China: Latest Indexes Indicate Inflation

China’s PPI numbers for April were released today and, to no surprise to those of my readers who agree with my argument that inflation in China is primarily a monetary problem, they weren’t good. Year on year the index was up 8.1%, a little below market expectations but above last month’s 8.0%. This was fastest pace of increase in four or five years. Just six months ago year on year PPI inflation was well under 3%.

Although the food component was up, by 11.9% year on year, much of the increase in PPI prices was driven by even sharper increases in the prices for crude oil, steel, raw materials, fuel and power. In my opinion it has become very hard to hope that inflation has not spread to other goods. We are seeing exactly what we would have expected if the monetary model of inflation in China is correct – for a while rapidly rising food prices absorbed much of the inflationary pressures caused by excess money, but as food inflation abates the inflationary pressure will spread more evenly among other goods and services. The debate still isn’t fully resolved, of course, but another month or two of these kinds of price increases should really damage the argument that this is “just” a temporary problem of too little food.

According to yesterday’s Bloomberg the median estimate from 22 economists for April CPI inflation is 8.2%, a moderate improvement from March’s 8.3%, with most predictions bunching around the 8.0-8.3% level. I suspect, however, that we are going to be disappointed, and that the actual number is going to come in substantially higher. With most economists continuing to believe that Chinese inflation is a food-supply constraint problem, the recent moderation in food inflation has led them think that CPI inflation is also moderating but, as I have been insisting for several months, we are going to continue to be surprised by accelerating inflation in the non-food component of the CPI basket.

Earlier today I had coffee with a group of people that included the chief economist for one of the larger Beijing-based securities companies in China (since I didn’t ask her opinion to quote her, I won’t mention her name). She struck me as an extremely smart lady, very knowledgeable, and probably very well-connected as far as her information sources. She told us that she expected April CPI inflation, which is due to be released Monday, will actually come in at 8.5%. As I mentioned in a posting on May 5, Stone & McCarthy’s Logan Wright, whose inflation pessimism in recent months has largely been justified, did his own counting and also came up with 8.5% as his prediction. Finally an article in today’s South China Morning Post cites two unnamed sources who are supposedly “familiar with the data” as making the same claim. Sounds worrying, although not at all surprising if true.

On that and other topics Vice Premier Wang Qishan gave a much-anticipated speech in Shanghai today and had some very sound things to say about China’s financial system. He stressed the importance of financial risk prevention. “Safeguarding financial stability and preventing risks will be one of our policy priorities,” Wang said according to Bloomberg. “The subprime crisis, globalization of financial markets, and financial product innovation have magnified financial risks to the world as well as China.” Given the huge monetary imbalances of the past few years and the enormous growth in bank lending, I think one of the biggest dangers facing China must be the increasing risk of a sharp financial adjustment leading to a crisis in the banking sector, and so I think it is very important that the financial authorities recognize and worry about these risks (actually worry is not strong enough a word, in my opinion – they should obsess about it).

Wang, who is widely described as the chief financial policy-maker, also insisted that China will maintain a tight monetary policy to cool price increases and prevent economic overheating, and he made some strong references to the need to “step up” its management of cross-border capital flows, i.e. hot money. As if on cue Xinhua published an article today on hot money, which, according to the piece,

…is becoming an increasingly important concern for Chinese regulators as anticipation of an inflow surge strengthens along with a widening gap between interest rates in the United State and that in China. The exact amount of “hot money” into the country would be difficult to discern, however, there is indeed an acceleration of capital influx into the Chinese market as investors bet on a stronger yuan and rising domestic interest rates.

Later on in the piece they quote a widely cited recent estimate of hot money inflows:

Zhu Baoliang, the chief economic analyst of the prediction department of the State Information Center (SIC), told an industry seminar last month the first-quarter speculative inflow exceeded $80 billion, compared with $120 billion for all of 2007.

The State Information Center has been arguing pretty consistently, it seems to me, against continued increases in the value of the RMB, and they have especially pointed to the acceleration of hot money inflows as one of the major reasons against rapid appreciation. Of course I would argue that the acceleration of hot money actually suggests something very different: that the only option left for the PBoC is a one-off revaluation.

The same Xinhua article then referred to another piece of research, this time one with which I was not familiar:

Speculative capital inflows into China may climb to $650 billion by the end of this year, or $800 billion by the end of 2009, Zhong Wei, director of the financial research department under the Beijing Normal University, said in a recent report without elaborating on his calculation method. He put the amount of hot money at $320 billion at the end of 2005, 400 billion at the end of 2006, and $500 billion at the end of last year.

