Banker or Grocer?

One of the students in Peking University’s Guanghua Students Monetary Policy Committee, a group for which I am an advisor, put together last week a summary of plans to raise capital adequacy ratios for Chinese banks. I thought it would be useful to reproduce his numbers. According to him, Shenzhen Development Bank, Everbright, China Merchant Bank and CCB have recently issued RMB 83.2 billion ($12.2 billion) in subordinated debt. Minsheng Bank, ICBC, Industrial Bank and BoC plan to issue an additional RMB 243 billion ($35.5 billion) of subordinated debt. Minsheng is also planning to issue RMB 1 billion in shares.

At the same time in December the CBRC required that the big five banks raise their loan loss provisions from 100% to 130% of the loans in the bottom three of the five credit categories. Off the top of my head I think the second category – “special mention” loans – comprises roughly three times as many loans as the bottom three categories combined, and many analysts assume that anywhere from one-half to all should properly be classified as doubtful or impaired. Given the huge growth in lending and lax lending standards during the past few years (during what had to be a great time to be a banker), I think skepticism about the quality of bank portfolios is very much in order.

Policymakers are assuring everyone that the banking system is healthy, as policymakers everywhere always do. I, of course, have my doubts, so I think it is very prudent that while they praise the banking system on one hand the authorities are making banks take on more capital and larger loan loss provisions. I think it is extremely unlikely that we don’t see a surge in NPLs over the next two years. This is particularly likely since credit expansion for February turned out to be RMB1.1 trillion, three to four times the amount of new lending last February which, when combined with last month’s RMB1.6 trillion, means than net new loans for the first two months of this year are significantly more than half of net new lending in 2008. Of course it might be pointed out that most of this new lending is to state-sponsored projects and was strongly “encouraged” by policymakers, so it is likely to come with explicit or implicit guarantees, but in the case of a surge inNPLs I suspect that banks will nonetheless be forced to take losses before the government itself steps in.

Aside from loan and capital-raising figures other numbers are not looking too positive. The wholesale price index came out today, with wholesale prices falling 6.0% year on year. Part of this was caused by falling crude and commodity prices, but there is enough left over to make me continue wondering about underlying liquidity conditions. Logan Wright told me Saturday that he expects to see very low, or even negative, reserve accumulation over the quarter, and regular readers of my blog know that I consider reserve accumulation to be the strongest indicator of underlying monetary conditions in China.

Manufacturing output for the first two months of the year was up 3.8% from the same period last year, which was well below already low projections (because of the moving Spring Festival holidays it doesn’t make much sense to compare individual months in the first quarter). Much of what little growth occurred was powered by a surge in concrete production and, to a lesser extent, by a sharp increase in vehicle sales. The optimists would say that this shows that the government stimulus is working. Pessimists would argue that the increase in auto sales may well be short-lived because it surged largely after a cut in taxes, and there are persistent rumors of a significant increase in car purchases by government-related entities. In both cases the growth in sales might then be seen as anticipated purchases that take will have trouble persisting.

Likewise pessimists would also argue that the surge in concrete production is not evidence that the stimulus is having an effect but rather evidence that people believe that it will have an effect, and so are building inventory in anticipation (the same is probably true of the recent surge in steel production and inventory levels). This is good news if the stimulus actually does have a big impact on demand, since rising inventory prevents bottlenecks, but of course bad news if the stimulus turns out to be weaker than expected, in which case the need to work off inventory will slow future production to below actual usage.

Aside from high loan growth numbers and low growth in manufacturing output, retail sales figures also came out last week. According to an article in Thursday’s South China Morning Post:

Growth in retail sales slowed to 15.9 per cent over January and February from December’s 17.4 per cent growth and 22 per cent in October, the statistics bureau said. “It seems clear the domestic demand is slowing in China, and this could be happening at a faster pace than the sales data suggest,” said Moody’s Economy.com analyst Sherman Chan in a report. “Having households pull back on spending is exactly what China does not need.”

Beijing is trying to prod consumers to spend more with measures that include subsidizing appliance purchases for rural families. But families save heavily for education, health care and other expenses, and analysts say they are unlikely to spend more on consumer goods until Beijing creates a social safety net to ease such burdens. A market research company, DDMA, said a February survey found 45 per cent of those polled had cut back on spending, down from 7 per cent in January.

Xinhua put a different spin on the numbers in an article the next day:

China’s retail sales grew 15.2 percent in the first two months to 2 trillion yuan (293.8 billion U.S. dollars), the National Bureau of Statistics (NBS) said Thursday. The figure, although lower than the 20-percent-plus increase a year earlier, was encouraging, analysts said.

Retail sales growth in January and February was equal to or even higher than last year adjusted for inflation, said Zhuang Jian, senior economist with Asian Development Bank. The consumer price index (CPI), a major gauge of inflation, hit a 12-year high of 8.7 percent in February 2008 but fell 1.6 percent in the same month this year. “Domestic consumption has remained stable so far, despite the economic slowdown,” he added.

