Chinese Box

Dear Andy Xie: Everything is not a bubble

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One of the problems with learning more about the Chinese economy every day, is that occasionally you find yourself disagreeing more and more with people whose opinions you respect and that you very much enjoy reading. Andy Xie, a former Morgan Stanley economist who prints monthly editorials in China International Business, despite being a thrill to read, mostly because of his grotesque use of metaphors and his insistance that everything is a massive bubble, is beginning to unfortunately fall in that category. I'm going to go through last months column and spend some time discussing why. 

The basic gist of his argument this month is that the appreciation of the Chinese currency will cause hot money inflows that will fuel the already crazy property boom. On the other hand an Interest rate hike would just make mortgages more expensive and savings less expensive - China has negative interest rates, so saving actually costs money - thus is a better policy move. 

But acting on the currency first, especially in small steps, would further inflate China's property bubble and inflation, potentially leading to a major economic crisis in two years. For China to achieve a soft landing from the current property bubble – if this is at all possible – interest rates must steadily increase by 2 percentage points in 2010, another 3 points in 2011, and further in 2012. Such a trajectory for interest rates would not burst the bubble, but it would prevent real estate interest rates from further declining in an atmosphere of rising inflation. 

At some point, real estate interest rates will start inching up and slowly rein in speculation. Stopping real estate interest rates from declining further would prevent inflation expectations from accelerating, which in turn could halt inflation's accelerating pace. 

He's right about the fact that hot money inflows help fuel the property boom, but I think he's miss representing the source of hot money inflows. 

It's lasted for so long because financial markets have few stories to stir fry, and an appreciation of a pegged currency is a free lunch. Nothing gets financial markets more excited than a free lunch. 

The intensity and persistence of yuan appreciation expectations point to support for China's vast property bubble. These expectations have increased the concentration of hot money in China, which in turn has caused excess liquidity and speculation, fueling the property bubble. 

The numbers that are being thrown around regarding the "imminent appreciation of the RMB" is nothing to write home about. 5% at most this year. 3% is more likely. Sure if you're investing billions of dollars 3% is quite a lot, but you can get better returns elsewhere. It's also really difficult to get billions of dollars around China's currency controls. What's really drawing hot money into China is the property boom, where on average you can get around a 11% return, and in certain places you can get a 100% return a year (different stat sources say different things). This also is in a sector more open to micro-investing than "banned forex trades," in other words an overseas Chinese businessman can easily get money into the country to buy a flat, and has plenty of incentives to, Goldman Sachs cannot easily get a billion dollars into China. 

This would all be academic, as the extra 3-5% on the RMB is rather delicious icing on the cake (a 15% return is quite a lot), and thus obviously driving some hot money flows, but it plays into the fundamental flaw in his argument, that the property boom is ALL speculative: 

By all measures (stock value to GDP ratios, inventory value to GDP ratios, new property sales to GDP ratios, price to income ratios, rental yields, and vacancy rates) China's property market is one of the biggest bubbles ever. It's probably much bigger than the U.S. property bubble relative to GDP. 

He forgot one measure: Price to upper-middle class wages, who are the primary purchasers of houses. According to this measurement housing prices are merely "expensive" and no where near the range of the Tokyo bubble (USD 200,000 for a flat in central Beijing is a lot less than USD 1,000,000 per square foot in Central Tokyo in the late 80s). Add to that the fact that the middle and upper-middle class are growing quite quickly, urban wages have in each of the past 10 years except for 2004 and 2009 grown faster than real estate prices, and that urbanization will continue probably through the second half of the century, and I don't think we yet have to worry about a "the biggest bubble ever," except as far as prices make people really really angry (renters rights don't yet exist in China), and there is a lack of housing options for lower classes (not saying they should purchase, but some solution needs to be provided that doesn't involve harassment by rental agencies). Still, investment in real estate isn't as dumb as he likes to make it seem. 

