My Blog

September 1, 2008

On Friday the Chinese stock markets had their second up day in a row (a rare occurrence this year), with the SSE Composite trading up 2.0%.  Today, however, the markets reverted to form, and the SSE Composite dropped 2.9% to close at 2327 which is, I think, the lowest point they have reached since February of last year.

What seemed to drive the market down today was a confluence of events suggesting that government fears of an economic slowdown may be reasonable.  Today the China Federation of Logistics and Purchasing released its calculation of August PMI (purchasing managers’ index).  It registered a seasonally adjusted 48.4, the same as in July, and the second month in a row that it came in at contractionary levels (anything below 50).  At the same time CLSA released its own PMI calculations, which also came in below 50 – the first time this has happened since the survey began nearly three years ago.

I think the main thing to watch now is consumer demand.  Growth in consumer demand in the past few months has been quite good, but as I discuss in my August 14 entry, it is not clear if at least part of this might not simply be anticipated consumption for the Olympics.  If that is the case, we may see a slowdown in consumer demand in the coming months.

Remember that the three pillars of Chinese growth are domestic consumption (both private and public), net exports, and domestic investment.  Global conditions are generally weak, which suggests that exports are going to be a lot less powerful in fueling Chinese growth than they have been in the past.  If domestic consumption also starts to grow more slowly, that places much of the burden of fueling growth on domestic investment, but without foreign or Chinese consumption to buy its production, it will only be a matter of time before the third pillar begins to wilt too.

Most hopes are on an expansion in fiscal spending to solve the growth problem, and there is little question that policy-makers are seriously considering their options here.  There has been a lot of discussion, both publicly and privately, about government proposals to stimulate the economy via tax cuts or infrastructure spending.  I have always been a little skeptical, however, about how easy this is likely to be.  

In first place, if there really is an economic slowdown we may see a sharp rise in NPLs in the banking system, and along with it a sharp rise in contingent liabilities on the part of the government sufficiently large to constrain their ability to spend.  Given how big the loan portfolio of the banking sector is relative to GDP, a small rise in the NPL ratio will have a big impact on total government debt via contingent liabilities.

Secondly I am less certain than others about the fiscal position of the government.  In this I guess I have been a bit of a contrarian, since nearly every other analyst I have read or spoken to points to the relatively healthy fiscal position of the government and the sharp rise in fiscal revenues as an indication of how much room the government has to prime the fiscal pump.

But for me, the fact that fiscal revenues have risen so sharply while the government has maintained its fiscal position in a small deficit or surplus, depending on which period you measure, indicates an equally sharp rise in fiscal expenditures, and I doubt that an economic slowdown will have nearly as big an impact on lowering expenditure growth as it has on revenue growth.  On the contrary.

In that light I was interested to see an article in today’s South China Morning Post that suggests that although not as pessimistic as I am, the Ministry of Finance might not be as optimistic as some others are:

The mainland's finance ministry yesterday warned of increasingly austere times ahead as funds flowing into government coffers last month slowed sharply from the revenue expansion seen earlier this year. Slowing growth in fiscal revenue reflects tougher times in the world's fastest-growing economy as well as heavy spending on disaster relief and earthquake reconstruction.

The July figures come at a time when economists widely expect Beijing to be more proactive in spending to boost the economy after first-half gross domestic product growth slowed to 10.4 per cent from 11.9 per cent last year

Fiscal revenue last month grew 16.5 per cent from July last year to 607 billion yuan (HK$692.83 billion), compared with the 30.5 per cent expansion in the first seven months, the Ministry of Finance said. Beijing projects an increase of 14 per cent in fiscal revenue for the full year, according to the government's budget at the start of the year. Fiscal revenue rose 32.4 per cent last year.

The article goes on to say that in July, fiscal expenditures rose 40.9% year on year, or 29.7% for the first seven months of the year versus the same period last year.  That disparity in growth between revenues and expenditures strikes me as worth wondering about, even before the economy faces the consequence of a slowdown.  

