[Vnbiz] Inflation equals monetary tightening equals asset deflation

Wed May 14 12:19:34 PDT 2008

Thanks, Craig.  Very interesting article.
Vietnam appear to take the same inflation fighting approach as China's, 
though with considerably less experience.
The links to the banks and real estate market  to inflation in China may 
be very similar to Vietnam's.
HPP

"Craig Stevenson" <cstevenson2000 at gmail.com> 
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05/14/2008 12:48 PM
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[Vnbiz] Inflation equals monetary tightening equals asset deflation

[ Vietnam Business Forum ]

http://www.rgemonitor.com/asia-monitor/252600/inflation_equals_monetary_tightening_equals_asset_deflation

The following article was written by:

Victor Shih
Victor C. Shih is a political economist at Northwestern University 
specializing in China. An immigrant to the United States from Hong Kong, 
Dr. Shih received his doctorate in Government from Harvard University, 
where he researched banking sector reform in China. He is the author of a 
new book published by the Cambridge University Press entitled Factions and 
Finance in China: Elite Conflict and Inflation. It is the first book to 
inquire the linkages between elite politics and banking policies in China. 
He is further the author of numerous articles appearing in academic and 
business journals, including The China Quarterly, Comparative Political 
Studies, and The Asian Wall Street Journal, and frequent adviser to the 
private sector on the banking industry in China. Dr. Shih holds a B.A. 
from the George Washington University, where he graduated summa cum laude 
in East Asian studies with a minor in economics. His current research 
concerns elite political dynamics in China and Chinese fiscal policies.

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I believe it useful in understanding the possible dynamics and problems 
associated with shifting levers to the real estate market.  Further the 
problems associated with real estate markets worldwide over the 
intervening years of monetary looseness since Central Banks started 
flushing markets with easy credit after the Dot.Com bust.  Also, the 
problems associated with too large a percentage of an economy being 
destined toward Capital Investment in a very contracted period of time, 
and is useful for pondering how those problems are made worse by pegging.