It doesn’t matter that these different estimates for hot money inflow don’t agree among themselves, because it is very difficult to measure what are after all often illegal transactions, and often buried in trade and other transactions, especially since there isn’t even an accepted definition of what kinds of capital inflows can be regarded as “hot money”. The important thing, I would submit, is that everyone who has attempted to construct proxies for hot money has reported a significant increase in his measure. With Wang Qishan bringing up the subject in his Shanghai speech, it is clear that this is a major consideration one way or the other.

I can’t finish the week with out noting that we had another bumpy day on the stock market. I will once again turn to my student Shang Ning for color:

It seems today the PPI number shocked some players, but not too much. The SSE index opened up by roughly 0.8%, and then bounced up and down within a range of + or – 0.8% from yesterday’s close. Around 10:00 a.m., the PPI number was released, and the market dropped sharply to 3556, for a 2.85% loss for the day. That was the day’s low, but in the last hour, it moved back with some volume and finally closed down for the day by -1.19%. Coal companies and consumers gained. Financial companies, banks, and real estate were the big losers, with the financial sector losing 3.16% on average.

Banks have been hit pretty hard the past few days, mainly on concerns about slowing growth and interest rate hikes. There still is very little conviction in the market. Today I was interviewed for CCTV’s current events program, Dialogue, and the topic of discussion was whether government interventions are likely to work to keep the market strong, at least until the Olympics. The other guest, Bi Jiyao, Deputy Director of the NDRC’s Institute for International Economic Research, was much more sanguine than I was about the ability of the government to support the market and turn around negative sentiment, but we both agreed that over the long term these interventions are not positive for the development of a healthy investor base.

Ultimately, he argued, the question is one of social stability, and although market interventions are not healthy in principle, it was very important for the government to keep the current market from turning into a rout and causing huge damage among the urban middle classes just before the beginning of the Olympics. I guess I agree, although I think I am also less optimistic than he is about how successful these interventions are likely to be.

Comments

[Diesel]

So judging by all your articles recently, you're thinking FXP is going to go through the roof sometime here in the next year?

[odin]

What measures are really available to the authorities to control the hot money flows? (Esp. if its difficult to trace them). Plus, with the flow of people in for the Olympics, will this not be doubly hard?

I suppose they could suspend/toughen convertibility at some point post the Olympics, but I'm not sure how you can fight fundamentals.

[J.D]

Good article. The in-China economists who argue that inflation is temporary and limited to food appear to be more interested in reflecting the priorities of senior leadership than independent economic analysis.

If they say otherwise, they're implicitly suggesting price controls will be neither successful nor limited to the short term. It's not good form to overtly criticize high-priority policies.

[sharpe_mind]

You're right- CPI will come in 8.5% barring an last-minute revisions. CPI has been leaked a few days to a week beforehand for the last 6 months or more, and has been spot-on every time. I strongly suspect the non-food component will show a significant rise from last month's 1.8% yoy.

Also, without including the boring details, using some data just released out of the Ministry of Commerce, in combination with previous months' export and import figures, you can deduce that the April trade surplus will come in at roughly $16.8 B (could be some rounding errors related to the imprecision of the inputs). Still strong, up from March, and above $15.5 B consensus (though clearly past its end-2007 peak). Export growth will be about 21.8% vs April 2007, and the dollar value of exports will be about $118.7 B, a new high for any individual month.

[M. Pettis]

Diesel, I had hoped that all my articles suggested that I have no idea where the market is going. The point I have tried to make several times is that the main driver of the market so far has been the PBoC's monetary policy (or lack thereof) and investor perceptions about government intentions. The former is chaotic and subject to large unexpected shifts, although always in the direction of excess growth, and I am afraid that the latter is losing credibility, so this is a highly speculative market and not one in which anyone can safely make short-term assumptions. If you are interested in long-term value plays, consider buying and holding B-shares for 3 to 5 years. If you want short-term speculation, keep your eyes on monetary policy and try to anticipate rapidly changing government actions and intentions -- that is what the local punters do.


Odin, there already is no free convertibility except for approved transactions (trade, direct investment, living expenses, etc.). The government can try to enforce some of the restrictions more stringently, and will probably do so because they love to blame foreigners for their problems, but I suspect that the big inflows occur though multinational family trading networks and so are very hard to stop, especially since corruption is endemic in China. The Olympics doesn't make things easier because suddenly there is going to be a swarm of foreigners in China all looking to convert their dollars, euros and yen into RMB to pay for expenses and shopping. One quick aside, the authorities have already warned about a significant pre-Olympic increase in counterfeit RMB bills, so even the criminals are pumping up the money supply.

