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China’s massive loan growth in 1Q06 has set off alarm bells in many parts of the government, and some tightening measures (e.g., increasing deposit reserve requirements and limiting land supply as in 2004) could be adopted.  However, such measures may not work, in our view, as they do not deal with the fundamental causes of surplus liquidity and reckless loan growth.  The former reflects expectations of RMB appreciation and the latter a politically-driven financial system.  Half-hearted tightening measures that do not work could damage the credibility of the central government and leave the impression that the government’s control over the economy is slipping.

Tighter lending controls could be effective despite the surplus liquidity.  Decreasing the loan/value ratios for loans collateralized by property and shares are especially effective.  Ensuring that equity capital is not simply debt capital transferred from an affiliated entity is another effective policy. 

In the medium term, I believe China needs to address expectations of RMB appreciation in order to extricate itself from the current macro trap – such expectations would draw in more liquidity if the tightening measures increased interest rates, thus defeating the purpose of the tightening.  Either appreciating the currency and/or increasing production cost through domestic measures could be effective.  The advantage of the latter approach is that it could boost household income and ensure a soft landing when effective tightening causes liquidity to recede.

Possible Tightening Measures

The massive loan growth seen in 1Q06 is the key concern in Beijing currently.  I gave a talk at the annual forum on the financial sector reforms organized by the Financial Research institute at the State Council Development and Research Center (‘FRI-DRC’).  In the Q&A section, most questions conveyed alarm over the massive loan growth.  Only one sympathetic voice raised the possibility that the loan growth may not translate into demand and could instead be used to repair business and local government balance sheets.

The widespread concerns are putting pressure on the government to do something.  The Chinese government has responded to such concerns before and will likely do so again.  However, the government has also been unwilling to address the root of the overheating problem – expectations of currency appreciation and the political nature of allocating financial capital in China.

China appears to have adopted a muddling through approach – only dealing with issues if they posed an immediate threat to the economy.  The tightening in 1H04 was in response to 50%+ annual growth in fixed investments, which it was feared would trigger a swift hard landing.  When fixed investment growth slowed to below 30% (even though it was still too high to sustain) and it was felt that the threat of an imminent hard landing had been lifted, the tightening was eased.

Fixed investment rose by 29.8% YoY in 1Q06 compared to 27.2% YoY in 2005, thus raising the possibility of a hard landing.  The government may tighten slightly to prevent further acceleration.  Such an approach, though preventing an imminent hard landing, tends to lead to further excesses in the economy, in my view, with the result that a hard landing may eventually occur anyway.

Further Tightening Measures May Not Be Effective

Raising the deposit reserve requirement and limiting land supply – the two most likely measures – may not prove effective at all.  The amount of surplus liquidity in the banking system is vast.  Normalizing liquidity conditions would involve driving the 7-day interbank rate to 5-6% from 1.7% now.  The government is unlikely to tolerate such an increase in interest rates. 

The political dynamic would not tolerate such a massive increase in interest rates, in my view.  Many of China’s businesses have high debt levels, make low returns, and would go bankrupt if interest rates normalize.  So, any increase in the deposit reserve requirement will likely be small and may increase the interbank rate by a small amount, probably much less than one percentage point.

Further, expectations of RMB appreciation would trigger further capital inflows if China’s interbank rates rose, making it profitable to arbitrage between the onshore and offshore market.  This would offset much of the tightening.

Limiting land supply may not slow down investment either.  China tightened land supply in 1H04; nevertheless, fixed asset investment in value rose 27.6% YoY in 2004 and 27.2% YoY in 2005, not much slower than in previous years. 

The Ministry of Land found that unreported conversion of agriculture land for construction use totaled 73,400 hectares in 2004, compared to 98,200 hectares used for urban development in 2005.  This example suggests that local governments have considerable leeway in using land.

The Ministry of Land also found that the urban land bank (land approved for development) was 135,600 hectares, well above one year’s requirements.  So, even if land supply is significantly tightened, the effect on investment demand could take considerable time to become apparent.

The tightening measures could have a psychological effect on local governments, which would stop fixed investment from accelerating further.  Because there are no stiff consequences for organizations that have fueled the surge in investment and lending, the deterrent effect may only be temporary.

Tightening Lending Standards May Be Effective

Tighter controls over lending could slow loan growth while surplus liquidity remains.  Decreasing the loan/value ratio for loans collateralized by property and shares, and more rigorous vetting of a borrower’s equity capital, would be the most effective measures.

