PBoC is biased towards more tightening

My third-year finance undergrad, Liu Bing, who is following in the footsteps of Logan Wright and becoming a central-bank sleuth and obsessive (almost literally following in his footsteps, I guess, since he is interning at Stone & McCarthy), sent me the following email today.  I have edited it slightly:

The PBOC released the Q1 monetary policy report yesterday.  I translated a special column on “hot money” as follows:

Summary: Special Column on FX Reserve Analysis

In the first quarter 2008 money kept flowing into China, mainly as the result of a good fundamentals for the Chinese economy and a large trade surplus and FDI.  Moreover, the sub-prime crisis and turbulent international financial markets have led to international speculative money pouring into China, which is thought a “Safe Market”.  Overall, the speculative capital is flowing into China through legal ways, and is the reasonable behavior of companies and individuals given the RMB appreciation expectation.  These legal channels mainly include: 1. Commodity trading: mainly as a result of the mismatch between the delivery of goods and the disbursement of payments. 2. FDI and foreign-invested companies borrowing in foreign currency and using the proceeds to inflate their registered capital figures. 3. Settlements of exchange under household account. 4. Companies undertaking IPOs abroad and exchanging the money raised for RMB (in 2007 this number reached $23.63 billion, mainly concentrated in non-financial institutions, especially domestic registered real estate companies). 5. Services account. 6. QFII 7. Trading gold and copper forward with the purpose of arbitrage.

In the near future, uncertainty about the world’s economic development, and the interest rate spread between China and the US may lead to more speculative money flowing into China, so increasing the difficulties of monetary policy.  We must resolve domestic economic imbalances first in order to reduce “hot money” inflows.

This strikes me as being a fairly accurate and realistic assessment of hot money inflows into China, although I would have substituted “good fundamentals for the Chinese currency” in place of “good fundamentals for the Chinese economy”, and it would have been better if they attempted some estimates of the amounts entering in via the various legal channels they identify.

There are two things that I find particularly interesting here.  First, according to the PBoC, one of the main channels for hot money is the trading of gold and copper futures for the purpose of arbitrage.  I am not sure what they mean – are they buying gold abroad for delivery in China?  At any rate I have often thought that now that it is much easier to trade spot and forward gold in China, with and without delivery, gold might be one of the preferred alternative investments for Chinese households if they ever decide to take their money out of the banks – either because of negative real interest rates or because of credit concerns.  

I don’t know enough about the gold market in China, and don’t know how easy it is to arbitrage spot and future markets in and out of China, but it is something worth looking into.  My hypothesis is that if there are significant frictional costs in the arbitrage, including capital controls, the spread between gold abroad and gold in China might tell us something about domestic monetary confidence.  Perhaps one of my smarter students or former students can start figuring out the mechanics of the market and how the arbitrage works.

The second thing of interest is the very last line, which suggests that, aside from the obligatory reference to foreign sources of hot money inflows, the PBoC recognizes that the main cause of hot money inflows is domestic imbalances.  It would have been nice if they had been a little more explicit about those imbalances, but I assume they mean the upward appreciation pressure on the RMB caused by the currency regime.  

Does this give some inkling about what kind of policies will be needed to resolve hot money?  It seems to me that they clearly understand that the problem can only be addressed via the currency regime.  But, so far, neither the policy of slow appreciation nor the policy of fast appreciation has helped much.  There is still, of course, the possibility of a one-off maxi-revaluation. 

This particular option has been so widely discussed, now, that it is no longer considered out-and-out lunacy, even though the government and most analysts, even those who believe that it is the best policy option (and who, I am glad to say, are not longer in a tiny minority), nonetheless insist that it is a wholly impractical policy option and is not likely ever to happen.  My view is that a sudden one-off revaluation is indeed impractical, but the alternatives are even more impractical, and I would argue that it is just a question of time before the perceived impracticality of current appreciation policies exceeds the perceived impracticality of the maxi-revaluation. 

The key is hot money. There are very few people left who still think China doesn’t have a serious hot money problem, and all the various attempts to measure the dimensions of hot money inflow during the first quarter came to the same conclusion – the amount of money flowing into China is unsustainable.  Unless second and third quarter numbers show a very dramatic reduction in foreign currency reserve growth, the pressures for a maxi-revaluation can only increase.

There were other things in the PBoC first quarter report.  Growth has been better than expected, they say, and inflation has remained high.  “We will strengthen the flexibility of the yuan’s exchange rate and utilize its role in optimizing resources to hold back rising prices,” they say.

Confirming the first of the two statements, fixed asset investment climbed 25.7% in the first four months of the year.  This is slightly above the same period last year and slightly below economists’ expectations, but it is still extremely high, and the PBoC says there is a risk it will accelerate.  In light of the need to rebuild Sichuan, this is almost certainly going to happen.

