China monetary-policy tools fooling no one – Economy heading toward stagflation, instability

By Andy Xie

BEIJING ( Caixin Online ) — The central government has embarked on a monetary tightening program to slow the nation’s growth rate and fight inflation, using credit rationing as its main tool.

It’s a policy that’s compounding the nation’s inefficient allocation of capital. It’s also contributing to slower growth potential in China at a time when the nation’s inflation rate is surging. Nominal gross domestic product in China has been increasing at a 20% rate, and much of that is tied to inflation.

Inflation expectations have been rising even as policy makers raise interest rates: The People’s Bank of China in early April raised the interest rate 25 basis points. It was the fourth rate hike in the current tightening cycle.

But the aggregate increase for interest rates has been small. A 25-basis-point rate hike hardly makes a dent in what’s actually a negative interest rate for the real economy.

Indeed, at this point, China’s monetary-policy makers are too far behind the curve. Inflation is entering crisis territory, as consumer prices for many products and services rise at double-digit rates. Signs of panic have appeared along with hoarding which, when it spreads, could trigger a social crisis.

Yet something else is happening. By shifting capital to inefficient users against the backdrop of negative real interest rates, China’s economy is being pushed toward stagflation. Meanwhile, the public is afraid that the government wants to inflate away the value of their money.

What’s prevented a full-blown crisis so far is a belief that the yuan will appreciate. If not for this assumption, capital flight from China would be rampant.

To change course, policy tightening must shift away from credit rationing and toward market mechanisms. Moreover, the interest rate must be lifted out of the negative column: It should be raised at least three percentage points to allay public fears. These changes are needed as soon as possible.

No one’s fool

Too many people in China’s officialdom believe in the power of psychology, particularly in its ability to fight inflation. But inflation is not a psychological phenomenon; it’s a monetary phenomenon. Excessive money supply leads to inflation. To contain inflation is to contain money supply at a growth rate in line with production.

Even when psychology succeeds by, for example, convincing people that there’s no inflation when in fact there is, the impact of these mind games does not last long. No one can fool all of the people all of the time.

Indeed, psychological tricks can backfire. People who suddenly realize they’ve been fooled can stop believing in other things. Hence, they might refuse to believe their eyes if inflation starts to cool. Policy makers would then have to react with monetary tightening that overshoots goals to calm public fears. An unavoidable consequence of interest-rate overshooting is a recession, which is certainly not a desirable outcome.

Neither will administrative power cure inflation. Even the most powerful government is not more powerful than the market. Yet administrative-power worship is pervasive in China, so many think the government can fight inflation by forcing businesses and merchants to hold down prices.

There have been recent examples of such price intervention. But forcing businesses to hold down prices is only a temporary fix. Input costs are rising 20% per annum for some businesses, and these companies will not survive unless they raise prices. Businesses pressured by the government to hold down prices might have to halt production or find other ways to increase revenues. For example, they might shrink portions or repackage old products, selling them as new.

State-owned enterprises can use subsidies and borrowing to slow price increases. For example, bank loans have been covering losses posted by thermal-power-plant companies, which have been forced to depress prices. Virtually every power company in China is losing money but survives on loans, basically shifting the inflation burden to banks.

This tactic has many side effects, including human health damage. Power companies limit costs by burning low-quality coal or switching off smokestack scrubbers, forcing people to breathe harmful coal smoke. True, the administrative approach to power-company price control keeps headline inflation rates in check, but is this good policy for the country overall?

Administrative-control worship is likewise manifest by credit rationing, which has been resurrected with a vengeance. Few private companies can get any credit from banks these days, forcing them to turn to the gray market for financing at interest rates often above 20%. Many, if not most, will not survive if these high financing costs continue.

Optimistically, most private company borrowers think the current credit situation is temporary. However, if inflation persists and the government’s credit-tightening approach remains unchanged, the private sector will see an increasing number of bankruptcies.

China’s capital allocation mechanism is likewise working against the private sector, with increasing bias toward state-owned enterprises. Banks have been lending to underperforming SOEs simply because they’re owned by the government. Most funds raised on the Hong Kong and Shanghai stock markets are for SOEs. Local governments have been raising massive amounts of money by auctioning land and taxing property purchases.

