profitability), combined with more worries about political instability in Xinjiang province, had a terrible effect on the country’s stock markets.  Declining international fuel prices and a strong market in Hong Kong were not able to alter the gloomy mood on the mainland.  After dropping 4.5% Friday – mostly at the end of the day on panic selling – the market opened down today, bounced around during the morning session, and then all but collapsed during the afternoon.  The SSE Composite lost 136 points to close at 2469, 5.2% down for the day.  That’s nearly 10% in two days, and it would have been worse if some companies today had not hit their 10% limit and stopped trading.

When almost exactly one month ago the SSE Composite finally broke 3000, the level below which it was believed the government wouldn’t allow the market to fall, it lost ground pretty swiftly (down 17.7% in the next month).  Rumors quickly emerged that the new minimum level at which the government would support the market was 2300.  I have already written several times about how damaging these perceptions of a minimum government-intervention level can be, but I would guess that Friday’s and Monday’s drops have already set alarm bells ringing in the offices of financial policy-makers.  If investors don’t see anything being done to stop the slide, after a short rebound tomorrow we could easily see the market test 2300 before the end of the Olympics.

The Olympic opening ceremony Friday was truly a spectacular event and left a lot of people here, at least among my students, with a sense of nearly euphoric pride.  I watched the ceremony on television at D22, my music club near Peking University, and during the ceremony I received dozens of phone messages from current and former students – most of whom were at home in various locations around the country – expressing their excitement and happiness about the magnificent display their country was putting on, and I suspect several of them were near tears.  I know a lot of people around the world were disturbed by what they thought was an ugly nationalism associated with the event, but I have to say that among my students and friends, the feeling was a very inclusive joy and pride, and it was infectious.  All of us, Chinese and foreign, were in a great mood that night.

We are still marveling at the technological and theatrical prowess displayed, and in D22 – and in many other bar and restaurants, no doubt – the first hour of the ceremony was regularly interrupted by cheering and whooping, although the nearly interminable subsequent march of 204 national teams dampened the mood somewhat (and is, in my opinion, one of the strongest arguments against the granting of independence to too many small countries).  The weather is not very good (in fact as I write this it is pouring rain outside) but Beijing is nonetheless in a festive mood.

The stock market, however, has decided to buck the festive trend.  On Friday, in spite of the tremendous anticipation is the air, the market had a sloppy day until, mostly in the last hour, sloppiness turned into what seemed like panic selling that saw the SSE Composite drop 121 points, to close at 2606, or down 4.5% for the day. 

Some analysts blame renewed worries about security and terrorist attacks (and I see in the press that over the weekend there were more terrorist attacks in Xinjiang province, with at least five dead), while others claim that investors were anticipating the announcement of additional government measures to shore up the market during the Olympics, and when no announcement was made, they panicked. 

It will be interesting to see what happens on Monday and during the rest of next week.  We may see some government-inspired buying, or even patriotic Olympic-related buying, or more measures from the authorities aimed at propping up the markets, but if none of those, I think the very bad mood could be extended.  As I’ve said before in this blog, I think expectations about the transformational consequences of the Olympics are unrealistically high, and I think there is bound to be some disappointment.

In that context I have previously mentioned on this blog the parallels with the 1873 crisis that began in Vienna.  Here is how I describe it in my book The Volatility Machine (Oxford University Press, 2001):

By the beginning of 1873 there was a general sense that the Viennese market was overvalued and unsustainable, but investors were looking forward to the World Exhibition to be opened in Vienna on May 1.  They were irrationally hoping that the Exhibition would change the underlying situation and somehow justify the high asset prices.  During April of that year, in response to a period of weak and declining stock prices, the local banking authorities became concerned about the position of banks and made a series of attempts to support the market.  As a precaution, however, nervous banks were contracting credit and attempting to raise liquidity by calling in loans.  When the Exhibition opened on May 1 and, not surprisingly, nothing really changed, investors lost heart and began selling.

The selling pressure in the market built steadily.  On May 5 and 6, the market began falling and on May 8 it suddenly crashed. With the crash a full-blown panic began in Vienna that was almost immediately felt throughout the country as banks and investors rushed to dump assets. 

I am not implying, of course, that events in China are going to resemble those of Austria in 1873, but 1873’s World Exhibition in Vienna drew some of the same fevered expectations as the 2008 Beijing Olympics have, and it is worth noting the impact of excessively high non-economic-related expectations on the markets.  So much hope has been invested in the success of what is, after all, just a sporting event, that it will be hard for any result, no matter how positive for China, to live up to expectations.  After the Olympics little will have changed.

Still, even during the Olympics work must go on.  We should soon be getting a new set of economic numbers for the month of July.  I hear that year-on-year CPI is expected to decline from 7.1% in June to around 6.5% or even lower in July, well below its April high of 8.5%.  Partly this reflects a high base effect, partly price controls, and partly continued food price declines from the very high levels of February and March.  What will be most closely watched is the non-food component of CPI.

In contrast year-on-year PPI, which hit a high of 8.8% in June (from 8.2% in May), is expected to stay high.  I think this may be the worst combination of numbers.  Declining CPI will convince many policy-makers, particularly those in the pro-growth camp, that inflation is no longer a problem and excessive monetary growth nothing to worry about.  High and rising PPI, however, indicates that inflation has already spread out of the food sector and will increase inflationary pressures by the end of the year.

For a couple of weeks now there have been rumors and reports about new foreign exchange regulations being put into place, partly to limit hot money inflows and partly, once these begin to reverse, to make it more difficult for money to leave.  Yesterday SAFE announced a new set of measures.  Today’s South China Morning Post says the following about the announcement:

China has issued new controls on transfers of foreign currencies, moving to contain growth in its foreign exchange reserves and curb speculative inflows blamed on fuelling inflation.  The new rules, issued late Wednesday with immediate effect, call for penalties of up to 30 per cent of the capital involved in any unauthorised inward or outward foreign currency transfers.

“As China’s economy becomes more internationalized and the movement of international capital flows accelerates, there is a need to improve the system and oversight of multinational capital movements,” the State Administration of Foreign Exchange, or SAFE, said in a statement posted on its website.

The new regulations appear broader in scope than new limits announced by SAFE last month that called for authorities to check invoices to ensure they are not being inflated as an excuse to bring unauthorised money into the country.  The new rules order government departments to simplify regulations on foreign direct investment and authorises them to crack down on illegal transactions.

Last Friday the State Council said it was revising the rules concerning capital inflows and outflows, and this was generally interpreted as revising the regulations so as to allow the authorities to impose emergency restrictions on a sudden outpouring of money leaving the country.  It is clearly important for SAFE to have some handle on inflows and outflows, but I am worried that most policy-makers continue to believe that rapid outflows leading to a 1997-style crisis is the only, or main, risk Cgina faces in relation to the current hot money inflow.  In fact in my opinion the main risk is that these inflows have created unsustainable and vulnerable structures within the domestic banking system, in which case the risk of massive outflows is only part of the problem.  