I know, I know, I am going to be accused of being overly pessimistic, but perhaps many years of bond trading (and in developing countries no less) has left me looking for potential trouble spots, and it really can’t be controversial for me to point out that when things go bad, they tend to go bad on several fronts simultaneously.  If there is an economic slowdown I am willing to bet that we will see both a sharp deterioration in the government’s fiscal position and in banks’ loan portfolios, and I also suspect that the growth impact of a major fiscal expansion will be less than we expect.

At any rate the newspaper quotes the MoF as saying:

"We expect fiscal income will follow this trend of expanding only moderately for the rest of the year and the pressure for spending to increase is big," the finance ministry said. "The past growth was achieved on the basis of the steady and rapid development of the national economy. Extra money is needed to stabilise prices and cope with natural disasters. We can't ignore the fact that the fiscal conditions are actually quite tight."

Perhaps the MoF really believes this or perhaps they are simply positioning themselves to ward off an expected massive call on their resources.  We’ll know some time next year, I guess.

Meanwhile the PMI release did bear some good news.  PMI input prices have dropped sharply in July, which suggests that PPI might not rise as quickly in the next few months as it has in the past.  I am prepared to be wrong about my alarmist inflation forecasts if PPI begins to subside quickly, but I am not ready to change my views for another two or three months since I think we can easily see temporary respite within a much longer inflationary trend.  I mention this especially since yesterday’s newspapers reported (another) strike by Shenzhen’s bus drivers and conductors that have left thousands of travelers stranded.  Although China does not freely allow workers to organize or strike, the fact regular strikes over low pay in Shenzhen over the past months have disrupted service suggests that wage pressures have not gone away.

Before concluding this already long entry I want to mention an August 28 MNI article forwarded to me by Logan Wright.  One of the things that I try to teach my students is to use simple models to try to anticipate changes that may take place in the economy, and then to look for these changes.  They are not always obvious if you are not looking for them.

For example, I have always assumed that the huge supply of money created by China’s currency regime and the huge demand for funding created by its inefficient growth would have to meet.  Much of the intermediation has taken place via the banking system, but of course with the lending constraints that were put in place over the last year, bank loans have grown much less quickly than we would have expected.

For many analysts, this is more or less then end of the story.  Policy-makers were able to slow lending growth, as planned.  But that didn’t make sense to me: the supply of and demand for funds was as strong as ever.  In that case, I assumed, lending constraints were just likely to force intermediation into other parts of the financial system.  

Based on this simple model, I made two predictions.  First, that the informal banking sector and other parts of the banking sector not covered by the lending constraints were probably growing very quickly.  Second, that banks would increasingly engage in activity that would allow loan growth to take place off the balance sheet and away from the formal constraints.  I remember telling my friend Chris Keogh, one of the heads of Goldman Sachs China activities, that I expected there to be a burst in securitization taking place as banks shifted loans off balance sheet.

The first prediction seems to have happened.  We have no good numbers on the informal banking sector but anecdotal evidence suggests that indeed it is growing quickly.  In fact over the past few months a lot of ink has been spilled on the subject – informal banks are now a hot topic.  Also, as Stephen Green of Standard Chartered pointed out a few months ago (see my May 18 entry), loan growth among policy banks and in the dollar loan portfolios of commercial banks, neither of which is covered by the lending constraints, have grown very quickly.

The second prediction turned out to be a lot less successful.  There have been loan securitizations in China in recent months, but not nearly as many as I expected.  I put this down mainly to a non-transparent regulatory system that made it difficult for banks to innovate around restrictions.  

It turned out, however, that I may have just been looking in the wrong place.  Here is what MNI says:

Chinese banks are bypassing tough controls on their lending behavior by raising money for their clients via wealth management products, a move which analysts said highlights the limits of the government's attempts to control the banking system through quantitative measures.

