Thursday, January 21, 2010

China looks good (2)



Here's an update to my post last month, showing China's GDP growth returning to double digits as expected. This is very impressive, and surely qualifies as one of the most impressive V-shaped recoveries to date. Yet the market is concerned that measures imposed by the government to curb bank lending, announced today, coupled with a rise in the required reserve ratio for banks last week, will threaten China's economic future. I see these measures instead as moves in the right direction.

Because China's currency is linked to the dollar, and the dollar is historically very weak and the Fed is promising zero interest rates for a long time to come, it is in China's best interests to resist the inflationary pressures that flow from a weak currency. Tighter monetary policy is one way to do this, but ultimately China will probably have to revalue the yuan against the dollar—unless the dollar rises appreciably in the interim. But neither a revaluation of the yuan nor a tightening of monetary policy should pose a threat to China's growth, because they would amount to appropriate measures to limit inflationary pressures. It's never a bad thing to do the right thing.

It's useful to recall the unwritten law of central banking. A central bank can successfully implement monetary policy by choosing one of three policy tools: controlling the exchange rate, controlling the money supply, or controlling an interest rate. Often central banks that choose the first option become tempted to use one or two of the other tools at the same time. We saw this in the years leading up to the S.E. Asian currency crises of 1997, when central banks raised interest rates to cool off their economies (at the IMF's suggestion, I might add) while also keeping their currencies pegged to the dollar. This can work for short periods, but it inevitably results in undesirable or unforseen consequences. The problem is that it is just about impossible for any human to use two policy tools to hit one policy target; the complexity is just too great. If policymakers can stick to just one tool, then markets and the economy can adjust given time.

Think about it: if China says the yuan will be fixed to the dollar, but then it raises its interest rates above dollar interest rates, this has the effect of attracting capital that would otherwise go to the U.S. Increased capital flows have to be purchased by the central bank in order to keep the exchange rate stable, but this increases the money supply and that, in turn, can put downward pressure on interest rates and/or result in an "overheated" economy. In short, the combination of these policies can end up in undesirable cross-currents.

So China is probably making a mistake by tightening monetary policy instead of just revaluing the yuan. But it could take a long time for this mistake to generate serious imbalances in the economy. In the meantime, investors know that China has a virtual mountain of reserves with which to back up its currency. That means the Chinese yuan is NOT going to lose its value; it can only remain steady versus the dollar or rise. So on the margin, the central bank's tinkering with monetary policy only increases the appeal of investing in China, since it means higher interest rates (which is equivalent to curbing bank lending) and/or an increased likelihood of further yuan appreciation against the dollar. And the more money that is attracted to China, the more resources it will have at its disposal to continue growing. For now, it's a virtuous circle.


Full disclosure: I am long CHN at the time of this writing.

13 comments:

Public Library said...

And another great post. In America, our central bank does not see higher rates as a sign of strength and stability.

So when American has a little sniffle, the Fed comes to save the banks day with unnecessarily low rates.

That begs the question, who is driving this country, the Fed or the banks?

Benjamin said...

China is too big and not transparent enough to really understand. But I also am optimistic about China, not just for one year, or 10 years, but rather generations.
People argue a lot about different government-economic systems, and which is best. But if a large number of people have the work ethic, and government is roughly pro-business, and technology is rapidly transferred around the globe, then I can see no reason for China not to boom for as long as the eye can see. I do wish they would ease up on human rights--in fact, it is probably an economic negative. If China becomes a more democratic and transparent place, it will boom more.
China will pull up the entire Far East, including Thailand and SE Asia. Not sure about Japan, as the two nations are at odds for historical reasons.
I think the future of the world is in the Far East.

Scott Grannis said...

Benjamin: it would be hard to disagree with what you say.

Benjamin said...

Well, that takes all the fun out of it.

Huntington Hartford said...

Just because it's a blog, and disagreeing is what people do, I'll disagree with Benjamin. Just because I'm disagreeing doesn't mean I'm betting my money in such a way. I have been to China. I have in-laws there running a business. I used to live in Chinatown in NYC. I like Chinese people, so take what I say with a grain of salt.

But here goes:

Work ethic. Yes they have it. I won't disagree with that.

They are also becoming a society full of "only-children." The personality characteristics of "only-child's" scares me, when applied to a large society. Parents also really spoil that only child.

They are becoming a society full of males. The female population is there to a lesser extent, but they're rarely registered. They're underground or aborted.

Now, I'll go non-PC. Cover your ears and don't read this if you're sensitive. Chinese people are cheap and selfish. Cheap and selfish are relative terms, so I compare them to their neighbors, or the Japanese, or the Germans or the Americans. I think this cheapness will make them short-sited and not so much team players. I don't know how it will pan out. Germans, Japanese, and even Americans are "geeks" or idealists in their pursuit of their individual crafts. Great businesses were built based on innovation (not great profits in the near term). Our economies are full of businesses where profits come 2nd to R&D.