The real problem is excess lending leading to misallocated capital, overinvestment, and what Hyman Minsky termed “Ponzi” debt structures, which are clearly already happening, if the evidence of SMEs borrowing at rates of 80% or more suggests anything.  The problem is that under these conditons we could easily see a sudden rise in inventories, non-performing loans, capital hoarding, and faulty debt structures among corporations – mainly small and medium enterprises, I would guess.  Unfortunately, in my opinion, the only adjustments that will prevent the system from getting worse – specifically a revaluation of the RMB to the point where inflows subside or even slightly reverse – have been put off for so long that it is becoming increasingly hard to see how the authorities will manage an adjustment without triggering problems in the banking sector.

At any rate I know that it is getting increasingly difficult to bring in money for my business here in Beijing.  I have a small, independent CD label specializing in developing the Beijing new and experimental music scenes.  It is officially registered as a cultural institution (all media companies require that or a similar registration), and we regularly bring in money to pay for operations and production costs, but we have to work harder than ever to bring money in.  Unfortunately the capital regulations do not easily distinguish between investors bringing in money to fund real activities in China and investors bringing in money to bet on RMB appreciation.  I recognize the desperate need of the PBoC to regain some semblance of control over the money supply, but there are economic costs to doing so, especially onerous for small companies like mine.

Meanwhile both HSBC and RBS, according to Bloomberg, have issued reports arguing that RMB forward contracts (NDFs) are priced low enough to offer “clear value”.  The recent slowdown in RMB appreciation has convinced many investors to lower their 6-month and 1-year expectations for RMB appreciation, but – and I agree with HSBC and RBS if this is their argument – the reduced pace of appreciation is not sustainable and soon enough, probably before the end of the year, the debate about what to do with the RMB will re-ignite.  This will lead to faster appreciation one way or the other.

He says, in response to a question about Hu Jintao’s recent statement about the need to “keep policy stable” that “There is no need to further tighten the marco-control measures. Given the economic environment, the current measures are already appropriate.”  In Beijing, it seems to me, the phrase “current measures are already appropriate” is usually code for policy recommendations to relax credit limits and slow RMB appreciation.  In case the message was ambiguous, he added “At the moment, we should not rush more tightening measures.”

He also repeated the by-now well-worn phrase: “We shouldn't sacrifice development to curb inflation.”  This is certainly not something anyone would argue against, of course, further and balanced economic development is the key issue for China, but the implicit dichotomy is a false one.  The fight against inflation is necessary precisely to ensure continued economic development.  It is not an alternative to development.

The most worrying part of the interview was, in my opinion, the following:

Q: Do you think it's possible to curb excessive inflation by the end of the year?

A: First of all, we should identify the main reason of the inflation. It's largely due to the depreciation of the US dollar, which triggers price rises of primary goods. For us, the key to deal with inflation is to stabilize our policy, ensure supply, subsidize the poor and adjust prices.

We should also tame the public's inflation expectations. We should not be afraid of price rises as the adjustment of some underpriced products is unavoidable. But it's possible for inflation to moderate in the second half as oil price is falling and domestic agricultural supply is recovering. Inflation may well ease by the end of the year.

Given that Chinese inflation has occurred mostly in domestic food prices, little of which is imported, and that many commodity prices, including oil, are price controlled, so that there is little to no pass-through in local costs, it is something of a shock to me that anyone believes that Chinese inflation is caused by a weakening dollar (and even more of a shock that this claim is used to buttress the argument against further appreciation of the RMB). 

It is also worrying to me that in the policy response to fighting inflation, taming inflationary expectations is considered a major concern, whereas nothing is said about the role of capital inflows in expanding the domestic money base.  I remember in my teenage years in the 1970s there was a belief in the US that then-rising inflation was largely an oil price and expectation problem, and so various administrations jawboned, imposed price controls, wore “Whip Inflation Now” buttons, and did everything else except adjust monetary policy to kill off inflation.  It didn’t work.  I am not going to pretend that in those years I was more interested in Nixon’s monetary policy than in the rumored upcoming Spanish tour by the Rolling Stones (I was living in Spain then – and unfortunately a sudden burst of ETA terrorism killed plans for the Rolling Stones tour), but I do remember how ineffective those measures turned out to be.  I guess I don’t really believe in “inflationary expectations” as a major cause of inflation.

At the end of the interview, Mr. Liu did point out to an important issue that needs to be addressed:  “In the second half, we need to push forward reforms in the financial sector.  Presently, SMEs are usually the first victims of credit tightening measures. This reflects the rigidity of China's financial system. Moreover, we need to push forward reforms of the pricing mechanism for energy and resources products.”  I think he is certainly right to be concerned about the unequal access to capital for SMEs, although I worry that he is pointing that out mainly to support an argument for credit loosening.

It has been an eventful week in the run-up to the Olympics.  Beijing is spruced up, traffic has improved dramatically, the weather is not too bad, most people are in a festive mood (although not artists and musicians – small clubs and CD shops specializing in Beijing art and music are being closed, presumably because the authorities believe foreign visitors will be more impressed with clean,  well-scrubbed middle-brow entertainment than with the messy and chaotic cultural vitality Beijing typically exhibits).  Even the stock market has been tame and well-mannered, if a little grumpy.  It market was slightly up today (0.3%), following a relatively good day yesterday (up 1.1%), although overall for the week to date it is down 2.6%  

Falling oil prices in the international markets haven’t helped local stock markets as much as they had in the recent past.  Oil fell earlier today to below $120 a barrel for the first time in three months, but the SSE Composite nonetheless dropped 51 points, or 1.9%, to close at 2690.  As in the recent past, the decline was led by property developers and brokers, which is particularly striking since we received confirmation today of last week’s rumor that the PBoC would relax the lending caps by 5% for national commercial banks and by 10% for local commercial banks (who are presumed to be more likely to lend to the struggling SME sector).  This means they can lend up to 105% or 110% of their lending caps, which should be good news for funding-pressed property developers.

For me however the most interesting news today was a report by Bloomberg on the possible acquisition of Germany’s Dresdner Bank by China Development Bank, the largest of the Chinese policy banks.  According to the article:

China Development Bank is competing with Commerzbank AG to buy Allianz SE's Dresdner Bank, Germany's third-largest lender by assets, three people familiar with the matter said.

China Development Bank, which funds the nation's public works projects, has conducted due diligence on Dresdner Bank in Frankfurt, said the people, who declined to be identified because they aren't permitted to publicly discuss the matter. The 23.3 billion euros ($36.6 billion) Allianz paid for Dresdner Bank in 2001 is more than six times the biggest overseas acquisition by a Chinese company.

It is probably unlikely that CDB actually makes the purchase.  Aside from the fact that the CDB, and Chinese institutions in general, have lost a lot of money so far in their acquisitions of foreign financial institutions (Bloomberg reports that their $19 billion of investments are now worth only $12 billion, including a $1.7 billion loss on CDB’s $3 billion purchase of a stake in Barclays), European governments have been very reluctant in the past to permit the acquisition of major domestic banks by foreign banks, even when the foreign bank is European. 

The fact that CDB is owned by a non-European government, and a government of a country that is largely, and increasingly, distrusted by Europeans, makes this a pretty tough transaction to approve politically.  Still, the fact the CDB is even doing due diligence on the deal must provide a frisson of thrill to investment bankers everywhere – it certainly indicates the global ambition of Chinese banks. 

