China's PMI Numbers Are Too Strong

Yesterday, I wondered if after their 29% decline year to date, and 3% decline that very day, the Chinese stock markets might be near a bottom. Today they dropped again, by over 4%. I guess my call was a tad premature. “People are rushing to sell shares in panic,” said Wu Kan, a portfolio manager at Dazhong Insurance Co. in Shanghai, according to a Bloomberg report. “Economic fundamentals and the lack of government support measures have both contributed to the plunge.”

So the market is down; what about other financial imbalances? In my January 24 posting I argued that although fixed asset investment and industrial production had eased a little in recent months, we shouldn’t take much comfort in those numbers as suggesting that the impetus behind the roaring trade surplus was weakening. It seems to me that every time the numbers let up, a lot of analysts sigh in relief and suggest that at last the tightening measures are beginning to work. But as I see it, the tightening measures cannot work as long as China retains an exchange rate policy in which rising foreign exchange inflows are tied to rising investment in the self-reinforcing mechanism I described in my March 26 entry. A slowdown in the rate of growth of industrial production, in other words, is temporary and likely to be reversed soon enough.

But the recent release of the purchasing manager index for March suggests that both headline PMI and the new orders index are near historical highs. According to Credit Suisse, from where I get these numbers, “this indicates a revival in economic activities, potentially fueled by the relatively looser credit control measures seen since the beginning of the year.” They are surprised at the strength of the rebound, especially the rebound in new export orders, and wonder if it has something to do with post-storm rebuilding. I am less surprised, and think it is largely part of the same old story we’ve seen over the last three or four years.

Where we are much more in agreement is on the indications of more inflation. According to Dong Tao, Credit Suisse’s China analyst:

Input prices index aggravated by 4.5pp to 74.6, the highest level ever. This has reflected the seriousness of rising inflation in China, coinciding with the rampant producer and wholesale price increases seen lately. Although the worst of the snow storms has passed, expectations of higher prices did not soothe but deteriorated further.

Almost all major sub-indices have pierced the sizzling 75 mark, with metal products (92.1), general machinery (89.1), and the smelting of ferrous metals (88.3) hovering around the 90 mark. We maintain our view that margins are shifting towards upstream industries at the cost of those downstream and that non-food inflation of the CPI index will face acute upward pressures.

I think Dong Tao is right, and I think (no surprise) that March and April numbers are going to show a slowing rise in food prices and an acceleration of inflation in the non-food sector. This would be consistent with the model of inflation I have discussed many times on this site. By the way the April issue of Far eastern Economic Review has a piece by me explaining in some length why I think high food inflation and low non-food inflation is perfectly consistent with the idea that inflation in China is a monetary problem. As soon as I am allowed to publish it here, I will. By the way March CPI numbers should come out in 10 days.

I was interviewed today by a Chinese financial journal planning a big feature on RMB appreciation and the prospects for China, and in the interview I briefly discuss all these subjects. Since the interview, which covers the range of topics I often discuss here, will be translated into Chinese and presumably read by people that don’t often read my blog (and anyway this blog is hard to access in China), I thought I would copy the questions and my answers into this blog posting. The questions sort of summarize much of what the financial press is thinking and worrying about in China.

In the first quarter of 2008 alone, the RMB has appreciated about 4%, the fastest pace since the exchange reform in mid 2005. What do you think of the appreciation progress? From your stand of point, is this pace good or bad for China?

China should have begun the appreciation of the RMB much earlier than it did and it should have appreciated more aggressively. Unfortunately, perhaps because of the excess global liquidity of the past few years and especially of the past few months, China is now caught in a monetary trap in which the high trade surplus forces the central bank to buy large amounts of foreign exchange, which of course causes very rapid domestic money expansion. This money expansion feeds directly into excessively high levels of investment, which force up industrial production and so causes the trade surplus to rise or remain high. It will be extremely difficult for China to get out of this trap.

