The last few days of Olympic fever

The stock market had its best day in a long time, with the SSE Composite rising 7.6% on the day to close at 2522. Most of the run-up came in the morning, and several financial sector firms, which were the best performers, had to stop trading when they hit their 10% price-change limit, suggesting that tomorrow there will be early upward momentum. Add today’s rise to yesterday’s 1.1% gain, and since Monday the market has recovered more than half of the 14.9% drop it suffered since the beginning of the Olympics.


There is less here than meets the eye, I think. Two things seemed to have driven the market up today. First there are a lot of rumors going around that the securities regulators are planning an important meeting with China’s major stock brokers tomorrow, to discuss market-boosting measures. Regulators actually made announcements over the weekend about steps they were taking to support the market, but these had almost no positive effect on the market at all – on the contrary they were judged to be so disappointing that Monday’s market was down 5.3%. In fact none of the measures announced during 2008 have affected the market by more than a few days. Perhaps rumors about an announcement are far more powerful than any actual announcement.


Second, Frank Gong, JP Morgan’s chief China analyst, sent a note to clients in which he claimed that China’s leaders are considering a RMB 200-400 billion stimulus package and further easing of monetary policy. With GDP of around RMB 30 trillion, this would represent a stimulus of around 1% of GDP.


I am not sure a 1% stimulus – which was not exactly unexpected given all the fears of an economic slowdown – should have had such a massive impact on the market, but after plummeting so quickly perhaps it was time for a bounce, and participants just needed a good excuse. We have seen lots of big 10% or more bounces in the past several months, and it will be interesting to see if this time around it lasts longer than the others. I am skeptical.


According to the South China Morning Post’s article on the JP Morgan note:


On the perpetual debate of how China should manage its US$1.81 trillion of foreign-exchange reserves, Gong said Beijing may have intensified sales of some dollar assets. But it aims to keep the bulk of its reserves in dollars – even if they are not invested in the debt of US mortgage agencies Fannie Mae and Freddie Mac – because it favours a strong US currency.


Gong said it was unlikely that China would diversify into the euro, yen or commodity currencies in a big way as these currencies may already have peaked. Instead, policy makers were studying a number of suggestions put forward by government researchers, including: Repatriating the money and investing it in on physical and social infrastructure to boost consumption; Using some of the money to set up a fund to stabilise the stock market, which is down 62 per cent from October’s record high; Diversifying into dollar-bloc currencies such as the Hong Kong dollar and other Asian markets.


I think there is an awful lot of confusion about what can and cannot be done with the PBoC reserves. The authorities cannot take the reserves and use them for the first two suggestions – spending on physical and social infrastructure, or supporting the local stock markets – simply because foreign currency cannot be spent in China.


Let us assume for a moment that the government wanted to take $100 of reserves and spend them domestically – whether to build hospitals or to buy stock. Once it received this money from the PBoC it would have to exchange these $100 dollars into RMB before it could spend them, and since the market is a net seller of dollars, who would do the exchange with them? The PBoC, of course, who would have to buy the dollars back and pay for them either by creating or by borrowing RMB. The net result would be no change in the total amount of foreign exchange reserves held by the PBoC.


So where did the money come from? If the government purchased the dollars from the PBoC, either taxes or its net domestic borrowing would have to increase by that amount. If the PBoC were forced to donate the money, either its own debt would rise (if it borrowed the RMB by issuing central bank bills) or the domestic money supply would rise (if it simply created RMB).


Either way, the Chinese government could only spend the money if it financed it by raising taxes, by borrowing – either directly or through the PBoC – or by simply creating money. It turns out that no matter how high or low the level of reserves, the Chinese government can only fund domestic spending by raising taxes, borrowing, or inflating. All three of these things the government can do without the need for PBoC reserves.


The only reason the reserves matter in this case is that if China were to reduce its net savings significantly by a large amount of government-related spending, so that total consumption exceeded total production, the result would be that China would run a trade deficit, which would draw down reserves. With reserve accumulation running at 20% of GDP, however, it would have to be a pretty large dollop of spending before it began to cause a decline in reserve growth, and with $2 trillion of reserves, China could survive a large trade deficit for quite a long time.


I am not arguing that China cannot or should not spend much more aggressively at the government level, although I would not want to see such spending directed at the stock market, since that would pretty much ensure that China’s stock markets would be inefficient and ineffective for several years more. On the contrary, although I am less optimistic than most other analysts are about the strength of China’s fiscal position, nonetheless I think China badly needs to alter the balance of factors affecting economic growth, and clearly domestic spending needs to be much stronger – preferably consumer spending. The point is that this spending cannot come from PBoC reserves.


In a few days the Olympics will be over, and we will probably see more serious measures and debate on economic issues. Over the last few days there has been a flurry of front-page articles and speeches by government officials assuring everyone that the economy will do very well after the Olympics. They seem worried. Electricity prices are moving up and fuel prices will probably do so too, given how severe the shortages have been. A number of analysts are arguing that hot money inflows are slowing and will perhaps even begin to reverse very soon, but I think they are wrong. The RMB is still undervalued, and if the economic stimulus measures have any impact at all, in the short term they will fuel the kind of growth that creates monetary pressure for revaluation and profit opportunities for investors. RMB non-deliverable forwards traded up sharply today, perhaps in response to news about the fiscal stimulus. The monetary debate has been put on hold, but it is far from resolved.

Originally published at China financial markets and reproduced here with the author’s permission.

One Response to "The last few days of Olympic fever"

  1. Asiaguy   August 22, 2008 at 6:42 am

    Pettis offers such good analysis and commentary, he makes us all better economists! Makes me think about policy in Asia and their success rate. Read an interesting article on the central bank of korea defending the Won on Is this policy feasible? Is there more to come from other countries?