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CLSA' Chris Wood On Why Chinese Inflation Is Not That Big Of A Deal, And Other Issues
When it comes to China, few people are as erudite (if somewhat biased) as CLSA's Chris Wood. Below we present his latest thoughts on the world's most populous country, which after tonight's inflation news is sure to be in the headline news for at least a few days, or at least until an iPad 2 prototype is shockingly stolen from Apple's offices. And according to Wood, tonight's Chinese news are, in the grand scheme of things, not all that material: "GREED & fear is not about to change the current view on China
since the view here remains sanguine on the near-term perceived risk of
higher CPI “inflation”. Still the issue of the fast developing
non-banking financial sector needs to be watched closely; most
particularly how the regulators respond to it since any aggressive crack
down will have negative market implications. In the longer term,
if the growing breed of financial entrepreneurs continue to find ways
around the rules, that might ultimately make policymakers consider a
more market orientated policy where interest rates are set by the
market. But that would have major political implications as it would
mark a fundamental departure from the command economy model. All this is
just another way of saying that there are limits as to how long China
can continue to run its weird hybrid of command economy and private
sector economy. But for now at least GREED & fear is going to give
Beijing the benefit of the doubt that the game can continue in 2011
since the empirical evidence continues to support it."
The much awaited Chinese CPI and PPI have been released: CPI came at
5.1%, on top of the whisper number, but higher than the official
consensus of 4.7%, and the highest number by far in over two years. PPI
beat by 100 bps, printing at 6.1%, compared to 5.1%. This "data" should
be sufficient to negate the impact of last night's RRR hike and force
the PBoC to raise its interest rate, as if the Chinese central bank does
not act, one would wonder why the Politburo would allow the release of
data which would only enflame the domestic inflation scare even more.
The view of the authorities is that headline CPI should peak at about 5% by the middle of next year at the latest, and decline back to below 4% in the second half of 2011 as the pressure from food prices goes out of the system. This is not far off from the view articulated by CLSA’s China macro strategist Andy Rothman, and would result in a cycle not so dissimilar from the food-driven inflation surge that occurred in 2007-08. It is true, however, that the pressure from food prices seems much more broadly based than in 2007-08 when it was primarily confined to pork prices.
True, the authorities could always be wrong about inflation; though in GREED & fear’s view it is a major assumption to believe that China is about to diverge wildly from its long established pattern of productivity-driven disinflationary growth. Far more likely is the pattern as described in the new proposed 12th Five-Year Plan where CPI inflation rises from a trend level of 3% to 4% on the back of a structural pick up in the share of wealth generation taken by labour in the form of higher wages. This is all part of the hoped for move to a more consumption driven economy, a trend which would surely be totally benign.
GREED & fear says “hoped for” since there is still no hard evidence that consumption’s share of GDP growth has stopped declining. Thus, final consumption expenditure accounted for 34.4% of real GDP growth in the first three quarters of this year, down from 76.8% in 1999 (see Figure 6). It is also the case that, with talk of yet more infrastructure projects in the continuing “Go West” programme, the escalating cranking up of social housing and the ongoing high speed development of a high-speed railway network, that China’s growth is still going to remain to a significant degree investment driven for many years to come. (On the railway story read a recent report by CLSA’s regional head of transport and infrastructure research Robert Bruce – China transport: Fast tracking, 29 November 2010). This macro-economic outcome is also a function of necessity. Net exports are likely to make only a minimal contribution to estimated real GDP growth of 10.5% this year (based on the latest official estimates). The contribution of net exports is also likely to be minimal at best in next year’s 9.5% real GDP growth rate as forecast by the authorities.
If the PRC is not worrying about inflationary pressures surging sharply to the upside as measured in the official CPI data, the authorities do want to appear to be “prudent” on monetary policy; to quote a statement made by the Politburo of the Chinese Communist Party’s Central Committee last Friday. This is why the loan growth quota in 2011 is likely to be in the Rmb6.5-7tn range, down from this year’s official Rmb7.5tn figure. Further moves in reserve requirements and interest rates can also not be ruled out.
