After a 4.2% drop Thursday on the SSE Composite the Chinese stock market turned around yesterday to close the day up, with the SSE Composite rising 1.1% to close at 1931. In spite of Monday’s global-sympathy surge the week turned out to be another bad one for Chinese stock markets, with the SSE Composite losing more than 3% over the week.
Friday’s modest rise seems to have come in response to comments by Shang Fulin, the chairman of the China Securities Regulatory Commission, who told a conference in Beijing Friday the government would unveil new incentives to stabilize the markets. This is the first time he has commented on the markets since before the Olympics, and this suggests – not for the first time – that the government is increasingly worried about the rapid decline in the stock market and is trying to talk its way back into confidence.
Actually the stock market is too small in China to have too much of a direct impact on the economy. Without checking the numbers I would say that total market cap is around 50% of GDP, and less than two-fifth’s of the listed stock really “float” in any meaningful way. This isn’t a big market relative to GDP, at least not compared to most other major economies, so losses on the stock market are unlikely to have anywhere near the same wealth effect (although this loss will be somewhat increased by its sheer magnitude – 70% in less than one year). My guess is that what drives government concern is the impact further declines might have on what is almost certain to be waning consumer confidence.
Unfortunately Shang did not say exactly what measures would be taken – besides demanding that Chinese commercial banks refrain from “excessive” financial innovation, although I am not sure “innovation” is the best word to describe the ways banks seem to be getting around regulatory constraints. He did warn, however, that the US credit crisis “poses grave challenges to China”.
I would agree, but I am beginning to think that it may very well do so via an unexpected channel. I am beginning to wonder if it is through its impact on South Korea that we should be most worried. So far there seems to be a widespread (and mistaken, I think) belief in much of East Asia that the region will emerge from the crisis in relatively good shape – perhaps even in great shape. Consequently anything that seriously strikes at that belief could cause a panicked reaction. For example, I think the brief run on the Hong Kong branches (and Singaporean and Japanese branches too) of Bank of East Asia struck real fear into the hearts of policy-makers here. A very visible bank collapse anywhere in the region would almost certainly undermine confidence in the banking system – especially in those countries where the banking system is relatively opaque.
South Korea is one of the largest economies in the region and often considered, in spite of the 1997 Asian crisis, to be relatively robust. But for now things do not seem to be going well there. According to an article in Saturday’s Bloomberg:
South Korea may guarantee bank debts and offer tax breaks for investors to bolster confidence after shares plunged to a three-year low and the won, Asia’s worst- performing currency, slumped the most since the 1997 crisis.
Saturday’s South China Morning Post had an equally pessimistic piece on banks in Asia in general, with South Korea meriting special mention:
South Korea, which has more negative rating outlooks on its banks than any other country in Asia, said on Thursday it planned to inject more foreign exchange liquidity to local banks to keep financing in its export-reliant economy working smoothly. But government moves did little to calm investors, with the country’s stock index falling over 9 per cent, led by top lender Kookmin’s parent, which plunged 15 per cent.
Many analysts fear South Korea’s banks could be the next victims of the global financial crisis, with their heavy exposure to the ailing property sectors and inadequate funding structures. The global credit crunch has also jacked up their funding costs and non-performing loans are likely to rise.
Kang Man-soo, the South Korean finance minister, announced measures on Friday, to address the plummeting confidence, including plans to raise spending and cut taxes as part of emergency measures to stabilize its economy, and to tackle a shortage of US dollars in the banking system. The announcements helped the Korean won, but not the stock markets, and according to yesterday’s Financial Times, more measures are expected over the weekend. Today South Korea announced the government will provide as much as $100 billion to secure the refinancing of external bank debts from now until next June 30. They said recapitalizing the banks and guaranteeing all deposits was not necessary “at the moment.”