As a result, government expenditures have risen as a share of GDP. Indeed, government and SOE expenditures may have reached half of GDP. This is by far the highest in the world. And China does not follow the model common in Europe, where sizeable levels of government revenue are redistributed.

History shows that government and SOE spending tends toward inefficiency. There’s plenty of evidence of this in China, where image projects have been sprouting across the country like bamboo shoots in spring.

Inflation is a byproduct of inefficiency. Money spent on activities with low productivity levels lack products or services to absorb the money, leading to inflation.

Credit rationing is making the situation worse. While the public sector wastes money and fuels inflation, efficient small- and medium-sized enterprises are being starved of cash.

Stagflation risk

As capital efficiency declines in a climate of persistent negative real interest rates, stagflation emerges. Stagflation eventually leads to currency devaluation, and devaluations in emerging economies in the past has led to financial crises.

But the forces that favor low interest rates are powerful. For example, China’s local governments are so indebted — with debts now averaging three times revenues, and some extended by 10 times revenues — that they could not possibly survive positive real interest rates. Their survival hopes rest with sales of land at high prices, and higher interest rates would burst the real-estate price bubble.

State-owned enterprises are in similar shape and thus favor low interest rates. They reported 2 trillion yuan ($305 billion) in combined profits last year but were still cash-flow negative. The SOE sector has never been cash-positive, and last year’s negative cash flow was the worst in years.

Accounting for profits is always difficult, and it’s doubly so in China with its vast SOE sector. Government companies are so cash-flow negative and so leveraged that one cannot help worrying about financial-health issues. Big problems could be impossible to hide if interest rates turn positive.

The force is with credit rationing and negative real interest rates, even though this combination of policy tools makes stagflation inevitable. But is stagflation really so bad? Many would love an economic equilibrium that lasts a few years because it would effectively wipe away debt for those unable to repay. Indeed, stagflation benefits debtors. At the same time, however, savers pay a high price. No one expects savers to sit idly by while their savings are wiped away. Thus, stagflation never creates a stable equilibrium but instead breeds social instability.

In an emerging economy, serious stagflation always leads to currency devaluation, which always triggers a financial crisis. China has vast foreign-exchange reserves and capital control. Devaluation risks are still low, but not zero. China’s money supply is about four times its foreign-exchange reserves. And the effective money supply may be much larger.

A massive amount of credit has been extended outside the official system. The nation’s vast trust sector, for example, is effectively arbitraging related interest rates, with a risk profile and thin capitalization that pose a risk to financial stability.

Changing speed

To control the money supply, China’s policy makers need to move away from credit rationing and focus on interest rates. Each interest rate hike should double to 50 basis points at minimum to signal a new approach. In this way, the interest rate should rise three percentage points as soon as possible.

To move away from credit rationing, lending rates should be liberalized further. For example, the band for lending rate flexibility around the official rate can be widened. At present, banks charge fees to increase the effective lending rate, but this system is neither transparent nor efficient.

Imbalance is no longer an issue just for the macroeconomy, since it’s affecting microeconomic efficiency, which in turn is leading to a macro consequence — inflation. China’s economic difficulties are caused by problems in the system. Unless the root causes are addressed, these difficulties cannot be resolved.

At the root of China’s problems is the rising level of inefficient public-sector spending. The system is biased toward supporting public-sector income growth. And as public-sector demand for funding exceeds what the economy can bear, money-printing is inevitable.

Tools for shifting money to the public sector are taxes and land sales. Unless these fall, all the talk about economic rebalancing will be no more than talk. So China should cut taxes, as soon as possible, to signal a new approach to economic growth. The top personal income tax rate should be slashed to 25% and the value-added tax reduced to 12%.

Until that happens, China’s growth model will be suppressing the middle class. A successful white-collar worker who has worked 10 years in a first-tier city cannot afford to buy an average piece of property in China. Suppressing middle-class growth is not in the country’s interest, since social stability in modern society is linked to a large, content middle class.