The increase in the loan/value ratio for loans collateralized by property and the increasing acceptance of shares as loan collateral may have been the main drivers behind the current lending acceleration, and it should not be too difficult to tighten up on standards again.  I believe that the loan/value ratio for land under development should be significantly below 50%.  In the previous property cycle, land prices dropped by more than 50% in many cities.  It is prudent practice to keep the ratio below 50%.

Chinese banks should be especially careful in accepting shares as collateral, in my view.  China’s stock market is highly volatile, making shares shaky collateral for banks.  It is quite common for a stock to drop by 10% or more in a day.  When a bank holds a big chunk of stock in a company, it becomes difficult to liquidate its holdings in a declining market.  In my view, banks are ill-equipped to handle shares as collateral for loans.  The relevant authorities should prohibit the use of shares as collateral in general and keep the loan/value ratio at a very low level (say, 30%) in cases where shares are accepted as collateral.

Checking the authenticity of equity capital is also another effective measure to check loan growth.  China’s local governments, private businesses and state-owned enterprises usually have complicated shareholding structures.  Debt capital in a complicated ownership structure could show up as equity capital in a business empire.  One possible policy is for banks to check the indebtedness of all significant shareholders in a company before a loan can be made.  There should be prudential standards for aggregate debt-equity ratios for all affiliated businesses combined.

ChinaNeeds to Address RMB Appreciation Expectations

China may be in a macro trap.  Expectations of RMB appreciation have sustained the massive surplus liquidity in China’s banking system.  The surplus liquidity may have already caused an investment bubble, especially in the property sector.  When the expectation reverses, China could suffer a hard landing. 

The fear of a hard landing in turn has led the Chinese government to sustain expectations of RMB appreciation, which has prolonged the investment bubble and could increase the likelihood of an eventual hard landing.  This is why I believe that China is unlikely to revalue its currency to eliminate expectations of appreciation.

One benign exit could be to increase production cost gradually to raise the real effective exchange.  It could curtail expectations of currency appreciation and expand consumption demand at the same time, as rising production costs could lead to rising household income.  The expansion of consumption could offset investment slowdown due to rising interest rate when currency appreciation expectation evaporates.

Removing export incentives (e.g., VAT rebates and profit tax reductions or exemptions) could increase the effective exchange rate by 5% or more.  The resulting fiscal savings could shift to spending on education and healthcare, which could boost household consumption by 3%.

Raising minimum wages is an even more effective means of raising the effective exchange rate and expanding consumption at the same time.  As minimum wages rise, the wages for non-minimum wage earners could rise as well.  A 1% increase in minimum wage could lead to 0.3% increase in household consumption.

In conclusion, I believe that simultaneously increasing China’s effective exchange rate and expanding domestic consumption constitute the best recipe for China to achieve a soft landing.

Mexico
Mexico
Apr 25, 2006

Gray Newman (New York) and Luis Arcentales (New York)

With the Fed approaching the end of its tightening cycle, Mexico’s central bank announced that it was bringing to an end its eight-month move in the opposite direction.  After cutting interest rates by 275 basis points during the past eight months, Banco de Mexico gave notice that it saw no room for additional easing in “the foreseeable future.”  The announcement came last Friday, April 21 along with one last 25 basis point cut — a move that surprised most local central bank watchers who had ruled out any further monetary easing.

Sounds like the easing cycle in Mexico is over?   We don’t think so.  We would characterize the announcement on April 21 more as a signal of a pause rather than the end to the easing cycle that began in August 2005 when overnight interest rates were standing at 9.75% and were first cut by 25 basis points.

The distinction to some might seem odd.  After all, we are not calling for a rapid bout of rate cuts for the remainder of 2006 and 2007.  Indeed, we are forecasting that overnight rates just dip below 7% where they stand today to reach 6.75% by year-end and 6.25% by 2007.

But our view stands in contrast with that held by many local analysts who expect that the next move of the central bank will be to raise overnight rates.  Indeed, whether you look at the local and TIIE-based yield curve, the market expectation is that overnight rates are likely to be on the rise before the year-end.  Meanwhile, the longer end of the curve slopes up to near 9% — a level that appears to be incompatible with our view of inflation and Banco de Mexico’s strengthened inflation-fighting credibility.

Inflation is dead

Our view that rates can still fall is largely premised on our view that inflation in Mexico remains dead.  As we have been writing for the past three years, Mexico no longer has an inflation problem.  Although core inflation has begun to bump up slightly, reaching 3.04% in March and could move up a bit further in April, most of the upturn seems related to construction material prices (which are used to calculate housing costs as measured by the central bank) and to tourism services related to Holy Week.  The central bank expects, as do we, that core inflation should fall back and remain near 3% throughout the year. 