The Bloomberg article goes on to say that South Korea relies on exports to China, Europe and the Middle East to drive growth as domestic consumer spending dries up. I don’t know much about Middle Eastern demand, but European demand is probably declining, and I am not sure Chinese demand is likely to be nearly as robust as everyone outside China seems to assume.
That could create an interesting and potentially dangerous feedback process if problems in the South Korean markets undermine confidence generally in Asia’s ability to withstand the crisis and, in so doing, further increase consumer nervousness in China, thus exacerbating Korean problems. My many years banking and trading experience in Latin America have made me very wary of these feedback loops since they can degenerate so quickly and so violently.
Trying to understand China is so difficult and complicated that in the past few years I have tended to neglect most of the rest of world and just focus on the Chinese monetary and financial systems. Now, however, I think it makes sense to get a better understanding of what is happening in neighboring countries. South Korea could prove to be a real problem for China. Remember that the 1997 Asian crisis saw large hot money outflows from China and real problems develop in its banking system, even though China had none of the balance sheet vulnerabilities that caused the crises in the afflicted countries. This time it does – most significantly heavy exposure to the real estate sector (as much as 40% of all loans, according to a senior CSRC official, even though only half of them are classified that way), excessive credit expansion, and too much capacity.
The Chinese government meanwhile is putting on a brave face and preparing measures. In fact I have heard from three different sources that one regulatory body (I prefer not to say who) has circulated a list of Chinese analysts who may no longer be interviewed on TV because their views are considered too alarmist. There are also lots of plans being announced about how to deal with the crisis. At a news briefing Thursday, for example, the NDRC made a series of announcement about their own plans. According to an article in Friday’s South China Morning Post:
Du Ying, deputy director of the National Development and Reform Commission, the mainland’s top economic planning agency, said foreign trade volume, value-added output and profit growth of manufacturers in coastal areas had been falling since July. “The State Council is studying a series of measures and is ready to announce them, as the downward trend has already caught the government’s attention,” Mr Du told a news briefing in Beijing yesterday.
He said the full impact of the global financial crisis had not yet been felt and the government “should have a full estimation of the difficulties and challenges [ahead]”. However, he was confident China could overcome the crisis.
As part of their crisis prevention the PBOC has taken a number of monetary measures already, but for the reasons I have discussed ad nauseum in this blog I do not think they will have had any major useful impact. For example in he past month or two the PBoC has relaxed lending constraints, reduced minimum reserve requirements twice, and cut interest rates twice, but just as their previous tightening policies probably had very limited impact (they mainly pushed credit activity outside the regulated areas into possibly even riskier ones), I don’t think their loosening policies will have much impact either – partly for the same reasons and partly because in a crisis lenders just don’t want to take risk. Caijing’s chief economist, Shen Minggao, has something similar to say, according to an article in last week’s edition of Caijing.
Shen thinks internal and external factors were behind this policy shift. Externally, the likelihood of negative economic growth next year in the United States and the European Union is escalating. As a result, a downward trend for China’s exports will be hard to reverse in the short term. Meanwhile, domestic inflation pressure is easing, leaving room for monetary loosening.
However, in Shen’s view, the effectiveness of rate cuts may be limited. A new trend is that a market-based credit shortage in China is replacing a credit crunch tied to monetary policy. Initially, tight credit was mainly caused by strict loan quota controls, or “window guidance,” implemented by the central bank. But since the second half of this year, signs of a credit shortage tied to natural market reactions have emerged. Financial institutions have become reluctant to lend due to fears of default by borrowers with deteriorating prospects for profits.
I disagree with Shen on some of these points. I do not believe there was either tight monetary policy or tight credit. PBoC actions had an impact only on limited parts of the financial system, with the rest of the system acting partly as a residual to counteract that impact. Still, his point that banks have been reluctant to lend, thus making credit relaxation somewhat moo,t is an important one.
