Zaiteku and China’s January inflation

By Michael Pettis

A large part of my newsletter earlier this week discussed emergent scandals in the railway industry and their implications for the overinvestment debate, and this was even before the Alibaba scandals broke, but I think a lot more interest this week surrounded the inflation numbers.  Last week the National Bureau of Statistics released inflation data for the month of January:

In January 2011, consumer price index rose by 4.9 percent over the same period of the previous year. Of which, urban area and rural area was up by 4.8 percent and 5.2 percent respectively; the price of foodstuff, non-foodstuff, consumable and services expanded 10.3, 2.6, 5.0 and 4.6 percent respectively. Compared with December 2010, CPI increased 1.0 percent. The price of foodstuff climbed 2.8 percent.

The market expected a much higher inflation number, but there was a revision of the CPI basket, which brought down what would have been 5.1% inflation year-on-year to 4.9%.  Here is Caixin on the subject:

The January CPI figure was based on a newly-revised CPI basket which lowered the weighting of food prices by 2.21 percentage point and increased the emphasis of the housing sector by 4.22 percent.

I don’t think we should read anything sinister into the revision of the CPI basket (although the timing was perhaps a tad convenient) since rising incomes generally mean a declining food share in the consumption basket.  At some point they had to revise the basket.

But even with the revision, the month-on-month increase in prices suggests that inflation is running at just under 13% annually, although month-on-month numbers are always suspect because they don’t correct for seasonality and one or two big numbers can have a disproportionate effect.  Still, although the CPI inflation number was below market expectations it is nonetheless well above the PBoC’s comfort level, which is officially 4%.  In December the year-on-year rise in prices was 4.6%.

This stubbornly high inflation number, coupled with good growth numbers and a surge in exports will, I suspect, give Beijing the sense that it has room to tighten, so I expect that we will continue to see measures such as interest-rate and minimum-reserve-requirement hikes to slow down economic growth.  In keeping with this on Friday the PBoC announced yet another 50-basis-point hike in minimum reserves (making it the fifth hike in five months).

But will these measures bite?  My guess is that they will at first, but that when they do they will be quickly reversed.  Any real attempt to reduce the sources of overheating will cause economic growth to slow too quickly, and Beijing will change its mind, especially if, as I expect, inflation peaks soon and starts to decline.

Let’s face it – most Chinese growth is the result of overheated investment, and removing the sources of overheating without eliminating growth is going to prove impossible.  I have been making the same argument for at least two or three years, and so far we have seen how Beijing veers between stomping on the gas when the economy slows precipitously and stomping on the brakes when it then grows too quickly.  I don’t believe anything has changed.

And deposits were down

The most interesting number in the NBS release, perhaps, was January the level of bank deposits.  They were down.  Dong Tao at Credit Suisse says that this is the first time this has happened since January 2002:

What was more concerning was that it was corporate deposits that went backwards, not household deposits, as may have been expected around Chinese New Year. This gives us reason to believe that the fall in deposits is not seasonal.

One of my clients asked me two weeks ago about continued tightness in the interbank market and this was my response:

My interpretation of the liquidity tightness is also maybe a little different.  If you check the latest NBS numbers you will see that deposits were actually down, and it was not household deposits that dropped, which could be explained by the holiday, but rather corporate deposits.  One month does not make a trend, but this is pretty consistent with the argument that highly negative real deposit rates will cause depositors to take their money out of the banking system.

In that case there may just be a mismatch between the lending and deposit side.  Loan officers are always encouraged to lend like crazy, and the funding side assumes the deposits are there, but perhaps they were caught off guard by the decline in deposits.  I am just guessing, as are we all, but we are trying to keep an eye on the topic to figure it out.

So why did corporate deposits drop?  My guess is that large businesses may be finding it much more profitable to lend money to other businesses, especially those who don’t have easy access to bank credit, than to deposit cash in the bank at such negative real rates.  Both the Credit Suisse report and an email I got last month from a friend of mine at Bank of China suggests that there may be an increase in intercompany lending, and to me this would be a very plausible consequence of negative real deposit rates.  And of course for those worried about systemic risks this would be very worrying news.  As Japan showed us in the days of zaiteku, when corporations turn to speculative financial transactions as a source of earnings they tend to increase systemic risk.

By the way, and as an aside, in my newsletter I discuss an important recent PBoC release Thursday on the true amount of new lending in China, including off-balance sheet items.  According to the PBoC, not only is new lending far greater than the official new loans number, but it actually increased from 2009 to 2010 – contrary to what the official new loans numbers imply.  This was not unexpected but nonetheless a little shocking.