The stock market started the day well, continuing its bull run yesterday on the assumption that the earthquake will cause an increase in demand and a ;loosening of monetary policies,  It trade as high as 3707, up 1.3% for the day, but in the afternoon the strong fixed asset investment numbers suddenly changed sentiment.  The numbers, plus the PBoC’as report, suggested that there is still a risk of tightening, and most if yesterday’s winner became losers.  The SSE Composite closed at 3637, down 0.55% for the day.

By the way I see that Morgan Stanley in their May 12 China Data Release (“Surprise Rebound in April CPI Inflation”) is predicting inflation for 2008 of 6.5%.  My quick-and-dirty calculation tells me that they are effectively predicting that inflation drops from an annualized 9.9% during the first four months of 2008 to an annualized 4.9% for the last eight months of 2008.  I am still predicting that it will exceed 8% for 2008 and probably will get close or cross into 2 digits.  Let’s see what happens in May.

One Response to "PBoC is biased towards more tightening"

  1. CHEN jiyao   May 25, 2008 at 3:05 am

    Prof Pettis, It is a wonderful piece. I completely agree. Now I am more and more inclined to believe that a larger RMB revaluation becomes increasingly necessary. It is an awful choice, but less awful than today’s go-and-see approach adopted by the PBOC. I guess one of the major concerns comes from the PBOC’s relative lack of autonomy in pursuing an independent monetary policy due to the factional strife. The housing and stock market interest groups still have strong presence and influence within the congress. But obviously, the government is doing two things now. One is that they attempted to apply a wide range of policies through legislations to curb or minimize the impact of hot money. I think this is a tinkering strategy. For instance, I remember reading a few days ago that the said that the SAFE will force the foreign investment bank in China to manage its foreign debt scale and their primary goal is to avoid financial risk caused by hot money. Nonetheless, those executive measures do not strike the root and they do this only to win time to see what happens. If those efforts pay off, then the maxi-revaluation can be put off again. Secondly, while the monetary tightening alone helps less and less in curbing the inflation, the PBOC also expressed their interest in using RMB to patch up the inflation problem on 15th of May. I agree with you that it is only a matter of time before they begin to touch on the RMB regime. All those capital control measures in fact also run in the wrong lane cos capital liberalization is the long-run goal of the policy-makers and SAFE’s employment of those strategies can only serve the short-term objective of controlling the hot funds, but it does not eradicate their fundamental interest in speculating. A Third Option? Now, I feel that the CCP is vacillating between further tightening the monetary policy in association with various policy and capital account restriction AND a maxi-revaluation. Both carry huge risks. And for the first option, I think what the government wants is the successful solution of CPI rise. If this immediate concern is addressed, they will quickly throw away of thought of maxi-revaluation, which seems to be their last resort. But their recent mentioning of domestic imbalance seems to point out their THIRD option. But just like you said, they did not give details on how to address it. At any rate, I think this is also a very good strategy. Just like the U.S government, when coming to deal with their trade-deficit, they become much more practical today. They tend to use less and less congressional pressure or retaliation approaches and start to acknowledge that the fundamental way is to solve the domestic imbalance. And what they do is attempting to SELL more and more. (that’s the focal point of three U.S-China Strategic Dialogues and the U.S also tries life sanction on many high-tech export. For instance, their close ties today with India represent their efforts of solving the trade deficit through trade expansion). China can do the same thing I feel. I always tend to argue that RMB expectation fundamental Stems from China’s Export-led strategy and FDI inviting. The emergence of RMB rise expectation will be a necessary result of that. One way or another, this will show. And now it is time. The 1997 financial crisis I think is also an expression of this risk when the ASEAN-4 achieved high export-led performance along with a weak currency (except Singapore which has a relatively strong SGD). Now as most Asian developed countries use China as the assembly site and export via China, China suddenly becomes the target of second round of large-scale speculation. Moreover, what added to my concerns for a maxi-revaluation is that Japan adopted a very large revaluation of 300% against the U.S dollar, but its entire economy was thrown into decades of slow-down still. And Japan’s economy was not completed defeated and its export industry eventually switched from labor-intensive towards capital-intensive NOT because the large revaluation does less harm than we imagine, but that the Japanese used to have a strong advantage in both the labor-intensive and capital-intensive, allowing a much more smooth transition while China is a different case. In this regard, I feel the Maxi-revaluation might not be the best option when there is a third option. (Of course, it is a better one if this third option is more expensive to implement.). Still, I don’t have the answer. By the way, just a joke. I remember in 2003, Larry Hsien Ping Lang proposed that instead of being forced to revaluate, China should devalued another 2% to discourage the Hot money. Because today’s inflation’s fundamental cause is the hot-money.