After a decent day Monday (up 0.7%) the market took a beating Tuesday, with the SSE Composite closing at 2779, down 3.4% for the day.  The decline was probably partly caused by mortgage fears in the US (insurance companies and banks, who may be big holders of Freddie Mac and Fanny Mae, led the declines), but worries about a slowing domestic economy were likely to be the biggest concern. 

There has been mixed news on the whether or not inflation is still the top worry.  There have certainly been a lot of statements that suggest that the authorities are very worried about a slowdown, and even some suggestions that they are willing to put the fight against inflation on hold, but a statement released by the NDRC Monday, in which they said that “upward pressure on prices remains strong” seemed to dampen at least some expectations that the government would loosen up on the monetary side.

I am still a monetary pessimistic.  I think the balance of opinion, or at least the opinion that matters, is tilted towards putting inflation-fighting on the back seat and worrying more about a possible slowdown.  I am worried that our inflation respite is going to be temporary, and certainly the data on money inflows doesn’t make it easy to be optimistic about the ability of the PBoC to control inflation.

On the other hand Tuesday’s Sydney Morning Herald has a very interesting article by John Garnaut (“Chinese calls for yuan rise to ease inflation”) that was sent to me by Jonathan Lerner, and I haven’t seen any other reference to the story.  The article starts out:

A GROWING number of top Chinese economists are advising their Government to consider a currency revaluation to fight persistent inflation and destabilising "hot money" capital inflows.  “The Chinese currency should be revalued as China's productivity is increasing," Professor Fan Gang, a member of the central bank's monetary committee, wrote in a paper that he was to present to the China Update conference in Canberra before being held back for a last-minute meeting with the Prime Minister, Wen Jiabao.

In recent years currency revaluation has been a taboo topic among Chinese policy makers.

The article goes on the quote He Fan, the assistant director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, telling Garnaut that “They don't need to say they are floating the exchange rate but they can at least test the market's view. With a one-off appreciation by 10 or 15 per cent, maybe the market will believe that's the end of the story. But maybe the market will still not be satisfied.”

There have been more and more think-tank and quasi-official comments recently about the one-off appreciation, and I suspect that the debate is fairly intense.  Yesterday evening I was with another senior think-tanker, who I have met several times on Dialogue and who has a very sophisticated view of the Chinese economy.  He told me flatly that the only hope of protecting China from the ravages of hot money was to peg the currency.  Since pegging it at these levels would be problematic for many reasons, he said that the PBoC should “surprise” everybody by first revaluing, and then pegging.  He told me that he thought the revaluation should be 5-10%, but agreed that this might be too little.

The Sydney Morning Herald article goes on the describe something that I think is extremely important and has perhaps been under-emphasized in the debate – the destabilizing impact of excessively loose monetary policy on the banking system.  Referring to the pressures on bank profitability caused by PBoC strategies to mop up liquidity, the article says:

Mr He said the main state-owned commercial banks were already devoting between 30 per cent and 40 per cent of their assets to such loss-making endeavors. This was creating "ugly" bank balance sheets and encouraging the banks to recoup profits with "dangerous" lending policies that might ultimately jeopordize financial stability and the Government's efforts to clean up non-performing loans

In his paper, Professor Fan writes that analysts have "correctly and convincingly" highlighted "structural distortions caused by repressed interest rates and an undervalued currency" which "may also lead to economic, financial and social problems".  His comments are significant because Professor Fan was previously a staunch defender of the status quo. Nevertheless, a one-off revaluation is unlikely in the near term because China's export sector is suffering from a downturn in their major developed-world markets and struggling to cope with rapidly rising input costs.

The idea of “dangerous” lending that is likely to be caused by excess control of parts of the system (their forced piling up of PBoC bills and minimum reserves) and by current monetary and credit conditions is something about which I have had a surprisingly hard time arguing, both with Chinese and with foreign analysts.  I am not sure why, since in most markets this is fairly well understood, and given the ongoing crisis in the US, the idea that seemingly smart banks can do some pretty dumb things during optimal times is getting quite a lot of newspaper coverage. 

None of this is new.  Hyman Minsky in particular, has long argued that it is impossible to protect financial systems from periodic crises because the very conditions designed to prevent instability are the ones that create the incentives for bankers to take excessive risk – usually in less well-monitored areas – that end up ensuring that at some point the system will go through a period of “adjustment” and distress.  The empirical evidence that loose monetary conditions and implicit or explicit credit guarantees lead to banking crises is also pretty ample.

I can’t prove it, of course, and no one will be able to prove it until we have our own contraction, but I would be willing to bet that over the last few years the banks and the financial sector in China have been engaging in behavior that will one day seem self-evidently dangerous.  That is both the biggest risk of a sudden revaluation and the strongest argument for doing it as soon as possible.

Speaking of monitoring the banking system, I saw another very interesting piece, this time in ChinaStakes.com (“Government Moves to Legitimize Underground Lending in Zhejiang”).  The title says it all, but here is what the article says:

In Zhejiang Province, with the most developed private companies and private capital in China, the government is trying to legitimize private capital, and set up small-sum loan companies to connect private capital with capital-hungry private companies.  The tight credit policy has driven many small and medium enterprises into hardship and even bankruptcy in coastal provinces like Zhejiang Province. Normally, formal banks, especially the state-owned banks, are reluctant to lend to private companies.

However, Zhejiang is also famous for its so-called underground banking, or back-alley banks as some analysts put it. The government has never issued lending licenses to them.  For some central bankers, like Wu Xiaoling, the former deputy governor of the People’s Bank of China, small-sum loans are an alternative under the current tight monetary policy in place in China.

So now Zhejiang is carrying out a pilot scheme for petty loan firms. If everything goes well, the first small-sum loan companies will start operations in September this year, and their experiences will help to set up more companies of this kind.  Zhejiang is the first province to react to the Guiding Opinions of the China Banking Regulatory Commission and the People’s Bank of China on the Pilot Operation of Small-Sum Loan Companies, which was released in May.

The article goes on to say:

The government has set strict limits for the establishment of small-sum loan companies in order to guarantee their development. According to the regulations in Zhejiang, investors in these loan companies should be chosen from private companies with regular management, sound credit, and are well-operated. The net assets of these companies should not be less than 50 million yuan (or 20 million yuan in less developed areas), and the asset liability ratio no higher than 70%. They should have made profits for three straight years and the total profits should be no less than 15 million yuan (or 6 million yuan in less developed areas).

The government has also banned these companies from collecting deposits or illegally raising funds from the public. Their loans should be dispersed to different businesses in small sums.

The “informal” banks are in many ways among the better-functioning parts of the financial system, although their dubious legal status means that it is probably hard for them to raise money and to collect on bad loans.  This of course raises their cost and forces them into otherwise non-economic behavior – for example I suspect that they tend to insist on short-term loans even when longer-maturities might be optimal – but at least their capital allocation process is probably better in many ways than that of the commercial banks.  Bringing them into the regulatory fold and improving their legal status will almost certainly improve China’s financial system.

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Michael Pettis

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