He also seems to completely misunderstand why the RMB is thought of as undervalued: 

Whenever a country successfully industrializes, its currency value should appreciate. This appreciation can come in the form of a higher exchange rate or inflation. What worries me is that inflation has already happened. China's real exchange rate may have appreciated greatly in the past three years. Even though China's reported inflation rate has been relatively low, prices that one encounters in daily life appear to have risen enormously. Foreigners who visit China are often surprised by prices, which are even higher than in many developed countries. Even China-made retail products are more expensive in China than in other countries. 

I wonder what foreigners he is talking about? The prices one encounters in most people's daily life, at least most people who don't get banker's bonuses, are exceptionally low. The only things that are really expensive compared to the GDP-per-capita are property prices and import prices (he earlier argues that Chinese domestically made cars are the most expensive in the world, which makes me think he's never been to the US). High import prices are pretty much par for the course in the developing world, where a combination of tariffs and a "status effect" jack up prices to levels much higher than those in the developed world. Oh, also, an undervalued currency might contribute something to import costs... just maybe. 

Most domestic goods are dirt cheap. Food prices in China are about 20-30% developed world prices, as are rental prices (My "decent" two-bedroom flat in a prime part of town goes for about USD 550 a month, which I of course split with my girlfriend. In the states it'd go for 3-4 times that). 

I think there are plenty of arguments that can be made for keeping the RMB relatively low, and a 3-5% appreciation is a much smaller amount than what people were talking about 2 years ago, when 15-20-30% was been bandied around. But Andy isn't making the right argument to make his case.

Chinese Yuan appreciation society

Last year when the Chinese yuan was in appreciation overdrive, there was talks of the currency hitting 6 to the dollar as early as December 2008. That of course didn't happen though, because as soon as the financial crisis started killing China's export market the government put all appreciation on hold. But there's a reasonable argument that the currency could start its upward trend again in the next few months.

Points to be made:

1. US inflation expectations are quite high right now, sending the price of gold back up to its historical highs.

2. If there is anything China cares about more than its export market, its the import of commodities.

3. Appreciation of the yuan would protect against commodities inflation

There are still quite a few maybes about the commodities re-inflation story, but I think that the logic behind yuan appreciation is returning to "normalcy."

Cracks in the Stimulus

So in my monthly macro-economic column, I'm officially not allow to state that I think China's 8% GDP growth target is ridiculous, but I'll say it now, its ridiculous. Economists will give you a lot of complicated reasons why I'm right (and quite a few why I'm wrong), but I think the simplest point to remember, is that GDP can be jacked up without anything good happening to the economy. Which many seem to be arguing is what's currently going on. Money is being invested in questionable goods with questionable utility. The act of investing jacks up GDP, but it doesn't necessarily solve the underlying problem of low unemployment and low real consumption. And it has the added problem of increasing trade tensions.

The two above links do a great job in describing more in depth the reasons why growth targeting might be causing problems, and also quite interestingly talk about some of the disagreements between the economic bureaucrats and the growth focused politicians, which if you take the time to read through the commyspeak is turning into quite aggressive comments in the People's Daily and such. (this decades long disagreement was the subject of the recent book by Victor Shih, who is one of the most enjoyable China focused academics, and bloggers, out there).

Still don't know who's swimming naked

A fun news bulletin from Moody's:

The Chinese authorities have issued the first ever bad loan reserve ratio requirement, a precautionary move that highlights growing concerns about credit quality on the mainland. Commercial banks in China will be required to maintain provision worth 150% of non-performing loans by the end of the year. Although some financial institutions are already compliant with the new rule, the current industry-wide provision of 134.3% suggests many still need to significantly boost their reserves. The government's step to tighten reserve requirements will better prepare banks for potential financial loss in the future and also reduce liquidity in the financial system for now.

The headline of this post refers to Warren Buffet's famous saying "it's only when the tide goes out that you learn who's been swimming naked" or in other words, a reserve requirement on bad loans does nothing to protect against the TRILLION dollars (or more precisely 1.08 trillion dollars) of loans that were given out in the first six months of the year, because they haven't been given enough time to go bad.