Many local governments have come out with property-price targets that seem to limit price appreciation but ignore what are now unaffordable levels. The system seems to have become incapable of addressing the public’s fundamental concerns. The average price for a square meter of property in a city should be less than two months of average, after-tax wages.

China’s prices are already high by international standards, and already take into consideration the high cost of building a city from scratch. Actually, current price levels are two to three times higher than this cost and can only be sustained by speculative demand. No wonder property sales collapsed after local governments started restricting multiple-property owners and non-resident buyers.

A turnaround for real interest rates is not only necessary for containing inflation but vital if China is going to shift its growth model to household spending from government spending and speculation. Savers who lose wealth to inflation are unlikely to be strong consumers but, instead, may speculate to recoup losses, trapping the economy in an inflation-speculation cycle.

China’s economic difficulties are interlinked and cannot be addressed separately. The root cause is the political economy that gives public spending the leading role in driving economic growth. A fundamental solution must involve limiting the government’s means for raising funds.

Containing inflation and controlling bubbles must be viewed in this context, as the current growth model is pushing the economy toward stagflation and currency devaluation risks loom large. China could see a devaluation-triggered financial crisis similar to what the United States has already experienced. The difference, however, is that China’s system is not robust enough to maintain stability during such a crisis. It’s easy to see why fundamental economic reforms are urgently needed.

 

Impact of Quantitative Easing on US 10 Year Treasury

Inter Market Analysis – Treasury Yield Vs S&P 500

I have been monitoring the price actions of the 30 Yr Treasury Yield for the past few days. The Yield has been inching closer and closer to the upper trend line resistance. Is the market due for a big correction? Let us see the outcome in the few weeks to come.

via $UST30Y – Weekly Line (solid).

Silver Options Trader Bets $1 Million on Price Drop by July

April 11 (Bloomberg) — A trader’s almost $1 million bet that an exchange-traded fund tracking silver will decline by July was today’s biggest single options trade on U.S. exchanges as futures on the metal reached a 31-year high.

The 100,000 puts, or options to sell 100 shares each of the iShares Silver Trust at $25 by July, changed hands at the ask price of about 10 cents and exceeded the open interest of 6,054 outstanding contracts before today, indicating that a buyer of a new bearish position initiated the transaction. The ETF rose to $40.33, the highest intraday level since trading began five years ago, before falling 1.6 percent to $39.21 at 4 p.m. New York time. It hasn’t closed below $25 since November.

“It’s definitely a massive downside bet on silver,” said Henry Schwartz, president of Trade Alert LLC, a New York-based provider of options-market data and analytics. “It’s so far out of the money that the buyer is probably just looking for a moderate pullback because a $3 retracement to where it was in March could double the position to $2 million.”

Silver for May delivery in New York climbed as much as 3.4 percent to $41.975 an ounce, the highest level since January 1980, when futures reached a record $50.35. It last traded at $40.61. Silver, where half of global consumption is industrial, has been rising because it benefits from a rebounding global economy as well as demand for a haven, according to UBS AG.

The trade accounted for almost a quarter of the 385,667 silver ETF puts changing hands today, the most since November and five times the four-week average. About 1.2 puts traded for each call.

Gold vs Silver (Relative Performance) Is Silver trend sustainable??

 

 

via $GOLD – Daily Candlesticks.

LVS – Daily Candlesticks – Chaikin Money Flow

 

How CMF is calculated. Finding the volume multiplier is the first step. This value is based on the level of the close relative to the high-low range. A close on the high equals +1, a close on the low equals -1 and a close in the middle equals 0. A close above the midpoint of the high-low range means the volume multiplier is positive and a close below the midpoint means the volume multiplier is negative. This value is multiplied by volume do get each period’s Chaikin Money Flow value.

 

 

via LVS – Daily Candlesticks.

Global Markets React To The Domino Effect

The Transmission Mechanism for Quantitative Easing (Wonkish) – Paul Krugman

The Transmission Mechanism for Quantitative Easing (Wonkish)

It’s now widely claimed that QE2 has been a success — and for sure, the US economy, which seemed to be sliding into a deflationary morass last summer, has perked up since then. But why? A few thoughts.