Analysts with greater faith than I have in the merits of a state-owned banking system will argue that the PBoC can simply mandate the banks to increase credit and make loans, but in my opinion that creates a very distorted incentive to lend, and will almost certainly result in non-economic lending. It might nonetheless create some credit relaxation immediately, but probably at the cost of storing up more problem loans, and anyway any relaxation in credit may be more than offset by the shifting of off-balance sheet transactions back onto the balance sheet and by a more rapid contraction in the informal banking sector.
I am not saying that this must happen, but simply that we have no idea whether or not it will happen (I think it probably will), so we should not place too much hope in PBoC measures. As my readers can easily see, I am very prejudiced in favor of the idea that markets do what they do in reaction to underlying conditions, and policy-based distortions often make things worse, not better. I can list so many Latin America cases in which what seemed an effective policy to distort conditions, in order to address an immediate problem, only made matters worse. I am by no means a market fundamentalist, and never have been, but I would argue that successful intervention is often much harder than we think, especially in a system that is rigid and opaque.
Shen also points out several other problems that constrain the PBoC’s ability to ease China’s way out of a crisis:
Other factors also will constrain future monetary policy. First, interest rate cuts by central banks in major industrial economies will have a direct impact on China’s monetary policy. After the latest cut by the Federal Reserve, the U.S. federal benchmark interest rate fell to 1.5 percent. Further cuts may lead to a zero rate. As a result, global markets may again experience excess liquidity, and the amount of capital flowing into China may rise. If yuan appreciation fails to curtail the flow, excess liquidity could again drive China’s inflation rate higher.
Second, in the latest adjustments, China’s central bank applied “asymmetric” rate cuts. Concerned about the vulnerability of commercial bank profit growth, the bank may hesitate to continue this approach. The latest move reduced both deposit and lending rates by 27 basis points, while the Ministry of Finance abolished a 5 percent personal income tax on interest income. For a depositor, the effective savings rate was cut by 6 basis points, not 27. If the central bank continues asymmetric rate cuts to stimulate consumption, the profit margins of commercial banks — which rely heavily on lending-deposit rate gaps — will be further squeezed.
Third, rate cuts may encourage large enterprises to increase investments. The current credit shortage is mainly affecting small companies. Without a turnaround in external demand, increases in investment may worsen the problem of excess capacity.
His third point is, I think, the most significant – at least to somewhat like me who worries about inventory buildup. It is also interesting what Shen has to say about inflation because of his concerns about actions that might lead to a resurgence of inflation – forcing the banks to expands their balance sheet may reverse the monetary contraction that brought inflation down in the first place.
On Monday the National Bureau of Statistics is slated to release inflation numbers. They were originally supposed to be released Tuesday, and the one-day-early release is being interpreted as indicating very good news. CPI may come in around 4% or not much higher – largely, I think, because of falling pork prices. That would be good news – and something I clearly misjudged big time in my inflation hawk days. I was pretty certain that the huge mismatch in monetary growth and economic growth would necessarily result in higher inflation, and I doubted (a tad too forcefully, I think) that there was any way that policy-makers were going to achieve their 4.5% target by year end. Actually no one seemed to believe the target – even Premier Wen more or less told us that the target was for symbolic reasons, and not a serious expectation.
But at this rate the authorities are going to hit the target. What seemed almost impossible just six months ago now seems easily achievable. How could that be? The worrier in me says that if excess monetary growth made inflation seem almost inevitable, then the collapse of inflation must also indicate a collapse in money supply. After all, for several years there has been a major mismatch between money growth and the needs of the economy, and as I see it there are only two ways for them to get back into line. Either the nominal value of the economy rises to meet the money supply (i.e. inflation) or the money supply contracts to meet the value of the economy (e.g. a bank contraction)
So what is really going on? Around the rest of the world it is pretty easy to see that the collapse in the balance sheets of financial institutions is causing a drop (perhaps only temporary) in underlying liquidity. Is that happening here? I wish I had some real sense of what was happening in the informal banking sector. Commercial banks seem reluctant to lend – are the informal banks drawing in loans even more quickly? I am honestly puzzled.