There will also be a continuing desire to rein in residential property prices, while it is clear that the government’s determination to deal with the housing affordability issue has this year seen the beginning of what is likely to be at least a five-year programme accelerating development of social housing. The official plan is to construct 5.8m units within this year (though GREED & fear hears that only 60% of that figure will be completed by year end) and for another 10m units in 2011. It is unclear whether the 10m figure includes this 40% not completed this year. But the point about these ambitious targets is less the details than that the central government is dead serious about social housing and local governments will be judged on their record in meeting such targets. This is good news for producers of steel and cement. Thus, 15% more cement per square metre is consumed building social housing than in regular private sector housing. While developers who want to get access to desirable land will need to show they have done their bit constructing social housing.
If all of the above is clear and reasonably well understood, a far more opaque issue in China is the real level of credit growth. GREED & fear refers specifically to a report issued by the credit agency Fitch Ratings this week arguing that credit growth has not slowed this year from the frantic pace seen in 2009 when new credit totalled Rmb11tn despite the slowdown in official bank lending data (see Fitch Ratings report – Chinese Banks: No pause in credit growth, still on pace with 2009, 2 December 2010). Fitch notes two reasons for this; first the growing use of higher yielding securitised products sold by banks and trust companies and second the manipulation of discounted bills. Thus, by the end of November an estimated Rmb2.5tn in credit was sitting off bank balance sheets in credit-related wealth management products while credit-related trust products had risen to about Rmb485bn. Fitch also estimates that the balance of Chinese banks’ discounted bills was understated by as much as Rmb1.65tn at the end of 3Q10. Adjusted for both factors, Fitch estimates that the amount of new credit extended in the first three quarters of this year is on pace with the Rmb9.3tn extended during the same period last year.
The above is a relatively non-transparent issue about which GREED & fear has in no way done enough legwork to make a definitive judgment on. But that Fitch may be on to something is suggested by the macro data. Thus, a look at the People’s Bank of China’s depository corporations survey data shows that bank loans and claims on other depository corporations and financial institutions grew by Rmb10tn through to the end of September (see Figure 7), or at an annualised rate of Rmb12tn which is equivalent to the level of lending seen in 2009 when the Chinese government abolished the loan quota given the PRC’s desire to use the command economy banking system to combat the post-Lehman collapse in growth.
If this is the top-down macro evidence of the growth in the non-banking financial sector, it is also clear from a bottom up level that bank depositors with capital to invest are now aggressively sold “guaranteed” securitised trust products offering yields on corporate loans of 3-4% and higher. Interestingly, in some cases the bank is selling as an agent loans made by a so-called trust company where the guarantee is made by a third party, be it a private or state-owned guarantee company.
GREED & fear hears that there are two basic types of credit-related wealth-management trust products. For the first type, the bank makes the loans and then sells them to a trust company which repackages the loan assets and sells them as a trust product. The incentive for the banks is that this process allows them to move the loan off balance sheet thereby getting around the loan quota. This type of product offers annual yields of 3-4.5% with a maturity period of up to three years. The second type of product is where the bank only acts as a sales agent for the trust company which makes the loan themselves and sells the repackaged trust product to the bank’s clients. This tends to be higher yielding product with annual yields ranging from 5-15% depending on the credit risk and a maturity period of up to three years. Note that both types of credit-related wealth-management products are usually built around loans to a single borrower or “credit”. One sector which has taken particular advantage of the second type of product is the property development industry. This is because of regulatory controls on lending to that sector.
It should be noted that in July the CBRC issued regulations which targeted the first type of product by ordering banks to move any loans securitised on to trust companies back on to their balance sheets, though implementation apparently only really started in November. Banks will, therefore, no longer have the incentive to do the first type of trust product. GREED & fear hears that, in practice, going forward the first type of product will likely shrink in size and the second type will grow.
All of the above is, as noted, a reflection of the rapid development of an increasingly entrepreneurial non-banking financial sector, a sector which seems to have expanded as a consequence of the liquidity surge triggered by the post-Lehman expansion in lending; as well as increased private sector demand for credit combined with depositors’ appetite for yield. The appearance of China’s version of the West’s now no longer expanding shadow banking system raises the issue whether this phenomenon can be managed by the PBOC and the China Banking Regulatory Commission given the somewhat primitive command-economy loan quota system. For if the Fitch analysis is accurate, it would suggest that credit now leaks to other channels not managed by the authorities.
