My Blog

August 20, 2008

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.

Comments (14) for "The last few days of Olympic...

Minoacid the meat man says: "The magic number, which Pettis will not talk about when he blogs, on and on, and continues to blog again, about hot money, GDP growth, and inflation, is the number 385." 385 is the magic number? That is so funny. They say a man with a little bit of knowledge is a bigger fool than a man with no knowledge. By Gao - 8/19/2008 6:33 PM Spend an afternoon, and take a gander, at all that James E. Hansen has to say. If you have the smarts to understand what Hansen is saying, then read it and weep. Hope you will take a gander. Any simpleton can understand it, once all the basic research has already been done for you. You can find Hansen at the Goddard Institute for Space Studies. Very glad you are interested in learning more about this important issue.. By SAN-BA:Gao, 5 - 8/19/2008 7:15 PM

Michael, A quick question: Why no position on the issue of increased government spending? From a global perspective, with the US weak and Eurozone weakening, it seems that we can ill afford a slowdown in China as well. Provided that the increase was focused on spurring increased domestic consumption, why would you not be in favour? By the way - great blog, I've learned alot. By Robster - 8/19/2008 11:27 PM

As far as I've seen, Frank Gong's goal is to become the Henry Blodget of China. I sat through an hour session from this Snake Oil Salesman last year, right at the top of China's market. It was an hour long stream of consciousness rebuttal of every argument he had ever heard about why the Chinese or H-share markets might fall. His favorite phrase was to repeat over and over how any portfolio manager who dared be underweight Chinese stocks would be wiped out by "the Chinese Tsunami of Cash". I reported back on the conference, calling him a Blodget, and my firm went even more underweight Chinese stocks. By V.N. - 8/20/2008 12:40 AM

Hey, I do not know how reserve work. But cant we use the foreign reserve to buy resource outside of China and use those reserve in construction? Like buy up as much as iron ore in Aussy? By money dummy - 8/20/2008 9:29 AM

To be honest, I don't think Frank's note was the primary cause of yesterday's rally. His note actually came out mid-day the day before, after which the H share market dropped 2%. By sharpe_mind - 8/20/2008 1:16 PM

Also, I sent Frank a message yesterday raising the same point Michael does in his note, about how exactly a "repatriation" would work given that this by definition would put pressure on the currency. It still seems that an enormous percentage of the financial world doesn't understand a very basic point: reserves aren't wealth. What's scary is that many of the reserve managers themselves don't understand this point, which is probably part of the reason China is willing to accumulate reserves with reckless abandon. Only the funds capitalized by prior sales of real goods (ie not printed local currency) such as ADIA and the rest of the middle eastern guys make sense to be characterized as sovereign wealth funds. Perhaps the US should print a bunch of dollars and convert it to CNY so that it might start its own yuan-denominated sovereign "wealth" fund. By sharpe_mind - 8/20/2008 3:58 PM

Robster, I am not sure that there is need for a fiscal stimulus yet since I think the risk of creating more overcapacity is a serious one. What is needed is a rebalancing of the economy towards domestic consumption, and the fiscal stimulus should be directed towards making the process, which is not likely to be easy, as smooth as possible. Anyway I am not sure the reported RMB 200-400 billion will have much effect. It is smaller than the Bush fiscal stimulus (which didn't have such a big impact, it seems to me) and unlike the Bush stimulus I doubt it will occur in the form of increased consumer spending since I think it is unlikely the authorities will give up the chance to manage the expenditures themselves via large infrastructure spending. MD, yes, one use of reserves is to buy foreign assets, whether commodities, stock, or real estate, but China wouldn't need to use its reserves directly to do that. A Chinese construction company or producer would simply raise money domestically and enter into business which, if it involved the use of iron ore or other commodities, would increase China's imports of those products (which indirectly reduces the PBoC reserve accumulation). Sharpe, I think the note was only widely publicized in yesterday's newspapers, which is why they might not have had much effect the day before. My skepticism about the importance of the proposed fiscal stimulus was reinforced by today's weak performance in the market. By Micahel Pettis - 8/20/2008 4:01 PM