Wealth management products have exploded in popularity this year, with 53 banks selling 2,165 products equivalent to around one trillion yuan ($146.3 billion)  during the first half alone, more than the 819 billion yuan in such products sold over the whole of last year.
    

But all is not as it seems. Industry observers note that over a third of the value raised has been for products which are structured like non-transferable debentures, with banks repackaging them as wealth management products and marketing them on behalf of clients.

Apparently the banks are packaging loans as securities, but rather than sell them in the public markets they have been selling them privately to their high net worth clients.  The article goes on to say:

Xu Hanfei, a Shanghai-based bond analyst with the Industrial Bank of China, said that around 300 billion yuan raised through the sale of these kinds of wealth management products in the first half of this year wound up with Chinese companies or local government vehicles.  Sichuan-based Southwestern University of Finance and Economics estimated that Chinese companies and local governments raised around 385 billion yuan via these products during the first seven months of this year.

That compares with the 2.8 trillion yuan that Chinese banks extended via their traditional loan books during the same period. The People's Bank of China introduced a quarterly loan quota system this year in a bid to hold loans at last year's 3.6 trillion yuan.

Xu acknowledged that wealth management products are being used to bypass the loan quota and continue raising funds for clients, even if the banks themselves aren't taking on the actual risk. “Wealth management products are a good substitute for bank lending – banks want to maintain the pace of loan expansion but the PBOC has capped lending growth with a quota so we've had to improvise," Xu said.

This kind of activity is not necessarily a bad thing for the banking industry – on the contrary, it helps banks to learn about securitization and to earn fee income while limiting their risks by passing them on to clients.  We should worry however about the level of sophistication of their clients and whether, if there ever is a problem, these loans are truly gone from the banks’ balance sheets.  The recent problems faced by UBS, Citibank and many others show that just because a loan has been shoved off the balance sheet onto investors does not mean that the bank has totally eliminated its exposure, especially if large scale defaults lead to political pressure.

But the real point of this article, as I see it, is to highlight the difficulty of addressing the symptoms of a problem without addressing its root cause.  China’s “tight” monetary policy has been anything but tight. 

It is easy to claim that China’s rapid monetary expansion can be controlled simply by placing limits on the consequent credit expansion.  It is naïve to believe, however, that the reality is that simple.  China continues to suffer from rapid monetary expansion.  When policy-makers try to control the consequences of that expansion without controlling the fundamental problem – for example by placing lending constraints on the banks, or by trying to control the rise of prices – they are likely to be doing little more than shift the problem from where they can see it to where they can’t.

Comments (11) for "Slowing economy and rapid cr...

Michael, interesting observations. This article in ChinaDaily has similar notion. GDP and private consumption in Shenzhen have risen by double digits, but production fell by 7%: “Shenzhen’s GDP reached 353.288 billion yuan (51.80 billion U.S. dollars) in the past six months, an increase of 10.5 percent compared with the same period last year,” Deng said. “The city’s economy is developing in a positive way, although we are still facing some difficulties and problems as the international economic environment is dim this year.” Statistics show that Shenzhen’s consumption market has increased quickly in the first half of the year, with 108.049 billion yuan of total retail sales of consumer goods, an increase of 18.2 percent. The gross value of foreign trade reached US$ 139.175 billion, an increase of 9 percent compared with the same period last year, according to Shenzhen Customs statistics. Shenzhen’s consumer price index (CPI) in the past six months increased by 7.3 percent compared with the same period last year mainly because of the increasing cost of food, especially meat and vegetable oil, which increased by 38.2 percent and 39.1 percent respectively. Urban fixed-asset investment growth also increased slightly. Total fixed-asset investment reached 57.523 billion yuan, an increase of 6.9 percent compared with the same period last year. However, Deng said the most obvious pressure facing Shenzhen was the dollar’s depreciation and RMB’s appreciation, which had caused Shenzhen’s industrial production to fall by 7 percent." http://www.chinadaily.com.cn/china/2008-07/24/content_6873765.htm I wonder, if we see a similar effect as in Spain. Real estate and infrastructure investment inflate GDP and stimulate private consumption. But this can't go on for ever. By Gregor Neumann - 8/31/2008 9:57 PM