Still even if it is assumed that the authorities are not on top of the issue, and that is a very big if given the PRC’s impressively pre-emptive track record over the past ten years and more, the publicity generated by the Fitch report will presumably have the merit of alerting them to it. Still a failure to bring the non-banking financial sector under control could ultimately serve as the trigger for the over-investment bust that many have been predicting for so long in China given the economic model’s addiction to investment and given the fact that interest rates have always been unnaturally low raising longstanding concerns about the inefficient allocation of capital. This is because it would mean the authorities were losing control of the credit cycle, meaning the banking system was less “command economy-like” and therefore more vulnerable to a classic capitalist over-investment bust.
Still all of the above is for now only interesting conjecture. GREED & fear’s point is to make investors and indeed bank analysts aware of the above issue, and to highlight the need to be alert to any possible policy measures that might be announced to address it; though ironically the greater reliance on quotas by administrative fiat the greater the entrepreneurial incentive for the banking sector to find new ways to get around them.
Meanwhile, the medium-term threats to the Chinese macro story posed by the development of a non-banking financial sector, in China’s command economy context, are a very different issue to the issue of whether inflation is about to surge in China today. In GREED & fear’s view, as already noted, there is no compelling evidence that inflation outside food in China is about to take off in coming months. This makes it less likely that the authorities are going to crack down aggressively on the trend highlighted by Fitch.
What about the macroeconomic argument that a surge in liquidity since 2009 is leading to an inflation threat, an argument clearly linked to the expansion of the non-banking financial sector? GREED & fear’s prime view remains that the liquidity is more likely to be reflected in rising asset prices in China than in a generalised rising CPI trend. The other point which has already been highlighted by Rothman (see CLSA research Sinology – Inflation: Causes and consequences, 30 November 2010), is the sharp decline in velocity of money which has occurred since 4Q08 (see Figure 8). This is the opposite of inflationary. Still the surge in overall credit in the system beyond formal bank lending is exactly what would be expected as a prelude to an over-investment bust, most particularly if it is taking more and more credit to produce a certain level of economic growth as was the case in Asia ex-Japan in the lead up to the Asian Crisis. See the chart below on the historic trend in Thailand and China (see Figure 9).
Clearly, over-investment busts are normally preceded by high investment to GDP ratios and asset bubbles. In China’s case the investment to GDP ratio has been at seemingly stratospheric levels for a long period (see Figure 10). Hence those premature forecasts of a collapse. It is also the case that the continuing policy of holding down the currency via intervention also encourages higher asset prices raising asset bubble risks. On the specific point of the renminbi, GREED & fear heard this week there will only be a 3-5% appreciation next year against the US dollar which, if true, is not going to please Washington.
Meanwhile, Beijing remains obsessed with the asset bubble risk, as reflected in the continuing focus on residential property prices. On that point nobody is expecting any easing of policy towards that sector. Rather if the official data shows property prices rising by more than 1% a month, then there will be growing expectation of more policy action. But for now the official residential property price index of 70 mainland cities rose by only 0.3% MoM in October (see Figure 11).
The net of all of the above is that GREED & fear is not about to change the current view on China since the view here remains sanguine on the near-term perceived risk of higher CPI “inflation”. Still the issue of the fast developing non-banking financial sector needs to be watched closely; most particularly how the regulators respond to it since any aggressive crack down will have negative market implications.
In the longer term, if the growing breed of financial entrepreneurs continue to find ways around the rules, that might ultimately make policymakers consider a more market orientated policy where interest rates are set by the market. But that would have major political implications as it would mark a fundamental departure from the command economy model. All this is just another way of saying that there are limits as to how long China can continue to run its weird hybrid of command economy and private sector economy. But for now at least GREED & fear is going to give Beijing the benefit of the doubt that the game can continue in 2011 since the empirical evidence continues to support it.
If Chinese savers are pursuing yield, as reflected in the surge in so-called trust company wealth-management products, it is also interesting to note that the chairman of the Shanghai Gold Exchange, Shen Xiangrong, stated last week in a speech that gold imports into China rose 480% YoY to 209.7 tonnes in the first ten months of this year. While there is no way to verify independently the figure, there seems no reason to assume he has made it up. It is also interesting to note that this import number is equivalent to about two thirds of China’s estimated annual gold output of 340 tonnes.
