Wednesday, April 27, 2011

Michael Pettis on China's Inflation & the US Dollar

Michael Pettis' private newsletter arrived by email on Monday and I am only allowed to excerpt from it.  Pettis began his newsletter by noting the recent Chinese economic data showing GDP Q1 at 9.7% year on year, CPI inflation at 5.4% in March, which was a 32 month high, and PPI inflation was 7.1% for March.  These figures were higher than what most analysts expected.  Pettis, however, does not believe these numbers mean much, because he continues to see the same pattern as the last two to three years of government reaction to overheating and then a resumption of acceleration.  Consequently, he expect the People's Bank of China to more aggressively raise rates and limit credit growth until those moves bite back.  Pettis sees nothing new here and everyone is just playing the expected game until the leadership change next year.

Maybe we will see a faster appreciation of the renminbi, because the market expects it.  The demand for renminbi denominated assets is so strong dim sum bonds are trading at negative yields.  This is what you would expect if there is speculation of a stronger renminbi.

With respect to Sunday's reserve hike, overall liquidity in the market is still high and he quotes Chen Long of Shenyin Wanguo as saying "Liquidity in the inter-bank system is sufficient as foreign exchange purchases by the PBoC have exceeded expectations despite the trade deficit.  Lending quota restrictions, however, have made it harder for borrowers in the real economy to get bank loans."  Pettis sees a paradox in the credit conditions, because "By some measures credit is very tight and borrowers are desperate to gain access to the limited loan quotas, and by other measures the market is drowning in liquidity."  While the percentage of bank loans as a part of total social financing is down, the proportion of entrusted loans and corporate bonds are up.  Credit is expanding faster than loan and deposit numbers would suggest.  For Pettis, the credit expansion is so great it is not useful to think of credit conditions as being tight even with so many desperate to access credit.  He argues "... that investment --- especially infrastructure, SOE and other official investment --- is so great that it is managing to overwhelm what would otherwise be considered very loose credit conditions.  If credit were in fact tight, growth would slow dramatically  but at least we would be rebalancing the economy and limiting future demand on household wealth transfers.  As it is, I don't think we are rebalancing at all."

The quarterly trade deficit was driven by commodity imports and was not unexpected as the Spring Festival quarter is always distorted.  He expects the trade account to bounce back with a big surplus unless "... a greater share of capital outflows are diverted into commodity stockpiling ...".  In fact, despite running a trade deficit, central bank reserves surged.  Net inflows were approximately $150 billion.  Given a trade deficit, there is renminbi exposure demand, such as those dim sum bonds, and hot money inflows seem to be increasing.

In an opposing view, Patrick Chovanec, who teaches at Tsinghua University, sees China's inflation problem as a problem of the money supply, because China buys all foreign currencies flowing in at a fixed rate and issues renminbi for domestic use.  He agrees interest rates are a part of the problem, but he believes the money supply has to be reined in.  Then the PBoC has to sterilize the increased money supply by taking money out of the economy by raising reserves.  Chovanec believes this is not sufficient to influence interest rates.  He sees letting the renminbi appreciate as necessary to establish economic tightening.  As low drawn out appreciation will only continue to attract inflows of hot money and the appreciation should be a dramatic one time revaluation of 20-30%.  Obviously, Pettis would point out, as he has on several past articles, this would be extremely disruptive of both private savings and consumption, business spending and investment, and wage expectations --- all of which would be not just economically disruptive domestically but potentially politically disruptive.

As Pettis wrote in a recent Financial Times op-ed entitled, "America Must Give Up On the Dollar", he continues his argument in this private newsletter because he believes it has a lot to do with China.  He points out that it seems as if every 20-30 years American current account deficits surge and dire warnings about the end of dollar dominance build.  "But I think these predictions about the end of dollar dominance are likely to be as wrong now as they have been in the past.  Reserve currency status is a global public good that comes at a cost, and people often forget that the cost is much higher than most countries are willing to pay."

Reserve currency status requires at least ample liquidity, central bank credibility, flexible domestic financial markets, deep and open domestic bond markets, and minimal government and political intervention.  As such, Pettis sees the euro as the only alternative currency, which I find unacceptable given the continuing eurozone credit crisis, of which I have written extensively, and the many qualities that eurozone credit crisis has consistent with a growing currency crisis.  In fact, as I have privately stated, it is almost as if the current account surplus euro nations are in a currency war with the euro current account deficit nations.  Pettis admits, however, that Europe would not be willing to pay the price of reserve currency.  He also says Switzerland is an example of a reserve currency based on national creditworthiness, but it the fifth most used and that volume is approximately one-half percent worldwide.  Additionally, Pettis is ignoring that the liabilities of the Swiss financial system exceed the GDP of Switzerland, which creates a systemically dangerous condition which the Swiss have been dressing with more financial regulation and higher capital reserves.

Still, he believes the United States should be encouraging the world to disengage from the dollar, because the global use of the dollar, in Pettis' opinion, is bad for the US economy and the global imbalances it creates.  Pettis sees the cost the United States as the choice between rising unemployment or rising debt.  Foreign acquisition of dollars causes the US to run a corresponding current account deficit.  The US must accommodate foreign trade policies diverting domestic demand abroad, which means the us must increase domestic consumption and/or investment to counteract the impact on employment.  "Without government intervention, there is no reason for domestic investment to rise in response to policies abroad.  On the contrary, I would argue that with the diversion of domestic demand, private investment might even decline."

Pettis believes the argument of reserve currency benefits in the form of reduced cost of imports and lower government borrowing costs are seriously flawed.  Americans already over consume and lower consumption means higher unemployment.  Thus, the US wants to increase exports and make imports somebody else's problem.  With respect to lower costs of government borrowing, Pettis sees that as a measure of creditworthiness, which is damaged by the current account deficits resulting from being the reserve currency.  "The supposed advantages of reserve currency status are simply the obverse of the cost.  As countries accumulate dollars, they force trade deficits onto the US, which the US can only manage by increasing borrowing.  This borrowing is financed by the foreign accumulation of dollars."

While that is factually correct, the Australian economist Bill Mitchell would argue that the sectoral balances are not being properly analyzed and there is a lack of appreciation of the inability of a fiat currency sovereign nation to default.

Pettis notes the massive imbalances which have been permitted are destabilizing as Joseph Stiglitz has also argued recently at INET and in the past as a need for a basket of currencies.  These are serious concerns but many economists and commentators look not at the imbalances and how to stabilize them, but focus wrongly on debt.  Pettis says, "If the world were forced to give up the dollar, there is no doubt that there would be an initial cost for the global economy --- it would reduce global trade somewhat and it would probably spell the end of the Asian growth model."  But he believes it would also reduce dangerous global imbalances.

Pettis ends his private newsletter with a a lengthy discussion of Kenneth Austin's recent article, "Communist China's Capitalism" published in World Economics (which is subscription read only), which is a re-reading of John Hobson's theories on underconsumption, which so many current students of economics under appreciate or are not sufficiently exposed to appreciate his contributions to modern economics.  Pettis finds it important and fascinating.  Austin finds the basic idea is that oversaving causes insufficient demand for economic output and in a closed society, excess savings cause recessions.  Basically Austin, according to Pettis, is arguing that under consuming countries like China are able to use the dollar today in the same manner that European countries used colonialism in the past to export capital and import foreign demand.

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