China Fin MKT New Numbers Lack Clarity 5-12-11

8/6/2019 China Fin MKT New Numbers Lack Clarity 5-12-11

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CHINA FINANCIAL MARKETS

Michael Pettis

Professor of Finance

Guanghua School of Management

Peking University

Senior Associate

Carnegie Endowment for International Peace

New numbers from China dont clarify much

May 13, 2011

Quite a lot of data came in this week as I was recovering from the jet lag

generated by last weeks trip to the US, and for good measure, the PBoC then

raised minimum reserve requirements Thursday evening. I dont have muchto say about the hike, beyond what will inevitably be in Fridays newspapers,

but on Wednesday the National Bureau of Statistics reported the eagerly

awaited inflation numbers. Here is what they had to say:

In April, the consumer price index went up by 5.3 percent year-on-year,

which was 0.1 percentage point lower than that in March 2011. The price

grew by 5.2 percent in cities and 5.8 percent in rural areas. The food price

went up by 11.5 percent while the non-food price increased by 2.7

percent. The prices of consumer goods went up by 5.9 percent and the

prices of services grew up by 3.9 percent.

So it turns out that year-on-year CPI inflation is down a little, although it is

more or less flat month on month (up 0.1%). The news on PPI inflation was

more dramatic. Year-on-year PPI inflation was 6.8% in April, down from last

months 7.3%

This seems on the surface to be relatively good news. I have been less

worried than others about an unstoppable rise in inflation, and expected it to

peak probably in the middle of the summer before coming down, but asidefrom the fact that one data point doesnt indicate a trend, the numbers arent

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totally comforting.

The drop in inflation was driven wholly by food prices, not non-food prices,

and at 3.9% year on year it seems that services inflation is starting to become

an important source of total inflation. Non-food inflation was steady at 2.7%but prices there might have been constrained by price controls in which

case we are simply hiding price increases by disguising them as hoarding,

illegal selling, or shortages.

The NDRC also seems to believe that attempting to suppress inflation by

providing subsidies to the energy and agricultural sectors is a sustainable

policy, something with which I suspect the PBoC does not agree. Of course

all subsidies accomplish is to reduce household income through hidden or

direct taxes (someone has to pay for those subsidies) while reducing price

increases. What we might have called inflation, in other words, we now call

taxes, but the aggregate impact on reducing real household income is of

course the same.

That doesnt mean however that it has no impact. It does, but the impact is

not to protect purchasing power in the aggregate but rather to redistribute

income. Since the poor consume disproportionately in the form of food,

agricultural subsidies benefit the poor disproportionately. I am not sure how

the costs are distributed, but they are probably more heavily concentrated

among the middle classes and this will determine the net distribution. It is not,of course, simply an issue of determining who pays taxes. Remember that

the most important taxes in China are hidden taxes that allow the

government to borrow cheaply from households. My guess is that the PBoC

does not like subsidies and price controls because they do not really address

the root causes of inflation and indeed disguise the problem, whereas the

NDRC likes them because they are a way to redistribute wealth downward.

But away from these policy complications and disagreements, all of this non-

food and services inflation worries me mainly because it might suggest that

inflation is spreading and getting embedded into expectations. This will make

inflation harder to wring out currency appreciation or better food harvests

will not be enough. I still think inflation will peak in the middle of the year and

then decline, but now I am a little more eager to see next months data than I

might otherwise have been.

The rest of the data suggests that growth is slowing. April industrial

production growth fell to 13.4% year on year, down from 14.8% in March.

Retail sales growth also dropped, driven mostly by a slowdown in car sales,

from 17.5% in March to 17.1% in April. Once you adjust for inflation this isone of the lowest retail growth numbers I remember seeing in many years. I

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dont pay too much attention to the growth in retail sales as a good proxy for

consumption growth, but the trend does confirm the claim made in the World

Banks quarterly report (which I discussed last week) that consumption growth

is still slowing and has been for much of last year. Since reported GDP

growth hasnt slowed, it is hard to conclude from this that consumption hasbeen rising as a share of GDP.

On the other hand investment seemed to have grown big surprise, right?

Fixed asset investment growth in the first four months of the year rose to

25.4% year on year, which is even higher than last years equivalent 25.0%.

If there is one thing we know how to do well here, it is to increase the level of

investment.