I think Xinhua’s interpretation is probably closer to the mark but in either case it seems, not surprisingly, that household consumption is almost certainly declining. Remember that retail sales are not a great indicator of household consumption in China because they include lots of other things, including government consumption. In addition I should add thatCICC , one of China’s three leading investment banks, came out with a report on March 11 which I cannot excerpt but which basically advised caution about the retail sales figures and the outlook for household consumption.

A difficult transition

On a very different subject, two days ago I received a very interesting and intelligent email from one of my readers, a student who I believe is from the South of China (I am guessing this because he mentioned his plan to set up a business in Guangxi) although I am not sure if he is currently at Peking University or at another school. He has allowed me to reprint his email, although I am not sure whether he is comfortable with my using his name, so I will reprint part of his letter while leaving out his name and any private references. I have edited the letter slightly to make it follow the format that I use in this blog:

Being a student and a loyal reader of your blog, you have all but convinced me that China should continue to allow its currency to appreciate, for China and the world’s sake. This is in spite of the fact that my family runs an export business and appreciation of the currency will most definitely affect our business in a negative way. In light of the global financial crisis, the big theme in China is how to increase domestic spending and gradually make the export oriented businesses more domestic-dependent. And I always tell myself that the appreciation of the RMB will help because imports will be cheaper and that will directly increase the purchasing power of Chinese consumers.

Today, I went shopping with my girlfriend at Carrefour and I was trying to find some evidences to support my theory. Today we bought about RMB100 of food, typical of the things that we would need for the next 2-3 days. Roughly, I would say we bought RMB30 worth of meat (chicken and pork), RMB40 worth of fish, RMB20 of milk/dairy and RMB10 of shampoo. Then I try to determine how much the Chinese consumers would save if the exchange rate was changed. Here is what I realize:

All RMB 100 of food are made right here in China. Even the RMB10 foreign brand shampoo is made by a factory in Shanghai. So, I thought, what would happen if the dollar to RMB exchange rate becomes 1:4? Well, the cost of making these items wouldn’t decrease that much because most of the components that go into producing these items are not imported and would stay pretty much the same. (Please correct me if I am wrong in this assumption.)

However, if the exchange rate suddenly becomes 1:4, a lot of Chinese exporters, including my family’s juice business, which actually has a good margin compared to other labor intensive industries, will go out of business.

In addition, perhaps now it would make economic sense for western companies to import their products (beef, fish, milk, shampoo) into China (of course assuming that the tariffs stay the same) and domestic consumers would buy imported goods because they are better quality and may now be cheaper.

So this also adds additional pressure to the manufacturers. furthermore, perhaps now P&G would in this new exchange rate environment consider producing its shampoo in the U.S., because relatively speaking, P&G’s cost of production in the U.S. would have gone down.So China gets hurt in a multiple of ways as a result of China revaluing its currency:

1. Export companies go out of business.
2. Domestic companies get more competition from foreign companies and are forced to cut prices and maybe wages.
3. Foreign companies will have less incentive to invest and do production in China.
The benefit is that Chinese consumers will buy more imported goods, but I am not even sure if the consumers will get more purchasing power as a whole because as in our shopping experience, almost all of the things that I buy are made locally, so the prices wouldn’t really drop. (I can see in the case of luxury goods, i.e. LV, or Gucci, where they would be come sufficiently cheaper if the exchange rate re-values.)

So in conclusion, on the one hand, based on PPP or Big Mac index, I get the impression that the RMB is greatly undervalued (i.e. 1 Big Mac in US is $4, and 1 Big Mac in China is RMB 12-15). Yet, if the RMB were to really go up in value, the economy would definitely be hurt in many ways.
What is wrong and what can we do?

This is a great letter because (aside from the fact that it shows why I enjoy teaching here so much, given the intelligence and thoughtfulness of so many of the students I meet) it indicates in a very concrete way how complex the policy decisions are and how difficult the transition process is likely to be.

The first thing I would bring up is the issue of the effect of revaluation on the food purchased at Carrefour. Of course it is true that the cost to make those Chinese-made goods would not decline in RMB terms except to the extent that they included foreign components (which may be more than many realize, since much of the fertilizer used by Chinese farmers comes from abroad, as does the oil they use to transport their products to Carrefour), but that does not necessarily mean that their cost to the consumer would not decline. All of these things can be manufactured abroad, and it may be that Malaysian chickens, Australian milk or the same shampoo manufactured in Vietnam would become so much cheaper that either Chinese consumers would begin to buy more foreign food, or Chinese producers would have to lower their costs or improve their quality to compete. This directly benefits Chinese consumers.