Ok, next they're incapable of 21st century thought. When we request that they respect intellectual property (software, music, movies, whatever) they laugh. In their minds, a product that relies on intellectual property protection is one with a weak business plan. Similar to branding, but on a grander scale, similar to religion or mind control. They think that if you make software, and you can actually get someone to pay you a per-use license on it, then you are a successful marketer and you've found a sucker. Chinese people are too smart to pay for something that they can get for free.

Just like the mortgage crisis in the U.S. was created by the government forcing lenders to lend to losers, effectively a breakdown in capitalism when risk & reward don't go hand in hand, the "central planning" aspects of China have resulted in Zillions (with a Z) of dollars in misallocated capital because there are NO CAPITALISTS directly responsible for said capital. The government is doing the best job they can but they're not incentivized like a true capitalist allocating hard earned money. They're allocating capital not for monetary profit, but to make their workforces happy so they can stay in their political offices. I have seen them build fancy building then abandon them. A capitalist would not build a fancy building and abandon it. He'd be taking flack from his creditors until he had it occupied. He'd be twirling signs out front on his knees. I saw many fancy buildings and structures that were vacant for a long time with no marketing efforts. In the U.S., somebody would be suffering over that capital.

Ok, that's all I can think of for now. I'm just disagreeing for the heck of it.

Scott Grannis said...

Thanks, I think this adds up to a positive contribution to the discussion.

Public Library said...

Well said HH. Lets not forget China was once the largest and most powerful country on this planet. Their Navy was 3-4 times the size of the great British fleets of the time.

What did they do? They burned and sank them because they no longer saw the need to expand.

China, if necessary, will cut-off its nose to spite its face. This is a communist country. Nobody should forget this simple fact.

Benjamin said...

My wife is Thai, and there is a lot of resentment among ethnic Thai (in Thailand) towards ethnic Chinese.
They are regarded in Thailand as cruel, heartless and money-driven, and dismissive of native Thai. Many Thai movies perpetrate this stereotype.
My wife's sister, as a girl, had a child from a local Chinese boy. The Chinese family refuses to even acknowledge the child! In America, we would so want to have the grandchild close, make sure it had a future.
No doubt China is a country of many, many faces.
But, in terms of economic growth, I think it plays out well for the Chinese. True, the government may misallocate resources through controls rather than free markets.
However, in the USA we have the Ag Department, vast rural subsidy programs, the mortgage interest tax deduction, the Fannies, and the military. We allocate vast resources resources galore in non-market directions.
Our system seems to overcome these misallocations. China? So far so good.
Remember, the Chinese have a very high savings rate, and so there is always lots of capital to fix everything.
If you watch Chinese movies (channel 44-8 in Los Angeles) you will see they are now a money culture. They worship economic success.
It will be a fascinating story to watch unfold.

bob wright said...
This comment has been removed by the author.
bob wright said...

I saw the same thing HH refers to.

In 1999 I was in Chongqing to take a Yangtze River cruise to see the Three Gorges Dam. There was a high rise building right outside my hotel [Holiday Inn] window that was simply a concrete skeleton occupied by squatters. There was just concrete floors and pillars. The squatters put up blue tarps and cardboard for shelter. There were many of these in the city. There was no building going on at the site - it was simply abandoned.

I saw the same thing in Chengdu and Wuhan.

So when I see the Chinese government report double digit GDP numbers, I question the validity of the government reported data. I don't doubt they have growth, I just wonder if the numbers are being goosed some.

I was also in Tibet for a week on the same trip. Like the Thais, the Tibetans loathe the Chinese. The Chinese have their foot on the throats of the Tibetans.

From what I saw, the Chinese are great merchants. Everyone in Macau was trying to sell me something. Even the bus driver was selling postcards.

instant said...

We can write 100 thick books about the mischief of Chinese and their government. If you look at them in details, you can write another library of books of what they have done wrong. However, you can deny the economic miracles in their achievement and how their people's life changed in the last 30 years.

Then the key question is: what have they done so right that to make these achievements? And what we can learn from them?

Scott Grannis said...

instant: I think it is this: they have turned their people loose by introducing free market concepts and individual liberties. Imagine what would happen if they were completely free...

Family Man said...

Recent uptick in risk aversion is mainly due to a wrong communication in China. Markets were cought off guard by lack of preannoucement on tightening. But the point was quickly taken by authorities, and now we see a proposal which should smooth the further way, as inflation is the main concern.
He Keng, a deputy director of parliament's Financial and Economic Committee, has said that the government should set an inflation target of between 3 and 5% for 2010 at next month’s National People's Congress.