If the deal were to happen it would be a very interesting transaction, not least, in my opinion, because of its impact on the valuation of CDB.  In the January/February issue of the Far Eastern Economic Review, I published a piece (“Buying Into China’s Volatility”) that uses an option framework for understanding the high valuations placed on Chinese banks by the international markets.  I argued that the very high valuations reflect not investor perceptions that the banks are in good shape but rather the desire of investors to bet on the expected volatility of the Chinese economy. 

In that discussion, which was extended in four consecutive October entries on my blog, I pointed out that insolvent financial institutions are usually the most effective vehicles for optional plays on an economy that is changing rapidly.  This fact explains the very high market valuations placed on troubled banks, not just in China but in a whole host of other developing countries experiencing major economic reforms (my own experience came from advising the Mexican government on the privatization of its largely insolvent banking system in 1990-92).  Insolvent or barely solvent bank share prices are not “encumbered” by intrinsic value (the excess of asset values over liabilities) and consist purely of time value, which is highly sensitive to changes in expected volatility.

The option framework makes two useful predictions.  First, and most obviously, since bank share prices are not anchored in intrinsic value, like they must be for highly solvent companies, their share prices will be extremely volatile.  This is because they will largely reflect changes in time value, whose value is set almost wholly by changes in expected volatility (and intrinsic value is usually far less volatile than time value).

The second prediction, which emerges from the first, is that if a Chinese bank were to make a large acquisition of a foreign bank its stock price would drop dramatically.  This is because a large acquisition abroad would significantly reduce the expected volatility (diversifying assets and earning streams always reduces expected volatility).

Since CDB does not have outstanding stock (it is preparing for an IPO), we will not be able to see the direct impact of a Dresdner acquisition on its share price if the acquisition does go through, but I would predict that when CDB stock is finally made available in the market, after its IPO, it will trade at a much lower multiple if the acquisition has been completed.  Investors will explain that lower multiple by complaining that unlike with the other large Chinese banks, with CDB they are not getting what they want – a pure play on the growth of the Chinese economy.

Note that I am not simply predicting an averaging out of valuations.  If a Chinese bank valued at three times book acquired an equally large foreign bank valued at two times book, it would not be a surprise if the new bank traded at less than three times book – say 2.5 times book.  What I am actually predicting is that the new entity will trade at a far lower valuation than the average of the two because of the impact of diversification on the very high time value implicit in the Chinese bank’s share price.  Intrinsic value for the two entities will actually rise (diversification usually increases intrinsic value because of its positive impact on financial distress costs), but time value will decline (diversification always harms time value).  Since Chinese bank share prices consist mostly of time value, the loss in time value will be much greater than the gain in intrinsic value, and the net impact will be a big loss for shareholders.

That doesn’t mean, however, that the CDB’s biggest shareholder, the government, will object.  Aside from the political considerations, the government has a very complicated economic relationship with its banks.  It is effectively the guarantor of the banks (or, in option terms, it is short a put option on the underlying assets), so that as guarantor it benefits both from the increase in intrinsic value and the reduction in time value brought about by diversification.  Reducing banking volatility is always a net benefit for the government – it is only the outside shareholders who will suffer.

The stock markets had a bad day, with the SSE Composite dropping 2.1% to close at 2741.7.  Part of the reason for the decline was concern that a roughly $1 billion upcoming share sale by China South Locomotive and Rolling Stock Corp. will draw a lot of liquidity from the market (stock sales tend to be vastly oversubscribed, with investors required to put up 100% of the bid amount in cash in their stock accounts), but the decline was hastened late in the day when reports came in of a terrible attack on a police station in Xinjiang province that left 16 policemen dead.  

Here in Beijing security has become so intrusive (although sometimes it is hard to see how some of the “security” measures can have any impact on actual security) that even my Chinese friends are complaining that they feel like outsiders in their own neighborhoods, and I suspect that the Xinjiang attack will only make things worse.  Still, traffic is certainly better, and except for today the past few days have seen an improvement in the air quality.  The town is slowly starting to fill up with tourists, and areas like Houhai (the lakes north of the Forbidden City) have a real lively atmosphere.  If we aren’t completely prohibited from drinking, dancing and arguing about sports this may turn out to be a fun couple of weeks.

But the rest of China continues without the distraction of living in an Olympic city.  Yesterday’s Bloomberg had an interesting article in which they quote the Wen Wei Po newspaper as saying that, according to “lenders and market watchers it didn't identify”, the total amount of underground lending in China exceeds RMB 10 trillion.  I don’t know how accurate this number is, but I think total loans in the system are about RMB 35-40 trillion, so this suggests that loans in the informal banking sector are roughly equal to 30% of loans in the formal banking sector.  A UIBE professor last year suggested that they were equal to around 25%, so assuming they are not simply quoting each other, the numbers are consistent.

Finally, and in contrast to the panicked reports of a sharp slowdown in China leading to a surge in unemployment, an article in People’s Daily reports that, at least officially anyway, Chinese unemployment is down:  “China's registered urban and township unemployment rate stood at four percent in the first half, down 0.2 percentage point from the same period last year, the Ministry of Human Resources and Social Security (MHRSS) said on Thursday.”  I don’t think anyone really believes that these numbers represent the actual urban jobless rate (I hear estimates that are two times or more as high), but the trend in the official unemployment number suggests that for all the talk of bankruptcies among southern exporters, it is not necessarily leading to rising unemployment.  Actually I have long argued that it is higher demand for workers that is the real culprit behind the declining fortunes of some of China’s exporters.

The stock market started out badly today, dropping 1.8% during the first two hours of the trading day, before a press conference by Hu Jintao, stressing the need for growth, brought back optimism over government-engineered policies to boost growth.   From its low the market surged 2.8%, to close at 2802, up 0.9% for the day.  According to an article in today’s Financial Times: 

Answering questions solicited beforehand, Hu used carefully worded answers to flag hopes to tame inflation while keeping the engines of growth primed, and he held out the prospect of some political reforms in the wake of the Olympics.  ”We must see that currently there are uncertain and unstable factors in the international environment, and China’s domestic economy faces increasing challenges and hardships,” he said.

 

Hu singled out inflation as a big concern but balanced that with a call for continued growth.  “We must maintain steady, relatively fast development and control excessive price rises as the priority tasks of macro adjustment,” he said.

None of this should have been a surprise.  There have been rumors for weeks of a shift in orientation and last week’s Politburo meeting and PBoC announcement have pretty much confirmed that the authorities are far more nervous about slowing growth than about rising inflation.  Of course lip service continues to be paid to fighting inflation largely, I suspect, because many seem to believe that inflation is more likely to be a consequence of rising inflationary expectations than of rising money supply.

As part of this effort to boost growth – and clearly as a sop to angry Southern exporters – export rebates were reduced effective August 1, according to an article in China Daily.  My student Cui Enze, who is currently in an internship in New York, reports in an email today: 

On July 30, State Administration of Taxation published a new policy that reduced textile industry export rebates ratio from 13% to 11%.  Obviously this policy is in response to ease the strong complaint from exporters and aimed to stop the slowdown of textile exports.  A government official in NDRC attributed the difficulty of textile exporters to four reasons, RMB appreciation, external demand slowdown, labor and material cost rise and domestic macroeconomic policy including export rebates, among which RMB appreciation is the most important.  

