Hot Money in China

Includes: FXI, PGJ
by: Michael Pettis

I was too busy to post anything Tuesday, but there wasn’t a whole lot new to say except to bemoan the stock market’s performance, again.  The SSE Composite dropped 3.1%.  Wednesday after a rocky start it seemed to find its legs, trading up 1.8% by lunch, before giving it all up to end the day almost perfectly flat at 2701.  It is now trading almost exactly 10% below 3000, which as recently as three weeks ago was the market’s imagined government-intervention level.


The property market doesn’t seem to be doing a whole lot better, at least in Shanghai.  Two articles in Wednesday’s South China Morning Post warn that Shanghai’s property sales are down.  According to one, “The sale of new flats in Shanghai measured by floor area, plunged almost 50 per cent in the first half, and sources said the market was unlikely to turn around until September, traditionally the peak season for property sales.”  Shanghai residential prices have been under pressure for a while as a consequence.  The second article suggests that commercial property is also seeing selling pressure, although increased selling interest is not necessarily causing prices to drop:


The queue of investors seeking to sell their Shanghai properties is getting longer, leaving analysts divided over the impact of a fresh wave of disposals on the market…


"All these asset disposal plans will add uncertainty to the outlook for the investment market," said Clement Leung Wai-ming, an executive director for China valuation at property consultant Knight Frank.  But with Shanghai residential prices holding firm despite a sharp fall in deal volumes last month and evidence that new investors are ready to step into the market, others have a more optimistic view.


I think the fact that there is so much hot money flooding into the country has made the clearing mechanism complex.  Fleeing sellers are matched with buyers flush with cash, and the market, while trending down, hasn’t really gone down as much as it might.  Needless to say, this is very worrisome (but you knew I’d say that, didn’t you?).  Property exposure is extremely high within the Chinese banking sector, and if what is propping up real estate prices, however tenuously, is hot money inflows, then we have yet another nasty little volatility machines embedded in the banks’ balance sheets. 


Why?  Because hot money, as is sometimes forgotten, is almost by definition highly pro-cyclical, and is likely to flee exactly when conditions are bad and it is needed most – just as the banks are struggling to deal with the consequences of a future financial or economic contraction, in other words, the legs are likely to be kicked out from under the real estate market.  China has too many of these busy little pro-cyclicality machines embedded in its balance sheet, which means that good conditions as well as bad conditions are likely to be exacerbated by the dynamics of the balance sheet.  Perhaps that is one of the major reasons why China has seemed like the rest of the world hopped up on super steroids.


By the way it is becoming increasingly clear that a lot of real estate developers – frozen out of the banking system – are turning to the informal banks for short-term and expensive funding.  For a long time I have been discussing and wondering about the role of the informal banks in all of this, and I said several times that I was willing to bet that the informal banking sector in China was growing rapidly, if only there where a way to measure it.  I am glad to say that over the past few weeks this has suddenly become a very hot topic, so it is getting a little easier to get a sense of its impact.  I was particularly interested by an article in today’s China Daily (“Irregular financing channels rampant”).  According to the article:


Many small and medium-sized enterprises now mainly rely on “underground” funding to finance their businesses as credit tightening measures have dried up bank loans.  Policymakers have been tightening the purse strings to fight inflation since last year. The benchmark interest rate has been raised six times, to 7.47 percent, and the reserve requirement ratio for banks raised 15 times since last year.  These measures have made it all the more difficult for SMEs to get bank loans, a vacuum promptly filled up by underground financing channels, said industry observers.


The article goes on to quote one of these informal bankers:


“A lot of small firms come to us. Only the bigger enterprises go to the banks,” said an underground lender, who declined to be named. He has lent out 10 million yuan - he declined to say how he made that kind of money - at 30 percent annual interest rate.  “Interest is not an issue. They will go bankrupt if they don't get our short-term loans,” he said. “Our money is available at short notice. We can deliver the cash within 24 hours, while a bank loan might take at least six months. But I am only small fry, there are bigger fishes out there with more than 100 million yuan parked in underground financing.”


The article also refers to a survey conducted by Beijing's Central University of Finance & Economics, which found that underground lending totaled 1.98 trillion yuan in 2007, equal to 28% of the amount banks lent.  This is a pretty large amount, and there is a lot of circumstantial evidence that the informal banking sector has gotten significantly larger, especially as hot money inflows seem to have grown very rapidly in the past few months at the same time that lending caps and hikes in the minimum reserve requirements have sharply curtailed loan growth in the formal banking sector.