It seems that many Chinese exporters such as textile and shoe makers can no longer bear a faster RMB appreciation. They say that the faster appreciation plus increasing costs plus decreasing demand nearly killed them. From your observation, are these exporters going to lose their competitiveness and collapse? What is the real picture of China's exporting industry?

I think they are mistaking the cause of their trouble. If it was the rising RMB that caused them difficulties or caused them to go bankrupt, we should see China’s exports slowing sharply and unemployment, especially in the south, rising quickly. But we see neither. Exports continue to surge and unemployment in the major exporting regions of the economy seems to be relatively low (indeed companies complain bitterly about upward wage pressures, which is not normally consistent with high unemployment). What is causing trouble to certain exporters is something very different. As China’s labor force, especially in the wealthy south and southeast, move out of low value-added assembly and into higher quality manufacturing and service jobs, companies that rely on cheap, unsophisticated labor will necessarily find conditions more difficult and may even go out of business.

Although these companies may suffer individually, their problems will have no impact on overall employment in China because it is precisely the higher wages and better employment opportunities for workers that caused them to leave. It also does not affect China’s overall exports because the production of these exports is shifting away from highly developed areas like Guangdong to less developed areas in the interior of China. The growing bankruptcies of these companies is not a sign that the currency is appreciating too quickly but rather a sign that policies aimed at creating a higher quality manufacturing and service base in places like Guangdong are succeeding. As long as overall exports continue to grow it is hard to see how the rising RMB has caused trouble for Chinese exporters in general.

As you know, the CPI of China has been very high in recent months. Many say that a faster appreciation will ease inflation. But we have seen now is that China's domestic prices keep increasing. Why?

This is another common mistake in the debate. In China, appreciation will not reduce inflationary pressures through the price impact on imported goods. It can only really reduce inflation if it reduces the amount of foreign exchange the central bank has to buy every month, and so reduce the growth of the domestic money supply. As long as China’s money supply keeps expanding at such a fast pace, it will be impossible to bring inflation down, and as long as the central bank is forced to purchase very high levels of foreign exchange every month, China’s money supply will keep growing too quickly. The recent appreciation has done nothing to slow the trade surplus but it may have increased speculative inflows, so it actually causes an even further increase in the money supply.

Many economists are calling the Chinese government to rethink the appreciation mechanism. Some suggests a one-off appreciation just like 2005 to reduce import costs. What do you think of this? What is your outlook for the RMB's exchange rate by the end of the year?

When I first argued, a little more than a year ago, that the government was eventually going to be forced into a large, one-off appreciation, I made the argument because no other solution would get it out of its monetary trap. I still believe this and I believe that recent events have actually strengthened the argument. It is a very difficult policy choice, but the alternatives are all worse. If China wants to reduce inflationary pressures it must move as quickly as possible to reduce foreign currency inflows, and the only way to do that is to surprise the market with a one-off revaluation large enough to slow export growth and, more importantly, to cause speculative inflows to reverse and leave the country.

But the revaluation must be large enough to be credible. A revaluation of less than 10-15% will almost certainly make matters worse since it will still leave the market believing that the RMB is undervalued, and it will signal how desperate the situation has become for the central bank – thus convincing everyone that the central bank will be forced to act again. This will cause speculative monetary inflows to surge.

Comments

[Thinkingahead]

Michael:
Would a revaluation such as you describe boost or retard (Chinese) domestic consumer spending?

[TanToday]

You know, I wish OUR LEADERS, would become as unsophisticated in economics as the Commies running China.

So, the "problem that needs 'fixed'" is that the world wants to send more money to China, growth is "too fast' and there is 'too much money' chasing everything in China?

SUCH PROBLEMS! OY, we shvuld hafv such problems!

Perhaps instead of the clowns running for president who are too busy fighting over what someones pastor said one day, or if a girl or a black is better to run the country, we should invite some Maoists/Dengists over to run for office and bring US some of those horrrid, terrible, "problems" that the so called economic geniuses that brought us the subprime meltdown, soon to be followed by the derivative meltdowns, and the hat in hand begging routine we are now engaged in with countries that only 30 years ago, were in the Rickshaw and water buffalo mode.