Craig 

Inflation equals monetary tightening equals asset deflation
 Victor Shih | May 14, 2008 
The rumors were correct. April inflation came in at 8.5%, showing no sign 
of slowing from the 8% range first reached in February. This will not 
allow the People's Bank of China (PBOC) to relax monetary policies. In 
fact, we can expect further increases in reserve requirements and quite 
possibly an interest rate increase before the end of the first half. As 
soon as the inflation rate was announced, the PBOC announced a 50 bp 
increase in reserve requirement, bumping it to 16.5%. This means 
unfavorable conditions will continue for both the equity and real estate 
markets. The continuation of monetary tightening may create a world of 
trouble for real estate investors in particular.
First, let's look at the inflation. Most of it still comes from food 
inflation, which grew by 22.1% YoY. The problem continues to be that once 
pork prices shot into the stratosphere, other food categories became very 
vulnerable to even small shocks because substitution puts high pressure on 
the prices of all foods. The latest fire to watch for is of course grain 
prices, which grew 7.4% YoY. The increase in grain prices is likely 
under-counted because of administrative control over grain prices. 
Non-food inflation remains relatively low at 1.8%. In fact, official 
figures show a decline in clothing prices in April. I am totally 
unconvinced of the official figures in this regard, however. A significant 
part of wage in many work places in China is food provided by the company 
cafeteria. As the prices of all food categories increase, the in-kind 
nominal wage of workers is increasing. Even if cash wage does not increase 
(big if), companies may soon find it necessary to increase product prices 
to reflect increasing wage costs. Of course, rising energy prices do not 
help (7% YoY even with price control).
The bottom line is that the food inflation will soon leak into non-food 
inflation in the official figures, which will sustain inflation momentum 
into the second half. I don't have a fancy model to predict the precise 
level, but this game of adjusting annual inflation estimate upward 
slightly every month because of the "surprising" inflation of that month 
is getting tiresome. I think major banks, the IMF, and the World Bank 
should just admit that annual inflation in China will be above 5% and will 
likely be closer to 7-8%.
Since late last years when inflation emerged as a problem, top policy 
makers have engaged in a latent debate on whether monetary tightening was 
a cure of inflation. Premier Wen Jiabao and a group of technocrats who 
fought the mid 90s war against inflation initially carried the day in the 
November (2007) Politburo meeting, which announced that inflation was 
threat number one for the regime. Soon after, we saw a series of increases 
in reserve requirements, an interest rate increase, and --perhaps most 
important-- credit ceiling on bank lending and a 30% down payment 
requirement for second mortgages. We know, however, that there is an 
opposing voice at the top of the regime. Princeling officials (princelings 
are children of high officials) with heavy ties to the real estate sector 
likely form the backbone of the opposing voice. The opposition has 
formulated an argument stating that inflation is caused by the 
"structural" problem of an artificially low RMB, which led to the monetary 
problem. At the March National People's Congress meeting, the opposition 
came out in the open to criticize continual monetary tightening. Li 
Yining, a Hayekian economist with ties with the real estate sector, 
articulated this argument in public. Nonetheless, as my book Factions and 
Finance in China shows, monetary conservatives--the central technocrats-- 
gained the upper hand whenever inflation rates were high.
To be sure, 8% is far from the record inflation in the past 30 years 
(around 30% was the record), but we certainly have not seen quarterly 
inflation at 8% since the mid-90s. The sustained inflation pressure will 
give Premier Wen the political leverage with which to continue tight 
monetary policy. His newly appointed helper, Vice Premier Wang Qishan, is 
a veteran inflation fighter first promoted by former economic czar Premier 
Zhu Rongji. At a recent speech given in Shanghai, he made it very clear 
that he will make fighting inflation a top priority and that fixed asset 
investment needed to be brought down to "a reasonable level." As long as 
inflation rates remain at a high level, I do not expect the technocrats to 
relax their grip on money supply.
The increasingly tight monetary policy coincided with a major correction 
of the Chinese stock market. I am no expert on this matter, and I leave to 
Michael Pettis to comment further on whether monetary tightening will 
continue to exert downward pressure on stock prices. It seems a reasonable 
conclusion, especially given that price controls are imposing heavy costs 
on oil, food, and even retail businesses. After the down payment 
requirement was imposed late last year, the real estate market in China 
experienced an instant cooling down. By February, month-on-month increases 
of average housing prices were basically flat in most of China's major 
cities. The March figures were literally 0s in many of China's major 
cities and negative in a few cases.
Shenzhen Today, China Tomorrow
We now get to the bottomline--real estate prices will likely get hit 
substantially in this environment, causing a major decrease in household 
equity, a substantial rise in non-performing loans, and sluggish real 
estate market in the medium term. Although official figures from March 
show declines in only a handful of markets, I would argue that official 
figures compiled by the National Development and Reform Commission (NDRC) 
are not reliable and that we will soon see widespread declines in many 
major markets. On the reliability issue, we focus on Shenzhen, the first 
major market to show a sizable decline. The NDRC reported a month-on-month 
decline of 4.9% for new housing in Shenzhen in March. Soon afterward, the 
housing authorities in Shenzhen reported a 16.53% monthly decrease for new 
residential housing in Shenzhen. THE NDRC UNDER-REPORTED THE DECLINE OF 
SHENZHEN HOUSING PRICES BY THREE FOLD! Of course, even the official figure 
from Shenzhen under-reports the true magnitude of the problem. The press 
is filled with stories of last-minute discounts, free renovation, free 
cars, which sum up to a 20+% price fall in Shenzhen residential real 
estate. Things are about to get worse in Shenzhen because 1 million sq mtr 
of new residential came on the market in the first quarter, adding to the 
5 million sq mtr in stock left over from 2007. April figures from the 
Shenzhen housing authorities show a decline of ANOTHER 12% for new 
residential housing, bring prices back to the level exactly one year ago. 
In the absence of systematic data, the press is reporting stories of 
highly leveraged investors beginning to resort to the desperate tactic of 
borrowing from "underground banks" at 5% a month to make payments. Of 
course, this is unsustainable unless a miraculous recovery of housing 
prices occur, and inflation makes this more and more remote for 2008.
Will this disastrous pattern be repeated elsewhere in China? The answer is 
yes with a high probability. The official figures show impressive run-ups 
of real estate prices in both east coast markets like Beijing, Hangzhou, 
Ningbo, and Haikou and inland markets like Nanning, Xi'an, Lanzhou, and 
Urumqi in 2007. These spectacular increases have no doubt attracted 
leveraged speculators as well as enthusiastic local officials who approved 
swathes of new projects last year, which will be completed this year. 
Unfortunately, the housing authorities elsewhere are not nearly as 
enlightened as those of Shenzhen, so we have no local figures with which 
to compare with the suspicious NDRC figures. If substantial declines occur 
in other markets, we will see widespread defaults among both individual 
investors and developers going into the fourth quarter of this year. At 
the end of 2007, loans outstanding to developers and buyers combined 4.8 
trillion RMB (700 billion USD at current exchange rate). Even 10% of those 
loans getting into trouble would generate half a trillion RMB of 
non-performing loans. Although this would not cause a financial panic, it 
certainly would cause investors to take a much closer look at Chinese 
banks. Furthermore, expensive write-offs from the CIC may once again be 
necessary. Finally, this decline of real estate prices, unlike previous 
such events, will be the first one experienced by a large number of 
Chinese households. This lesson will (hopefully) instill caution among 
Chinese real estate investors. 
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