For those who believe the US economy will not get real traction resulting in ever greater waves of monetary and fiscal stimulus, gold remains an essential hedge. On this point CLSA’s Australia office has this week published a research report covering seven Australian mid-cap gold mining companies (Australian goldminers - The elusive quest, 7 December 2010). Meanwhile, GREED & fear maintains the biggest Australian goldminer Newcrest Mining with an 8% weighting in the Asia ex-Japan long-only portfolio. The operating leverage of those mining companies who actually produce gold remains an interesting investment story for those equity investors who sympathise with GREED & fear’s longstanding gold price target of US$3,360/oz. Meanwhile, back in China, the China Securities Regulatory Commission (CSRC) in late November approved the first QDII gold fund where domestic Chinese investors can invest in a fund of offshore gold ETFs. It will be interesting to see how much money is raised in this product.
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Thanks for real data again!
Where is the "fake" data?
http://www.youtube.com/watch?v=PTUY16CkS-k
Of course its not a big deal.
China can export that inflation back to the US so fucking fast that nobody will know what hit them. Printing less RMB means buying less dollars.
As the RMB appreciates, commodities get cheaper for the Chines and they get incrementally more expensive for Americans. If the Chinese are paying less for commodities, they will have more discretionary income to spend on consumer goods, their own production.
Hey Bernanke.
If inflation is so great, why don't the Chinese want to keep it ?
As they raise rates even more hot money pours in.... You will see this happen over the next 12 months you will also see 4or5 more rate hikes.... They cant de-peg. The banks borrowed yuan at suppressed rates. They would get blowtorched with a 3-4% rate hike. China can't let the market set rates, yet. A few more years ...
Mike Pettis talk about the de-pegging issue alot.
China Financial Markets
Also- Victor Shih
http://chinesepolitics.blogspot.com/
Who said anything about raising interest rates in China ? Certainly not me.
Notice how I said, revalue..Revalue does not mean depegging.
Its all the same. The inflation we exporting cant be stopped. They can revalue whatever ....
The act of revaluing eliminates the inflation. The low peg is the inflation.
The only problem we have here, other than a failure to communicate, is, Banana Ben Bernank needs to spend 6 months in a crash course in China learning how to manage a super massive hyperinflated economy.
We're catching up though, while China has hundreds of thousands of square feet in retail space just itching for a tenant, we can give them a good run for the money in our endless lists of foreclosed residential properties.
Maybe with all our borrowed dollars from the Chin Dynasty we could rent up all their unused retail/office space, and with all our dollars from the purchase of cheap slave labor electronics they could buy up all of our distressed residential properties.
That way the Wall Street boyz could roll the dice at a new casino on a new set of MBS's and CDO's.
I'd much prefer if Benny did a full 20 year course in China (with complimentary labor).
It seems to me that the drop in money velocity growth, M2 growth, and internal consumption's share of GDP growth indicates the inflation is mostly coming from the USA and not any threatening internal activity. If they tighten up on internal controls, such as interest rates, they are going to be possibly addressing the wrong issue. The obvious answer, as stated by others, is fix the dollar peg to stop eating our inflation, and let internal consumption grow before they choke it off.
Does anyone think that we don't do such a great job of managing our own economy and currency? I submit that we have a command and control economy not very different from the Chinese. The only difference is we elect all our idiots except the Fed.
Everybody's been waiting for the Black Swan to paddle in. When the swan finally gets here it's going to be RED! Get ready for the RED SWAN, the only swan that we can't maniputate.
Victor Shih
Since the publication of my editorial in the Asian Wall Street Journal on local debt, there has been a wave of interest on this issue. Several investment banks have issued reports on local debt, and some of them have disputed my main finding that current local government investment vehicle debt stands at around 11.4 trillion RMB. The World Bank likewise addressed this issue and came up with a much lower estimate on local investment company (LIC) debt. In the discussion below, I outline some reasons why I still adhere to my estimate that existing local investment vehicle debt stands at around 11 trillion RMB. Furthermore, I once again reiterate that local debt is a serious problem which will require decisive actions from the Chinese government.
Some points people have raised about my estimate of local debt:
1. The Chinese government claims that there is only 6 trillion RMB in local investment vehicle debt.
My response: A. This widely cited figure was produced by a 6/2009 CBRC survey of the situation. The exact methodology is unclear, but informants state that the CBRC extrapolated this amount on the basis of a partial study of a few provinces.