Of course it might hurt Chinese farmers and producers, and this is why the transition becomes difficult. In a very abstract way we can argue that whatever pain the farmers feel is less than the gains other Chinese enjoy. Cheaper food for Chinese consumers means that they have more money leftover to go to restaurants, buy books, or get haircuts, and so Chinese businesses that supply these services will benefit.

In an even more abstract sense we can argue that China does some things relatively better than other countries, and some things relatively worse – that is, the specific conditions in China, including its infrastructure, labor markets, educational systems, and so on mean that Chinese can do some things more productively and efficiently and other things less so. By allowing the RMB to appreciate (or by otherwise relaxing constraints that affect the relationship between production and consumption), Chinese businesses and producers will be forced to concentrate on the things they can do more productively and efficiently than others, while leaving others to do the things they don’t do so well.

This increases the total economic well-being of China and the countries with which it trades, and so at least in principle every country can become a little better off. Remember that if China buys more from abroad, that doesn’t mean that Chinese producers must sell less. Whatever money China exports to pay for those imports represents a net increase in either 1)foreign buying of things that Chinese producers are good at making or 2)foreign investment in China, which increases the productivity of Chinese workers. Both of these are good for China’s economic prospects and both result in rising employment.

But there is no getting around the fact that the process will be painful in the short term, as the student writing the letter has pointed out. Although in the long run China and Chinese workers and consumers will almost certainly be better off as China makes the transition to a more balanced and domestic-driven economy, there are nonetheless short term costs. Resources and labor will not be smoothly reallocated from exporters to domestic service producers and manufacturers who serve the local markets. What usually happens is that, to use the very dry jargon of economists, these resources and labor will be “freed up” as exporters go bankrupt or downsize.

As economic conditions change, and as exporting becomes less profitable, businesses aimed at local consumers will take advantage of newly available assets, resources and labor to begin operating, and gradually China will once again reach more or less full employment with a very different economic structure. But of course remember that at first, domestic demand (and domestic employment) will actually decline as workers lose their jobs. This is where the government can and should play an important role, for example by boosting domestic consumption as much as possible so that it quickly becomes profitable for Chinese companies to target the domestic market.

Allowing and even encouraging this transition may therefore seem like a bad idea for China, but as the global crisis shows, it will be impossible for a large economy like China’s to continue depending so much on the export sector and on foreign investment. It must make the transition, and the later it does so the more difficult it will be.

When the US made a similar transition 200 years ago, after the panic of 1797 when the Bank of England suspended gold payments, and when the US Quasi-War with France and the Napoleonic Wars in Europe decimated the US export trade, it did so over at least two very difficult decades, and after sharp rise in unemployment in the early years. Eventually the whole country shifted its economic structure and, needless to say, the shift turned out to be crucial for the subsequent success of the US economy.

Japan was forced to confront the failure of its own export-led model in the late 1980s and early 1990s, and, as everyone knows, the process has not been easy. Of course it would have been better for the US and Japan if they had try to adjust earlier, when global trading conditions were optimal, but like China in the past decade, it is hard to make an adjustment when things seem to be going so well. It almost always takes a crisis to force the change, even though this makes the process of change that much more difficult.

By the way although much of the above is a fairly standard exposition on how free trade benefits everyone, I am not necessarily a believer in unfettered free trade for China. Remember that under conditions of free trade and no currency intervention Chinese businesses and producers will be forced to concentrate on the things they can do better than others, while leaving others to do the things they don’t do so well. This of course benefits the whole world in the short term, but China may not be happy over the long term with its comparative advantages. It might find that cheap labor and low technological skills are not the kinds of advantages it wants to enjoy.

In that case a very strong argument can be made that selective protection can alter the relative advantages China has by encouraging innovation and development in areas in which China now has a relative disadvantage. I won’t say much more about this (which is anyway likely to be highly controversial) except to note that as far as I have been able to determine from the historical evidence, with exception of a few very small trading nations, every technologically and socially advanced country since the British in the 17th and 18th centuries did so behind trade and other barriers aimed explicitly at altering the country’s technological and commercial position. Much of this theory is beautifully summarized and implemented in Alexander Hamilton’s writings, and it is worth noting that the US, unlike its largely free-trading counterparts in Latin America, had the highest import tariffs of any major country for most of the 19th Century. The risk of this kind of protectionist policy of course is when trade protection is allied with attempts to foster national champions, which almost always results in the worst of both worlds. Competition breeds innovation, and state-supported national champions are almost always global losers.

Before closing I should switch the subject and mention that Canada’s Globe and Mail had an article Friday about my insistence that a very wide-spread claim — that China is Washington’s banker — is based on a misunderstanding of the reserve accumulation process, and that it is probably more useful to think of China as a shop that sells to the US and accumulatesIOUs, rather than as its banker. You can find the article here. Banker’s lend discretionary money, whereas grocers only accept IOUs from important clients on purchases from the store. It is an important distinction, I think.

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