I've put our finance reporter on this, and I'm going to do a bit of work in this direction for our September issue, but I don't think anyone in their right mind believes that credit quality at the big Chinese banks is going to stay remotely decent as we get farther away from the stimulus. Of course people still assume that the government has infinite amounts of money to pay for bailouts of large banks for ever and ever into eternity.

At least that's the only explanation I can see for this.

Shanghai still shouldn't be a financial center

The "Shanghai as the next New York" conversation has kept on coming up, once in a more official context, when I saw a representative of the Shanghai government speak at the recent IIF forum.

Others have reassured me since I wrote my last piece on the subject that the main intention of the declaration was to tell Tianjin and Shenzhen that they're out of luck, and the government is encouraging Shanghai to specialize in that area. But the questions were still always: "what about convertability" and "what about Hong Kong."

The Shanghai government representative did seem to indicate that convertibility was coming as soon as feasibly possible, which anyone who was following the hubbub about US bond yields could have guessed, though the definition of feasibility is probably going to stay rather questionable.

To the Hong Kong point, he answered that Hong Kong, which derives advantages from being separate from the Chinese financial system, is also held back from taking full participation in the Chinese economy. Which therefore means that Shanghai could be made into a much more efficient location for Chinese listings.

Except no. The problem with Shanghai is that its not enough like Hong Kong, which means that if Shanghai were to become China's financial center, China would have to unify its financial standards with Hong Kong, basically throwing out any of the supposed advantages of being within China's system.

Add to that the often made point that all the banks and regulators are in Beijing, and I'm still not seeing what Shanghai has, except growing government antagonism towards Hong Kong.

Thought from IIF meeting: Why aren't financier's sexy?

I was at the meeting of the Institute of International Finance today, climaxing in a speech by Paul Volcker. The whole thing was rather interesting, and I'll post more about it when its not 12:30 in the morning, but I must say, as blown away as I was by Mr. Volcker's speech, he didn't have the physical or verbal presence I was hoping for. He was in fact rather mumbly (luckily they provided a transcription).

The other interesting things that came out of the meeting included a speech from an official from Shanghai about turning Shanghai into a financial center (its still nonsense), and quite a few things on Chinese banks going abroad, which I'm now relatively enthusiastic about. I also met some rather pleasant Brazilian economists, who I might go out drinking with tomorrow.

Is the Chinese financial system a dysfunctional 3D puzzle?

I just want to quickly recommend this quite good article from Forbes. The piece goes into some of the more arcane and unknown aspects of the Chinese finance system, and how they're completely falling apart. It particularly focuses on loan guarantors, which act as a sort of second hand risk management, given the less than adequate risk management systems set up at the big four banks. Going through a loan guarantor is pretty much the only way for an SME to get a loan from a state-owned bank, which prefer to lend to SOEs with the government guaranteeing their loan. Its one of the increasing signs out there that lending is not growing as much as the numbers say that it is, and its the kind of sign that one would rarely look at if you assumed that the Chinese financial system at all resembles the western one.

The Chinese financial system is showing cracks

There are times when a person in China can almost convince themselves that the financial system is functional here. In the past few months that's getting to be incredibly hard to do. I will now point to 3 articles from roughly the same week and see if you can note a steady decrease in tone.

First, from Caijing, a note on the astounding January lending numbers.

China’s banks issued a record 1.6 trillion yuan in loans in January, Caijing has confirmed from several sources including a central bank official. 

a rising number of loans involve mid- to long-term debt, Caijing learned from several banks. ICBC said most of its individual loans in January were issued for long-term infrastructure projects.

Great news right? Lending is up, which is a sign that banks have more confidence in the Chinese economy after stimulus measures were introduced. Worst one could say is that SMEs can now take working capital loans from banks instead of back-alley lenders who charge 10% more interest.

But then there are articles like this one:

China is prodding banks including Citigroup Inc and HSBC Holdings Plc to support the weakening economy by accelerating lending, after the threat of defaults caused them to rein in credit last month.

Foreign banks should "increase their contribution" to China's economy and lend more to small firms, the Shanghai branch of China's banking regulator said Saturday. An earlier report showed advances by foreign lenders in the city dropped in January. Shanghai accounts for 61 per cent of overseas bank lending in China, the watchdog said.