JD, I think publicly most Chinese economists, especially those at the think tanks, do argue that the inflation problem is mainly a food problem, but privately a very large number are much more pessimistic.

Sharpe_mind, yes, trade data are not bad, but there is a ferocious campaign being mounted here to argue that exports are on the werge of collapse. At yesterday's meeting one Chinese economist suggested that although the bankruptcies of many of the southern process-trade exporters was a very natural consequence of a welcome shift in the struture of China's economy, they had very strong lobbying power and were determined to protect their interests.

[Daniel K]

Michael, I've read many of your articles before; are you teaching at Beida (spelling?)? What I don't get here is your recommendation to buy the B shares, combined with a gloomy view of inflation and Chinese banks. Most recessions in market economies in the recent past have been triggered by central bank reactions to inflation. In this case, a recession might cause many real estate loans to go sour. Why would a downturn bring an investor a positive return in 3 - 5 years? Why shouldn't an investor feel frightened of political and economic instability instead?

[kelaido]

FXI and Shanghai Comp Index dont correlate very well. They went into exactly the opposite directions, strongly, between mid-March and mid-April 2008.

[rlirph]

FXI is for H shares. Shanghai Composite Index is for A shares. Even though the underlying stocks are Chinese mainland companies both indexes do not correlate.

IMHO China brings a lot of problems upon themselves. The local Chinese now have national pride compared to ten years ago. However they blindly believe they are smarter than everybody else...but they are not.

The government has talked about "hot money" pouring into the country. Why in the world they still do not allow local residents invest in oversea stock markets?

The government restricts my capital inflow of US$50K per year. However, once when it gets here, I cannot wire the money out legally. Why do I have to pay an underground finance company 1% to get my money out? Shouldn't the government overjoy that I am taking money out considering the huge amount of inflow of money?
In other words it is a third world country practicing third world economics.

[M. Pettis]

Daniel K, yes I do teach at Beida. I don't want to make timing recommendations, and I would probably wait even to buy B-shares, but the reason I like B-shares for the medium term is because they are fairly cheap (around 40% discount to A-shares) and so represent a much better way to bet on medium-term Chinese growth than A-shares, especially since they are likely to be converted into A-shares in the next few years. Most of the companies listed in the B-share markets are likely to be protected from inflation since they own real assets and are involved in manufacturing and commodities -- there are no banks, for example. I expect that China's average annual GDP growth will stay well above 8% for the foreseeable future, so corporate profits should also grow at a fairly rapid pace on average, even if we have a sharp adjustment in the next year or two. The biggest risk for me is that a financial crisis in the near term become a political crisis.

RLIRPH, the government should in principle be happy to see you take your money out, but they are still terrified about the possibility of an Asian style crisis and massive capital outflows at the wrong time. In the sense they are indeed a third world economy with third world risks. By the way I don't think they "blindly believe they are smarter than everybody else." On the contrary I think unfortunately there is such a lack of confidence here sometimes that it makes them overreact to perceived slights, as we have seen in recent weeks. This is a very interesting country with a huge range of opinions and attitudes, and some real difficult problems that will be hard to resolve easily.

[odin]

MP, re: convertibility, I dont doubt at all that most of the currency flow does happen under the radar -- but my concern was more from the perspective of foreign investors who invest in China thru the NDF instruments.

Under the covers, I have no idea how the banks pitching NDFs structure the instrument (and how they hedge it). But I suspect if convertibility is tightened, even if the RMB revalues, there will be a significant discount applied to the NDF conversion (just as there is a premium now).

And while you arent advocating specific investments, I'm sure many readers look at your articles from an investment perspective. My feeling is that related currencies will undergo a knock-on effect after a RMB revaluation (particularly HK, to some degree Singapore) and generally involve a lot less risk than participating in the RMB hot money flows.

[M. Pettis]

Odin, yes, if the RMB revalues sharply I expect other Asian currencies will follow. China is not the only country importing excessively loose monetary policies and as long as they intervene so heavily in the fx market to keep their currencies down, they will suffer the cinsequences of rapid money growth. Many of these countries, e.g.vietnam, are worreid about reserve buolidup and would like to slow it down, but as long as the RMB is cheap it reduces the scope for other Asian countries to let their currencies revalue.