QE2 and asset bubbles

One final note before closing, my former student Chen Long in an email to me said the following about a new SAFE report:

SAFE calculated the total amount of “hot money” in a report released on Thursday, coming in at $35.5 billion for the last year and $250 billion for the last decade. This accounts for only 7.6% of new foreign reserves in 2010 and 9% during 2001-2010.  The calculation made by SAFE is: hot money = total increased amount of foreign reserve – (trade surplus + FDI + investment gains + overseas stock offerings).

These numbers are much smaller than the market estimated because the market was unaware of the previous investment gains from SAFE. The number is too small to affect either China’s economy or the A-Share stock market. The Hong Kong RMB market is growing very quickly, but it is also too small to affect the Chinese market. It also shows that the correlation between hot money inflows and the stock market is not very positive, as the market dropped in 2008 and 2010 when hot money inflow was quite large. All the bubbles in China are still there because of robust monetary supply growth in 2009 and 2010.

There are at least two conclusions from this.  One of them is brought out, perhaps surprisingly, in a People’s Daily article:

China has only seen a moderate growth in speculative “hot money” inflows in 2010, said the government’s foreign exchange regulator yesterday, despite the extraordinary loose monetary policy by the US Federal Reserve to prop up its flagging economy.

A good number of Chinese economists have criticized the Federal Reserve for releasing the so-called “quantitative easing” policies, but the State Foreign Exchange Administration (SAFE) said yesterday that it only detected $35.5 billion of hot money slipping into China, which was relatively “very small-scale” as compared to the size of China’s economy.

It has been almost an article of faith here that the Fed’s QE2 was responsible in large part for Chinese monetary expansion and asset bubbles because it has created massive hot money inflows.  According to an article in the Financial Times:

In the run-up to the G20 summit in South Korea last November, when it looked that China might come under attack for artificially depressing the value of the renminbi, Beijing joined several other governments in accusing the US Fed of causing huge capital flows and inflation in the developing world.

Zhu Guangyao, a deputy finance minister, said that the Fed “did not think about the impact of excessive liquidity on emerging markets by having launched a second round of quantitative easing at this time”.

“If you look at the global economy, there are many issues that merit more attention – for example, the question of quantitative easing,” said deputy foreign minister Cui Tiankai, when asked about US proposals to limit current account surpluses.

I think I agree with deputy minister Zhu that QE2 does cause liquidity growth in developing countries, but mainly for those countries that intervene in their currency markets – no intervention, in other words, and no liquidity growth.  But the idea that it was QE2 that caused China’s asset bubbles was always pretty questionable because they long pre-date QE2, and more importantly any impact of QE2 had to be minimal compared to the sheer explosion in lending.

The ant-hill of hot money

To return to the SAFE report, hot money inflows have actually been negligible, they say, and so perhaps QE2 didn’t matter at all.  I am not sure I agree completely.  SAFE’s calculation on hot money inflows assumes that everything called the trade surplus and FDI really is FDI and the trade surplus.

But is it?  FDI has surged recently, as it always seems to do whenever the market increases its RMB currency appreciation expectations. Pretty funny, right?  As the People’s Daily article goes on to say:

Also yesterday, the Ministry of Commerce said that foreign direct investment rose 23.4 percent in January from a year earlier, as the country attracted $10 billion. The January figure compares to growth of 15.6 percent in December, when $14.1 billion in investment flowed into China.

Foreign direct investment (FDI) hit a full-year record of $105.8 billion in 2010, the ministry said last month, reflecting growing foreign confidence in the economy.

Perhaps it does reflect growing foreign confidence, as the MoC says.  But perhaps it simply reflects growing Chinese eagerness to speculate on the RMB.  I suspect FDI may be including a lot of disguised hot money inflows.

The same by the way is true about the current account surplus numbers.  It is very easy to disguise hot money inflows or outflows by under- or over-invoicing imports and exports, especially given the ease with which guanxi and cash can subvert the regulations.  This was clearly supported by another part of the article:

Illicit cash inflows were more like “ants moving home”, coming in bits and pieces via multiple deals and transactions, the regulator said.

It turns out, according to most interpretations of the SAFE report, that the speculators creating the hot-money inflows are not the much-vilified foreign hedge funds – surprise, surprise – but Chinese businessmen bringing money into the country in dribs and drabs.

Of course this wouldn’t have surprised anyone who has actually seen how hot money works.  The most destabilizing hot-money flows are almost always those generated by local businessmen, who understand better how to navigate the rules and constraints and who have a better sense of changes in risk and return.  Hedge funds matter in certain kinds of markets, but their only important role in a country like China is to serve as the scapegoats when China begins to see severely destabilizing outflows.

This is an abbreviated version of the newsletter that went out Tuesday.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please.  Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter.  Investors who are not clients but who want to buy a subscription should write to me. also at that address.