American-style crises versus Latin-American-style crises

This news is four days old, but it is still worth noting that according to a Xinhua report, the NDRC released a circular Friday to announce that, in an attempt to slow hot money, it will institute new controls to manage foreign investment inflows.

The move will also safeguard the country’s economic safety, protect ecological environment, optimize develop and reform mechanism, and prevent industrial monopolization, said the National Development and Reform Commission (NDRC) in a circular on Friday. Projects that are not approved by the government, provide fake application materials, or use foreign exchanges improperly, will be punished.

Local governments will also investigate and supervise foreign enterprise-involved programs, including joint ventures, exclusively foreign-owned firms, bilateral cooperation projects, mergers and acquisition programs. Meanwhile, regional economic regulators should look at the projects, monitor foreign exchange inflow channels, and enhance finance management of foreign enterprises.

With so many new, and economically intrusive, steps being taken to control hot money, it seems to me that the authorities are seriously worried about hot money, but in fairness I have to add that some analysts claim that their conversations with Chinese authorities suggest that while the authorities are watchful, they do not seem to be terribly concerned about hot money. It is worth pointing out that there is no unanimity on the subject among China watchers.

My friend Xinxin Li of The Observatory Group, for example, in his July 17 report, says that policy-makers think the market is overstating the hot money problem:

  • Policymakers deem that the continuous capital inflows will not be as destructive as they were to other Asian economies in the 97-98 financial crisis. They are largely not associated with China’s asset prices at present and there is no signal that hot money may flow out massively in the foreseeable future.
  • In Beijing’s view, hot money can be devastating only if some extreme scenarios occur to the Chinese economy, such as a financial crisis or war. The current probabilities of these extreme cases are very small. In addition, due to China’s strict capital controls, it is technically difficult for speculators to convert RMB back to foreign currencies and flee away from China.
  • Therefore, its major negative impact at present is the PBoC’s sterilization costs. Policymakers tend to downplay the role of hot money in China’s monetary creation, and do not view speculative inflows as a major driving force of China’s rising inflation and over‐investment.

He concludes his report by saying:

In contrast to various market estimates, Beijing’s policymakers believe that the impact of hot money flows on the Chinese economy is limited and controllable. They tend to use stricter capital controls to address continuous inflows, but are reluctant to allow a faster appreciation of the RMB.

He does say this in the context of their view that “the CASS report on $1.75tn hot money was irresponsible and misleading.” According to Xinxin, SAFE was subsequently told to “ensure a right public understanding of the facts.” In my opinion any claim that the sum of hot money in China amounts to $1.75 trillion is excessive, and I agree that the truth is likely to be a lot less dramatic, but if Xinxin is right about opinion among policy-makers (and he has had great information in the past), I would caution that when markets and policy makers disagree on the nature and size of a problem, it is not obvious to me that policy-makers have had a better track record of getting it right.

More specifically, many of the analysts and policy-makers insist on seeing the capital inflow problem exclusively in the context of the 1997 crisis, in which case the danger is that sudden outflows overwhelm the country’s foreign currency reserves, so that the currency is forced to depreciate, setting off massive financial distress in a corporate sector saddled with too much foreign-currency debt. This is also very close to the classic Latin American style financial crisis, except that in the latter the currency mismatch is usually on the government, rather than corporate, balance sheet.

This may be the wrong model. I would argue that the danger for China is not a 1997-style crisis but rather a much more “American” form of financial crisis (I am thinking of the US in the 19th Century, but perhaps the current crisis is not so different), in which excess monetary expansion leads to severe overextension of the financial system and a vulnerability to a sudden contraction. In that case an unstable and risky banking system becomes the danger, not foreign debt, and the rapidity of hot money flows can lead first to financial imbalances and then to rapid financial contraction.

At any rate, and leaving aside the question of whether or not the PBoC is very worried about hot money, will these new controls have much effect? Perhaps, but I would guess that there isn’t likely to have been much more than $20 billion that came in this year through the FDI account, whereas the actual amount of unexplained, and possibly hot, inflow is many times that amount. Going after speculative inflows through the registered trade and FDI accounts may be relatively easy, but I am not sure that they justify the disruptions to real economic activity.

Where there does seem to be greater unanimity among economic analysts is that the pro-growth shift in thinking among the most senior leaders, towards concerns about an economic slowing, has been pretty complete, even if the PBoC and some of its allies in the NDRC and the National Bureau of Statistics are still worrying about excessively loose monetary policy. Today’s South China Morning Post has an article by Carey Huang subtitled “Top leaders to meet over slowing growth” that says:

The nation’s top decision-making body, the Politburo, will meet this week to consider major economic policy for the mainland for the rest of the year amid growing concerns over slowing growth, rising inflation and, in particular, a dramatic decline in exports as the global economy slows. All the most senior leaders completed fact-finding missions to economic strongholds and key export bases early this week, according to reliable sources.

The fact that they are holding this presumably urgent meeting just two weeks before the beginning of the all-important Olympics suggest that they are very worried about the possibility of an economic slowdown, even while inflation continues to nag at them. One argument making the rounds is that the political infighting between the pro-growth camp and the monetary alarmists has gotten ugly enough and visible enough that the leaders are trying to smooth things over and broker a compromise.

This may be true, and it wouldn’t surprise me at all. My impression, and that of many of the people I talk to, however, is that there is a real worry that the normal macroeconomic tools aren’t working and that policy-makers don’t know what to do. I expect we’ll see more piecemeal policies and tinkering on the side, especially with administrative measures, for the next few months or so. I think it will still require a big increase in inflation to concentrate policy-making.

There is another piece of news that is several (four) days old but which I wanted to address. According to an article in Bloomberg, “China’s stockpile of unsold new vehicles rose about 50 percent in the six months ended June, hitting a four-year high, as automakers expanded production and sales growth slowed.”

I don’t want to make too much of this single data point, but I have often argued (and do again above) that China’s financial cycle is going to look more like the overproduction cycles in the US of the 19th and early 20th centuries than the sequence of events that led to Latin American financial crises or the 1997 Asian crisis. If that is true, one of the classic events to watch for is a sudden run-up of inventory as excessively loose monetary conditions lead to overcapacity in the industrial sector. So far, China’s exports markets have been able to absorb its periods of excess capacity, but as Chinese production gets larger relative to the world economy, and as global demand contracts, it will be harder and harder for the world to absorb Chinese overproduction.

I don’t think we have reached the point of worry yet, but rising inventories are one of the three main triggers I watch for as an indication of the beginning of trouble for the financial system (the other two are rising inflation and bank deposit withdrawals).