It is easy to lecture policy makers on what they should be doing. The Federal Reserve Chairman Ben Bernanke has been lectured by everyone on why quantitative easing is evil, etc. But for investors, that’s what policy makers actually do that matters.
Many, including myself, have been lecturing Chinese policy makers on what the Chinese policy makers should be doing in dealing with inflation and real estate bubbles. Andy Xie, of course, is among the most vocal of all, and he once went so far by suggesting that the government screw him up because the government did not follow his policy description, making his forecast of imminent crash not materialised.
Ultimately, I would rather be more practical: it is more about guessing what they do than lecturing them as far as investors are concerned.
In early April, I blasted Goldman Sachs’ idea that the tightening cycle was over, and wrote that it would be a huge mistake if tightening cycle ended then, and later in early May, I wrote that China has not slowed down much so that tightening would be continued. Now, sharp readers may sense that the mood here has changed from being confident that tightening will continue to feeling uncertain. The reason is simple: there has been slowdown, although only a bit if the latest GDP figure is the only metric you would like to consider, while some earlier figures caused more worries, but still hardly a significant slowdown.
Land this damn thing, or not? Where’s the landing gear? (Image: Wikimedia)
As the slowdown is not significant enough to bring inflation down, and as inflation proves to be very sticky, the choice is between hard landing and not landing at all: either you have to slow the economy so much (let’s say sub-7%, using Dong Tao’s definition) or you just can’t get inflation below the 4% target (even though it is expected to peak within these few months). Earlier, I suggested that the risk of hard landing has increased as the government is facing a slight slowdown while inflation remains very high, such that the margin of safety for not over-tightening has been narrowed. Despite the headlines floating around suggesting that the GDP growth has slowed, growth has only slowed very slightly, hardly significant enough. In any case, this should suggest that the margin of safety is wider that previously thought, and there should be even less reasons to think that the tightening is over.
That said, hard landing is not what the government wants to see. In fact, no sane governments on earth would like to see a hard landing happening. Indeed, we have heard some rather inconsistent tones among policy makers on which is the top priority: price stability or growth? Clearly, policy makers are feeling less certain, giving erratic policy guidance. One day, Wen Jiabao said inflation is under control. The other day, Wang Qishan is less certain. One day, the governor of PBOC Zhou Xiaochun said inflation is not the only target of the central bank, the other day he said “prudent policy” will be maintained. Then Wen Jiabao reiterates that price stability remains as the top priority, but also wants to see stable growth picture. This suggests that while there is little reason to end tightening, there are probably some changes happening in policy makers’ mind. Perhaps they believe that the margin of safety is very narrow, and wouldn’t risk a significant slowdown.
There are various reasons not to take the risk of over-tightening, including the on-going local government debts saga and the credit crunch in small and medium sized businesses. A recent interesting view comes from Roy Ramos, previously an Asian banking analyst at Goldman Sachs. Early last month, he came up with an interesting 15%-rule, which says [emphasis mine]:
What we have observed empirically is that every time interest expense for the aggregate private sector goes beyond 15% of GDP, a banking crisis has ensued for that particular sector/country. We can think of only exception to this rule -Hong Kong in 1997/1998, but even here, we saw a sharp spike in NPLs, a deposit run on one institution, and prolonged asset markets deflation through 2003. We point to several instances of banking crises ensuing at an even lower (10%-11%) interest expense to GDP ratio.
While hardly a very precise metric (for instance, that figure was a mere 10.25% for Japan in 1990, while the US was at 21.3% before the financial crisis), he found that the China is currently at 11.3% in his base case scenario, assuming that the credit/GDP ratio of 162% and 7.0% of average borrowing cost. If 15% is the threshold for banking problems, China can only tolerate an average borrowing cost of 9.5%. After the People’s Bank of China raised interest rates by 25 basis points, so the margin of safety is narrowed to 225 basis points. Even if the People’s Bank does raise borrowing cost by 225 basis points higher towards the danger zone of banking problems at one go, real deposit rate is still slightly negative at 6.4% of the rate of inflation. And given that problems can happen even at a lower interest expense to GDP ratio, China probably does not have too much room left.
Take these all together, it is then easy to understand why policy makers are being inconsistent. While growth is really not slow enough, China may be closer to the tipping point of so-called hard landing than previously thought.
This article originally appeared here: Between Hard Landing And Not Landing
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