Reserve is wealth, kind of. The idea is FX reserve can be used to buy something China does not have or cannot produce itself. Since it is a huge amount of reserve, government can afford to spend a little. The problems are what Beijing should and can buy. It is another topic for debating of course. By fatbrick - 8/20/2008 9:14 PM

if reserve is wealth, then why do people worry at all when china has such a huge reserve? isn't that foreign reserve is central bank's asset, the more the better. now with such a huge reserve, chinese central bank can buy, like, anything in the world. say if oil price goes up, just buy up a lot and donate to domestic oil companies, so chinese get a cheaper gasline than others. rice price go up too much, central bank do the same thing and reduce inflation. what problem will this kind of operation cause? am I being hopeless dumb here? By money dummy - 8/21/2008 2:27 AM

You are not being dumb, MD. It seems an awful lot of people, even those who should know better, have trouble understanding what reserves are. For example, the US, the richest country in history, has only about $30-40 billion of reserves. In contrast, the countries with the largest amounts of reserves as a share of GDP are more likely to be poor and middle income countries than rich countries. Reserves are not wealth (my "Money Matters" column in Saturday's South China Morning Post will go into this in more detail). They are the asset side of the central bank balance sheet against which the central bank has domestic liabilities. They exist primarily as insurance for a country's access to foreign currency financing, and like most forms of insurance, come with a cost. Countries run up reseves primarily to protect themselves from an interruption in external financing. They do this by borrowing in local currency and buying foreign currency when access to foreign currency is plentiful. In cases where central banks intervene in the currency markets to prevent their currency from appreciating, like in China, they must automatically accumulate reserves whether or not they want. In countries that intervene to keep the currency from depreciating, they automatically lose reserves. By Michael Pettis - 8/21/2008 2:23 PM

I am thinking that you are talking about orange while others are say apple, professor. Yes, in accounting, reserve is just the other side of domestic money supply, an item in your balance sheet. You spend it, then either you increase tax or you cut other spending. But isn't that the definition of wealth? You spend it, then your wealth will decrease. The amount of reserve is an indicator of total state wealth/spending power. How much foreign resources and goods you can get decided by how much foreign money you have. Foreigners won't accept RMB. Also, the fact that rich country like US has little reserve is becasue US actually has infinite amout of reserve: US can print reserve at will, at least this is what my friend in congress budget offcie told me. MD, my answer to your idea is that, yes, China can use its fx reserve to buy resources like oil and rice from international market. But, didn't you watch the news in the past few years? Oil price was $140 when people contributed that to China buying. Rice exporters stopped export. Chinese companies were not allowed to buy foreign firms. When China developed foreign oil field, people accused you for that. You cannot just drop a billion here, a billion there. The recent saying: everything China wants to buy is exetremly expensive, and everything China wants to sell is exetremly cheap. By fatbrick - 8/21/2008 10:06 PM

sorry for the rush and i did not have time to correct my english. By fatbrick - 8/21/2008 10:08 PM

Reserves do represent wealth, but not public sector wealth. Essentially, China's reserves represent a forced collectivised overseas savings scheme. Private sector wealth from accumulated exports (of real goods, sharpe-mind) is built up in renminbi financial assets which are ultimately supplied by the public sector, which in turn invests the proceeds in foreign currency assets, taking the currency risk. The difference between China and the Middle East oil exporters is that, in the Middle East, the state owns the oil. Nevertheless, China's reserves could become state wealth if the public sector runs a persistent budget surplus, as in Singapore. As money (not so) dummy says, China could convert some of its reserves into a stockpile of useful commodities (most countries own some gold of course), but these do not bear interest, so there would need to be some other motivation for doing so. US shareholdings and other real assets might be a good investment for China, but as Fatbrick says, the Americans won't let them! By RebelEconomist - 8/21/2008 11:38 PM