But isn't a deterioration in the government's fiscal position good in a downturn? Also, from a fiscal perspective, aren't lower net revenues equivalent to higher spending? Automatic stabilisers, etc...? By A Chan - 9/1/2008 7:37 AM

Ignore the 'net' in the above comment... By A Chan - 9/1/2008 7:38 AM

Thanks Gregor. The Spanish comparison is interesting and one I hadn't thought about (even though I grew up there). Europe's monetary policy turned out to have been highly inappropriate (too loose) for Spain and osme other countries in the EU. There was insufficient capital and labor mobility within Europe to to permit a single monetary policy for the whole region. I have seen studies that suggest that the transmission of monetary policy is very uneven throughout China, too, which suggests to me that different that a given monetary policy might be too tight in some cases while too loose in others. This is not likely to be an easy problem to resolve and suggests that averages are even less useful in China than elsewhere. AC, yes, normally fiscal policy acts as a stabilizer to the extent that it works against current trends (contract during the boom and expand during the slowdown). If there is a slowdown it definitely makes sense for China to expand fiscally. My point is that China's fiscal position might not be nearly as strong as a superficial look at the numbers would suggest. I would also argue that policy-loans, especially to the extent that they may be hard to collect, should be seen as part of fiscal spending, in which case the government's fiscal position may have been far more expansionary than we think during the period of high growth. By Michael Pettis - 9/1/2008 10:51 AM

Very interesting point. If I understand, you are saying that the "fiscal expansion" has already happened when the banks made the policy loans during a period of rapid growth, but the debt will only become visible during a slowdown when NPLs rise. If you are right, this could be worse than merely "pro-cyclical." By Francois L. - 9/1/2008 11:08 AM

Fascinating entry. I don't know how you keep doing it. From the numbers you quote I guess these quasi-securitizations amounted to 10-14% of total loans. Am I right in saying that this implies that the loan cap (I think it was growth in net new loans of 16% or so) is closer to 18%? Do you have any estimates for total growth in net new loans, including the informal banking sector? I know it is hard to get accurate numbers, but I am curious about a ball park estimate. By BVE - 9/1/2008 11:27 AM

Michael Could you please do something about your blog posts font size please? It is very small and hurts my weak eyes. I like to read your blog but my eyes always win the argument. Thanks Aditya By aditya kumar pandey - 9/1/2008 5:57 PM

Aditya, I will start publishing with a larger print, but I think there is a way for you to increase the font size when you read it. By Michael Pettis - 9/1/2008 6:26 PM

Aditya, try "CTRL +" (Control-key and the plus-key simultaneously). This shortcut tells most browsers to zoom a page. The font gets bigger and better readable. Works great with tiny graphics and charts as well. By Gregor Neumann - 9/1/2008 6:51 PM

Michael/Gregor Thanks for helping. I read through FeedDemon (a popular RSS aggregator) and it doesn't seem to increase font-size beyond a point. Yes, opening up the post in external browser like Firefox might make sense (where ctrl-+ would work). Good idea. I would appreciate if the default font size is increased, however. Thanks By aditya kumar pandey - 9/1/2008 7:11 PM

If the CCP does undersell the majority of its dollar assets in its foreign reserves, it will result in global economic chaos. Although Secretary Paulson of the U. S. Treasury said China, being the second largest holder of U. S. treasury securities, possesses less than the daily trading volume of these securities, Paulson had to give this confidence talk as a political figure. What Paulson said is true. However, once the underselling starts, through the exaggeration of media reports, the international“ hot money” ... By forexbacktestingsoftware.com - 9/21/2008 5:31 AM