The debate over growth

So what would I conclude from this weeks data release? Unfortunately I

cannot come up with anything very dramatic. As far as I see it nothing has

changed. The fundamental imbalances are all in place and are not beginning

to reverse. They will not reverse until there is a radical change in the growth

model, and investment comes down sharply. Unfortunately that will also

mean a sharp decline in growth.

Clearly this isnt happening, and neither I nor anyone else expects it to

happen this year or next unless a surge in inflation causes the whole thingto unravel much earlier than I expected. For now, the lower inflation numbers

and slower growth will probably mean that the State Council is leaning

towards being more expansionary.

And clearly there are concerns about growth in China. My friend Wei Liao

from Paridon, in Singapore, sent me while I was traveling last week a

reference to an interview in21st Century Business Herald(a well-regarded

local newspaper) with Zhu Bailiang. Zhu is the chief economist at the State

Information Center of China, a policy think tank affiliated with the NDRC, and

in the interview he argued that the government shouldnt introduce tighter

monetary policies because existing limits on car and home purchases will hurt

the economy.

Zhu is not a policymaker but he is a senior advisor to the very powerful

NDRC, an entity usually considered less focused on correcting domestic

imbalances and more focused on maintaining high growth and redistributing

income to the poorer sectors of the economy. As Wei Liao points out, it is

pretty rare that someone from Chinas economic policymaking circle makes

such a comment in the midst of what is supposed to be a tightening cycle.

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I am also hearing, by the way, that there is a lot of opposition from local and

municipal borrowers towards raising interest rates even further even though

in real terms interest rates have decline quite substantially. This shouldnt be

a surprise since they have a lot of outstanding debt and are expected to

borrow even more this year and next. Servicing the debt is unlikely to be easyand they want more, not less, relief.

I would argue that Zhu Bailiangs comments and the rumors of opposition to

further interest rate hikes probably indicate that the very intense debate within

policymaking circles continues unabated. In fact, on that note, for me the

most interesting thing that happened during the SED meetings in Washington

this week involved Mondays much-commented interview on the Charlie

Rose show with Wang Qishan who is expected to be named Vice Premier

next year.

While perhaps a few too many people focused on his claim that Americans

were too simple to understand the inscrutable Chinese, I was more struck by

his references to the difficulty of the debate within China over economic

policy-making. Here is what Bloombergsays about it:

The biggest hurdle facing Chinas economic rebalancing is reaching

internal agreement that the country should rely less on exports and more

on domestic consumption, Chinese Vice Premier Wang Qishan said.

Actually the biggest challenge for us in this respect is to make sure thateveryone is on the same page, Wang said in an interview on the Charlie

Rose show, which aired yesterday on PBS and will be broadcast on

Bloomberg Television today. We need to come to the same conclusion

that we must transform our economic development pattern.

Wangs remarks, in response to questions about when China may let the

yuan rise and take other steps to shift its economy toward domestic

demand, acknowledged debates within the Chinese government over the

pace of gains.

Notice that reaching agreement over rebalancing is the biggest hurdle,

according to Wang, who has a reputation of being very smart and very

knowledgeable about economic issues. The gossip that I have hears in

Beijing is that both Wang and Li Keqiang expected to be named Premier

next year understand Chinas debt position, worry that the current growth

model is unsustainable, and want to move quickly towards an economic

growth model that de-emphasizes investment and exports. They also

recognize that this will result in a sharp slowdown in growth although not

nearly as sharp as I expect.

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But they will not be able to do so without a pretty complete consensus within

policymaking circles. A lot of very powerful constituencies the export sector,

local and municipal borrowers, SOEs have benefitted from distortions, like

the currency and the interest rate regimes that have created the imbalances.

They are likely, not surprisingly, to be loathe to give these up, and so it will notbe easy to arrive at a consensus.

Aprils trade surplus

There was more data this week. The day before the CPI data was released

the customs bureau reported Chinas trade surplus for April, and it came in at

a higher-than-expected $11.4 billion. Here is what Bloomberg had to say:

China reported a more-than-estimated $11.4 billion trade surplus for April

as U.S. officials pushed at talks in Washington for faster gains in the

yuan. Todays number, released by the customs bureau, compared with

a surplus of $140 million the previous month and $1.68 billion a year

earlier. Import growth slowed to 21.8 percent in April from a year earlier

while exports grew 29.9 percent.

