My Blog

October 15, 2008

After the globally coordinated rescue package was announced Monday the Chinese stock markets boomed in sympathy with the rest of the world, with the SSE Composite closing up 3.6% for the day.  Tuesday the SSE Composite shot up 3.5% within minutes of opening, but the party was already over in China.  Over the rest of the day the SSE Composite drifted down nearly 6% from its peak to close the day down 2.7%.  Wednesday was another bad day with the marking closing once again below 2000, at 1995, down 1.1% for the day.  Nothing, it seems, is able to keep this market up.

The announcement that the US government would use about $250 billion of the $700 billion rescue package to re-capitalize the largest US banks is in line with actions by other European governments, and will reduce some of the credit pressure on the banks.  That’s a good thing, even if it turns out not to be enough.  A lot of people are calling this move unprecedented, and representing a major change in the institution of financial capitalism in the US, but to me it only confirms that in time of crisis the government has been willing to change its ownership position.  I don’t have the numbers in front of me, but I believe that the current move to purchase equity stakes in the large US banks is not much bigger in real terms, and probably smaller in relative terms, than the purchase of bank stocks by the Reconstruction Finance Corporation in the 1930s.

As an aside, rumors are once again swirling around about leadership changes in the large Chinese banks and among regulators, but these rumors have been around for several months, and with everyone expecting announcements around the time of the October holidays, this seems to be happening more slowly than expected – a possible indication that leadership discussions are paralyzed by the uncertainty surrounding the crisis.  I have also heard several of my friends in the written and broadcasting media say that there are increasing constraints on what may and may not be said in the press and on TV about the international financial crisis and its possible impacts on China.

All this suggests that authorities are very nervous.  While the PBoC periodically announces that conditions are solid, the banking sector sound, and the economy slowing but still strong, the South China Morning Post reported yesterday the creation of a new very high level crisis committee:

Vice-Premier Wang Qishan will head a committee being set up to deal with fiscal uncertainties caused by the deteriorating global financial crisis, according to an official source. The decision to set up the committee is the latest step by mainland authorities to try to prevent the domestic economy following western countries into recession.

At the end of the Communist Party Central Committee plenary session on Sunday, the leadership said that despite the international turmoil, the mainland's basic economic situation had not changed. However, precautions to guard against the side effects of the international slowdown were needed. The source said the central government believed "losses from the international financial crisis are limited and the country's risk and exposure to the crisis is still controllable".

The new committee will be at the core of efforts to deal with the international problems. It will monitor financial changes overseas and respond by adjusting mainland economic policies when necessary.

It is definitely a good idea to create a high level crisis committee to monitor risks and to formulate policies for a rapid response, but if the thinking really is that the main risk to China is of contagion from international exposure, I am a little puzzled. 

To me the real risk has always been that the same excess monetary expansion that led to overextended and vulnerable financial systems abroad will have done the same thing in China.  In other words the risk was not so much (in my opinion) that there was a huge amount of hidden exposure to sub-prime mortgages or some other foreign toxic waste that will bring the Chinese banking system down, but rather that we have our very own time bombs hidden in the various formal and informal parts of the domestic banking system and that any sufficiently large adverse shock – financial or economic or even political – can cause a sharp contraction in the banking system. 

The fact that the authorities seem much more obsessed with the direct contagion impact – and that the media may have been instructed not to discuss these issues too openly – makes me wonder if there is not a lot more here than I at first imagined.  I am surprised that there has been so little debate within China about whether or not the crisis presents a huge buying opportunity for China (the foreign media has been much more excited about discussing this).  Could it be that SAFE and the CIC already have such a mess on their hands that no one has any intention of buying more assets abroad for a long time?

This is all just speculation, of course.  The real news yesterday was the release of PBoC reserve numbers, but as an indication of how furiously busy things have been, it was only by late today that I have been able to look at the numbers.  After going through the numbers and talking to my friend Logan Wright, who keeps sharp tabs on the PBoC, I have to say that there are two easy conclusions from the latest release.  First, hot money inflows have almost certainly slowed and maybe even reversed.  Second, the data is getting fiendishly hard to interpret, just as we are most eager to get a little clarity.

Headline reserve growth was $96.8 billion in the third quarter.  This is an extraordinarily high number by any standards, but it is a measure of how out-of-control reserve growth has been in China that it is being seen by researchers and the press as a serious moderation in reserve growth.  Once again (as in the good old days before hot money hijacked the process), most of the reserve growth is fully explained by the trade surplus (which soared in the third quarter of 2008) and FDI, which was higher than average for the last few years but lower than the first two quarters (much of it puffed up by anticipated investment – a nicer name for a form of speculative inflows).

