Is the PBoC running out of capital?

Another terrible day on the stock market saw the SSE Composite, led kicking and screaming by energy and financial companies, trade more or less straight down by 3.2% to close the day at 2203.  The brilliant autumn weather in Beijing (and the best week for air quality I have seen in seven years of living here) seems to have bypassed the market altogether.

Away from the weather there is plenty of bad news for those looking for it.  Yesterday Reuters cited a Lehman Brothers report on declining August car sales:

China’s passenger car sales fell 10 percent in August from a year earlier, preliminary data showed, due to the impact of the Olympics and weakening consumer confidence, Lehman Brothers said in a research report on Thursday.

The report said auto sales in China, the world’s second-largest car market, were expected to remain lacklustre for the rest of 2008 and possibly into early 2009. Compared with the month before, sales were down 12 percent, the report said.

Also yesterday the Financial Times warned that “Chinese steel consumption set to fall”:

Growth in Chinese steel consumption is expected to slow markedly in the second half of this year amid weakening demand from the construction, household appliance and automobile industries, according to industry experts.

Yang Siming, general manager of Nanjing Iron & Steel told a steel conference in Xiamen this week that most Chinese steel mills had cut output last month, because of shrinking demand and high costs of raw materials. ”We’ve been cutting production since last month, and according to my knowledge, most domestic mills are cutting output too,” Mr Yang said.

One of the possible adverse consequences of excessively rapid money growth has been the channeling of this money via the banking system into excess production.  This was fine as long as a healthy world economy could absorb Chinese excess production, but a slowing global economy has meant that Chinese producers have been forced to turn to a domestic consumer market that hasn’t been able to take up the slack.  As I have mentioned many times before, rising inventories are one of the warning signals I am most concerned about.  I don’t think we are there yet, but I will be trying to keep an eye on the subject as well as I can.

All this bad news is making policy-makers worried, and they seem eager to try to encourage some optimism.  I was struck by the list of top five articles under the “Macro-Economy” section in today’s Xinhua:

Analysts: China’s inflation to continue easing in August China economy “slowing but resilient,” HSBC report says Noted Chinese official: Chinese economy not in downturn, but adjustments needed Crude oil plunge good for China economy, analysts Economists: China’s economy still in shape 

Three of the top five articles today and all of the top five yesterday seem to be saying the same thing:  Don’t worry, things are still ok.

Still, not all the news is bad.  As I wrote Wednesday it looks like CPI numbers for August, which will be released next Thursday, are going to come in without too much implied inflation.  Most estimates are that CPI inflation will come in below 6% for August.  Today Xinhua reported that “China’s consumer price index (CPI), a key measure of inflation, was expected to show a rise of about 5 percent in August from a year earlier, said analysts on Thursday.”  They go on to quote Fan Jianping, chief economist of the State Information Center, as saying that “the CPI growth rate might sink below 6 percent in August.”  Logan Wright of Stone & McCarthy told me today that he expects it to come in around 5.5%.

Of course CPI numbers are pretty tainted by price controls at this point, but I am willing to bet that a low CPI inflation will make it much more likely that energy prices are allowed to rise again.  Shortages continue to be a real problem and energy producers are being squeezed mercilessly by rising costs and frozen prices.  In his comments yesterday Fan Jianping said he expected August PPI to rise by 10.0-10.3% (compared with the 10.0% rate posted in July).

On a separate note a very interesting article by Keith Bradsher in today’s NY Times discusses a predicament for the PBoC that many of us have been wondering about for a while.  As the RMB rises against the US dollar, the PBoC is forced to take losses on its currency mismatch – it buys dollars and funds them with RMB borrowings.  These losses have become so big that, according to Bradsher, the PBoC has been warned by the IMF that it may have too little capital.  The article says:

Now the central bank needs an infusion of capital. Central banks can, of course, print more money, but that would stoke inflation. Instead, the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.

The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts. This could heighten trade tensions with the United States. The Bush administration and many Democrats in Congress have sought a stronger yuan to reduce the competitiveness of Chinese exports and trim the American trade deficit.

