Michael Pettis is Professor of Finance, Guanghua School of Management, Peking University, author of The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy, Avoiding the Fall: China’s Economic Restructuring and The Volatility Machine: Emerging Economics and the Threat of Financial Collapse. Pettis is out with his latest missive on Chinese WMPs. Below is an excerpt from his latest newsletter.
There certainly will be more WMP scares. We have already seen two this year, the first of which was mysteriously “resolved”, and the second of which is still outstanding. The regulators are faced with the tough choice they always face when moral hazard has been taken to extreme levels, as it has in China.
Prevent bankruptcy, and moral hazard is only encouraged. Allow bankruptcy, and money may
flee WMP at a pace that will be difficult, even for the healthier borrowers, to sustain. Because the money that escapes WMP is likely to show up as bank deposits, in principle this might simply mean a reversal of the disintermediation process of the past few years, in which both loans and deposits were transferred off the balance sheets of Chinese banks. But transferring them back on again might not be what the regulators want to see. Most of us believe that credit standards for WMP have been extremely weak (at best), and if banks are forced to take on the loans as WMP funding dries up, it is hard to believe that this will not represent a significant deterioration in the banks’ balance sheets.
This is going to be one of the big stories this year, and by the end of this year I suspect there will be few people who are not aware of WMP risks in China. We will all be watching China closely for signs of a slowdown. The most recent CPI inflation number posted by China’s National Bureau of Statistics seems to have surprised most market participants.
According to the NBS release: Today, with the efficiency of borrowing having plummeted so sharply, I am no longer as sure that the relationship holds, but I suspect it still might. At any rate this is how I read the lower CPI inflation numbers:
1. Disinflation in the CPI index might not suggest at all that the economy is slowing. It might just suggest that the process of rebalancing has stalled, or even gone in reverse. In that sense CPI disinflation is indeed bad news, but only because of what it implies about the rebalancing process.
2. We are much more likely to see the impact of a slower economy in PPI disinflation, which is indeed occurring. Consumption is such a low share of China’s GDP and production such a high share that we cannot simply assume that CPI inflation means that same things about the Chinese economy that it means about the US, in which consumption is nearly twice the share.
3. Lower CPI inflation does not indicate that the PBoC should lower interest rates or increase the money supply. Doing either only increases the implicit transfer from households to business or the state sector, and so is likely to put even more downward pressure on CPI inflation by reversing the rebalancing process.
4. PPI disinflation is the more useful information, but even this is pretty compromised. To the extent that lower producer prices are caused by excess capacity, the PBoC reaction should not be to expand credit and lower interest rates. The correct response to excess capacity cannot possibly be to encourage the creation of additional capacity.
Of course in China understanding January’s CPI and PPI data is made all the more difficult by the Spring Festival holiday, which has a huge impact on demand, but because it migrates between January and February, monthly comparisons are pretty worthless. Before we come to any conclusion we will have to wait until we get February data.
The main thing to consider is that CPI disinflation does not mean that monetary policy can be relaxed. If anything it probably means the opposite, and it may also mean that the rebalancing process has stalled. Fortunately I think the PBoC understands this far better than do the sell-side analysts. For two years or more some of them have been calling urgently for looser monetary policy and lower interest rates, but the PBoC has resolutely ignored them. I hope it continues to ignore them.