There are also strong rumors – and of course not at all unexpected – that the strict new lending caps announced late last year are going to be further softened.  According to an article in the South China Morning Post, “China’s central bank has raised banks’ lending quotas by 5 per cent, banking sources said on Friday, the most substantial move yet by Brijing to prop up the economy in the face of slowing demand for the country’s exports.”  Because this move hasn’t been put in writing – it was apprently announced during meetings on Thursday, according to unnamed sources – it is not totally clear what this actually means in terms of loan volume, but it is clear that loan caps are being relaxed.  

It is worth pointing out that the recent surge in bank deposits means that loan caps have been a far more serious constraint on lending than have the several increases in minimum reserve ratios.  This relaxation comes just in time.  An article in the current National Business Daily warns that, given current rates of loan growth, the existing lending caps mean that by November Chinese banks will have to stop all new lending.

More interesting to me was the announcement yesterday in the China Securities Times of the creation of a new department within the PBoC whose mandate, it seems, is to coordinate and manage foreign exchange policies.  Cui Enze also compiled information about this in his email to me.  He continues:

A new department launched within the PBoC – the Exchange Rate Department – has just been approved by the State Council.  This new department will combine part of the PBoC's monetary policy department, financial market department and also parts of the functions of SAFE, and it will be an individual department dealing with exchange rate policy research and formulation.

 

This suggests that the government wants to pay more attention and place a more important status on the exchange rate.  It will help also help smooth the process of exchange rate reform.  Moreover, it is very interesting to note that under the current difficult conditions that this Exchange Rate Department has been set up.  I think it is a preparation for more aggressive RMB reform. So far, no time schedule has been set.   

A very interesting report on ChinaStakes.com gives us additional color:

The PBoC has twelve departments and six bureaus. The exchange rate office currently operates under the Monetary Policy Department. Now the PBoC seeks to strip the exchange rate office from the Monetary Policy Department and make it an independent department.

 

A researcher，under anonymity, at the Chinese Academy of Social Sciences told Chinastakes.com that by making the exchange rate office an independent department, the PBoC may reinforce the influence of exchange rate policy in macroeconomic control in future. The Monetary Policy Department is the most important department at the PBoC. The director of this department will usually be promoted to a higher position in the PBoC.

 

It has been three years since the launch of exchange rate reforms in July 2005. The establishment of the Exchange Rate Bureau indicates the increasingly important or even key role of exchange rate policy in China’s current monetary policy system.

 

It may also mean that the Monetary Policy Department is unable to formulate internal and external monetary policies at the same time, and it may be better to transfer the responsibility of making exchange rate policy to the Exchange Rate Bureau, so the Monetary Policy Department can focus on domestic policies such as interest rates, and credit.

Victor Shih has an early and thorough analysis on his RGE blog entry of what this may mean, and some of the potential problems that may arise.  To me it is interesting that they are trying to coordinate exchange rate policy within the larger context of capital flows in China and abroad and local financial markets.   China’s monetary policy is, for the most part, simply an extension of its currency regime and it does make sense to place the exchange rate at the center of a whole set of policies.  

I am not sure, however, about separating monetary policy from the exchange rate policy, but perhaps this is in preparation for a future in which the PBoC will actually be able to determine domestic monetary policy (after the currency floats?).  Whether Enze is right – that this is preparation for more aggressive RMB reform – will take time to decide, but my guess is that whether or not that is the intention, when the exchange rate moves back squarely back into the center of the policy debate, as I expect it to do by the end of this year, this department may play an increasingly important role in Chinese policy formulation.

Standard & Poor’s have just raised China’s long-tem sovereign credit rating to A+, based on its strengthening external position.  In part this reflects China’s strong fiscal position – in June according to a release today by Credit Suisse, China’s consolidated fiscal surplus for the previous twelve months reached RMB 443.5 billion, equal to about 1.5% of GDP (although needless to say I am worried about hidden expenditures that may one day show up as contingent liabilities).  But the upgrade mainly means, I think, that China has accumulated so much in the way of foreign currency reserves that it will have little difficulty in repaying its very limited foreign-currency external obligations. 

Even though I am pessimistic on the domestic side, I agree with the S&P upgrade, and would even argue that China deserves a better rating.  The authorities are so determined to avoid a 1997-style crisis that they have made it all but impossible for the country to face pressure on refinancing (or simply paying off) its external debt.

However, rising oil prices and increasing talk of coal shortages at home put a damper on the stock market today, with the SSE Composite down 1.2%, led by refiners and airlines, to close at 2802.  Fan Gang, a member of the central bank’s monetary policy committee, is nonetheless pretty upbeat for the post-Olympics market.  According to an article today in the South China Morning Post, he recently told a local magazine, the Xinmin Weekly, that since we have already seen an adjustment in stock market and real estate prices, there is no need to expect one after the Olympics.  “We needn’t worry about the post-Olympic economy at all. How could [stock] prices drop any further?”

Perhaps he really believes that, or perhaps he is just keeping in step with the request by regulators to stay upbeat before the Olympics.  About a week after foreign newspapers reported that regulators had instructed domestic fund managers and market participants not to say or do anything in the next few weeks that might hurt the market, the China Daily reports:

Top securities regulators have vowed to maintain stability in and strengthen supervision of the capital market to ensure orderly trading in the run-up to and during the Olympic Games.  "Preparations should be made to deal with any emergency and prevent trading from being harmed by rumors or hackers' attack," Shang Fulin, chairman of China Securities Regulatory Commission (CSRC), said.

Meanwhile I think a new entrant has joined in on the battle of the RMB.  According to an article in today’s Bloomberg:

The appreciation of China's currency has hurt employment in the country's east, where most exporters are based, Yin Chengji, a spokesman for the Ministry of Human Resources and Social Security said.  “There has been some regional and structural impact,” he said in Beijing today after a news briefing.  “But employment demand remains strong in central and western parts of the country. The overall employment situation is basically stable.”

The argument that a rising RMB is contributing to unemployment is now very widely proposed and accepted.  This is going to make it very difficult once again to shift concerns back to China’s monetary regime, and I would guess that we are going to need quite a setback, probably in the form of inflation or a banking setback, before China’s monetary problems are addressed.  This means, to me, that the adjustment, when it comes, is likely to be much more painful than necessary.

At any rate as these stories indicate, on the policy front there isn’t a whole lot new happening beyond the knocking of heads together to achieve (a very fragile and probably temporary) consensus in favor of growth over tightening and, of course, the endless hunt for security threats in the run-up to the Olympics.

On a different topic altogether, in my June 29 entry I mentioned that one of my former students had called me up to tell me about growing worries in the derivative markets.  In my attempt to explain the problem on my blog I wrote the following:

According to him, a very popular recent lending structure involved lowering borrowing costs for corporate borrowers by having the borrower implicitly sell a complex derivative (this is a common, and often dangerous, way of lowering borrowing costs).  Let me explain this as schematically as I can.

A corporation borrows some notional amount from a bank, for five years, and agrees to pay 8% on the loan.  The corporation and the bank simultaneously enter into a swap, for the same notional amount, in which the bank agrees to pay the corporation 1% annually, as long as the euro interest rate curve is “normal”.  Should the curve invert, however, the corporation must pay the bank some amount, typically 4 bps per day according to my source.