B. Other government agencies have provided conflicting and higher amounts. For example, a MOF research team uncovered "well over 4 trillion" in late 2008 (excellent Credit Swiss research even states that the 4 trillion was a YE 2007 figure).
C. The CBRC finding concerns only bank loans, but total debt should also include bond issuance and accounts payable, which constitute triangular debt.
D. if we sum the gross debt of just the top 50 or so LICs, we quickly arrive at gross debt of over 2 trillion (try adding the gross debt of Guangdong Highway, Guangdong Transportation Group, Chongqing Highway, Beijing Basic Construction, Shanghai Urban Construction and Development Company, Shanghai Pudong Development Co., Tianjin Urban Basic Infrastructure, Binhai Development...etc.), so the remaining 8000 or so entities only owe 4 trillion (on average 500 mln RMB each)?
2. The 11.4 trillion is too high when compared with total bank loans in various categories.
My response: A. First of all, total loans outstanding at the end of 2009 was well over 40 trillion RMB, and I think it is completely reasonable to believe that nearly 1/4 of it was loans to LICs. In fact, I wouldn't be surprised that a higher share of bank loans ended up in LICs.
B. Some analysts have trouble believing that such a high share of medium and long-term loans ended up in LICs. When we consider how many LICs there are and the vital role they play in the local economic strategy, it is not surprising that likely as much as 3/4 of new medium and long term loans in 2009 ended up in LICs.
C. Beyond medium and long term loans, many LICs are holding companies with subsidiaries engaged in a wide range of businesses. For example, the LICs run thousands of hotels across China, and loans to these hotels would be classified as loans to the service industry. Thus, in addition to medium and long term loans and loans to infrastructure, it is perfectly reasonable for a sizable share of working capital loans, trust loans, and loans in the "other" category to end up in LICs. Again, gross debt of these entities would also include bond issuance and debt owed to each other.
3. LIC debt can be calculated by subtracting government spending on basic infrastructure from the total infrastructure spending figure. In that light, LIC debt only increased by 2.8 trillion RMB in 2009.
My response:
A. First, as pointed out, LIC are diversified holding companies which do not only engage in infrastructure construction. For example, thousands of subsidiaries of local investment companies engage in real estate development and absorb some share of the real estate loans. The figure generated using the method above, however, may be meaningful one-day when the government decides how much of the existing LIC debt it will seek to take over as part of a bail out.
B. The calculation above assumes that much of the extrabudgetary revenue from local governments derived from land sales went to infrastructure construction. According to excellent research done by Standard Chartered and UBS on land sales, much of the land sales revenue is spent on compensating original residents, leaving only a minority share for actual investment. Thus, a realistic application of this methodology would lead to something like 3.5 trillion RMB in new loans to LICs, not just 2.8 trillion.
4. My estimate of 12.7 trillion in future LIC debt is baseless and is way too high for YE 2011.
My response:
A. To be sure, I now think most of this debt will not realize by YE 2011 also. However, it would not be far-fetched to think that most of this debt will be realize by YE 2012. This estimate is not "baseless" as it comes from the hundreds of lines of credit that banks have granted to local governments. As long as banks more or less adhere to these lines of credit, they will lend this amount to local governments at some point in the future.
B. Although the State Council has called for more caution in lending to local investment vehicles, we still see local governments aggressively trying to raise money from the banks. Hubei, for example, has an investment plan worth 12 trillion RMB, and plans on investing 6 trillion RMB between now and 2012 (please see http://nf.nfdaily.cn/epaper/21cn/content/20100324/ArticelJ07002FM.htm). Of the 6 trillion, at least 3 trillion will come from bank loans and other forms of debt. If Hubei is able to realize its ambition, we are already 1/4 of the way toward my 12.7 trillion estimate. Thus, unless the central government harshly restricts overall credit, I think local governments at the provincial and municipal levels will have no trouble borrowing an additional 12.7 trillion by YE 2011 or 2012.
Beyond critizing my estimate, some investment bank reports also argue that whatever the debt amount, the Chinese government is fully capable of addressing this issue and in heading off a financial crisis. On this point, I mainly agree with my colleagues, but I still don't think the problem is trivial, especially in light that local governments seem determined to take on trillions in additional debt in the coming two years to finance ambitious investment plans. My main worry is that unless Beijing decisively restricts local investment projects, local investment companies will continue to borrow in large quantities in the coming two years.