The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

There is no need to worry about whether or not the PBoC is insolvent – the central bank is not a commercial stand-alone entity and its credit is at least as good as that of the central government (sometimes better), but the article is nonetheless interesting.  I hadn’t really thought of the political ramifications until I read the article, but if the PBoC needs to turn to the MoF to shore up its capital, and if this represents a transfer of power from the PBoC to the MoF, it may very well represent a further weakening of the monetary camp in China.

This might not bode well for the future of the financial system in the short term, although in the long term it is not clear to me that monetary soundness is necessarily correlated with more rapid growth.  I say this because I have seen no evidence that countries with very sound and conservative financial systems grow faster than countries will looser and riskier financial systems (although they do seem to have fewer financial crises).  I have more than once made reference to Belgian bank historian Raymond de Roover’s comment that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.”  Still, excess financial instability can significantly raise financing costs and in the case of China, where political credibility is always an issue, there may be other things to worry about if the guardians of monetary soundness are further weakened.

Astonishingly enough (but perhaps not surprisingly), a lot of mid-level policy-makers in China seem to believe that the PBoC currency losses are the “fault” of the US, according to my friend Victor Shih of Northwestern university.  The New York Times article goes on to say about Victor:

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

Many Chinese seem to be inordinately fond of conspiracy theories, but in this case it seems pretty obvious that if the RMB were indeed undervalued all these years – like the US government has been saying for a long time – then exchanging Chinese goods for massive amounts of US Treasuries by definition meant that China was subsidizing American consumption, and that this subsidy necessarily represented a loss for China.  If you exchange something below its fundamental value for something above its fundamental value, it is only an accounting trick that allows you to pretend you haven’t booked a loss.

Revaluing the RMB does not create the loss.  It simply forces recognition of that loss.  And as long as China continues to accumulate US dollar assets purchased with undervalued RMB, the PBoC will continue to run losses, whther or not they are fully recognized.  Perhaps you need to be a trader, and not a government official, to get the point.

Talking about Victor Shih, I should highlight another very interesting commentary by him on RGE Monitor.  He starts his entry:

Due to strong political pressure at the highest level and seemingly declining inflation, the State Council caved and increased the credit quota by some 200 billion RMB.  Well, that only goes so far, and much of it still goes to larger firms.  So, how are they dealing with the continual liquidity problem?  Bundling!!  Local governments, including Sichuan, Chongqing, Henan, Beijing, Liaoning, Zhejiang, and Shenzhen, are all planning to issue tranches of corporate bonds whose cash flow comes from a group of small and medium enterprises (SMEs).  Each province will issuing 1 to 2 billion RMB of notes for the approved SMEs.

The local governments will guarantee these notes, which have 3-5 years maturity!! This is a familiar scheme of borrowing to fulfill current policy needs and leaving bad debt for future leaders of a province or city.  This is why the central government banned local governments from issuing debt, but it is coming back in a latent form.  Granted, it is on a small scale now, but it can really take off.

I think the NDRC is backing this effort, though I am not sure if the financial regulators in Beijing like this.  This will also create good business for domestic investment banks, especially those with local government ties.  It might also give a boost to state owned asset management companies which are trying to transform themselves into investment banks.

When we all start trying to figure out how much debt the central government really has (something that will become a popular sport sometime next year, I suspect), it will be useful to remember that these notes are going to be guaranteed by the local municipalities, and these municipalities in turn are guaranteed by the central government.

On Sunday I am off to New York for a week where I will have a number of meetings and presentations which will give me the chance to gauge the mood of investors and financial policy-makers outside of China.  It’s been over a year since I went back, and I suspect the gloom and worry I saw last July hasn’t fully lifted, to say the least.

2 Responses to "Is the PBoC running out of capital?"

  1. Victor   September 8, 2008 at 10:36 am

    Hi Michael, indeed, I agree that guessing deficit will be the main sport of 2009. Another factor: local government relied heavily on land sale to finance a lot of projects. That has come to a halt or has slowed drastically, creating another fiscal hole for the central government to fill.

  2. Alex   September 12, 2008 at 8:47 am

    Hadn’t thought much about China as a country with fiscal deficits, I would like to explore this further. The unravelling of BWII may finally come when China’s ‘true fiscal gap’ shows up. Suppose it will then stop exporting its masive savings to fund the US.