China: Can Smoot-Hawley Return in a Wholly Different Guise?

Chinese stock markets have bucked the trend in the rest of the world by posting a decent day yesterday and a great day today. Yesterday the SSE Composite rose 0.8%, and today it rose another 3.7% to close at 1928. I don’t think the rally was caused by good economic news – today’s data release showed October’s industrial production up a surprisingly low 8.2% year on year, although yesterday’s retail sales were in line with fairly high expectations, of which more later – so much as good technical news, or rather a rumor that has caused a certain amount of “technical” excitement. According to an article in today’s Economic Observer, one of the local papers I read regularly:

An anonymous policy recommendation calling for an RMB 600-800 billion fund to buy up mainland stocks in the event of a market crash has made its way onto the desk of top banking officials. The report, which included three pages of discussion and a two-page list of target shares, was first sent using an anonymous internal email account to a mailing list at the Research Center of International Finance (RCIF), under the Chinese Academy of Social Sciences, on October 30. It was later submitted to top banking officials as policy advice, the EO learned.

It suggested the government use such a fund to unconditionally buy shares in 50 heavyweight firms listed on the Shenzhen and Shanghai exchanges if the Shanghai index hit 1,500 points. The RCIF’s director Yu Yongding confirmed the authenticity of the report. According to a researcher at the Center, the report was well received by the financial industry, and the Center had so far received much feedback. Banking officials had long considered establishing such a fund, he added. According to the report, in extreme cases, the stock market might drop between 800 and 1,000 points, when rescue measures from the government would be meaningless. To effectively prevent panic selling, the government should take action if the index approached 1,500 points, it suggested.

By its estimate, RMB 930 billion would be needed to buy all circulating shares if the index reached 1,500. But, it added, buying one third of the total circulation would be sufficient to bolster the market, which would cost RMB 300 to 400 billion. Based on these calculations, the report then suggested that the government establish an RMB 600 to 800-billion stabilization fund.

For nearly a year there has been talk of using stock market stabilization funds to halt the collapse of share prices. Chinese regulators, to their credit I think, have pretty steadfastly rejected the rumors and denied they had any intention of doing so. Officially they have argued that this kind of intervention would seriously set back the development of the stock market as an efficient allocator of capital, and unofficially a lot of people have worried about the opportunities for manipulation and conflicts of interest.

I have no idea if the most recent proposal is likely to have more traction, but Chinese investors certainly seem to be “buying” the rumor. Whether they subsequently sell the fact we will have to wait and see. By the way, as a total aside, for those who are skeptical about how modern our modern financial experiences really are, I found the following quote in the first dialogue of Jose de la Vega’s 1688 classic work on the Amsterdam Stock Exchange, Confusion de Confusiones, “The expectation of an event creates a much deeper impression on the exchange than the event itself.” This I guess is the 17th century version of Wall Street’s “Buy the rumor, sell the fact.

As for other news, yesterday the authorities released retail sales figures, which although not a perfect proxy, are often used as an indicator for domestic consumption. The numbers were surprising, at least to me (Bloomberg says that it was equal to the median expectation among the economists it surveyed). Retail sales rose 22.0% in October, down somewhat from September’s 23.2% but still close to its fastest pace in nine years – July’s 23.3%.

I expected retail sales growth to be much lower than that. Certainly the economy is not acting like it is experiencing a consumption boom. Today the authorities released industrial output numbers for October and they were much worse than anyone expected – the lowest since 2001. According to an article in today’s South China Morning Post:

Mainland’s industrial output slumped to a seven-year last month as manufacturers throttled back production in response to weakness in the domestic property market and an unfolding slowdown in export demand. Growth in factory output slowed to 8.2 per cent in the year to October from September’s reading of 11.4 per cent, the National Bureau of Statistics said on Thursday.

“It’s a horrible-looking figure. It’s a shock figure,” said Ben Simpfendorfer, an economist at Royal Bank of Scotland in Hong Kong. Zhang Shiyuan with Southwest Securities in Beijing called the outcome terrible. Economists polled by Reuters had forecast a rise of 11.3 per cent.

Some of the other numbers were really grim. Power use was actually lower in October than it was last year – the first time this has happened since the 1997 Asian crisis – and iron and steel production was down sharply. But I am having trouble putting all this together. Industrial output is slowing considerably, it seems. But domestic demand is still very strong and the trade surplus is at a record. And yet as far as I can tell inventories are rising. This doesn’t add up. Perhaps there are significant lags in some of the data and we are still seeing the delayed effects of Olympics spending, but if output continues slowing and demand continues growing and the trade surplus keeps rising, either inventories are collapsing, the numbers are lying, or I am going to have re-jigger my understanding of how these things work.