Our optimism on core inflation, particularly core goods inflation, stems from a more competitive retail space and from pressure from imports of Chinese goods.  We expect both to remain as disinflationary forces in Mexico.  From consumer goods to steel, China has helped to produce lower inflation in Mexico.  Service inflation appears a bit more sticky, but even there we expect to see some declines as agents realize that lower overall inflation is here to stay. 

Headline inflation is likely to remain more volatile thanks to the importance of rain-dependent produce in Mexico’s consumer price basket.  We expect headline inflation to end the year at 3.2%, right near the centre of the central bank’s forecast range of 3% to 3.5%.

But what seems clear at Banco de Mexico is that what matters most is the performance of core inflation.  Although Banco de Mexico’s inflation targeting regime defines headline inflation as its target, for practical purposes — and as long as headline remains within the 1% plus or minus variation range around 3% — the central bank is rightly focusing on the performance of core inflation.  Why then the decision to stop rate reductions in April if inflation remains in line with the central bank’s targets?

Growth and neutrality

Three uncertainties are holding Banco de Mexico back from further easing at this time: uncertainty over how to define a neutral rate, uncertainty over the precise path of the Fed, and uncertainty on Mexico’s political and policy front.  There is still discussion within the bank on what is the appropriate or neutral level for interest rates.  But with the economy showing signs of stronger than expected growth, monetary authorities are likely to feel little pressure to reduce interest rates.  Indeed, we expect the central bank to announce in its quarterly inflation report, due out on April 26, that it is now expecting GDP growth for 2006 to be closer to 4% rather than the 3.25-3.75% it had assumed at the beginning of the year. 

Indeed, we are revising our GDP forecast for 2006 up to 4.1%, from 3.5% on back of a stronger first quarter GDP report — which we now expect to reach 5.3% — and the first signs of continued strength in the second quarter.  Traditionally, private consumption receives a boost in the first half of a presidential election year thanks to increased election spending, only to find that investment spending moderates its pace in the second half as uncertainty around the change to administration cools business spending.  With the link between the US and Mexico still very much alive and with our US economists expecting a reacceleration in growth in the second half after some slowing in the second quarter, we suspect that any slowdown in investment spending in Mexico may be more muted than usual.

Fed concerns

Although the Fed suggested in even stronger language this past week with the release of the March 27-28 FOMC minutes that it was “likely to be near” the end of the tightening process, there is still uncertainty if that means the Fed hikes once more in May and stops at 5%, or reaches 5% and pauses before one more hike to 5.25% later in the year as our US economists expect or eventually moves even higher.  Given that Mexico’s growth is coming in stronger than expected and given the uncertainty over the final Fed stance, Banco de Mexico is signalling that it has little desire to move too aggressively.

However, once the Fed has stopped at, for example, 5% or even 5.25% and remains at that level for an extended period, it is likely to signal a period of good US growth and limited inflation concerns.  At that point, once US inflation is under control and growth has moderated, we would expect Banco de Mexico to have additional room to cut.  Perhaps Mexico’s cuts will not be much more than 25 or 50 basis points in the next twelve months.  But if Mexican core inflation remains near 3% and US core inflation settles near 2%, it is difficult to understand why Mexico needs overnight rates wider by 200 basis points over the Fed or why the longer end of the curve needs to be wider by nearly 400 basis points.

Political concerns

Finally, Banco de Mexico’s decision to pre-announce no more rates cuts in the near term after the April cut also appears to be related to political concerns.  Although we expect that whoever is elected president of Mexico will face similar challenges — and we are concerned that all three of the leading candidates are likely to suffer from the same convergence curse that has limited reforms in Mexico in recent years — the 2006 election is becoming a disturbingly polarized event.  Our sense is that Banco de Mexico would prefer not to try to fine-tune its interest rate policy in the midst of a volatile market. 

Again, however, after the election, we suspect that there will be some room to continue easing interest rates.  The next elected president, long before he takes office on December 1 — nearly five months after the election — will need to reassure an electorate, a majority of which will likely have voted for another candidate, that he will work toward a common good.  By year-end, we suspect that Banco de Mexico will once again be in a position to begin easing interest rates ever so slightly.

Bottom line

The greatest challenge facing Mexico is not monetary policy.  Mexico needs to boost public and private investment to address its infrastructure and human capital shortcomings.  Certainly prudent monetary policy helps, but ultimately Mexico must turn its attention to making more progress on the fiscal front.

We do not believe, however, that these challenges are likely to prevent Banco de Mexico from easing its interest rate stance a bit.  While few at the central bank are willing to pre-announce what a neutral policy stance is, most seem to agree that the neutral rate around the globe has likely declined and there is little reason to suspect that Mexico is an exception.

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