However there is a lot of confusion in the numbers.  Currency valuation changes during the quarter, especially in August, added a lot of volatility to our analysis.  We can only guess at the currency composition of PBoC portfolio, so unfortunately even small errors in our estimate are going to have a magnified impact on our final numbers.

There were also some strange goings-on in the dollar account at the PBoC account which, following my previous usage (although the name is no longer fully appropriate) I have put in the “Reserve hike” account.  I won’t go into too much detail here because the numbers aren’t big enough to change the conclusions.

The results of my calculations, with input from Logan Wright, I have listed in the table above.  Don’t focus on the absolute numbers because there is a lot of possible error in the numbers.  What seems pretty certain is that the huge unexplained inflows of previous months (a proxy for hot money and its various close relatives) have all but vanished by July and August and in fact have probably turned into outflows by September.

Should we worry?  Yes and no.  Obviously since China was, and still is, suffering from explosive monetary growth, and it is precisely this monetary growth that is creating so much risk in the domestic financial system, the fact that hot money inflows have slowed and may have even reversed is unquestionably a good thing, especially as the trade surplus has surged.  Make no mistake, however – having reserves rise by roughly $100 billion in a single quarter would in any other time or country be seen as outlandish.  If we eliminate non-monetized components of this increase in reserves (interest income and currency valuations), there were net inflows into the country of $120 billion that had to be purchased by the PBoC with a combination of currency and PBoC bills. 

This is more than twice the $60 billion quarterly average of 2006 – a number which once seemed astonishing.  This is a lot of domestic money growth.  Fortunately for the monetarists out there (but not for those who fear that the economy is slowing too quickly) it seems that the banks are not eager to expand loan volume too quickly.

But there is something about the latest PBoC numbers which should indeed cause worry.  For me one of the bad-case scenarios that we have most to worry about is a sudden reversal of hot money inflows, large enough that it puts liquidity pressure on the formal and informal banking systems.  This is clearly not a problem yet, but the shift in a matter of months from massive inflows to moderate outflows is not confidence building.

As a related aside, and I am now straying into areas about which I need a lot more information, by coincidence I had two meetings yesterday – one with a world famous Harvard economist and a group of PKU professors, and the other with a group of traders and bankers – in both of which South Korea suddenly became the topic of conversation.  I am no expert on Korea but the kinds of things I was hearing raised all my Latin-American-bond-trading hackles.  One of the academics said he thought that Korea would come under tremendous liquidity pressure in the next three months.  If there are problems once again in Korea I would lay pretty serious odds that capital flight will become a serious problem all through East Asia.

Comments (10) for "Hot money inflows have gone ...

Yes, the South Korea rumor has been there for a while. I could even find the discussion about it outside the academic circle on some regular online forums. People are saying SK is working hard to get some external helps right now. You are right to worry about the hot money outflow. The crisis committee is precisely there to address the potential liquidity problem that could be caused by the hot money outflow. Having seen the panic in the rest of the world, nobody could afford to be unprepared. About the SAFE and CIC's investments, they are cerntaily taken loss, how could it not be? Compared with the real economy, it is just not that important. It is important to those officials though. By fatbrick - 10/14/2008 9:31 PM

Very good analysis Prof. Pettis, thank you for the break down, it is very useful. I can also point out that Yuan fowards are for some weeks now implying a devaluation, which is another gauge for hot money (one way or another they should arbitrate each other). I hope that just like in 97, China manages to go through this crisis better than the rest, but it is certain that there will be more casualities, S. Korea included. I was pleased to look at last months numbers that finally Chinese comsuption is growing faster than the export sector, perhaps the internal market will be able to endure this global slump... By Eduardo Guelman - 10/15/2008 6:15 AM

Eduardo, July and August consumption numbers might have been inflated by Olympics-related spending (for example in August TV sales were up 70-80% year on year). We need to see September and October numbers to see if they hold up, but there are warnings that they won't -- car sales in September, for example, are dramatically lower. By Michael Pettis - 10/15/2008 5:02 PM

i agree with fatbrick that SAFE and the CIC have taken modest investment losses. SAFE's roughly $100b external equity portfolio as of say june 08 cannot be worth $100b any more - and SAFE likely has some credit losses. The only thing limiting the CIC's losses is the fact that it doesn't seem to have invested most of its $100b (counting the funds for external investment) Michael and Logan -- even after correcting an embarrassing initial error, I get somewhat larger reserves growth for august and september, mostly from my valuation adjustment. there is a risk that this is off in a big way tho. I also am not sure of the $11b fall in $ reserves in September (based on the info in China stakes) but that should be clarified soon enough. all told, I am getting about $150b in reserve growth in q3 (adjusting for currency valuation effects, but not any mark to market loss on SAFE's equities) -- which is bit higher than you all seem to be getting. It seems like in the table above valuation losses are subtracted from reserve growth -- when i am adding them to it (i.e. in August, China added $63b to its reserves, but headline growth was only around $40b b/c of valuation changes) By bsetser - 10/16/2008 4:06 AM

