Michael is right: policy priority shifted

This short commentary basically echoes Michael Pettis’ last post.  Over the weekend, Wen Jiabao, Vice President Xi Jinping, and Vice Premier Li Keqiang took trips to the southern and eastern provinces to “inspect” exporters.  They assured manufacturers that they will not be squeezed between tightening monetary policies and rising RMB valuation.  In official announcements, the priority now is “preventing the major ups and downs of the economy” rather than fighting inflation.  This is despite the fact that PPI is almost certainly going to creep up further.

What we see today is nothing new, and as my book points out, has occurred repeatedly in the past 20 years.  Even Li Yining’s call for “acceptable inflation” is not new.  He made exactly the same argument in 1988 when inflation was nearly 30%.  The problem is that Hu Jintao now has many followers serving as provincial party secretaries, and they are lobbying Hu not to squeeze money supply so hard.  Thus, unlike a few years ago, when Hu supported Wen’s inflation fighting effort, Wen now fights inflation alone.  I think this is a very dangerous situation for future inflation trends in China. Besides allowing inflation to get even more serious, loosening monetary policy, even if it specifically targets exporters, would create even more risks in the system.  Let’s say the government relaxes lending restrictions or lower interest rates for small and medium enterprises that export, they will get relatively cheap money.  Currently, the Wenzhou curb market in which exporters are lending export receipts to desperate real estate developers is paying anywhere from 30% to 100+% in annual interest rates.  What is the rational course of action for exporters who obtain easy credit from the official banks?  Yes, they would turn around and lend to real estate developers, which actually would continue to boost the supply of housing and depress the market.  Although these high interest loans tend to be short-term (less than 90 days), when the music stops and someone defaults, the chain of defaults can ultimately lead back to the state banks.

Of course, first half performance of the state banks is better than ever.  This is because housing prices only began to fall seriously in March.  More and more people in southern China are trapped in negative equity, but banks are colluding with borrowers to keep official NPL figures low.  A loan has to be 90 days behind in payment before it even becomes special mention loans, and banks are classifying loans as current if the borrower pays once every 90 days.  Because these loans are not securitized, the fall-out may unfold slowly over time until NPLs cannot be hidden any more.  It could take until the first half of next year before any serious problem becomes apparent in the banks.  However, that may not be such a blessing because people know about this potentially giant risk hanging over everyone’s head, and until the exact magnitude of the fall-out is known, a cloud will continue to hang over China.

3 Responses to "Michael is right: policy priority shifted"

  1. Guest   July 10, 2008 at 9:39 am

    Do you have any estimates of how large the defaults/number of NPLs could get?

  2. Anonymous   July 10, 2008 at 9:40 am

    With Industrial output and now even exports slowing, do you think all hope for inflation fighting is off the table?

  3. Victor   July 13, 2008 at 9:04 am

    Dear Guest, the NPL size is anyone’s guess. I tend to be more pessimistic rather than optimistic. There won’t be a financial crisis, but another sizable bailout from the fx reserve is on the horizon. Is inflation fighting off the table? I hope not, but there is certainly political pressure to do so.