One last point, and as an explanation of the title of this entry, the world is agonizing over the possibility of a return of protectionism, especially US protectionism, with innumerable references to the notorious Smoot Hawley Tariff Act June 17, 1930. As the US department of State website says, “To this day, the phrase “Smoot-Hawley” remains a watchword for the perils of protectionism.” However as often happens by a too-facile re-reading of history, we may be looking for an exact repeat of history rather than see the new way it sneaks up on us.

To get a quick review Smoot Hawley let me reprint the Wikipedia entry:

Smoot-Hawley was an attempt by the Republican Party to deal with the problem of overcapacity that plagued the U.S. economy in the 1910s and 1920s, which was the result of extremely-high-throughput, continuous-flow mass production and, in agriculture, the widespread efficiency gains brought on by the use of farm tractors. Although rated capacity had increased tremendously, actual output, income, and expenditure had not. Under the direction of Senator Reed Smoot of Utah, the party drafted the Fordney-McCumber tariff act in 1921 with an eye to increasing domestic firms’ market share. Weakening labor markets in 1927 and 1928 prompted Smoot to propose yet another round of tariff hikes.

The important thing to remember about Smoot-Hawley may be not so much its provenance but rather than underlying conditions that led to it. The US was at that time, remember, running massive current account surpluses. In 1929 it exported 75% more to Europe than it imported. Deficit countries financed their trade deficits in part by running down gold reserves (Keynes complained that the US was accumulating “all the bullion in the world”) and in some cases partly by capital exports from the US (although, consistent with rising gold reserves, the US was a net capital importer).

When first the stock market crash and later the banking crisis caused a collapse in US financing and in global demand, the US trade surplus also collapsed – with exports to Europe dropping by nearly 70% over the next three years. It was in this context that Smoot-Hawley was passed in 1930.

Just as the end of the liquidity cycle in the 1930s caused a collapse in the export sector of the world’s leading current-account-surplus country, it seems to me that much of the brunt of the global adjustment in the current crisis is likely to be absorbed once again by today’s current-account-surplus countries. If the global problem is likely to be a drop in demand, it is countries with too little demand who will adjust more than countries with too much demand. And if their exports drop quickly, for the obvious domestic politics reasons there may be significant pressure for current-account-surplus countries to engineer moves to support their export industries. Since most of them lack large domestic markets, the result isn’t likely to be direct import tariffs. It is more likely to be various permutations of competitive devaluations (which were also quite common during the 1930s).

In that context it is worth considering a note by Credit Suisse in their November 12 Emerging Markets Economics Daily:

PBoC Zhou Xiaochuan hinted yesterday that China could depreciate its currency. Answering a journalist’s question during the BIS meetings in San Paolo, Brazil, Zhou said that he would not rule out any options to help ease the pain of exporters. The Chinese currency started depreciating against USD since 1 July 2008. While there is clear demand from the local exporters for a weaker RMB amid the economic downturn with a stronger USD against other major currencies, we think the RMB can only manage a small depreciation against USD and a small appreciation against other major currencies under international pressure.

Yesterday Xinhua, in a very brief piece, noted that “China’s State Council said on Wednesday the country would raise export rebates for more than 3,700 items from next month to further boost the export sector.” Raising export subsidies, raising import tariffs, and depreciating the currency all have the same trade effect. They are ways of boosting domestic growth by boosting exports. But as we learned in the 1930s, countries cannot all export their way to growth unless they also collectively act to boost imports.

While everyone watches fairly closely and with dread to see if the US re-enacts new versions of Smoot-Hawley by attempting to resolve declines in domestic demand via beggar-thy-neighbor trade polices, the real threat may come from somewhere else. Current-account-surplus countries may, just as they did in the 1930s, find themselves under immense pressure to support their export sectors. Already we are seeing this in China, and I suspect a lot of other Asian exporters are also casting at ways to boost their own export industries.

One of the things the participants in the upcoming G20 meeting Washington should watch very closely is export subsidies and currency policies aimed at boosting exports. US imports must decline as a share of global demand, for reasons that have been widely discussed and widely accepted, and because of this, unlike in previous crises in the past two decades, the world won’t all be able to export its way out of this crisis.

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About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

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