The size and growth of the informal banking sector is not just of academic interest.  It has at least three implications for those of us worried about monetary conditions in China.  First, it makes the management of domestic monetary policy, to the extent that such a thing exists, much more difficult because the PBoC has no direct control over the informal banks.  If, for example, a lending cap on the commercial banks simply pushes loan origination off the commercial bank balance sheets and onto the informal banking sector, the lending cap can’t and won’t have much of an effect on domestic money or credit growth.  In addition, because the rate informal banks charge on loans is also beyond the reach of the regulator, the PBoC’s management of interest rates is also partially constrained (although on balance, given negative real rates and the consequent misallocation of capital, this is probably a good thing).


Second, it raises important questions about the structure of Chinese corporate balance sheets.  We don’t know for sure, but there are very good reasons to believe that loans extended by the informal banking sector are of much shorter maturity and of much higher rates than is typical for the commercial banks.  If this is true, and it almost certainly is, corporate balance sheets are much more vulnerable to an economic downturn or a sudden liquidity contraction than we might otherwise think (yet another dynamic little volatility machine embedded in China’s balance sheets).


Third, the rise of informal banks partially answers the question about where, if China is indeed being flooded by hot money, as I have been arguing since early last year, is all this money going?  Part of it is going into the informal banks.  Add the role of informal banks to the mix of rising bank deposits, the hoarding of commodities, real estate investment in secondary cities, and so on, and it is not so difficult to see where the money goes.


At the end of the China Daily article, the piece confirmed in a rather macabre way what my lunch companion last Saturday told me.  As I wrote on my Sunday blog entry:


We discussed what would happen in the case of a default besides the proverbial visit by the man with a baseball bat he suggested, with a completely straight face, it was also likely that one of your kids might be kidnapped.


According to the China Daily article:


“Many a time, the borrowers cannot pay back,” the private lender said. “What can you do in such cases? You just have to resign yourself to your fate.”  But not all lenders give up that easily. Some can go to the extent of hiring gangs to kidnap the borrowers or their family members to recover the loan, he added.


We definitely need to think more about the informal banking sector in trying to get our arms around China’s financial risk profile. 


Besides informal banking, the other “hot” topic about which a few of us have been pounding the table for months is, of course, hot money inflows.  I think increasingly people in China – and not just at the PBoC – are waking up to the sheer magnitude of the problem.  Wednesday’s Xinhua has an article titled “Unprecedented capital inflows test Chinese regulators.”  According to the article:


China has taken a series of increasingly aggressive measures in the past several months to blunt the impact of so-called "hot money," amid the explosive growth of its foreign exchange reserves, which have soared beyond what can be explained by trade and investment flows.  The inflows have been so massive as to raise alarms over the country's financial security.


The article is worth reading because it gives a sense that either there is rising concern in official circles about the impact of hot money in China or, alternatively, someone, probably in the PBoC, wants to raise such concern.  I am working on a piece, which I hope to complete soon, discussing the implications of the increasing role of hot money in China’s burgeoning reserve accumulation.  One interesting data point:  In the first quarters of 2005 and 2006, the combination of FDI and the trade surplus accounted for 60-70% of reserve accumulation.  By 2007, it accounted for only 46% of reserve accumulation.  This year, it accounted for 45% of headline reserve accumulation, but if you adjust for the “outsourced” portion of reserve accumulation (transfers to the CIC and minimum reserve redenomination), it amounted to barely 20%. 


This is a dramatic shift.  I know I have been pounding this drum over and over again quite a bit recently, but I am absolutely convinced that it is just a question of time that this, too, becomes a hot topic.  My prediction: worries about the shifting composition of China’s reserve accumulation will soon be one of the big stories in the financial pages.


As an total aside, after complaining last week that since the fuel price hike it has been almost impossible for me to find a taxi with air-conditioning here in hot, sticky Beijing, three of the four taxis I rode today were air-conditioned.  This is not a very scientific indicator, but given that taxi fares haven’t risen to match the increase in fuel costs, and their incomes must be wilting, I wonder if taxi drivers have at least come to some sort of agreement with the government.  Yesterday I had lunch with my friend Pierre Mongrué, with the Economic Department of the French Embassy, and he thinks that there may be an agreement to subsidize or otherwise accommodate taxi drivers.  If there is, the process of managing the very complex relationships of subsidies related to fuel price caps must be a nightmare, not to mention highly distortionary.