Tuesday, February 22, 2011

Michael Pettis on China's Growth

In Michael Pettis' private newsletter "China Financial Markets" published on February 21, from which I am only allowed to quote, he discussed corruption in China's high speed rail lines which he basically sees a typical fraudulent behavior manifested towards the top of a market.  

Contrary to those who cite him to legitimatize their opinions that China will collapse, it is his opinion that "...a financial collapse requires specific balance sheet structures in which inverted liabilities (i.e. the opposite of hedged) are combined with self-reinforcing mechanisms that exacerbate changes on both the up cycle and the down cycle.  I believe however that with Beijing’s control of the liquidation process, of interest rates, and of investor behavior, the Chinese financial system is organized in part to prevent financial crises. 

"But in so doing it is also organized to exacerbate underlying imbalances and ultimately to increase the cost of the adjustment.  This means that if we are nearing the end of the growth model’s life (in the next year or two if there is a strong consensus at the top, or in the next three to four years if there is a difficult leadership transition), the adjustment will not occur as a crisis but rather as a long and sharp slowdown in economic growth."

In January, the inflation rate came in at 4.9% versus the same period last year, which was lower than the market expected.  However, the CPI basket was revised at the same time, bringing down what would have been 5.1% to 4.9%, by lowering the weighting of food prices by 2.21% and increasing the weighting of the housing sector by 4.22%.  Pettis sees this as convenient timing but not sinister.  Even so, the month-to-month increase suggest just under 13% annual inflation.  He believes the central bank's fifth 50 basis points increase will help temporarily, but "... most Chinese growth is the result of overheated investment, and removing the sources of overheating without eliminating growth is going to prove impossible.  I have been making the same argument for at least two or three years, and so far we have seen how Beijing veers between stomping on the gas when the economy slows precipitously and stomping on the brakes when it then grows too quickly.  I don’t believe anything has changed."

Most interestingly, bank deposits were down in January for the first time since January 2002 and he quotes Credit Suisse as stating that it was corporate deposits that went backwards and not household deposits as would have been expected near the Chinese New Year, which would indicate it is not seasonal and may be of concern.  Pettis, on the continued tightness in the interbank market, said "So why did corporate deposits drop?  My guess is that large businesses may be finding it much more profitable to lend money to other businesses, especially those who don’t have easy access to bank credit, than to deposit cash in the bank at such negative real rates.  Both the Credit Suisse report and an email I got last month from a friend of mine at Bank of China suggests that there may be an increase in intercompany lending, and to me this would be a very plausible consequence of negative real deposit rates."

He sees the Japanese concept of zaiteku (raising capital for securities investment, real estate, etc.), which cause increased speculation rather than business operations to build in the late 1980's leading to a subsequent painful contraction, as taking hold in China.  "From the Japanese experience (and many others) it is clear that when SOEs and large businesses find it profitable to speculate on asset markets, intermediate loans, or otherwise earn financial profits, they usually do, in which case we need to worry about three things.  First, financial transactions – especially when they largely replicate risks that are being taken already within the financial system – increase systemic risk even as they disguise risk-taking.  A problem in the financial markets is reinforced by a drop in corporate profitability tied to financial speculation, which then reinforces the problems in the financial markets.

"Second, Chinese banks already do a bad enough job of assessing credit (why not, when most credit risk is socialized?), and it is hard for me to believe that we are going to see much better credit risk management from corporate treasurers, and even harder not to wonder if guanxi will play an important role in this whole process.  Third, the more lending occurs away from the purview of the PBoC and the CBRC, the less control and oversight monetary authorities will have over the financial system...

"On the one hand overinvestment, excess liquidity and credit expansion, off-balance sheet activities, and zaiteku are generating huge growth and, along with it, huge risks, while on the other the PBoC and the CBRC are doing what they can to monitor, manage, and limit risks in the banking system.  I wonder if they can pull it off."

With respect to the problem of hot money flowing into China, Pettis suspects foreign direct investment (FDI) may be including a lot of disguised hot money inflows.  He agrees with Deputy Finance Minister Zhu that the United States' QE2 does cause an explosion of liquidity growth in developing countries if those countries intervene in their currencies; if there is no intervention there is no liquidity growth.  The State Administration of Foreign Exchange (SAFE) report said hot money inflows have been negligible.  "It turns out, according to most interpretations of the SAFE report, that the speculators creating the hot-money inflows are not the much-vilified foreign hedge funds – surprise, surprise – but Chinese businessmen bringing money into the country in dribs and drabs."

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