Back in the old days, when dinosaurs roamed the earth and students still learned Keynesian economics, we used to hear a lot about the monetary “transmission mechanism” — how the Fed actually got traction on the real economy. Both the phrase and the subject have gone out of fashion — but it’s still an important issue, and arguably now more than ever.

Now, what you learned back then was that the transmission mechanism worked largely through housing. Why? Because long-lived investments are very sensitive to interest rates, short-lived investments not so much. If a company is thinking about equipping its employees with smartphones that will be antiques in three years, the interest rate isn’t going to have much bearing on its decision; and a lot of business investment is like that, if not quite that extreme. But houses last a long time and don’t become obsolete (the same is true to some extent for business structures, but in a more limited form). So Fed policy, by moving interest rates, normally exerts its effect mainly through housing.

Not this time, however, since housing is deeply depressed and there’s a huge overhang of excess capacity.

So if QE2 did work, how did it work?

Well, if you look at the sources of fourth-quarter growth it looks like this:

BEA

It’s basically consumption and net exports. Now, that net export number is a bit funny: there was a huge drop in imports, which probably came largely from a rundown in inventories, and isn’t sustainable. Still, trade does seem to be making a positive contribution. Nonresidential investment has been rising rapidly, but it was doing that even before QE2 was announced.

And what might be driving consumption and net exports? How about this?

For what it’s worth, casual observation suggests that a lot of the growth in consumer spending has been at the high end, which suggests in turn that a higher stock market might be driving it. And the lower dollar has clearly helped US exporters and import-competing firms.

If QE really is working through stocks and the dollar, are there further implications? I’m not sure — in a highly indebted society, you might hesitate at policies that would increase private debt further, but if stocks are driving the story, the consumers now spending more aren’t the same people who are in debt trouble — so that’s actually OK. And as for the weaker dollar, if the Chinese and the Brazilians don’t like it, they are free to let their currencies appreciate.

Anyway, that’s my casual take on what has happened. I would say that if it’s right, it’s far from clear that the recovery will prove self-sustaining.

Treasury Yield Vs S&P 500 – Inter-market analysis

I think the inter-market analysis prove to be valid with the price reaction when it touches the trend channel.

That is why we hear ppl talking about removal of the QE 1 beginning of last year (2010) before the European Crisis blew out in the 1st Qtr. The treasury yield was moving towards the upper trend channel (beginning of 2010) before testing the lower trend channel (3rd Qtr 2010). The Fed was forced to ( or is it a conspiracy?) introduce the QE 2 again – led the Treasury yield to test the upper trend channel recently. That is why we are hearing ppl talking about removal of the QE 2 again – deja vu.

The recent market correction is short-lived as Mr Ben has hinted that he may delay the removal of the QE 2.

I personally think that the S&P 500 upside should be capped in reference to the upper trend channel resistance. But the risk will be whether inflation can be tamed while economic activity starts to pick up again. If the Fed correctly timed the QE2 exit when the economy are able to self-sustaining, we may not see a big correction. Even if it happens , we will see introduction of QE 3 (new normal & Fed’s mandate)

New Normal

We coined the term “New Normal” at PIMCO in early 2009 in the context of cautioning against the prevailing (and dominant) market and policy view that post crisis industrial economies would revert to their most recent means.Instead, our research suggested that economic (as opposed to financial) normalization would be much more complex and uncertain—thus the two-part analogy of an uneven journey and a new destination.

Federal Reserve Act

Section 2a. Monetary Policy Objectives

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

 

 

via $UST30Y – Weekly Line (solid).

QE (Quantitative Easing) never ending Cycle – Hugh Hendry

In a sense, the macro outcome hangs on one’s interpretation of quantitative easing. It is my assertion that monetary easing represents an enormous change to the benign policy which has driven global growth for the past 15 years. I equate the easing program with Roosevelt’s devaluation of the dollar in 1931 (that year keeps reappearing). By this I mean it could mark the moment when modern American policy makers rejected globalisation. It is a direct attempt to address and remove the free rider (or mercantilist) problem associated with managing the dollar as a public international good.