The first trading day after the Asia-wide three-day holiday, and following the weekend announcements of Lehman Brothers Chapter 11 filing and the buyout of Merrill Lynch, China’s stock markets dropped in tandem with Asian and world markets.

China Supertrends has been following the financial implications of the sub-prime crisis for a while now and will comment on this latest development and the state of China’s stock markets in a separate post. Today, Tuesday, September 16, was yet another blood-bath in the markets, but at a time like this it is worth remembering that China’s underlying economic fundamentals remain very strong.

In fact, China just came off yet another strong month of growth. If this is true, what causes the apparent contradiction of one of the world’s best performing economies having one of the worst-performing stock markets?

In brief answer to this complex question, let’s just say that the theory of decoupling - the idea that China and other developing countries are mature enough to continue to develop on their own during an economic decline in the US and elsewhere - is increasingly discredited.  We wrote as much in Supertrends: We are living in an inter-connected world, and nothing, not even neo-Mercantilist policies, a protected currency, nor the world’s largest foreign reserves, can resist the forces that are sweeping our world.  As John Donne famously said, no man is an island. This financial crisis calls to all governments to act.

China, with its strong economic performance in August and year-to-date, may appear to be in the eye of the storm, an island of calm and prosperity. Last week was the Mid-Autumn Festival, and the economists at China’s National Bureau of Statistics were producing new data faster than mooncakes at Wang Jia Sha. Virtually everything seems according to plan.

Starting with the drivers of the economy, consumption continued to show signs of strength, with retail sales maintaining a 23.2 percent pace of growth in August, only slightly lower than July’s 23.3 percent, the fastest rate since 1996, according to the Shanghai Daily.

The level of retail sales growth is far above the most recent inflation levels, meaning retail sales growth is not just about price increases, there is real growth there.  In fact, CPI - the consumer price index, or basic inflation - decreased to 4.9 percent in August, continuing the downward trend, but worrisome PPI - the prices producers are paying for raw materials and commodities - continued to climb, to 10.1 percent in August. PPI increases will, at some point, either result in decreased margins and profits as companies absorb the increases, or get passed on to consumers as price increases, so China is not out of inflationary woods yet.

Many were regarding the fight on inflation to be one of China’s core economic policies of 2008, but in a surprise move today the People’s Bank of China decided to cut interest rates by about a quarter percent, down from 7.47 percent to 7.2 percent and, in perhaps the most surprising move of all, cut the reserve ratio by a full one percent after having just increased it by one percent in June.  Now that the Olympics are over, micromanagement of the economy seems back in style.

But the message, that the economy is ready for a rate cut and wants to increase money supply, could be evidence that the PBOC overshot the mark and caused money supply to shrink too quickly, contributing to some of the summer’s abysmal stock and real estate performance.  Growth in M2, the money supply, decreased to 16 percent in August, down from 17.4 percent in June.  It is important to point out here that we are still talking about an increase of 16 percent, just that the rate of speed it was growing simply slowed down a little.

Is the PBOC acting wisely or foolishly? Time will tell if they are cutting too soon, a knee-jerk reaction to the latest sub-prime casualties, trying to prop up the falling stock and property markets, or if they are presciently avoiding a much harder crash in the wake of Fannie/Freddie/Lehman fallout and other factors yet to come.

While some of this data could be construed as negative, China had a lot of other positive economic results in August. For example, the trade surplus is up by 25.7 percent year-to-date, compared with Jan - Aug 2007 figures.

In August, with industrial output growth the lowest in 18 months, a mere 12.8 percent increase, exports decreased to 21.1 percent from 26.9 percent in July. Imports were down more dramatically, from 33.7 to 23.1 percent, mostly because of commodity import price decreases  (i.e. oil), so the trade surplus actually still got bigger. 

Though slowing its rate of increase slightly, clearly China’s export prowess is not affected significantly by the world-wide financial crises, and despite the 2008 increase in  the strength of the RMB exporters seem to have adapted. The sky, it woud seem, is not falling, though its perhaps a paler shade of grey. Ecnomists, analysts, and the Chinese media make a lot of dire proclamations about how the Chinese economy is in decline but this is better thought of as healthier, sustainable growth.