So your saying anyone with commitment to their shareholders is actually decreasing their exposure? Besides the gutsiness of telling a bank that's looking to raise USD 20 billion while activist shareholders are telling them to cut their ties to risky lending markets that they have to lend more to risky lending markets, this is a fairly clear sign that something odd is going on in the lending market. One has to either be questioning the headline lending numbers, or the sanity of shareholders in Chinese banks.

Then there's this article:

Turned away by banks caught in the credit crunch, Roger, like many Chinese businessmen, borrows from pawn shops instead. In this case, he paid off the loan a few days later when a customer made payment on a big steel purchase.

"Banks are reluctant to lend," said Huang Jing, deputy business manager at Shanghai Oriental, the city's second-biggest pawn shop. "But we have a lower threshold and can provide loans much more quickly and with shorter terms".

Businessmen pawning their goods in order to get a working capital loan? 

Obviously that RMB 1.6 trillion dollars is going somewhere that's having a lot of effect.

Financial services industry eat your heart out

People out there are still stimulusing, which means there is still absurdity to point out. 

While China has been mostly livid about America's new stimulus plan, the unbelievably absurd "buy American financial workers" clause should be a cause for joy among them. Essentially America is contributing to its already absurd work visa scheme, in which the entirety of a years worth of Visas is distributed one day in June, by forcing financial firms taking government money to only employ Americans. The effect is basically another point for London in its attempt to overcome New York as the world financial capital (though by some people's standards its already well overcome NY).

The effect for China though might be surprisingly good. Though the talk about China using the slump to make reforms and push itself into the realm of developed countries by 2030 might sound idealistic (See Andy Xie's article in the upcoming issue of our magazine), China could definitely use this opportunity to poach more talent from the United States, or more accurately encourage talented Chinese expatriates to return home. The Chinese stock market is something of a joke, but no more so than American visa regulations, and with a series of reforms and a growing talent pool they could be at least competitive with some of the lesser regional bourses (Singapore perhaps). 

The "series of reforms" is the most questionable piece of that proposal, I'm also pretty sure that the stock market will have a difficult time being effective as long as currency outflows/inflows are strictly controlled, which is completely out of the stock regulators hands. Andy Xie advocates full convertiblity within 5 years, but personally I don't see it happening. The financial system is too dysfunctional, and there is little political will to change it.

Though who knows, maybe the current lending boom will end poorly, and the government's hand will be forced... We can only hope.

Exchange rate nonsense

As everyone seems to be up in a hubbub about Timothy Geitner and his foot in the mouth disease protectionist talk. I thought I'd throw out this review of a fairly clever paper on the South China Morning Post(subscription). Or if you don't have a subscription to the SCMP, and have a decent sized attention span you can read the actual paper.

The main points, all of which are very true, are:

1. RMB appreciation wouldn't end the US-China trade deficit. Just as the appreciation of the Yen in the 1980s didn't end the US-Japan trade deficit.

2. RMB appreciation wouldn't end inflation. The reasons here are well known. Unlimited appreciation potential means that people have plenty of reasons to bring money into the country, which by definition increases inflation

3. A floating RMB would not find an equilibrium rate. This is somewhat more complex, and has to do with the dollar and not the RMB being an international currency, combined with China's unusually high savings rate. Basically banks would be uneasy about buying unstable dollars, meaning there would be no point that they would defend the current exchange rate in order to protect their assets. There are other nuances but the basic gist is a floating exchange rate would push upward indefinitely.

While having out of control appreciation would sound great to my paycheck, it probably isn't what Geitner is looking for.

The solution they give is an internationally agreed upon peg, which could stand for the foreseeable future. I doubt that China would be willing to give up currency autonomy, but I think the authors are right in saying that coming to an agreement with America over currency policy would do a lot to stem the bullshit and move forward with trade agreements. 

It would be very nice if China had some sort of long term plan that they could tell us all about, but that's not like them.

On America's side it would be nice if they weren't lying their pants off about the strong dollar policy.