Even relatively bullish investment bank report suggests that new non-performing loans in the banks can increase by 2-3 trillion RMB in the next couple of years. To be sure, this is well within the government's ability to handle and likely will not lead to any kind of financial crisis. However, this remains a daunting problem for the government and for current shareholders of China's banking stocks. This will require the China Investment Corporation to inject tens of billions of dollars into banks through Huijin. Additional asset management companies will have to be formed to take over the NPLs. This is a lengthy and difficult process involving numerous ministries and interests, which is expected to generate a great deal of uncertainty. If the expectation indeed is a couple of trillions in NPLs, it deserves careful watching rather than dismissal.
Finally, some investment bank reports suggest that the enormous sum of state assets must be considered along side of the debt. If debt ever becomes a problem, the Chinese government can always sell state assets to repay the debt. Here, I am in complete agreement with my colleagues. It will be a great day when the Chinese government decides to privatize trillions in state assets to raise money to repay local debt.............------- http://chinesepolitics.blogspot.com/
Read what you you want to believe, I look at the facts.
http://www.youtube.com/watch?v=0h7V3Twb-Qk
And here...
http://www.pbs.org/pov/utopia/
puff.puff.puff
http://www.foxnews.com/images/236587/0_61_bubble_girl_2.jpg
Thanks for posting, interesting piece on a very important and often overlooked topic. Glad there was something worth coming to this page, as the OP is a bunch of horsehockey.
How do you know the top is near?
Answer: Barry O'Potus abdicates the bully pulpit to well-known Wall Street Shill Bill Clinton to sell tax breaks for the rich. What's next, Newt Gingrich on supply side tax cuts?
Regarding China.
Even if stocks go to zero, you're still missing the point. Chinese have been learning new technologies and these are fairly transferable skills. Let's say that this bubble will collapse soon, they'll still be alright, just not as paper rich, being able to produce just about everything under the sun. If anything, this collapse, and associated deflation that comes with it, will rebalance growth from financial growth to more real growth.
I think to the Chinese people it is quite a big thing having food go up...
What you meant to say is that you believe China will manage to manipulate commodity prices somehow to lower inflation. I think that China's interest rise is insufficient to stop this from happening. Maybe they will ask N. Korea to shoot some S. Koreans?
Article misses the point: Chinese establishment is massively indebted to Chinese savers (remember the 'savings glut'?) with the savings used to blow an equally massive 'investment' bubble in real estate lending.
If the bubble unwinds the borrowers will be ruined by deflation of RE values which will flow to the 'little people'. Inflation will ruin the Chinese little people (savers) and their 'worth' will be transferred to the government.
Which of the above do you think is going to happen, folks?
Correct! Chinese investors will be made whole @ the expense of savers. This is hyper-inflation. The investors happen to be the Chinese government elites. These are not going to take a bullet for any lousy, stinkin' peasants no matter what Chris Wood or anyone else sez!
I'm positive Mr Bernanke feels the same way. He is, after all, pumping ASSET PRICES in dollars and does not care whether inflation is in China or on the moon, just so it is somewhere.
The deflationary 'other way' would require China w/ a current account deficit (so as to 'finance' the required bailouts. The US current account deficit is financing US establishment bailouts. It is why the inflation/deflation argument even EXISTS in the US. We are massively borrowing everywhere outside the country to finance ... JP Morgan- Chase and the rest of Bernanke's wiseguys.
Put another way, China has no yuan reserves only dollar/gold/foreign exchange reserves. Using these reserves to bail Chinese establishment dudes and dudettes makes them either US vassals or international economic exiles, wannabe 'Americans', effectively stateless. This is so if the non- yuan reserves are prevented from trading inside China.
If non- yuan 'currencies' circulate within China or are exchanged for more commodities or have printed the F/X equivalent in yuan -- the effect is massively hyper-inflationary.
... as has been the case up to now!
Think about it!
This is but a sketch, you must fill in some blanks, but the differences between the hyper-inflationary Chinese economy with its (aggregate) savers and the deflationary US with its *aggregate) insolvent borrowers is pretty obvious.
We should ask Bernanke to manage the Chinese currency and bring the Chinese team to the Fed to manage ours.