The net result is that the corporation is able to borrow money at 7% instead of 8%, and in exchange it agrees to pay a significant penalty if the euro curve inverts – something that is extremely unlikely to occur, the CFO is probably told.  From the bank’s point of view, they are still getting 8% funding, because they simply strip the option and sell it on to the foreign banks, who have the capability and expertise to monetize the option.

It sounds great on the face of it.  As long as the euro curve does not invert, and I am sure the corporate borrower is given reams of data showing how rare that occurrence is, everybody is happy.  The corporation borrows at 7%.  The local bank lends at 8%, and makes additional fee income by implicitly buying the option from the corporation at a lower price than it sells to the foreign bank.  And the foreign bank gets to sell a fairly complex derivative whose pricing formula is opaque (in investment banking jargon, “opaque” means “I can get away with charging a lot”).

Unfortunately, from what I have been told, the euro curve has inverted, and has been inverted for over a month.  Furthermore, it is deeply enough inverted that there is little expectation that it will normalize soon.  Corporations have suddenly seen their borrowing cost mushroom.  The transaction that had previously reduced borrowing costs by 1% a year was now increasing borrowing costs by 10% a year on an annualized basis.

About a week after I posted this a couple of newspapers, including the South China Morning Post, wrote stories about these transactions – the losses had become big enough to generate some attention.  Last week another of my students called me up to tell me that the story hadn’t ended.  He sent me this (slightly edited) email today:

Basically all the major foreign banks (i.e their credit portfolio managers) are buying protection against the Big Four Chinese banks to hedge their counterparty risk.  Although there is a standard CSA signed between foreign banks and Chinese banks, as a matter of fact all the Chinese banks nonetheless have refused to settle margin calls on their MTM losses in the Euro CMS trades they put on as a hedge against similar transactions with their corporate clients.  5yr CDS of ABC and ICBC is bid at around 170 bps, but nobody is willing to show an offer at all.

According to my student, and to explain the above, the cost of default protection against the Big Four has soared because all the foreign counterparts, unable to get margin posted as required by the derivative agreements (MTM refers to “medium-term notes”, which is usually the structure in which many of these derivative agreements are imbedded) and unwilling to take the Big Four to court, are now facing the possibility of credit losses uncovered by margin.  They are running around looking to buy credit default protection, but there are few sellers.  He goes on:

One of the things being discussed around here is that each of the Big Four probably has $1-3 billion in paper losses already.  

I heard some of the contracts expire in September or December this year, and there is no sign of any normality of the inverted euro curves, especially when you have such a hawkish ECB.  Given the liquidity and cash position of the big four Chinese banks, there is no worry of any credit event to be triggered so far. But going forward all foreign banks will definitely act in a more prudent way when dealing with Chinese banks whose credibility and professionalism will be given a big question mark after the recent unpleasant experience.

I remember in the late 1980s there were similar difficulties dealing with Japanese banks, who didn’t seem to understand many of the risks they were taking and refused to play by the rules, even after having agreed to them.  After an initial rush to deal with them (Japanese banks, it seemed, were going to rule the world one day), most bankers and traders I know decided that they weren’t worth the trouble – I myself came to that decision in 1988 after a particularly annoying and difficult transaction – and stopped dealing with them.

My student tells me that the Chinese banks are refusing to settle with the foreign banks largely because their corporate clients won’t settle with them and pay up on the bet-gone-wrong.  This, of course, should be irrelevant – a bank takes on only his counterpart risk, not the risk of his counterpart’s counterpart, unless it is explicitly agreed to in the contract.  Chinese banks must keep to the terms of the deal entered into whether or not their domestic clients have done so.  One explanation of why the Chinese banks may refuse to put up margin could be that these transactions are not well-known within the bank, and no loan manager wants to draw his superior’s attention to them.  Requesting liquidity to post margin would probably elicit questions.

The scale of these losses isn’t huge, relative to the bank balance sheets, but the types of transactions entered into, and the responses to market losses, should set some alarm belles ringing.  This isn’t the sort of information that should strengthen our confidence in the ability of local banks easily to withstand a slowdown.

There is an interesting article in yesterday’s Xinhua headlined “Capital shortages top risk for China's SOEs.”  This seems at first counterintuitive given China’s rapid reserve accumulation, but the explanation may be in the article itself.  According to the article:

Lack of capital was the biggest risk facing China's centrally-administrated State-owned enterprises (SOEs), according to a risk assessment report released by the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) on Monday.

A lack of capital worried most SOEs, especially those in electricity, petroleum, steel, investment, energy and real estate, said an expert participating in the evaluation of the report. The expert, who declined to be named, attributed the shortage of funds to the tightening of credit, materials price hikes and reckless expansion.

The rapid expansion of some SOEs was believed to have resulted in the capital scarcity as the continuous tightening of monetary policies and bank loans failed to slow acquisitions and mergers.

SASAC director Li Rongrong warned against the "strong expansion impulse", saying investment beyond main business lines and capacities as well as investments with very low returns must be prohibited.

The SOEs, which traditionally get almost all of their funding from the large commercial banks, are being affected by the lending caps, although I suspect that these caps are likely to be relaxed in the upcoming months.  It is interesting to me that one of the reasons cited for the capital shortages is “reckless expansion.” 

The capital allocation mechanism in China is weak, and one normal consequence of excessively cheap money tends to be overinvestment and excessively rapid expansion.  It seems that SOE expansion may have reached the point where the debt servicing costs exceed the returns on investment to an extent that it is putting a burden on SOE capital needs. This is particularly likely to be the case if we start seeing a build-up in inventories.  So far we have only seen this in the real estate sector and the automobile industry, as far as I know, but I suspect we will see references to inventory build-up more often in the coming quarters.

Meanwhile Jake van der Kamp has an article (”Policymakers grappling with inflation monster”) in today’s SCMP with which I am in broad agreement.  One of the interesting points he makes is in an attached graph that shows CPI inflation from 1983 to the present.  The article and the graph, which I can’t insert here, indicate at least two things that I find interesting.  They demonstrate the fallacy of the way-too-common argument that for all the naysayers China has been able to run very smoothly without serious economic problems or crises for the last thirty years, so it is unreasonable to expect anything to go wrong now. 

In fact, there have been several periods that are only not called crises by Westerners because the links between the Chinese economy and the rest of the world were too small for the rest of the world to be affected.  The graph also shows how quickly inflation can surge – from very low levels to well above 20% in two or three years.

Meanwhile the stock market seems to be ignoring the government’s recent injunction against bad news.  It dropped 1.8% yesterday and drifted down another 0.5% today, to close at 2837.

On a very separate note, and for those interested in some of the smaller corners of china’s financial system, I have probably said it more than enough times before, but I am really fortunate in having so many incredibly smart former students from Peking University and Tsinghua University in the world of Chinese finance.  They have been able to keep a close eye on the nuts and bolts of finance and come up with very useful information.  One of my smartest kids, now a rising star at a major private equity group, sent me the following (slightly edited) email late last week:

As we have invested a substantial amount of capital in a financial leasing company in China, I’ve gotten to know this industry well and would like to share with you some observations.  Basically, financial leasing companies here provide 2-3 year asset-backed financing for equipment purchases, with ticket sizes anywhere from RMB 1 million to RMB 50 million.  The company in which we’ve invested focuses on the RMB 1-2 million segments, with the underlying assets being construction equipments, printing equipments, etc.  Our customers are SMEs which are either too small to obtain bank financing, or have exhausted their real estate as collateral.