Since Chinas very low trade surplus in the first three months (actually a small

deficit) can be explained mostly by the combination of commodity stockpiling

and rising commodity prices, the fact that China ran a large surplus should not

be too big of a surprise (although the recent sharp decline in commodityprices wont have affected April numbers much). We can expect continued

large surpluses for the rest of the year.

I dont think there is a whole lot I can say about the trade numbers that isnt

obvious or that hasnt already been said. Instead I want to digress on the

subject of copper imports. I know I have spoken a lot in earlier newsletters

about goings-on in the copper markets in China, and I dont want overdo it,

but so many people I met with last week during my trip to the US continued to

be interested in the story that I thought I would cite what one of my smartest

students reported to me recently.

Michael Liang, who heads my trading seminar, wrote me about a recent

conversation he had with a commodity trader he had invited to speak later this

week at the seminar. According to him, this conversation confirmed the story

we have put together over the past five months.

He [the trader] said that on March, clothes makers, food manufacturers,

and others who have never bought copper before were massively buying

copper from the tariff-protected warehouses, in Guangdong for example.The warehouses are in China, but tariffs on the goods there haven't been

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The debt carried by Chinas real-estate developers jumped 41% in the

March-ended year from the same period 12 months earlier, according to a

report by Chinese state media. Debt carried by the nations developers

was 1.05 trillion yuan ($162 billion), the Xinhua News Agency reported onMonday, citing figures compiled by the Shanghai-based data provider,

Wind Information.

The figures were based on the 113 mainland-listed developers and their

first-quarter filings. The value of unsold houses was up 40.2% to

CNY903.5 billion, the Xinhua report said. Average profit was down 4.9%

to CNY54.65 billion yuan.

None of us are terribly confident about the validity of the numbers, but what

matters here is likely to be the trend. Needless to say it would not be at all

surprising to see a strong correlation between declining sales and rising debt.

This just suggests that as developers have trouble selling projects they have

already financed, they need to roll the debt over rather than repay it.

The second interesting piece was from the current issue of the always hard-

hitting Caixin:

Angry institutional bond investors holding a Sichuan Province highway

construction company's debt are stirring a hornet's nest over a financialpractice that's apparently commonly used by local government financing

platforms across China. The practice is called internal asset transfer, and

investors who purchased bonds backing Sichuan Expressway

Construction & Development Corp recently learned the hard way that it

can be used by local governments to burn corporate debt holders.

Investors say they were forced to accept higher default risks for their

Sichuan Expressway mid-term notes because the transfer involved the

construction company's most valuable asset a stake in the Chengyu toll

road between Chengdu and Chongqing worth about 3.85 billion yuan.

I dont want to read too much into this one incident, but of course as the GFC

and the European crises remind us (especially some recent moves in Ireland

to abrogate the bank subordinated-debt contracts), in overly liquid markets

with rapid credit expansion, lenders tend to overlook mechanisms that

weaken their ability to protect themselves generally on the assumption that

protection is unnecessary. This issue of internal asset transfers is something

about which I have heard a lot over the years, but I always resolve to learn

more about it at some later date and so have never dug too deeply into it.

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1-year benchmark lending rate was only raised by 50bps from the end of

last year. In March, 56% of new bank loans were lent out at a premium to

benchmark rates and only 14% of new loans went lent out at a discount.

Last year only 40% of these loans were lent at a premium while nearly

30% were lent at a discount to benchmark interest rates. The majorcauses of this change are the recent property regulation measures and

tighter credit quotas.

I have thrown in an awful lot of information in this weeks issue of my

newsletter and I apologize to my readers if it is a little overwhelming, but what

strikes me about all of this is that is that there seems to be a lot of stress and

strain in the system, with different indicators pointing in very different

directions and policymakers offering very different strategies. Add in all the

uncertainty surrounding US growth, Fed monetary policies, the debt crisis in

Europe, and commodity prices and it is easy to see why people may be fairly

concerned about the outlook over the next few years.

The key is likely to be the evolution of the internal policy debate.

Sections of this newsletter may be excerpted but please do not distribute.

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China Fin MKT New Numbers Lack Clarity 5-12-11

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