THEN perhaps, we could 'import' those MASSIVE ISSUES that China is facing?

{ ... am I the only one that believes our opinion makers are from Alice-in-Wonderland and Oz? }

[roamantik]

Michael:
I really enjoy your blog, but I wonder whether the Cassandra in you might be causing you to overlook feasible alternatives to massive revaluation.
For one, didn't Chile, some years back, impose a 1-year quarantine on new investments specifically to discourage speculation on its Peso?

[whidbey]

I think the analysis is just the kind we all need to engage in before doing business with China. The problem with China is "free trade" based on a price advantage in labor, currency and etc, and the inability of the USA to do without the junk from China. Now it appears that unemployment in the USA will help do some throttling of demand. But god at what cost! China can not slow down without political instability. Another unmanageable cost. This going to be a longrun problem.

[M. Pettis]

Roamantic, Chilean-style restrictions cannot work in China since the official restrictions on capital inflows are already much stricter than they were in Chile. You already cannot bring one-year money into China, so imposing the Chilean tax burden on one-year inflows would be pointless. Hot money inflows into China are either illegal, or hidden in legitimate flows (under- and over-invoicing exports and imports, for example). China already imposes a whole series of capital controls, but over time these kind of controls always erode, especially for such a large country and more especially one in which corruption is common, and in China they have long past the point where they were effective. Anyway most of China's inflows consist of the trade surplus and the FDI surplus, neither of which can be affected by capital restrictions on hot money.

Tan, perhaps this largely reflects our inability to understand much of what happens outside our borders but although it is fashionable in the US to think the opposite, but I am pretty sure US problems in the medium term are much less severe than those faced by most other major countries, including China. I would not for a minute trade our problems for those of China. They are not even of the same magnitude.

[Silver-Bullet]

China currently has the capacity to produce the entire wolds' goods. Looks like they have a lock on this - even the Mexicans can't compete with them in cost structure.

Next, do you honestly think China will go on financing US debt? It has already started reducing dollar holding. I think an appreciation is inevitable. The question is - how much.

[chinesepetti]

Mike,you have no respect for history; look what happened in japan when they appreciated their currency 20 years ago? 10 year economy slump and still going down as we speak. thanks to the Japanese; Chinese will not listen to your nonsense this time around, you might spend more time to give your own government advice to fix its miserable credit crisis!

[sharpe_mind]

openminded, I completely disagree. Though I can see where you picked up this argument- there have been those in China which have used the same argument to push for slower appreciation. Yet this is a complete misreading of the economic facts (as an aside, I believe it is either Wen Jiabao or Zhou Xiaochuan who has hinted at discounting this argument as China needs to "accurately read from historical lessons", or something to this effect). Firstly, the yen appreciated tremendously in the 1970s, and yet Japan continued to have some of the strongest growth in the world in the 70s and 80s. USD had two episodes of strong appreciation in the first half of the 80s and second half of the 90s, neither of which led to prolonged economic slump. And even if we focus specifically on the period in question, starting with the Plaza Accords in 1985, the Deutchemark appreciated significantly along with the yen, but Germany avoided the decade long slump of Japan. Even its slower growth in the 90s is much more attributable to the costs of integrating East Germany.

No, the currency is ancillary to Japan's problems in the 90s. They stem from too lax monetary policy in the late 80s, and then a series of blunders in the 90s including too tight monetary policy (as evidence by the continued strong appreciation of the yen after the Louvre accord). In addition, Japan began suffering as their exports were cut into by the rising Asian tigers, and behind them China.

In the case of China, there really is no other China to threaten Chinese exports. No other places have the one-stop shop quality and the infrastructure. Vietnam and Cambodia are far too small, India has far too much red tape, poor infrastructure, and is much more union-friendly, and Africa continues to be a basket case. Latin America and Russia are far too expensive. The era of disinflationary prices of imports from the developing world is over.