Obviously those are also the companies most vulnerable in period of a downturn. It is interesting to see that our financial leasing company has sort of become an informal bank, charging its customers an interest rate of around 25%, and funding itself at 7-8%.  The credit default cost will definitely be higher than normal, although we don’t have a clear view as to how high it can go.  Hopefully, after deducting the credit default cost we can still make decent returns.

There are at least three things to note there.  First, the business is very risky but can be very profitable.  A credit spread of 17-18% can tolerate a lot of defaults.  It is also growing very quickly, albeit from a small base, at a rate exceeding 30% a year.

Second, I am not sure about, but am very interested in, linkages between these kinds of activities and the rest of the financial system.  I assume that the leasing companies get at least part of their funding from banks, and my student confirms that they do (in fact banks are aggressively entering the market), but since the SMEs turn to the leasing companies precisely because lending caps at the banks have cut them off from bank financing, I would guess that much of their funding is direct and not intermediated by the banks.  Still, as they mortgage their assets to raise financing from leasing companies, they are effectively putting the commercial banks in a junior position in case of payment difficulties.  This means that defaults in the SMEs will have a bigger-than-expected impact on losses in the commercial banks.

The third thing worth mentioning is that neither minimum reserve requirements nor interest rate controls – two of the main tools used by the PBoC to manage monetary conditions in China – are likely to have any direct impact on the loan activity of the leasing companies (or indeed any of the other informal banks).  As they increasingly take up the slack forced by the lending caps and minimum reserve requirement hikes, they further marginalize the PBoC.

After Friday’s Politburo meeting it seems that the perception that there has been a shift in policy-making is nearly unanimous.  The meeting’s focus on “stability” and “continuity” included as a major objective the maintenance of “sustained, stable, and relatively fast growth.”  And although “preventing prices from rising too fast” continues to be described as an important policy goal, gone are the references to preventing overheating and maintaining the tightening bias in monetary policy.

In that context it is not as surprising it otherwise might have seemed, I guess, that the PBoC is now calling for growth while ignoring references to tight monetary policy.  According to a report from today’s Xinhua:

China's central bank said Sunday it would seek to create conditions for "relatively fast" economic growth in the coming months, despite the ongoing threat of inflation.  "We will use various monetary policy tools to create good conditions for stable, relatively fast growth," the bank said on its website.

The central bank's statement came after recent figures suggested growth in China's economy -- the world's fourth-largest -- is beginning to slow.

This has caused quite a lot of heated discussion in the financial markets.  One of my students who works in a large city bank in one of the rich southern provinces told me by email this morning that "everyone in my bank is discussing the new statement by the PBoC – and their reluctance to use the phrase tightening policy for the first time.  This is close to Wen Jiaobao's voice. "

According to him, however, the PBoC is unwilling to lose their hawkish reputation too quickly, so the consensus in his bank is that they will continue to talk tough, and maybe even make a very ugly face soon, but will in fact actually take actions to loosen credit and liquidity conditions.

It’s not that the monetary alarmists have given up the fight.  Today’s People’s Daily has an article citing a speech, also made on Sunday, by the chief economist of the National Bureau of Statistics, generally considered to be on the side of the monetary hawks.  The article starts out:

The Chinese economy was likely to maintain stable and fast growth this year, despite being beset with problems and uncertainties, as fundamentals of the economy remained unchanged, Yao Jingyuan, National Bureau of Statistics chief economist, said on Sunday.

The article then goes on to say “He believed the most outstanding challenges China faced were an unbalanced economic structure and big inflationary pressure.”  It seems to me that one of the arguments made by those wanting to maintain a tight monetary policy is to insist that the economy is not slowing as precipitously as the growth camp fear.

Meanwhile the stock market seems to have decided that monetary tightening is out, and easy credit, at least easier credit, is back in.  The SSE Composite was up 1.33% today, closing at 2903, led largely by banks and real estate developers.  Most analysts are saying that the new policy-making consensus reduces the chances, at least in the very near term, for more interest rate or minimum reserve requirement hikes, and that this is good for bank profitability and very good for the property developers.  The latter have recently found it very difficult to get financing except from the informal banking sector.

In the first half of 2008, according to a Ministry of Commerce release today, investment flows from Hong Kong to the mainland rose by 95% over the same period last year, to $23.4 billion.  Interestingly enough, the number of projects declined by 8.2%, to 6,900.  I suppose it is possible that the average size of each project has more than doubled, but given the large number of projects, I think this is extremely unlikely.  So why the discrepancy?  According to an article in today’s Xinhua:

Given the close trade and economic ties between the Hong Kong Special Administrative Region (SAR) and the mainland, analysts said, at least some of the investment might be speculative funds.

It very well might.  The article goes on to say that Ministry of Commerce figures indicate that since 1978, 40.7% of all FDI entering China, or $331.9 billion, was sourced through Hong Kong.   

FDI in the first half of last year amounted to $36.0 billion, if I remember correctly, so using these Ministry of Commerce numbers I calculate that Hong Kong accounted for around 33% of that total.  For the first six months of 2008 FDI amounted to $52.4 billion, and the Ministry of Commerce numbers suggest that Hong Kong accounted for 45% of the total. 

If I am doing my calculations correctly this implies that the increase in Hong-Kong-sourced inflows accounted for 69% of the total increase in 2008 year to date.  Given that last year HK accounted for only 33% of FDI, contributing 69% of what was a large overall increase means that Hong Kong investors are clearly playing a disproportionately large role in that increase.

Of course I can’t prove it, but for all the obvious reasons it is probably safe to say that most of the hot money coming into the mainland comes from Hong Kong, from Taiwan, and from Chinese family business networks, so the fact that Hong Kong accounts for such a disproportionately large share of the rise in FDI is, at the very least, suspicious.  I think this is clearly more evidence, if any is needed, that much of the money coming into China is speculative.

By the way according to the Ministry of Commerce release, investment abroad by Chinese companies more than doubled in the first half or 2008, relative to the same period in 2007, to $25.7 billion.  I think this is pretty impressive, especially given that investing abroad is a tough proposition when you have an undervalued and appreciating currency.  The release did not specify how much of this investment was funded abroad, but I suspect much of it was, so the domestic monetary benefits of this outward investment are probably pretty limited.

Meanwhile the local stock markets seem to be in a less gloomy mood than they have been during the past few months.  The two strongly positive days (Monday and today) and the two mildly negative days have left the SSE Composite – which closed today at 2910 – up 4.75% so far this week.  Part of the improvement is probably due to declining international oil prices, but given that financials have been the leaders, I think that most of the improvement comes from speculation that inflation may be easing, or at least that the authorities are likely to take pressure off the monetary side in their bid to promote growth.

By the way I heard confirmation today from another friend of the rumors to which I referred earlier this week – that the infighting between the two main policy-making camps has gotten so fierce and so visible that part of the purpose of the recent leadership meeting was to broker a compromise and calm things down.  Unfortunately given the apparent current tilt towards “growth” within the leadership, I do not think this controversy is going to die down, and I expect that rising inflation later this year will re-ignite it.