I could go on. FDI and other investments - still strong. Foreign reserve size- still troubling, but thanks to the Fannie Mae / Freddie Mac bailout, the 20 percent of reserves held in US mortgage debt appears safe.

So the question originally posed, why is there a contradiction? China’s strong economy (with all the usual provisos and assumptions about the data, of course) on the one hand, and its weak stock and property markets on the other. What gives?

Is this a sign that global markets cannot decouple and are doomed to falter together, or is it a sign that somebody needs to act more decisively?  Just as China became a stabilizing force in the Asian Financial Crisis of 1997, is there are way it could use its economic and financial strength to do so again?

No country is an island in our globalized world.  Everybody has a stake.  With the alarm bells sounding, can China passively wait for the U.S. to get through its bailouts, and hope that the world financial system remains intact?  Or does this bell ring for another?  Whom does the bell toll for?  China, it tolls for thee.

Categories: Affluencing, China Supertrends, Consumption, Drivers of the Drivers, Foreign Direct Investment, Globalization, Trade
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Who wants to be a multi-trillionaire?

Based on the apparent pace of growth in China’s foreign reserves, the State Administration of Foreign Exchange may need to answer this question in a mere three months. Its answer should be an emphatic “Not China.”

In fact, SAFE’s next quarterly announcement of foreign reserves is not due until July but unconfirmed reports have been flying through state and foreign media (covering an unofficial number in China Business News interestingly) that China’s foreign exchange reserves increased by US$74.5 billion in the month of April alone, to reach US$1.76 trillion.

As a point of comparison, the world’s second largest foreign reserves are held by Japan, and in March 2008 they increased by one tenth of China’s apparent April gains - just US$7.6 billion. Incidentally, it was only in February that Japan’s foreign reserves surpassed one trillion for the first time, and they have since fallen back below the trillion mark, once again leaving China the lone member of the trillionaire’s club.

China first hit the one trillion mark way back in November 2006 but, unlike Japan, its foreign reserve increases are usually measured in double-digit billions. If later confirmed by SAFE, April’s increase of US$74.5 billion will be the biggest ever increase, anywhere.

If this pace continues, China’s foreign reserves could reach two trillion as early as August this year.

This is perhaps not the message China’s government wants to send to the world during the Beijing Olympics (”All your money are belong to us”), so there is intense discussion at the highest levels of China’s government over two issues: How to reduce the foreign exchange reserve, and how to use the existing foreign reserves more efficiently.

Reducing China’s Foreign Exchange Reserves

At one time, having enough money on hand to pay for imports might have been a prime consideration, but this has not been the case in China for years. Its current amount of reserves may cover monthly imports 15 times over, or more. What about another main reason countries keep a large foreign exchange reserve on hand, to defend the currency from speculative attack?

China does not allow convertibility of the yuan, which curtails the possibility of a run on the currency, but as well, China, together with the ASEAN countries plus Korea and Japan (the so-called ASEAN + 3), recently pushed forward the Chiang Mai Initiative, a US$80 billion foreign reserve pool that could be swapped to any member country experiencing speculative pressure. In theory, from 2009 this could reduce the need of Asian countries to hold such large foreign reserves. Until then, Asian central banks may feel better safe than sorry and decide to keep more reserves on hand, but China really doesn’t need to do this in the first place, so it needs to more aggressively reduce the size of its foreign currency holdings.

One way to reduce the size of the foreign reserve is to encourage foreign currency outflow. At present, the yuan’s continued and still expected appreciation has actually increased inflows, both as FDI and as hot money, to record levels.

In the first four months of 2008, FDI was up almost 60 percent over the same period last year, while the total number of company registrations actually decreased by 23 percent, according to the Ministry of Commerce. One likely explanation for this is that foreign firms inflated their average investment size so as to benefit from the future yuan appreciation. In fact, for hedge funds and other investors, this is one of the only methods they have to skirt Beijing’s capital controls, sneaking money in as legitimate-seeming FDI. The exact amount of hot money is unclear but can be inferred from known inflows (e.g. announced FDI), the estimated trade surplus, and other data.