ok, let us see how it work. say a couple years back, 8 rmb = 1 usd, without chinese central bank's intervention. lot of people outside china want rmb, the demand for rmb increase a lot, the equilibrium could be 7 rmb = 1 usd. however, central bank come in to say, no, i want it say at 8. so, it print a lot of rmb and use them to exchange all the excess usd. for sure, that increase the asset side of its balance sheet. that is what michael say "In cases where central banks intervene in the currency markets to prevent their currency from appreciating, like in China, they must automatically accumulate reserves whether or not they want". i think i can understand this part now. now that the next question is what can central bank do after holding those excess usd? will central bank worry those people holding RMB come to demand for exchange of USD right away? why would those people want to do so? just to pay two times transaction fee if the exchange rate do not change that much? those people who use usd to buy rmb will not let rmb just sit idle, right? they put those rmb to work, in A share, housing, whatever denomiated in RMB. investment or speculation. Fine, as long as they can not convert back to USD easily, the central bank do not need to worry about a bank run, or a sudden decrease of their liability side. They can make those money easy in, difficult out. Then, the central bank can hold a relatively stable foreign reserve. once they have a stable foreign reserve, they can afford to do something else more than putting them in the highly liquid US T-bill. remember that investment gain of those foreign reserve still count as reserve, add to its asset side of balance sheet. Image that in a one hypothetical extreme case, say, at one point, the asset side of balance sheet is 1 Trillion USD and the correponding liability side of the balance sheet is 8 Trillion RMB. Now that, something extremely lucky happen, the central bank's investment arm hit all the jackpot in the whole world in one day. the reserve now goes to 1.5 Trillion USD. At the same time, the liablity side of the balance sheet is still 8 Trillion RMB, we assume that those people who hold that 8 Trillion RMB are as dumb as me, did not make any gain at one day. So, the net effect of this case is the central bank now has 0.5 Trillion of USD at their disposal at will and will not mess up the balance sheet at all. so, is it right that this 0.5 Trillion USD of reserve is wealth? If the reserve is accumulated through this way, I do not see any bad about massive reserve. analogy to a person. if we see this person drive a luxury car, live in a mutimillon home. it can be that he really made so much money. well, he is rich. or could it be just that he has a way to borrow so much money to consume. in that case, the more expensive his car, the more liability he has and more to pay back later on. let us assume that this guy give out the right of using his land in exchange of USD for car and house. He could be in trouble if he only drive his car for fun and doing nothing else. a couple years later, he got nothing to pay back and he lost his land (at that tiime, whoever use that land do a good job and been very productive by using the land). comparing his luxury car and multimillon home to chinese foreign reserve, what position is chinese central bank right now? are those reserve all borrowed money? i think mostly are. however, in another senario, the person who use land to exchange for car and house and use them as a starting point to have a very successful business, couple years later, he not only made all the money back to cover the car expense but build another home. at the same time, those people held the land do nothing about the land but just watch it to let weeds up. well, this guy has nothing to lost. he probably can even use the money he made to buy the land back. but not to return the car if someone come back and say I want to return the land and get my money back, so he need to sell his car. In this analogy, land is his liability and car is his asset. If he can make a good use of his asset (car) better than other people make use of his liability (land), I do not see a problem there. Well, following this thought, we know that there are a lot of growth in China right now. the investment return supposed to be higher in china than outside. say, I use 1 USD to exchange for 8 RMB. now that central bank asset increase by 1 USD and liability increase by 8 RMB. I put 8 RMB to work, a year later, that 8 RMB grow to 10 RMB, but at the same time, those assets denomiate at USD did not change much, for simplicity, say, the 1 USD in chinese central bank stay as 1 USD. then, in order for chinese central bank to say in solvent, they should exchange only 1 USD for me when I present to them 10 RMB. Gee, why people think the exchange rate should be something like 7 or 6 RMB to 1 USD? I am totally lost here. fatbrick, i agree that it was an investment thesis for a while, "hold what chinese want to buy and avoid what chinese want to sell". it was a way to ride on chinese's growth, i call it the second derivative of chinese growth story. however, there are subtle changes going on right now. we know all too well this strategy is self-defeating, there is a very limit space for that. look at what happen in July, commodity tank big time. By outlier - 8/22/2008 12:36 AM