This week’s rising bank stocks prices don’t mean that there isn’t nervousness in atleast some quarters about credit risks.  According to Jamil Anderlini in today’s Financial Times (“China’s banks told to tighten mortgages”):

Chinese officials and government economists have warned domestic banks to tighten their mortgage lending criteria after the US government’s action to prop up Fannie Mae and Freddie Mac, the giant mortgage agencies.  

Liu Mingkang, China’s top banking regulator, has in recent days urged the country’s state-owned commercial banks to beware of risks in the real estate sector and ordered them to tighten loan approval processes.  Others among China’s policy community have also begun to express concerns about the health of the country’s banks amid signs a once-booming property sector has begun to slow

Jamil goes on to quote Yi Xianrong, at the China Academy of Social Sciences, as making the very sensible observation that “If financial institutions of Freddie Mac and Fannie Mae’s calibre could get into such a bad situation, then what does that mean for Chinese financial institutions?  The only reason we haven’t seen similar problems here is because property prices have continued to rise rapidly.” 

Needless to say I think Mr. Yi is absolutely correct, and I expect that he will have proven to be when and if ( and I really just mean “when”) we see a serious monetary or economic contraction.  He elaborates:  “Anyone can get a mortgage loan in China, no matter who they are. There is also a huge amount of speculation in the market and insider dealing when it comes to bank officers granting loans.”

In that context I heard from a normally plugged-in friend of mine that the authorities are planning to reshuffle the top positions in the big banks after the Olympics.  My friend tells me that the new leaders are likely to be more sympathetic to industrial and provincial leaders’ beliefs that slowing growth is a bigger worry than rising inflation.  If true, I think we can expect to see deterioration in the credit quality of bank portfolios, even as they take on more market risk.

SASAC already announced yesterday that “China will restructure centrally administered state-owned enterprises after the Beijing Olympics”, according to Xinhua.  Perhaps this has something to do with the fact that profits at centrally administered SOEs are down 10.3% in the first half of 2008 (compared to up 30.9% last year).  I am not much of an expert on the industrial sector, and I don’t have a lot to say about this, but I was interested to see that Dong Tao at Credit Suisse says that this may indicate inflationary pressures:

We believe the weakened profit growth at the SOEs is a major concern. It suggests continued rising production costs and increasing pressures caused by the government’s caps on fuel prices and power tariffs.  Besides surging prices of raw materials, rising inflation expectations are leading to an acceleration in wage growth, in our view.  In addition, the continued losses in the oil refining and power production sectors have led to a further deterioration in fuel and power supplies. This may force Beijing to raise fuel prices and power tariffs again after the Olympics.  The shift in the source of inflation is of real concern, and we do not rule out the possibility of a second round of inflation as cost pressures continue to build.

A report in today’s China Daily says:

Second-quarter housing prices in 70 large and medium-sized Chinese cities rose 9.2 percent year-on-year, said the National Development and Reform Commission and the National Bureau of Statistics on Monday.  The rise was 1.8 percentage points less than in the first quarter.

One of the regular debates on this and other sites is over whether there really is a problem of excessive hot money inflows, as I have been arguing for over a year.  If stock market and real estate prices are collapsing, skeptics ask, then how can hot money inflow be excessive?  Where does the money go? 

Aside from the fact that there are many other places where hot money can go (commercial bank deposits, deposits in informal banks, and commodity hoarding are just three of the most obvious), I think we have to distinguish between slowing growth in real estate prices and declining prices.  There are declining prices in certain real estate sectors – for example in some of the major cities – but overall prices still continue to rise, even in spite of what seems to have been massive overbuilding.  It is hard to prove this, but the combination of overbuilding, hot money inflows, and all the gossip about SUVs carrying armed men in sunglasses and bags of cash suggests plausibly that hot money inflows have managed to keep up demand for real estate in what otherwise might have been a sharper supply/demand imbalance,.

Gregor Neumann, in the comments to Friday’s posting, cites a piece that argues that at least some property markets in China are seriously oversupplied, and yet we haven’t seen a real collapse in real estate prices anywhere.  I think we are seeing a tug of war between oversupply and excess monetary-based demand.  I am not a real estate expert and I hesitate to speak authoritatively on this very complex subject, but any time spent over drinks with my more expert friends in the real estate business leaves me very gloomy about the impact of an economic or monetary contraction on the real estate sector.

But for today we should be cheerful.  A great start to the week saw the SSE Composite run up 2.99% today to close at 2861.  Financial companies led the rise after CITIC reported better-than-expected earnings, although you might not have guessed it from Xinhua’s article headlined, “Slump hits CITIC’s profit rise”, which said that the collapsing stock market had slowed first half profit growth to 13.3%.  Over the weekend meetings among senior officials suggest that the authorities are still tilting towards an economic slowdown as the more serious of two problems (the other being, of course, inflation) and so most of us continue to think we are less likely to see dramatic tightening moves in the immediate future.  That is likely to be good generally for financial and real estate companies.

The stock market was also helped by an article in China Securities Journal that said that regulators would slow approvals for stock sales in order to ensure “stable and healthy” markets.  This doesn’t come as a big surprise, but because it does indicate continued government concern about the performance of the market this year, people see it as yet another signal that the government will intervene to stabilize the market..

On that subject the current issue of Caijing has a very interesting article, in which they say “A report that criticized regulatory intervention in the securities market appeared briefly July 16 on the official Web site of the Shenzhen Stock Exchange (SZSE) before being quickly removed.”  The article goes on to say:

The 129-page report, compiled by the research arm of SZSE, said China's “securities regulatory bodies intervene too often and distort normal market operations.” The report also said misplaced regulatory clout partially contributed to widespread illegal activity on the mainland bourses in Shenzhen and Shanghai.   

An anonymous source at SZSE told Caijing that exchange officials had asked the Web manager to remove the report the night of July 16 because “further review is needed about the content, and it will be published in the future when the timing is right.”

The now-you-see-it, now-you-don't report shed light on what the authors said are four major factors behind illegal market behavior last year: legislation, the market, participants and regulations. The report said the China Securities Regulatory Commission (CSRC) had expanded its jurisdiction with little oversight, and now oversees a wide range of issues including professional standards, business approvals, IPO regulation, and investor education. Meanwhile, CSRC gave itself the right to make rules as well as supervise the nation’s bourses, and had assumed a bailout role during market troubles.

The report said the current securities market is “overburdened with administrative regulations.”  According to the report, CSRC's overbearing control contributed to irrational swings in the stock market, since administrative commands often hindered market mechanisms and poor implementation of regulations -- included some laws flawed from the start -- disrupted market order. Gray legal areas also leave the market open to exploitation.

There was also a call for better supervision of regulatory bodies and the media. The report suggested a securities court and arbitration bodies that could interpret existing laws, strengthen law enforcement and launch class action lawsuits.   The report also said lax law enforcement, not a clean market, is the reason why China has been reporting few insider trading cases.