To lessen the inward flow of hot money, China could either reduce interest rates to make passive funds less profitable in China, or could revalue the yuan exchange rate in a one-off revaluation similar to 2005 when the original dollar peg was removed. The former is likely to exacerbate China’s current inflation problem, while the latter would shock the country’s exporters. On balance, allowing the yuan to appreciate faster seems the lesser of two evils for the government.

An appreciation will cause outflows for several reasons. Some of the hot money will repatriate, while the stronger Chinese currency will encourage more consumption and imports from abroad. If the trade balance can reverse the current trend of annual surpluses, foreign reserves will dwindle rapidly.

Using the Foreign Reserves more Effectively

The second issue on China’s leaders’ minds is how to use existing reserves more efficiently. Some may even wonder why large foreign reserves are a problem at all. A rich country is a strong country, as this argument goes.

But the foreign reserves are, in effect, sitting in the central bank earning meager returns and keeping the yuan under-valued. Each unit of foreign currency that enters China is bought up by SAFE and yuan notes are issued by the central bank.

China does not actually hold wads and wads of cash, like a high-roller hitting Macau’s new casinos. Most of its funds, especially those denominated in US dollars, are in the form of US Treasury bills and other long term securities. T-bills have a notoriously low interest rate because they are seen as the safest investment available.

With China holding an estimated US$466 billion in T-bills alone according to the US Treasury, earning interest in the low single digits, this means China is literally leaving billions in potential investment income on the table.

Couple this opportunity cost with the depreciation of the US dollar against major world currencies and China’s US dollar holdings are looking even less attractive. Given a common estimate that China’s total foreign reserves are comprised of about 70 percent dollar-denominated securities and cash, and that the depreciation in the US dollar over the last year has been about 10 percent against the yen and 13.5 against the Euro, that is like saying those Chinese reserves in US dollar terms have lost about US$100- 150 billion in spending power.

Of course, China’s Euro and Yen holdings have increased buying power in terms of US dollars, but they only represent about 20 percent and less than 10 percent respectively of China’s foreign reserves. With such low interest returns and the passive depreciation of its US dollar holdings, China is anxious to look for other ways to spend its growing fortune.

In the last six months, SAFE has made a number of portfolio investments abroad in an attempt to diversify and increase returns, while China created the China Investment Corporation, a US$200 billion sovereign wealth fund, in 2007 to place funds in higher-growth areas. [ED: I covered the uses of China's foreign reserves by both SAFE and CIC in an earlier post, The New Gold Mountain.]

At the time of writing, the yuan appreciation has reached 20% against the dollar since that fateful day in 2005 when the peg was finally removed. It has taken three years to get here, and if it takes three more for the next 20%, I worry about the effect this will have on inflation in China as the foreign reserve will continue to surge.

There’s no easy solution to China’s growing problems of inflation and low rate of return on its reserves, but letting the yuan appreciate more quickly is probably the best place to start, for the sake of the Chinese economy, and maybe even the global economy, as a whole.

[UPDATE: June 25 - Two notes which just came to my attention: In regard to how some foreign media have not covered the April 2008 rise of US$75 billion as alarming or even sufficiently surprising, Yves Smith of Naked Capitalism commented yesterday on the apparent nonchalance, and overnight Brad Setser added some data on changes in China's portfolio investments and overall foreign asset growth. On the point of western media attention: I don't think the lack of in-depth coverage on the ramifications is indicative of disinterest. As I pointed out above, the April foreign reserve figure of US$74.5 billion hasn't been officially confirmed and will not be until July, most likely. I held off reporting on this figure in my newspaper column until June 23 expecting a repudiation by SAFE or the PBOC, but their combined silence on this issue has been deafening.]

Categories: Affluencing, Foreign Direct Investment
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