Brad, is it possible that China has quietly shifted its portfolio towards a larger share for dollars? That would be consistent with dollar strength (although in times of global crisis the dollar usually strengthens). Otherwise the implied valuation changes are so large that I find them a little implausible. By Michael Pettis - 10/16/2008 2:50 PM

Yes. A Very good and perhaps prescient blog entry today, which might foretell the near future. Or, just might be useful to someone, for some unknown reason. However, what must be kept in mind, is that the ultra-superficial topics discussed on this blog, are just such chaff. The true economic issues which impact almost everyone are those which influence most people's lives. And this blog does a very piss poor job of addressing these. If one were to look back over time, to evaluate both the blogger and the commenters, on this blog, then it would be simple to see that such a great percentage, perhaps 99.85 percent, is just true pure Bull Sht. And, as can be seen from reading other news sites, this Bull Sht gets picked up by others, with not much better to say, and gets put on other news servers. So the Bull Sht just keeps rolling down hill. Surely someone must be able to discriminate between the Bull Sht on this blog and the actual science that is being done by real, dedicated researchers around the world? Truly, this blog seems like a game of checkers when the real discussions are being carried out elsewhere by significant minds that are playing Chess. Don't forget. Fck the optimists. The Fckn optimists will willing eat sht and pronounce it Grade A. Also, if any Idiot Fckrs on this blog want to do good, it is possible to set up a fund to sue, in absentia, all the Chicom assholes who have Fckd Over the people in China. Every time the Chinese courts refuse to hear a worthy court case. For example, it might be possible to set up a court, in cyberspace, to put any Chicom Fckrs, who screw over fellow comrades, on trial. And even jail them for life, virtually, in cyberspace. But anyway, until this blog finally progresses to a point where it can discuss important economic issues, and discuss these issues in a much more thorough way using far more extensive data from many more data points in the real world, then this blog will just remain an extremely well written blog, which has no true lasting value, other than self stimulation. It will remain a young child's naïve rendition of a Warhol. By . - 10/17/2008 4:06 AM

I suppose if we wait long enough eventually the anonymous comment guy will say something useful and intelligent in one of his comments, but the wait seems long. At first I though he might be one of the professor's students who got a bad grade and is still angry, but as a PKU student I can say no one here is dumb enough to be him. As someone has said recently he is full of highschool thoughts and books. By XuX - 10/17/2008 2:01 PM

Professor why don't you erase the comments of the sad, lonely guy who writes so many and such long dumb comments on your blog? It is a waste of time to read so much self-important posturing by someone who knows so little, and most of the other comments are very enlightening, so I try to read them all. You would be doing us all a favor. By TR - 10/17/2008 2:27 PM

To all you Kommie Fckrs on this blog. Don't think change is not possible. 10 years ago, no one would have predicted a Black President of the USA, other than B movie scripts. But, it is now happening before our eyes. And, about time, too. This should provide hope to all the people in China, even China's second class citizens, who work under the boot of the Chicom Fckrs in Shanghai, Beijing and other major Chinese cities. If a black man can be elected president of the US, then, anything is possible. Any good change might be possible for the future. And no need to give up hope that change might be possible if one only has enough patience. But, meanwhile, fck the Chicom Kommie bstards. And, if you see Fuld on the Hill, give him a good sock in the kisser. This is what Bogart might do. Also of particular note is that the next president of the USA spent many formative years in Indonesia, growing up. So, this might also bode well for better international relations. Or, do you like the fcking fckr who is now in the White House who, according to Stiglitz, has already spent 3 Trillion USD on fcking the Iraqis? Depends on one's point of view. By FckPower SoakTheStinkingRich - 10/18/2008 3:49 AM

Fatbrick, I will post a little more about South Korea later today. Any insights or knowledge you have would be great. I think many might underestimate the impact of a Korean problem on China. TR, I do erase comments -- and I have erased many -- if I think they are wholly irrelevant or if they get bogged down in vituperation or silly nationalism. It is not always easy because sometimes a comment filled with ranting may have something that, even if it is not particularly insightful, refers to the discussion. In that case I try to leave it. Many bloggers attract stalkers, and I guess I would be a little disappointed if I couldn't draw one or two myself. Just tolerate it in the same way you might reluctantly tolerate people who talk too loudly on their mobile phones or who wear inappropriate designer clothing -- good education is not universal. By Michael Pettis - 10/18/2008 2:15 PM