None of these criticisms are new or surprising, of course, and I have made the point dozens of times on this blog that the overbearing administrative measures used by authorities to control the market actually have the effect of increasing speculative behavior and volatility.  What this report suggests is that there is a real attempt internally to roll back government heavy-handedness, although I am pretty skeptical that it will succeed.  The article also suggests how powerful, important and perhaps even necessary to China’s further development Caijing is, that they can openly discuss a report that seems to have been suppressed almost immediately upon publication.

Finally, following up on last Thursday’s post, today’s South China Morning Post says “Chongqing starts to ration power.”  Chongqing is one of the largest cities in China and the world, and one of four cities in China separated from their provinces and granted provincial status as municipalities (the others are Beijing, Shanghai and Tianjin).  Within China people often think of Chongqing as a sort of Chicago, the large urban and industrial gateway to the west.  According to the article, brownouts and declining coal stocks have forced the city to join more than a dozen other provinces in rationing power.  This has been a long, hot summer, and it isn’t over yet.

The stock market raced up today, with the SSE Composite closing at 2778, 3.49% higher than yesterday’s close.  Since investors are still digesting yesterday’s mix of good news and bad news – GDP slowing, fixed asset investment soaring, CPI down, PPI up – I suspect the main cause of the decline may have been the decline in oil prices to $130 a barrel.

Cui Enze, one of my Peking University students currently completing a summer internship at Van Eck in New York, was nice enough to sleuth out the CPI numbers for me on the National Bureau of Statistics of China website.  According to him, this is the breakdown of the food and non-food components of CPI:

Without the actual index numbers, it is hard to extract much information from this series except to note the obvious – that non-food inflation is low but rising.  If I make a simplifying assumption that non-food inflation last year ranged from zero to 1%, it implies that non-food inflation year to date is probably running at an annualized pace of 2-3/4% to 3-3/4%.  This is not particularly high in itself, but remember that these numbers are being held down by price controls and, more importantly, that if Chinese monetary policy were consistent with low inflation, the surge in food prices should have caused at least some deflation in non-food prices.

Enze also sent me a separate note in which he alerted me to an article in this week’s Caijing

Just read news on the Caijing website that the CEO of a big private company (GoldenSun) in Yi Wu of Zhejiang province disappeared the other day.  The reason is that this company has 1.4 billion RMB outstanding debt which was borrowed through informal banks. Of the 1.4 billion, 800 million is principal and 600 million is interest not paid. The asset of this company has been audited or sold to repay part of debt.

This company had been borrowing through informal banks at an interest rate of only 2%-3% in 2005, but ever since late 2007, the interest rate has climbed as high as 12%, which brings a huge cash flow pressure to the private companies in Zhejiang. This year, several other owners of private companies in Yi Wu have fled because they can't repay the high interest.  As most of the small companies in Zhejiang are export companies, the RMB appreciation and rising price of raw materials have significantly reduced their profit margin.

I checked the English version of Caijing and saw the story, although it didn’t have as much information as the Chinese version which Enze cites.  It did say the following:

A source told Caijing that Zhang raised money through a local version of China’s informal “gao li dai” credit system, which lets private individuals lend cash at high interest rates to persons or companies through go-betweens known as “hui tou.”  The system flourishes thanks to legal loopholes.  In Zhang’s case, the hui tou allegedly included local officials and lawyers. Many lenders mortgaged homes to raise the money that Zhang borrowed over the past two years, the source said.

The article closes by quoting a Yiwu-area banker as saying: “More bosses will flee later this year.”  I suspect that these sorts of stories are going to become more common.

For now I don’t know how common these sorts of defaults are likely to be, but at least this article does address one question that comes up a lot.  I have often heard people assert that the informal banking system is not a significant source of banking risk because loans are too small to matter, even in the case of serial default.  But this story involves loans from the informal sector of significantly more than $100 million to one client.  This sounds like regular banking to me.

Another student, who wants to remain anonymous for obvious reasons, also sent me an interesting note today (it’s great to have such great students).  He is spending the summer as an intern at one of the larger and better city commercial banks in the southeast.  He tells me (with some editing on my part, largely to hide names):

We saw some weird stuff yesterday in the money market.  If you only looked at the money rate, it was a normal day, but in the real market, a Big Four bank unexpectedly ran out of liquidity, and they were asking for money eagerly from other banks.  Because this bank is a major money-provider in the market, small or city banks like us cannot lend them money at a very high rate (because of their power and "mianzi").  We worry that they may punish us later when we lack money ourselves, so most of us choose to say: "Sorry, but we also lack money."

It wasn’t until 3:30 in the afternoon, that the bank finally got the money it needed, but because of their lack of money, small banks also could not borrow.  Our bank was also caught in this trap and not able to borrow one cent before 3:30.

My student goes on to tell me that his money market traders told him that these sorts of liquidity squeezes have become increasingly common during this quarter.  I haven’t been able fully to figure out what this means.  It may simply be the expected consequence of the several hikes in minimum reserve requirements.  If so, this puts a little hair on the statement I cited yesterday by a banking regulator who warned that further reserve hikes were hurting the system. 

I wonder if anyone else among my readers saw something similar and can explain what happened or how common it is.  One of the few things I learned from my banking classes at Columbia Business School (and amply confirmed in my many years as a bond trader) is that problems in the banking system usually first turn up in the plumbing – the otherwise very unglamorous money markets.  I always tell my finance students to keep an eye on the money markets, and I am glad to see that at least one of them has taken me seriously.

As expected, the National Bureau of Statistics of China released a new set of economic numbers today.  According to the release, CPI inflation year on year for June was 7.1%, its lowest level since January.  It was 7.7% in May, 8.5% in April and 8.3% in March.  On a month-on-month basis CPI declined by a little under 0.2% (following a 0.4% decline last month).  This is more or less in line with expectations.  The information is presented a little differently than it has been in the past, and I cannot back out the food and non-food components.  I am hoping some cleverer analyst will be able to do so, but so far I haven’t seen anyone else provide a breakdown.

PPI numbers, also as expected, were much worse.  PPI prices rose 8.8% year on year in June, compared to 8.2% in May, 8.1% in April, and 8.0% in March.  I have already pointed out many times before that as the CPI numbers become increasingly tainted by price controls, more and more of us are looking at PPI to get a sense of underlying inflationary pressures.  I think any sense of relief prompted by the continued decline in CPI inflation will be held in check by the frankly very poor PPI numbers.

On a related topic today’s Financial Times has an interesting article by Jamil Anderlini and Geoff Dyer with the rather worrying title “China on the brink of electricity shortfall.”

China faces its worst power shortage in at least four years as soaring coal prices and government-set electricity tariffs force dozens of small power plants to shut down rather than face mounting losses.  Nearly half of China’s provinces have started to ration electricity as the country enters the peak summer season, facing what analysts describe as its worst coal shortage.

Analysts warn that this year’s electricity shortfall could be more severe than in 2004, when the country was affected by its worst power shortage in decades because of soaring demand for power as the economy boomed.

This is part of the problem with the inflation numbers.  We are exchanging higher prices for shortages, and although one is as much an indication of inflationary pressure as the other, only the former shows up in the CPI and PPI numbers.  These kinds of shortages (and there are many more) are masking very real inflationary pressures, but earlier experience, such as those of the US in the 1970s, suggest that shortages are only a temporary way to mask inflation.  I expect price increases will have